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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 section 8a of the Corporation Tax Act). The new thin capitalization rules went into effect on 1 January 1994 for loans then or thereafter outstanding to German corporations. Transition provisions exist only for profit-linked loans made before 9 December 1992.
The new thin capitalization rules apply to loans received by German corporations from foreign shareholders holding, directly or indirectly, more than 25 % of the shares in the corporation or from foreign persons related to 25 % shareholders. They also apply to loans made by unrelated third parties (e.g. banks) if such third party has any recourse against a foreign 25 % shareholder or foreign persons related to him (or against a domestic related person if the shareholder is a foreign person).
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). In addition to the safe haven, the taxpayer may make a showing that it 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. They likewise do not apply to the German branches of foreign companies.
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. 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.
