On 14 March 2007 the German Government approved a draft corporate tax plan (enterprise tax reform) which is scheduled to become effective on 1 January 2008. The draft bill has been sent to Parliament for debate and possible changes. The reform seeks to create a more competitive tax environment for companies by reducing the nominal tax rates, avoid the (further) erosion of the tax base in Germany by limiting in particular the amount of interest companies can deduct from their taxable income, and limit the use of loss carry forwards by remarkably tightening the change of control rules. Notwithstanding the reduction of the tax rates, the intended limitation of the deduction of interest would result in a notably higher effective tax burden on leveraged financing structures in Germany.
Reduction of nominal tax rates
The draft bills provides a reduction of the average tax burden for corporations from 38.65 per cent to 29.83 per cent, consisting of a corporate tax of 15 per cent (currently 25 per cent), a solidarity surcharge of 0.83 per cent (5.5 per cent of the corporate tax) and an average trade tax of 14 per cent, depending on the tax rate of the local community.
Limitation of interest deduction for corporate tax
For corporate income tax purposes, lawmakers have proposed that an interest surplus is only deductible up to 30 per cent of the EBIT. Interest surplus means the difference between interest expenses and interest income. EBIT is understood as taxable earnings before interest and taxes, i.e., non-taxable income of a corporation like dividends do not count for the determination of the EBIT. The exceeding interest surplus can be carried forward to following fiscal years and can be deducted in these years under the same prerequisites. The current thin-cap rules for shareholder loans will be abolished.
There are three exceptions to this limitation:
€1 million exemption limit
Interest expenses are fully deductible if the interest surplus of the corporation does not exceed €1 million. If the interest surplus rises just 1c above the €1 million threshold, the entire surplus is only deductible under the above described general rule.
The limitation clause only applies if the corporation seeking the deduction of interest belongs to a group of companies. This is assumed if the corporation is or could be part of a consolidated group for accounting purposes, or the financial and business policy of the corporation is factually controlled and co-ordinated together with one or more other business entities. It is currently uncertain whether private equity funds or a master Luxembourg S.A.R.L. would qualify as head of a group.
However, this "no-group exception" is only applicable if there are no harmful shareholder loans. According to this re-exception, the limitation for all (not only shareholder loans) interest expenses will be applicable if interest on shareholder loans exceeds 10 per cent of the interest surplus (interest expenses/interest income) and the shareholder loans are owed to:
- Shareholders holding a participation of 25 per cent or more in the German entity claiming the deduction of interest.
- A related party to these shareholders.
- Third parties who can recourse against such a shareholder or a related party. In contrary to the current thin-cap rules a recourse right is already assumed if the third party has a pure legal recourse right. This includes a pure guarantee by a group company, as well as a pledge of shares the parent company or a related party has given to a loan creditor.
Sufficient equity/debt ratio
If the no-group clause is not applicable, the general limitation rule can only be avoided if the equity/debt ratio of the German corporation is not lower than the overall equity/debt ratio of the entire group the corporation belongs to (so-called escape clause). According to the draft bill only a shortfall of 1 per cent is accepted. The relevant ratio will be mainly determined according to international financial reporting standards (IFRS); under certain circumstances US generally accepted accounting principles (GAAP) are also applicable. A group is assumed according to the prerequisites mentioned under the "no-group clause". Comparable to the "no-group clause", the escape clause is only applicable if there are no harmful shareholder loans. The prerequisites of a harmful shareholder loan granted by a person not belonging to the group are basically the same as under the "no-group clause". However, there are two crucial differences:
- 10 per cent of the interest payments on shareholder loans are already harmful, regardless of its seat or place of management, not only on shareholder loans granted to the German entity actually seeking the interest deduction, e.g., the shareholder financing of a French subsidiary could lead to a denial of the escape clause for the German subsidiary.
- The re-exception for the shareholder loans does not apply to shareholder loans that are consolidated in the balance sheets of the groups.
No grandfathering rules for established structures
As there are no grandfathering rules provided for the new regime, it would not only have immense impact on the structuring of newly set up leveraged transactions but on established structures as well. With regard to those structures, an application of the current thin-cap rules on third-party loans is very often avoided by using the present narrower understanding of a recourse loan which is basically only assumed in a back-to-back financing structure.
Limitation of deduction of financing parts of payments for trade tax
For trade tax purposes, there are additional rules which provide for a supplemental limitation of the deduction of interest and a fictive "financial part" of leases, rent and royalties. They further restrict the deduction of payments which were already deducted for corporate income tax purposes. Interest not deducted for corporate income tax purposes remains fully non-deductible for trade tax purposes too. Additionally the following expenses cannot be deducted for trade tax purposes:
- 25 per cent of interest payments which include payments to a silent partner (note that under current law 50 per cent of the interest is non-deductible provided they are made for long-term financing)
- 18.75 per cent of rent and lease payments on immovable assets such as property
- 6.25 per cent of rent and lease payments on movable assets and of royalties under a license agreement
There is only a tax free amount of €100,000. The non-deductible part cannot be carried forward.
Use of loss carry forward after a change in control
According to the draft bill, the use of a loss carry forward after the acquisition of the shares in a German corporation will be remarkably tightened. Currently, the use of a loss carry forward is denied if more than 50 per cent of the shares in a corporation are directly transferred and the business of the corporation is continued with mainly new assets.
The draft bill abandons the new business assets test. A utilization of the loss carry forward is restricted if there is a direct or indirect chance in ownership within five years:
- If more than 25 per cent, but not more than 50 per cent of the shares are transferred within five years, the loss carry forward can not be utilized at the rate the ownership has changed.
- If more than 50 per cent are transferred within five years, the use of the loss carry forward is entirely banned.
An interest carry forward will be fully or partially lost under the same prerequisites.
Another part of the counterfinancing of the tax rate reduction will be tighter transfer pricing rules, especially regarding a change of functions.
Likelihood of implementation
Although there will be further discussions during the parliamentary processes whether these rules are too tight (e.g., the only 1 per cent difference between the debt/equity ratio of the affiliate and the overall group for the application of the escape clauses regarding interest deductions). It seems to be more likely than not that the new law will be implemented. A final decision in Parliament is planned on 20 July 2007.