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1. Introductory

To prevent foreign shareholders from draining off the earnings of their German subsidiaries in the form of interest on loans (or other compensation paid for debt capital), an anti-earnings-stripping provision was recently added to the German tax code (new sec. 8a of the Corporation Tax Act). For a summary of basic provisions, see section 11 below.

The German tax authorities have now issued a directive addressing questions of interpretation and application of the new thin capitalization rules for corporations. These rules apply to loans to German corporations from foreign shareholders or related persons from 1994 on. Transition provisions exist only for profit-linked loans made before 9 December 1992.

Following enactment of the new law, practitioners quickly determined that it left many questions unanswered and was therefore not a sufficient basis on which to plan investment decisions. In response, the tax authorities first circulated the draft of a directive intended to provide guidance. After receiving comment from tax practitioners and industry, they have now issued the directive in final form. The directive binds tax enforcement officials in their application of the law until it is revised or withdrawn, but does not itself have the force of law and can be challenged by taxpayers in the courts.

The directive leaves some questions unanswered and resolves others in ways which lead to more extensive taxation. The following is a summary of positions taken on selected issues. It is intended to provide a general guide to the subject matter. Specialist advice should be sought with respect to specific questions.

2. Lenders covered by the law

The thin capitalization rules apply to loans made to German corporations by three categories of lenders. The first two categories are 25 % foreign shareholders and foreign persons related to 25 % shareholders, whether or not such shareholders are foreign persons. Attribution rules apply in determining whether a person is a 25 % shareholder, i.e. holds directly or indirectly more than a 25 % share of stated capital. The third lender category covers unrelated third parties if such parties have "recourse" against a foreign 25 % shareholder or a foreign related person (or against a domestic related person if the shareholder is a foreign person). Loans to which the law applies are hereinafter collectively referred to as "shareholder loans". It is primarily the third party loans which are controversial.

3. Meaning of "recourse"

The meaning of "recourse" is a matter of dispute. The tax authorities have decided on a broad interpretation covering all situations in which the lender will in fact be held harmless by the shareholder or some related person in the event of default on the loan, whether or not the lender has rights enforceable at law against such persons. The directive thus states that, in addition to guarantees and "hard" letters of comfort, a "soft" letter of comfort in favor of the lender will also suffice to constitute "recourse". Furthermore, the directive establishes a rebuttable presumption for corporate groups that the parent company will cure any default on a loan to its German subsidiary, hence that there is always recourse against the parent company. Back-to-back financing, in which the German subsidiary receives a loan from a bank and the bank receives a deposit from a shareholder or a related person, also constitutes "recourse" under the directive, whether or not the deposit is pledged to the bank.

4. Third party loans from German lenders

On the positive side, the directive establishes an important exemption from the workings of the thin-capitalization rules for loans received from German banks or the German branches of foreign banks. As long as the German debtor corporation can prove that the interest received on the loan by such lenders was subject to tax in Germany and was not in effect passed along to a foreign shareholder or related person through back-to-back financing, it does not matter whether the lender has "recourse" on the loan.

5. Debt/equity ratio for purposes of the safe haven

For purposes of the safe haven (3 to 1 for interest bearing loans, 1 to 2 for loans linked to profits or sales), equity is measured using the commercial balance sheet at the close of each fiscal year for the entire fiscal year to come. Debt, on the other hand, is monitored constantly as it fluctuates throughout the fiscal year. In effect, the current level of debt is always compared with equity at the outset of the fiscal year. For companies which began the year at the limit of the safe haven ratio, this means that new shareholder loans can only be added at the end of the year, because equity injections made during the year will not count until the following year for safe haven purposes.

6. Equity of newly formed corporations

For newly formed companies, the directive provides that the equity in the opening balance sheet determines the safe haven for the first fiscal year of existence. The opening balance sheet date is the signing of the articles of association, not the date of entry in the Commercial Register. The period between these two events is subject to the thin capitalization rules as long as entry in the Commercial Register later occurs. Consequently, full capitalization of new corporations must be guaranteed from their inception in order to use the safe haven in their first fiscal year.

7. Temporary reduction in equity

The law contains a provision providing that a "temporary reduction in equity" due to net loss for the year will not count for safe haven purposes provided equity is fully restored to its previous level within three years by any combination of contributions to capital and retained earnings. The directive speaks in this connection of "temporary losses".

The directive in its final form differs from the draft directive in two important respects.

The first aspect concerns restoration of equity using subsequent earnings. The directive makes clear that an increase in the balance sheet item "retained earnings" is not strictly necessary. Instead, it is sufficient if a net profit for the year is, by formal shareholder action, netted against a loss carried forward. The same applies to constructive contributions to the corporation, which are treated as revenue for commercial accounting purposes but not for tax purposes. The net profit for the year resulting from such constructive contributions must either be appropriated to retained earnings or formally netted against a loss carried forward.

The second aspect concerns restoration of equity using subsequent contributions. In the draft directive, the position was taken that subsequent contributions were inadequate to restore equity whenever subsequent profits did not by themselves restore equity within five years after the loss was suffered. The reasoning behind this was that losses not equalized by gains within five years were not "temporary losses" to begin with, and the provision in question only applied to "temporary losses". The relevant passages in the draft directive have been deleted from the final directive. The tax authorities appear to have completely abandoned their initial position, the statutory support for which was questionable.

8. Definition of debt

The directive provides that short-term credit extended within the context of a normal trading relationship will not count as debt for purposes of the thin capitalization rules. Whether trade credit is short-term or not will depend on what is customary in the particular trade, with a six-month limit applying as a rule. Current account credit of all sorts will, however, count as debt for thin capitalization purposes, whether or not the same debt is "long term" for trade tax purposes.

The directive further states that debt is not to be disregarded merely because no interest (or other remuneration) is owing or paid on a loan. Interest free loans are thus debt for thin capitalization purposes and reduce the safe haven.

9. Order in which loans made

The directive takes the position that the order in which loans are made determines which loans are within the safe haven. The consequences of this are best illustrated by an example.

Let us assume that the X-GmbH begins the fiscal year with equity of DM 1,000 for purposes of the thin capitalization rules and then receives two shareholder loans at one month intervals, each in an amount of DM 3,000, but the first at 7 % p.a. and the second at 10% p.a.. Let us further assume that both interest rates are arm's length rates, i.e. that the jump in interest rate is justifiable because of changed economic conditions. In the view of the German tax authorities, the interest on the first loan will be deductible in full, while that on the second loan will be non-deductible in full. They reject a pro rata approach to determining how much interest is deductible. Under such an approach, one month's interest on the first loan would be deductible, and thereafter half of the total interest would be deductible (average rate 8.5 %).

If one varies the example to assume that the first loan was interest free, then (according to the new directive) no interest would be deductible, because the interest free loan would have used up the entire safe haven.

10. Holding companies

The statute establishes a basic debt/equity ratio of 9 to 1 for (domestic) corporate holding companies (for interest bearing debt) and also provides that no safe haven at all exists for loans made by other persons to the direct or indirect subsidiaries of such holding companies. This means that all shareholder loans to such subsidiaries must be channeled through the holding unless it can be shown that the subsidiary could have had the same loan on the same terms from an unrelated third party.

The directive states that a holding company must have direct participations in at least two other corporations, including foreign corporations. Shares in corporations without business function do not count. "Participation" is a term of art defined in the German Commercial Code, generally requiring a 20+ % share of stated capital (sec. 271 HGB).

To qualify as a holding company, one of two tests must be met: either a corporation's principal activity must consist in holding and financing participations in other corporations (1st alternative), or participations in other corporations must make up more than 75% of its balance sheet total (2nd alternative - 75 % asset test). The directive states that, in applying the 75 % asset test, debt claims against direct or indirect subsidiaries will not be counted as assets. This reversal of the position taken in the draft directive results from objections that otherwise this test could scarcely ever be met. As for the first alternative, the directive provides that the principal activity of a corporation generally consists in holding and financing participations in other corporations if 75% of the average gross earnings for the three preceding years is derived from the corporations in which it holds participations, either in the form of dividends or loan remuneration.

It remains unclear under the directive whether a corporation with significant interests in both corporate and partnership entities can qualify as a holding company. Such a company might well fail both the statutory 75 % asset test and the 75 % earnings test established by the directive.

11. General structure of thin capitalization rules

The new rules establish safe havens in differing amounts depending on whether the compensation paid for the use of the debt capital is measured in terms of the loan principal (i.e. interest, either fixed or variable), or in terms of some other factor (e.g. profit or gross sales). To the extent shareholder loans exceed the safe haven, deductibility is denied for corporation tax purposes for the interest (or other compensation) paid or accrued on the excessive part of the debt capital. Furthermore, when such non-deductible interest (or other compensation) is paid, this constitutes a constructive dividend and leads to dividend withholding tax at the applicable rate (statutory rate 25 %, current rate inside the European Union for qualified shareholders 5 %, tax treaty rates varying generally from 5 % to 15 %).

For fixed or variable interest bearing loans, the interest paid is non-deductible to the extent the loan amount exceeds three times the pro rata capital of the 25 % shareholder (safe haven ratio of 3 to 1). As an alternative to qualifying under this safe haven, the taxpayer may make a showing that he could have obtained the loan on the same terms from an unrelated party. If this burden of proof can be carried, interest bearing loans will escape the new rules even if the debt-equity ratio permitted under the safe haven is exceeded.

Banks are exempted from the 3 : 1 limit with respect to interest bearing loans taken out to finance their own standard banking transactions.

For loan compensation linked to profits or sales, the applicable debt-equity ratio is 1 to 2 instead of the more generous 3 to 1. Furthermore, there is no opportunity to show that an unrelated third party would have made the same loan and no exemption for banks.

For German holding companies, a higher 9 to 1 ratio applies to interest bearing debt, but this must suffice to finance all of the subsidiaries under the holding as there is no safe haven for shareholder loans made directly to them. If an interest bearing loan is made to such a subsidiary, the possibility remains to demonstrate that an unrelated third party would have made the same loan.

Since the applicable debt-equity ratio for purposes of the safe haven is determined at the outset of each fiscal year, considerable planning may be necessary to ensure that adequate equity is injected in time. While equity added during the fiscal year will not count for safe-haven purposes until the start of the following year, any increase in debt during the year can lead to a loss of safe-haven status. There are special provisions regarding declines in equity due to operating losses.

The new rules do not apply for purposes of the trade tax on earnings, where, it will be recalled, half of all long term interest is non-deductible in any event irrespective of whether it is paid to a shareholder. The new rules also do not apply to partnerships, even to partnerships with a corporation as sole general partner.

Disclaimer and Copyright

This article treats the subjects covered in condensed form. It is intended to provide a general guide to the subject matter and should not be relied on as a basis for business decisions. Specialist advice must be sought with respect to your individual circumstances. We in particular insist that the tax law and other sources on which the article is based be consulted in the original, whether or not such sources are named in the article. Please note as well that later versions of this article or other articles on related topics may have since appeared on this database or elsewhere and should also be searched for and consulted. While our articles are carefully reviewed, we can accept no responsibility in the event of any inaccuracy or omission. Please note the date of each article and that subsequent related developments are not necessarily reported on in later articles. Any claims nevertheless raised on the basis of this article are subject to German substantive law and, to the extent permissible thereunder, to the exclusive jurisdiction of the courts in Frankfurt am Main, Germany. This article is the intellectual property of KPMG Deutsche Treuhand-Gesellschaft AG (KPMG Germany). Distribution to third persons is prohibited without our express written consent in advance.