Professor Xaver Ditz and Dr Daniel Licht, from German Taxand member firm, Flick Gocke Schaumburg, outline proposed changes in Germany’s tax treatment of interest expenses. These changes include amendments to the existing interest barrier rule, which has raised concerns from the German Federal Tax Court regarding its conformity with national constitutional law. Despite these concerns, as the rule adheres to the EU’s Anti-Tax Avoidance Directive (ATAD) and takes precedence under EU law, it is believed to be in line with constitutional regulations.
In addition, a new interest rate cap is planned. This cap will limit the deductibility of interest expenses based on a maximum rate and will apply to related parties and companies lacking substantial economic activity in their domicile state. The regulation is slated to come into effect after December 31, 2023, pending approval from the German Federal Council.
In Germany, there will be some change in the tax treatment of interest expenses. We outline changes concerning the existing interest barrier rule and address the introduction of a new interest rate cap.
I. Interest barrier rule
a) The existing German interest barrier rule
The German interest barrier rule was introduced into the German Income Tax Act (with a supplement in the Corporate Income Tax Act) by law of 14 August 2007. The provision first applied (in most cases) in the 2008 assessment period.
The interest barrier rule stipulates that a company’s interest expenses (such as sole proprietorships, partnerships, and corporations) are in principle deductible only to the extent of its interest income. Any additional interest expenses can be deducted up to the calculated EBITDA, which equates to 30% of the profit adjusted for specific items. Non-deductible interest expenses are carried forward indefinitely. When a change of shareholder takes place, the interest carried forward is usually lost.
There are three exceptions to the interest deduction limitation:
- Exemption limit: The interest expenses are deductible if the interest balance (net interest expense) is less than EUR 3m.
- Stand-alone clause: The interest is deductible if the company is not part of a group.
- Equity-escape clause: Interest expenses are deductible if the company is part of a group and its equity ratio at the end of the previous reporting date equals or exceeds that of the group (falling below the group’s equity ratio by up to 2% is not harmful).
However, there are two exceptions in connection to the latter two clauses. The stand-alone clause and the equity-escape clause do not apply with harmful shareholder financing, i.e. if the remuneration to significantly-involved shareholders (shareholding of more than 25%) or related parties is around more than 10% of the interest balance.
Overall, the German interest barrier rule introduced in 2008 is very similar to Art. 4 of the EU’s Anti-Tax Avoidance Directive (ATAD) of 12 July 2016. The interest barrier rule aims to encourage internationally operating groups to finance its domestic entities with equity and to increasingly deduct interest on borrowed capital in other countries.
b) Compatibility with German constitutional law
The German Federal Tax Court has some doubts as to whether the interest barrier rule is in line with Germany’s national constitution (Federal Tax Court of 18 December 2013, I B 85/13; Federal Tax Court of 14 October 2015, I R 20/15). The court perceives the prohibition of deductions as violating the ability-to-pay principle, and something that cannot be rectified by the interest carryforward.
Further, this infringement upon the ability-to-pay principle cannot be justified on the grounds of abuse avoidance. According to the German tax authorities, the Federal Tax Court’s doubts on this issue are unreasonable (Ministry of Finance dated 13 November 2014). The Federal Constitutional Court (Germany’s highest court) was asked to clarify this issue in 2016. Ever since then, the case has been pending and is still yet to be decided (file number: 2 BvL 1/16). At the time of writing, the German Federal Constitutional Court is yet to make its decision. However, due to Art. 4 of the ATAD and the primacy of application under EU law, a lot suggests that the interest barrier rule (at least with regard to corporations) does not violate constitutional law.
c) New draft legislation
In draft legislation of 8 September 2023, amendments are planned (draft of the Growth Opportunities Act or the “Wachstumschancengesetz”). According to the German legislature, the amendments are proposed to adapt the interest barrier rule so that it better fits to the requirements of the ATAD. As things stand, the basic concept of the interest barrier rule remains in place but with the following detailed changes:
- Defining “interest expenses”: While the definition of interest expenses in the context of the German interest barrier rule has so far exclusively referred to remuneration for the provision of borrowed capital, under the ATAD, in addition to interest expenses for all types of receivables, other expenses economically comparable to interest are also included. Furthermore, according to the ATAD, expenses linked to the acquisition of (borrowed) capital are subject to the prohibition of deduction. As a result, under ATAD, the term “interest expenses” is defined more broadly. Therefore, the term “interest expenses” is to be extended to economically equivalent expenses and other expenses linked to the acquisition of debt capital and a reference to Art. 2 ATAD is made.
- Interest carryforward expiration and the EBITDA carryforward in the event of discontinuation or transfer of a partial business: Where a part of a business is discontinued or is transferred, an unused EBITDA carryforward and an unused interest carryforward shall be lost proportionately in the future.
- Exemptions: The exemptions to the interest barrier rule (Exemption limit, stand-alone clause, equity-escape clause) will no longer be applicable in the future insofar as the interest expenses of a year have been increased due to an interest carryforward from previous years. As a result, an interest carryforward will only be deductible if there is sufficient calculated EBITDA.
- Exemption limit: If the interest balance exceeds EUR 3m, the German interest barrier rule applies without restriction. This differs from Art. 4(3) ATAD as the German rule is stricter. As things stand, no change will be made in this respect. However, in future a following provision will be introduced to prevent arrangements for multiple use of the exemption limit: “Similar businesses which are under common management or control are considered as one business for the purposes of the interest barrier rule.” Subsequently, the EUR 3m exemption limit is to be divided among these businesses according to the ratio of net interest expenses. This anti-fragmentation rule is intended to prevent taxpayers from deliberately setting up subsidiaries in order to claim the exemption limit more than once.
- Stand-alone clause: Up until now, the German interest barrier rule has not applied if a company does not belong to a group. The ATAD stipulates, however, that is permissible to exempt independent companies from the interest barrier. In order to adapt the German provision to the ATAD, it will be later stated that the German interest barrier rule does not apply if the taxpayer is not affiliated with any individual (typically involving a 25% ownership stake) and does not have a permanent establishment outside the state in which its domicile, habitual residence, registered office or place of management is located.
- Investments in infrastructure-projects are exempt: Interest expenses or interest income from loans used to finance long-term public infrastructure projects and granted on the basis of general funding conditions do not constitute interest expenses within the meaning of the interest barrier regulation, provided the funds are granted from the public purse. This amendment corresponds to Art. 4(4) letter b ATAD.
- Harmful shareholder debt financing: The stand-alone clause and the equity escape clause do not apply if the remuneration to significantly-involved shareholders (so far: shareholding of more than 25%; in future: shareholding of at least 25%) amounts to more than 10% of the interest balance. In this context, in 2015 the Federal Tax Court ruled that the remuneration for debt capital of the individual shareholders involved is not to be added together when examining this 10% limit. Germany’s tax authorities had previously not agreed. Subsequently, the law now stipulates that the remunerations for borrowed capital of the individual shareholders are to be added together when examining the 10% limit.
The new regulation of the interest barrier rule is to apply for the first time to financial years that begin after the resolution of the law (see below).
II. Interest rate cap (Sec. 4l Income Tax Act – new)
In the current draft legislation of 8 September 2023, the introduction of an interest rate cap is planned, which will be applied alongside the interest barrier rule. According to the interest rate cap, interest expenses are not deductible if they are based on an interest rate that is above a certain maximum rate. The maximum rate is the base rate, which is re-determined and published twice per year (currently: 3.12%), and increased by 2%. This means a total of (as it stands) 5.12%.
It can be demonstrated that the creditor and the ultimate parent company would have received the capital only at a higher interest rate in the same situation (counter-evidence of an alternative maximum rate). The refinancing rate of the ultimate parent company may be considered as evidence. Mere opinions from a bank, on the other hand, shall not be sufficient.
The interest rate cap only applies to interest expenses due to a business relationship between related parties (usually a shareholding of at least 25%); this means the rule applies in particular to debt financing within the group. Further, the interest rate cap only applies if the creditor does not engage in any substantial economic activity in the state in which it is domiciled or has its place of management, or if this state is not obliged to provide administrative assistance; this means the focus is on financing by companies with less substance. The substance requirements correspond to those in the area of the German CFC rules.
If the maximum rate is exceeded because the base rate is increased, the prohibition of deduction does not apply until one month after the increase in the base rate.
The regulation will first apply to interest expenses incurred after 31 December 2023.
The new law has not yet been passed and is awaiting approval from the German Federal Council (the “Bundesrat”). This is expected by the end of October 2023.
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