Are they legally binding?
Whether or not “heads of agreement” (Absichtserklärungen) are binding always depends on the wording and the parties’ intention in the individual case: it has to be ascertained from the wording whether the parties only intend to summarise the results of the negotiations which were made up to that date, or whether they intend to create a binding pre-contract (Vorvertrag).
Designating a letter or agreement as “heads of agreement” (or any similar expression for a pre-contractual document, eg "letter of intent" or "memorandum of understanding") is generally considered to create a refutable presumption that the letter/agreement is not binding, but only reflects a summary of the current status of the negotiations. However, to avoid that the parties conclude a binding pre-contract without such intention, the wording in the relevant document should be sufficiently precise. This also applies in case the parties explicitly wish a "heads of agreement" to be binding.
Even if a “heads of agreement” is not binding (ie the parties are not committed either to continuing negotiations or to entering into a definitive contract) it may contain single binding clauses on confidentiality, exclusivity, costs, applicable law and place of jurisdiction. Such clauses do not have an impact on the binding effect of the “heads of agreement” as a whole, but bind the parties only regarding the particular aspect contained therein.
In any event, it is advisable to clarify, whether a “heads of agreement” (in its entirely or only specific clauses therein) shall be binding or not by explicitly mentioning this point in the wording.
Are any specific terms/formalities required to make them legally binding?
If the “heads of agreement” contains specific wording that indicates that it has binding effect, the Agreement is binding on the parties. In general, no specific formalities are to be adhered while entering into a “heads of agreement”. However, in exceptional cases, for example, when a “heads of agreement” already constitutes the obligation to conclude an agreement that later on requires notarisation itself, the “heads of agreement” will also need to be notarised. In such cases, the “heads of agreement” serves as a kind of binding “pre-contract” (Vorvertrag).
What are the consequences of breach?
If a “heads of agreement” is non-binding, a party who violates such agreement by acting in bad faith may still be liable to pay damages for breach of fiduciary duty. Under such circumstances, the same principles apply as for pre-contractual negotiations.
With respect to a binding “heads of agreement” (or binding parts of a “heads of agreement”), the non defaulting party may claim damages or specific performance in respect of any obligations that have been violated, in accordance with the general rules of German law regarding the consequences of a breach of contractual obligations.
Can heads of agreement have any tax implication/adverse consequences?
If a binding “heads of agreement” leads to specific obligations, under certain conditions and depending on the nature of the respective obligation, the “heads of agreement” may have tax implications.
If, for example, a binding clause of the “heads of agreement” refers to the transfer of German real estate or other similar rights, then subject to certain conditions, real estate transfer tax could be triggered already in this early stage of the transfer.