Yes. The principle is based on disallowance of "excess" interest, rather than on re-qualification of liabilities as "deemed" capital. The safe haven debt/equity ratio is 1.5:1 (3:1 for holding companies). The rules apply to corporation tax only, i.e. not to trade tax. On December 12, 2002, the ECJ held the German provision to be in conflict with European law and thus inapplicable to companies with EU shareholders. Draft legislation proposed in the meantime would cure the discrimination by applying the rules to companies in domestic, as well as foreign, ownership.

The German rules apply to interest-bearing finance provided by shareholders or their related-parties to German subsidiaries. Broadly, the allowed debt/equity ratios are 1.5:1 for operating subsidiaries and 3:1 for German intermediary holding companies without their own business operations. These ratios are "safe-havens", that is, it is at least in theory possible to justify shareholder loan finance in excess of these ratios by claiming that the German subsidiary could have obtained identical finance from a third party on exactly the same terms.

If these ratios are exceeded, the interest paid on the excess loan will be disallowed as a business expense for corporation tax purposes and will be treated as a hidden distribution of profits. In contrast to the corresponding rules of many other countries, the excess liability is not reclassified as deemed additional capital; the ultimate effect of a disallowance is thus more severe in Germany than it often is elsewhere. It is also worth noting that, as a somewhat unusual feature in German tax law, this form of disallowance as a hidden profit distribution applies to corporation tax only. In other words, the finding is not taken up into the trade tax computations. However, the trade tax rules in any case disallow one-half of all long-term (over 1 year) loan interest borne.

The rules for calculating the ratios and the disallowable portion of the interest expense are detailed, somewhat inconsistent and not always entirely clear. In at least one instance, there are serious grounds for believing them to be in conflict with European law; consequently, it is not recommended to set up any medium or long-term financing arrangements for German subsidiaries without an escape clause allowing for prompt revision of the arrangements should the need arise.

On December 12, 2002, the European Court of Justice held the German statutory provision on "thin capital", Sec 8a of the Corporation Tax Act, to be contrary to European law and therefore that it should not be applied to companies insofar as their shareholders reside in other EU countries. This case, Lankhorst-Hohorst, must be followed in Germany for all open tax years up to 2002 until the statute is changed. The non-discrimination clauses of the tax treaties may operate to the benefit of shareholders from other countries so, for the moment, companies with foreign shareholders from any country are advised not to let corporation tax assessments with an "8a hidden distribution" for those years become final and binding, until the government and tax authorities have decided on the position they wish to take. For the future, the government is proposing legislation to remove the discrimination aspects by applying "8a" to all companies regardless of their shareholders. At the same time, the 3:1 holding company privilege would be withdrawn and the rules tightened to disallow all related party interest costs of borrowing to finance an acquisition from within the group.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.