Germany: Shareholder Debt: Draft Finance Ministry Decree on Thin Capitalisation

Article by Hans Martin Eckstein

The finance ministry has drafted a new decree to resolve some of the doubts on the application of the thin capital rules following a change in the law for 2004.

The revised statute significantly extending the coverage of the German thin capitalization rules contains many unclear provisions. In a noteworthy effort to provide timely guidance, the Federal Ministry of Finance has drafted a decree dealing with some of the more urgent issues in interpreting the new rules. The new decree is intended to be read in concert with its predecessor of December 15, 1994 which continues to apply to the extent that it does not conflict with the new provisions. Changes to the draft have been requested by the provincial ministries of finance and there are comments on the draft to be expected from the various trade associations before the text can be finalised. However, we would like to take this opportunity to summarise the position the federal ministry of finance would like to take.

• The draft decree does not deal with the anti-debt-pushdown rules (Sec 8a (6) Corporation Tax Act). These will be the subject of another decree, to be issued later this year.

• Interest disallowed under the thin capitalization rules will be requalified to "hidden distributions" or "constructive dividends". The tax authorities are seeking to apply this to the shareholder and to all other related parties within the group. Thus, they do not accept the argument of some authors that only the corporation paying the interest should bear any consequences of a breach of the thin capitalization rules.
• · Where the group financing is provided from a level in the group structure higher than the immediate shareholder the hidden distribution flows through the whole chain of companies. If the financing is provided from a fellow subsidiary, the hidden distribution flows up to the first common parent. Its balancing item is a series of "hidden capital contributions" down to the entity making the loan. Each German company receiving a hidden distribution will have to charge 5% of it to tax. Apart from this "leakage", the effect within a group is to reallocate the interest income from the lender to the borrower. If a German resident individual is the common parent, half of the hidden distribution will be subject to income tax. A hidden capital contribution increases the (tax) book value of the investment.
• The authorities confirm the view that the hidden distribution is subject to dividend withholding tax when the interest is paid. This withholding tax is creditable against the tax liability of the resident entity or person receiving the hidden distribution.

• The draft decree would also apply the shareholder debt rules to so-called upstream loans. This presupposes, though, that the parent company taking out the loan from its subsidiary has at least one shareholder owning more than 25% of its nominal share capital. On the other hand, the prevailing opinion in the professional press is that upstream financing is not a case of shareholder financing and does not fall subject to the thin capitalization rules. Unfortunately, the tax authorities seem unwilling to accept this argument.

• According to the wording of the statute a loan from a third party is treated as group financing if the third party has recourse to the shareholder or a related party. In their draft decree, the tax authorities propose to apply these rules only in cases of true back-to-back financing, i.e. in cases where the shareholder or a related party makes a deposit with the third party lending the funds. The German corporation claiming the interest deduction has to provide proof that there is no back-to-back arrangement in place. The authorities suggest that the confirmation of the lender can be seen as proof if the letter details the security for the loan. If this interpretation survives the discussion of the draft decree, shareholder guarantees of third party debt would therefore not force it into the scope of the thin capitalization rules. The third party debt secured by recourse to a member of the group reduces, however, the available safe haven.

• In cases of outbound financing, i.e. where the German parent company lends to a foreign subsidiary, the German tax authorities are willing to follow the application of the thin capitalization rules in the country of the subsidiary. Thus, the interest income of the parent would be requalified to a (tax-free) dividend to the extent the foreign state disallows it as an expense.
• The tax authorities do not comment on the determination of the safe haven of the foreign subsidiary in the outbound financing situation. It is debatable whether the foreign subsidiary has a safe haven at all (most commentators conclude this not to be the case) and if so, what the basis of its calculation might be (fictitious tax book values versus statutory book values).

• The thin capitalization rules only apply if the total related-party interest for the year exceeds € 250,000. However, if they apply at all, they apply to the entire amount. The threshold is for the company and not for each shareholder. The draft decree states that all third party debt with recourse to a shareholder shall be taken into account in applying the threshold, even if the company is able to disprove the back-to-back presumption and so avoid the other "hidden distribution" consequences.

• The safe haven equity is to be determined from the statutory German financial statements at the end of the previous business year of the company. If the company is a member of a partnership, the book value of the partnership share is to be substituted by the proportionate net assets of the partnership with a corresponding adjustment to the equity base. The tax authorities state that the net assets of the partnership are to be determined from its statutory German GAAP financial statements. There is controversy over this in the professional press, not least because it can lead to a significant understatement of the net assets of recently acquired partnership shares if the price paid exceeded book value.
• The book value of investments in other companies is to be deducted from the equity as shown in the statutory accounts, unless the company qualifies as a holding company (see below). Up to now, the earlier, 1994 decree only required this deduction for domestic investments. The present draft extends this deduction to all investments, including those abroad. This also applies to investments held through a partnership, although only to the extent the book value is included in the net assets of the partnership.

• All but short-term debt falls under the thin capitalization rules. The precise definition of short-term has long been a subject of controversy.
• Under the old rules, debt from trading activities was considered short-term debt as long as it was kept within usual payment terms. Any other debt outstanding for not more than six months was also considered to be short-term.
• The tax authorities have now dropped the reference to trade debt from the definition of short-term debt. Thus any debt outstanding for more than six months is now debt within the scope of the thin capitalization rules.
• Furthermore, debt outstanding for less than six months but subject to a standing credit arrangement with a contractual term of more than six months (e.g. an overdraft facility) also constitutes debt subject to the thin capitalization rules. Revolving facilities will also be treated as debt within the scope of these rules, even if there is no umbrella agreement and the individual debt is outstanding for less than six months. Thus cash pool arrangements are certainly within the scope of the thin capitalization rules.

• A holding company within the meaning of the thin capitalization rules has to hold investments in at least two subsidiaries. Either those investments represent more than 75% of all assets of the holding company (balance sheet test), or at least 75% of the gross income of the corporation comes from the subsidiaries (activity test). Investments in held through partnerships also count as qualifying investments in subsidiaries.
• A corporation without its own single shareholder of more than 25% cannot qualify as a holding company under these rules.
• Based on this draft decree, any corporation in a group of companies that fulfills the criteria for a holding company would qualify as such, irrespective whether the entity is a German taxpayer. This issue is also hotly disputed amongst German tax professionals.
• A direct subsidiary of a holding company within the meaning of the thin capitalization rules does not have a safe have under the clear wording of the statute. The tax authorities nevertheless are willing to allow shareholder financing of the subsidiary of a holding company within the relevant safe haven if the finance comes from the immediate shareholder. In consequence, the group financing has to follow the shareholding chain if there is a qualifying holding company at any level.

• The thin capitalization rules also apply to a partnership taking out shareholder or related party loans if a corporate partner, alone or together with related parties, owns an interest of more than 25% in the partnership. In this case, the financing is deemed to have been taken out by the corporate partner.
• The tax authorities make it clear that the thin capitalization rules only apply on the share of the corporate partner in the interest payments. The determination whether the safe haven is exceeded is to be made for the corporate partner, although any resulting disallowance of interest expense will fall on the partnership. This ensures that the trade tax consequence is borne by the partnership.
• If the provider of the loan is not only a related party to the corporate partner but also himself a partner in the partnership, the interest is not deductible under the normal partnership income determination rules – it is deemed to be a profit share allocated to the financing partner. Although the remuneration on this debt has therefore not reduced the taxable income of the partnership the tax authorities want to apply the thin capitalization rules to the corporate partner's share in the interest, thus requalifying the interest to a hidden distribution.
• If remuneration on shareholder or related party financing of a partnership is to be requalified to a hidden distribution under these rules, the tax authorities expect the partnership to assume liability for the withholding tax. This statement is astonishing, given that a dividend withholding tax can only be due from an entity able to pay a dividend – i.e. only from a corporation.

It is very positive that the tax authorities are making every effort to provide the guidance to the taxpayers on a timely basis. Some of the statements are welcome relaxations of, perhaps, an overly harsh statute, such as that on third party financing with related party guarantees. Unfortunately, a number of questions still remain unanswered, and the hope is that the discussion of the draft will help to clear some of the open issues as well as making some of the answers already given somewhat more practicable. We will take an active part in these discussions and keep you posted on the outcome.

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