Substantial Tax Cuts in Germany's 2008 Corporate Tax Reform
Who would have thought that Germany would one day stand side by side with Luxembourg in its corporate income tax (CIT) rates? It will happen on 1 January 2008, when Germany will impose the lowest effective CIT rate among the G7 countries and compete with countries generally perceived as low tax jurisdictions. This provides ample reason to take a closer look at two main aspects of the recently passed corporate tax reform, the implications for businesses on an international level and the responses that may be triggered.
The Bright Side: Significant Cuts in CIT
The key element of the reform is a reduction in the effective profit tax burden for corporations. Germany-based corporations are subject to CIT (plus a solidarity surcharge) and local trade tax. Currently, the total tax burden amounts to roughly 40 percent on a corporate level, depending on the trade tax multiplier, which varies from city to city. The law passed by Germany's legislature will reduce the CIT rate from 25 percent (26.375 percent including solidarity surcharge) to 15 percent (15.825 percent including solidarity surcharge).
This will place the combined CIT and trade tax rate for corporate taxpayers below the "magic" threshold of 30 percent or to be precise, 29.83 percent on the basis of an average trade tax multiplier of 400 percent.
Trade tax exempt investment income not generated by trade or business will only be subject to an exciting 15.825 percent CIT.
The Price to Pay: New German Thin-Capitalisation Rules
Amongst several others, the most drastic adjustment to the tax base is the complete change in approach to the deductibility of any and all interest expenses – and not just interest for shareholder loans or in relation to cross-border funding. Where formerly thin-cap limits were based on shareholder debt/equity ratios, the new law uses an interest-to-income ratio. Thus, whether interest expenses are tax deductible will depend on a taxpayer's income for a particular fiscal year adjusted by interest, tax, depreciation, amortisation or capital allowances (EBITDA). The consequence is that interest deductibility will be just as volatile as income, making medium- and long-term tax projections more difficult, to say the least.
In the broad picture, the new regime works as follows: tax deductible interest is limited to 30 percent of EBITDA, with a very broad definition of "interest." Excess interest, for example in loss situations, may be carried forward indefinitely and used to offset income in the future, but this treatment may be endangered by tax regulations tied to corporate change of control or corporate restructuring due to mergers or share-for-share transactions. No grandfather relief is granted, so the new regime kicks in for all taxpayers beginning 1 January 2008.
It is important to note in this context that the interest base is defined as taxable EBITDA, not statutory EBITDA for accounting purposes. Therefore, exempt income, e.g., from foreign sources or from shareholdings (dividends and capital gains), does not qualify, further increasing the negative effects of the new regulations specifically for holding companies.
There are four exceptions to the general regime described above, but unfortunately none of them is likely to draw any enthusiastic cheers:
- All interest expenses up to the amount of interest income are fully deductible.
- An annual interest threshold of €1 million per entity is prescribed. Thus, for example, a leverage of €20 million at an interest rate of 5 percent will be completely disregarded and all interest will be deemed deductible no matter what the EBITDA may be. However, if the interest amount exceeds the prescribed threshold only by €1, the aforementioned general regime is applicable and the 30 percent of EBITDA rule applies to the whole interest amount.
- The general regime does not apply if the entity is not part of a group of companies subject to consolidation rules under IFRS, an EU- or US-GAAP. The entity is deemed to be part of a group if it is "controlled" within the meaning of IAS 27.
- The reform prescribes an escape clause if the entity is part of a group but does not exceed the equity ratios of its group.
So what kind of response to the new thin-cap regime may be expected and what type of financial services may benefit from the new scheme? We will likely see a trend to splitting or setting up more entities and special purpose vehicles because the €1 million threshold applies per company, whether or not part of a group. Beyond that, there seem to be two principal avenues by which to mitigate the effects of the new rules: increase EBITDA or lower interest expenses. The first alternative is likely intended by Germany's legislature, but it may also make sense, for example, to generate more income in Germany than via foreign subsidiaries – specifically if the foreign tax rates are higher than in Germany, which is becoming more likely due to the new tax cuts.
Experts also predict an increase in the popularity of alternative financing instead of simple debt funding. Such a trend could build on the recently enacted German Real Estate Investment Trusts, or G-REITS. To read more about the consequences of Germany's G-REITS, click here. Selling real property to G-REITs and leasing it back will be very tax-efficient and at the same time provide for funding without getting caught up in the new thin-cap trap. Sale and leaseback will also be available for movable property, but may not be as tax beneficial. Asset-backed security transactions (ABS) and receivable finance follow the same strategy – at least if structured as true sales: the idea is to securitise property instead of using it as collateral for debt funding. What may also work under specific circumstances is to borrow assets instead of money – the interest for an asset loan is not covered by the new regime and thus is fully deductible. Finally, "hybrid financing" may become more common provided the hybrid instrument is treated as equity for tax purposes.
In conclusion and to a certain extent, the new thin-cap rules are thus largely a test of tax professionals' creativity, not an insurmountable problem. Therefore, the bottom line is clearly positive. With a 29 percent tax rate, Germany will leapfrog to the front of the industrialised countries' tax rates – a huge jump from the 59 percent imposed only 14 years ago. This is very good news for inbound investment. If tax is the cost of companies doing business in a specific country, Germany is coming up with quite an attractive cost-to-benefit ratio these days