In a recently published ruling dated 22 June 2010 (I R 78/09) the Federal Fiscal Court held that loans are characterized as profit participating loans, if interest payments are due and payable only if and to the extent the borrower has sufficient liquidity for such payments. Such characterization as profit participating loans would result in the interest being subject to withholding tax and — in case of tax-resident borrowers — to a limited tax liability for foreign lenders.
Interest on loans is, in principle, not subject to withholding tax in Germany unless the loans are securitized or the interest is profit-related. Loans bearing a profit-related interest include in particular profit participation rights and profit participating loans. Profit participating loans are characterized by the consideration for the provision of capital representing a participation in the economic performance of the borrower.
In its ruling, the Federal Fiscal Court argues that the fact that interest payments only become due and payable if and to the extent the borrower has sufficient liquidity also constitutes a participation in the economic performance of the borrower. Such a provision resulting in a principally unlimited deferral, the lender only has an enforceable claim for interest payments if the borrower generates corresponding earnings and liquidity.
Due to the broad wording used by the Federal Fiscal Court in its argumentation, the ruling causes significant uncertainty with respect to the treatment of loans providing for a deferral of interest payments with regard to the liquidity of the borrower (or similar criteria). Affected by this uncertainty are for instance typical mezzanine financings or loans providing for so-called “pay if you can” clauses
In our opinion, however, the ruling’s wording is misleading. For the qualification of a loan as a profit participating loan it is in our view irrelevant whether and under what kind of conditions interest payments are deferred during the term of the loan. The crucial question is rather whether the lender has an enforceable claim for payment of interest accrued at least at the end of the term of the loan. Insofar, the Federal Fiscal Court does not make clear enough in the relevant section of its ruling that one crucial aspect of the case is that accrued interest was to be deemed as waived if the proceeds derived from the sale of the borrower’s sole asset (the borrower being a closed-end shipping fund) should not suffice for paying the interest accrued under the loan. The Federal Fiscal Court more clearly points out the critical relevance of the lack of an enforceable claim for the payment of the principally non profit-related consideration especially at the end of the term of a loan in another ruling dated 26 August 2010 (I R 53/09), which deals with the similar question whether interest payments under a profit participation right qualify as a “profit participation” under the double taxation convention between Germany and Austria, contrasting the profit participation with “mere conditions for a deferral”.
Plain vanilla PIK-loans providing for the interest to become unconditionally due and payable at the end of the term of the loan should therefore not be affected by the ruling. In contrast, with respect to loans bearing bullet interest or interest deferred under certain conditions, any clause providing for such interest to be waived at the end of the term of the loan if at this point in time there are no sufficient funds available for paying the interest should be detrimental. It is currently unclear whether the same applies if the interest claim is not waived at the end of the term but may in fact not be enforceable because the interest claim is subordinated to other liabilities of the borrower.
As long as the tax authorities have not yet published their view on the general application of the principles stated in the discussed ruling, such provisions should be avoided, their treatment covered by a binding ruling from the tax authorities or, if a binding ruling is not available, the risk of the deduction of withholding tax should be reflected adequately in the loan agreement.