In Germany, interest on debt is generally deductible for tax purposes, unless the deduction is denied or restricted due to:
- taxation on excess of permitted withdrawals
- interest ceiling rule (“Zinsschranke”)
- add-back under German Trade Tax Act (GewSt)
- the interest being re-characterised as a dividend; or
- other rules with a similar effect.
Anti avoidance rules
Taxation of excess of permitted withdrawals
As far as German partnerships (GmbH & Co. KG, GbR, OHG, KG, dormant partnership, partner company) are concerned, the possibility to deduct interest expenses for debt financing from taxes is limited insofar as, in case of excess of permitted withdrawals (withdrawals exceeding the sum of profits and deposits) within a financial year, the interest expenses of partnerships for debt financing are to be reduced by fictional lump-sum interest expenses for excess of permitted withdrawals in the amount of 6 % p.a., unless the interest expenses exceed a tax-exempt amount of EUR 2,050 per annum. Interest expenses exclusively resulting from financing fixed assets (assets permanently used in business operations) are the only exception from this reduction. They may be fully deducted from taxes payable.
Interest ceiling rule
Content of the regulation
The so-called "interest ceiling rule" is probably the most important restriction set forth by German tax law when it comes to deducting interest expenses for financing. The deduction restriction becomes relevant as soon as the interest expenses exceed the interest income ("excess interest on debt") and these excess interest on debt exceed the exemption threshold of EUR 3 million. Attention should be paid to the fact that, when calculating the relevant interest expenses, not only actual but also fictional interest expenses are considered such as non-interest-bearing shareholder loans.
Only an amount of up to 30 % of the EBITDA may be deducted from the excess interest on debt, however, excess interest on debt exceeding this amount can be carried forward in the subsequent five years in compliance with the requirements explained above and the respective maximum limits.
The deduction restriction set by the interest ceiling rule is basically only applicable to companies that belong to a consolidated group ("consolidated group clause"). The definition of "consolidated group" in this case has to be construed extensively from the definition set forth by German corporate law.
Furthermore, the provisions of the interest ceiling rule are not applicable if the equity ratio of a group company falls below the group's equity ratio by only two percentage points ("escape clause"). Here, too, special requirements are to be considered when calculating the equity ratio, in particular, consistent exercising options with respect to inclusions in the respective annual statements.
However, the exceptional provisions of the "consolidated group clause" and the "escape clause" do not apply if, with regard to corporations and partnerships in which no corporations participate (not partnerships in which only natural persons participate), interest expenses arose from "shareholder debt financing" which is "harmful" pursuant to the German Corporate Income Tax Law (KStG). A "harmful shareholder debt financing" is given if the company pays interest expenses exceeding the amount of 10 % of its net interest expenses to shareholders that directly or indirectly hold more than 25 % of the company's nominal or share capital. In this context, it has to be taken into consideration that, pursuant to law, the circle of shareholders is also extended to "related parties" and, under certain conditions, also to third parties.
Loss of interest carried forward
If the actual business carried out by the company is closed down or sold, an unutilised interest carried forward (interest expenses which could not be deducted in the previous business year) is entirely lost. This also applies mutatis mutandis if a partner leaves the company, specifically in the amount of the participation.
In case a company is reorganised, the interest carried forward is treated the same way as the loss carried forward and is thus as well fully or partially lost.
Add-back under German Trade Tax Act
25 % of the overall interest expenses for debts (pursuant to the German Trade Tax Act, not only interest expenses for long-term obligations are taken into account as "interest expenses for debts" but also interest expenses such as for liabilities vis-à-vis suppliers or current account payables) are added back to the profits when determining the assessment basis for trade tax. Thus, 25 % of the interest expenses for debts are subject to trade tax. Trade Tax is a municipal tax which varies from 7% to 17.12 %.
Interest treated as a dividend
Interest paid by a company to its shareholder or a related company as to be reasonable (i.e. the "arm's length principle" has to be taken into account here). To the extent that the interest is to be found unreasonable by the tax authorities it is not deductible. This works in both directions and applies if a subsidiary borrows money from its shareholder (or an affiliated company except for lower-tier subsidiaries) the interest paid by the subsidiary to its shareholder is unreasonable high or if the shareholder borrows money from the subsidiary against payment of an unreasonable low interest rate.