12 November 2007
18 December 2013
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19 November 2013
Since the German Corporate Tax Reform Act 2008 was published in the Federal Law Gazette (BGBl - Bundesgesetzblat) on 14 August, the local tax law community has had a difficult time. With the reform taking effect on 1 January 2008, in-house tax departments, accountants and tax lawyers are still trying to make sense of the new interest stripping rules and find ways to mitigate any downsides for their clients.
The intent of the reform is clear: to lower the rates, from around 39 per cent to just below 30 per cent on average, depending on the local trade tax rate (local trade tax comes on top of corporate income tax for most taxpayers, but property companies are exempted), and to broaden the tax base.
For that purpose the reform introduces inter alia tighter tax loss forfeiture rules and the base for trade tax is increased by enlarging the catalogue of expenses, which are tax deductible for income tax purposes, but are re-added for trade tax purposes. For example, the interest element of rents and lease payments will be subject to re-addition in the future.
At the heart of the reform, however, are the new earnings stripping rules, which tighten the rules on interest reductions, replacing the current thin capitalisation rules with a general limitation of deductible interest expenses. The German legislator cites the US archetype, but in fact goes far beyond that model because the German rules catch any kind of debt financing, whether by related or third parties. The new rules are giving German tax practitioners a hard time because, even by German standards, they are very complex and difficult to read.
The main body of the new rules, which will affect all businesses irrespective of their legal form, is relatively easy to understand. Interest expenses are tax deductible if they do not exceed taxable interest earned and an excess of interest expenses over interest earned is fully deductible as long as the balance is below EURO1m (£695,000) in a given tax period.
Where the balance of interest earned and interest expensed is EURO1m (£695,000) or more, the deduction of interest expenses is limited to 30 per cent of the taxable profit before interest and regular depreciation and amortisation (largely referred to as earnings before interest, taxes, depreciation and amortisation (EBITDA) by tax practitioners, although it is determined on the basis of German tax rules and not taken from the accounts).
This is the problem with the new rules: 30 per cent EBITDA is too low for a number of industries, especially in the financial and real estate sector. The legislator disregards industry differences. Also, an absurd result, irrespective of the industry, is that the rules will have a more severe impact when the EBITDA reduces. Companies will be hit by the rules when they are in a crisis.
Management and advisers have tried to numeralise the tax cost over the past few weeks, as have the in-house departments of banks, with significant exposure on acquisition and property finance. Organisations have now realised that this cost, and the ensuing cash outflow, will be significant. Hence, they are trying to find ways to escape those rules when they cannot take advantage of the e1m (£695,000) threshold per company.
The new rules offer two potential exits: a company that is not (and could not be) fully consolidated by a parent entity is not subject to the rules; and a company that is a fully consolidated subsidiary escapes the rules if it is able to demonstrate that its equity ratio is not lower than the equity ratio of the group to which it belongs.
To meet this test would have been difficult enough in practice, but the German legislator has added further complexity by introducing a specific definition of what is a group, providing for tax-specific modifications of the accounting figures, both at group and company level, and by clinging to limitations on shareholder financing - remains of the current thin capitalisation rules.
Both escapes are only available if interest expense incurred under related party debt does not exceed 10 per cent of the net interest expense of the company. It is the intent of the legislator to put bank debt on par with related party debt where the bank has any possibility to take recourse against a shareholder outside the group. Joint ventures, especially project finance and PFI projects, then would be unable to escape the rules, making it even more difficult for business entities that are fully consolidated, as they have to demonstrate that the 10 per cent test is not only passed by themselves, but also by any other entity that is part of the same group.
International Financial Reporting Standards
Certainly, the most innovative feature of the reform is its reference to International Financial Reporting Standards (IFRS)-based accounting to determine whether a taxpayer is part of a group and whether it has an adequate level of equity. The law requests that tax professionals now have an understanding of and practical experience in dealing with IFRS accounting matters. As the international law firms will not want to leave this to the big four, they will now have to build up expertise in IFRS accounting.
The Italian government has recently announced plans to follow the German example and introduce comparable rules, while other tax administrations have also shown an interest in the German rules. However, the German legislator is already considering modifications of the rules to counter certain structures designed for escaping the new rules, which are heavily marketed at the moment.
If it should turn out that the new rules deepen the financial crisis because of their negative effects on highly leveraged structures, the German legislator may well end up in a position where the rules have to be attenuated. There is certainly more work to come for tax lawyers, in Germany and elsewhere.
Michael Dettmeier is a partner at Lovells
but what do the changes mean for business? Michael Dettmeier reports