On May 25, 2007, the German Parliament approved a draft corporate tax plan (enterprise tax reform), which is scheduled to become effective on January 1, 2008. The reform seeks to create a more competitive tax environment for companies by reducing the nominal tax rates, avoiding 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 limiting the use of loss carry-forwards by significantly tightening the change of control rules. It is very likely that the new law will be implemented. The second chamber of the Parliament still has to approve the tax plan. A final decision is planned on July 20, 2007.
Notwithstanding the reduction of the tax rates, U.S. investors likely will find that the limitation of the deduction of interest will result in a notably higher effective tax burden on leveraged financing structures in Germany.
Reduction of Nominal Tax Rates
The draft bills provide 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 taxable earnings before interest, taxes, depreciation and amortization (EBITDA). Interest surplus means the difference between interest expenses and interest income. The exceeding interest surplus can be carried forward to later 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 falls below €1 million. If the interest surplus just hits the €1 million threshold, the entire surplus is only deductible under the general rule described above.
The limitation clause only applies if the corporation seeking the deduction of interest belongs to a group of companies. 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. In the case of harmful shareholder loans, 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 a shareholder with a minimum participation of 25 percent, to a related party to these shareholders, or to 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.
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 to which the corporation belongs (the so-called escape clause). According to the draft bill, only a shortfall of 1 percent will be accepted. The relevant ratio will be mainly determined according to international financial reporting standards (IFRS). 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:
- A shareholder loan is “harmful” if 10 percent of the interest payments on shareholder loans are already harmful, regardless of the entire group’s seat or place of management, not only on shareholder loans granted to the German entity actually seeking the interest deduction.
- 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 that provide for a supplemental limitation of the deduction of interest and a fictive “financial part” of leases, rent and royalties. Interest not deducted for corporate income tax purposes remains fully nondeductible for trade tax purposes, too. Additionally, for trade tax purposes:
- 25 percent of interest payments that include payments to a silent partner (note that under current law 50 percent of the interest is non-deductible provided they are made for longterm financing)
- 18.75 percent of rent and lease payments on immovable assets such as property
- 6.25 percent of rent and lease payments on movable assets and of royalties under a license agreement cannot be deducted. 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 signivicantly tightened. 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 percent, but not more than 50 percent of the shares are transferred within five years, the loss carry-forward cannot be utilized at the rate the ownership has changed.
- If more than 50 percent 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.