Since 1994, Germany's thin capitalization rules have been defined by statute. This enables international groups to prepare their tax planning with sufficient certainty. However, an annual review process is required, because the permissible debt-to-equity ratio is linked to the level of equity reflected in the commercial accounts at the beginning of each fiscal year. Therefore, even financings required in the course of a current fiscal year need to be anticipated before the end of the preceding fiscal year, to increase the level of equity in sufficient time to be able to cover all borrowings due within the next fiscal year.
It is also necessary to check whether operating losses which temporarily have not been deducted from the relevant equity have been recouped by profits within three years. If they have not been recouped, such losses must be wiped out by a contribution to capital, to avoid the relevant equity being reduced retroactively.
For straight interest bearing shareholder debt extended by a foreign shareholder or a foreign related party to a German group subsidiary, the 1994 rules provided for a debt-to-equity ratio of 3:1 for a directly-owned subsidiary, and of 9:1 if the intercompany borrowing was routed through a German holding company.
During the electoral campaign in 1998, the social democrat party promised certain tax benefits to low income taxpayers. The new German government promptly amended the tax law in 1998, but without having first completed those changes in the tax law needed to raise the funds to finance the new tax benefits.
The resulting implementation of the "poison list" agreed between the two governmental parties was delayed until early 1999, after pressure groups tried to stop the tax amendments adversely affecting certain branches of industry. Although more time was needed to discuss the proposed tax amendments, the intention was to make such amendments effective retroactively as of January 1 1999, despite the delayed approval by the German parliament.
The poison list
The poison list did not provide for any changes to the thin capitalization rules. But as a trade-off against certain concessions made to the pressure groups, a tightening of the permissible debt-to-equity ratios was suggested at an early stage, on the grounds that the German debt-to-equity ratios implemented by the 1994 rules were very favourable in comparison to international standards. The German federal Constitutional Court's recent declaration that certain family-related provisions of the German tax law are unconstitutional created an unforeseen hole of about Dm10 billion ($5.7 billion) in the German federal budget. As a result, the German government lost its flexibility and a change in the thin capitalization rules became likely.
A recent draft of the 1999 Tax Amendment Act which is likely to be passed by the German federal parliament in March 1999, provides for a substitution of the 3:1 ratio for operating subsidiaries with a new 1:1 ratio, while the 9:1 ratio for German holding companies would be replaced by a new 3:1 ratio. The less favourable ratio for hybrid financings of 0.5:1 for operating companies and for holding companies will remain unchanged.
Retroactive effect?
After the poison list was approved by the German federal government and published in 1998, taxpayers could no longer rely on the continuation of the relevant German tax provisions in their existing form. This justifies the retroactive effect of the 1999 Tax Amendment Act as of January 1 1999. However, as the change to the thin capitalization rules were not mentioned on the poison list, it is not obvious that the debt-to-equity ratios will be changed retroactively.
The recommendation by the specialists in the federal Ministry of Finance has been not to provide for a retroactive application, but instead as of June 30 1999. According to new instructions by the German government, the ratios will probably be changed as of January 1 2000 as part of a new Business Tax Amendment Act. It remains to be seen what will result from the further discussion in parliament. First rumours say that the 3:1 ratio for holding companies might be further reduced to 1:1 and the ratio for hybrid financings might be deleted completely.
In all likelihood, the reduction of the debt-to-equity ratio from 3:1 to 1:1 and from 9:1 to 3:1 respectively will require the level of equity to be increased, or for a portion of the outstanding shareholder debt to be converted into capital, to maintain the deductibility of the interest to the greatest extent possible.
It should be noted, however, that under the present rules which will remain unchanged for the time being, interest on shareholder debt exceeding the permissible ratios will still be deductible if the German subsidiary could have obtained the excess financing under similar conditions from any unrelated third party, in particular from commercial banks, without support from the ultimate parent company. However, a high level of shareholder debt is permitted under the 1994 rules, and additional third party debt is not considered under the German thin capitalization rules. Therefore, it was fairly unlikely, in particular for holding companies, that any excess shareholder debt could also have been obtained under similar conditions from outside banks, unless the underlying assets of the borrowing German subsidiary had substantially appreciated over book value, and thus could have been used to collateralize the excess financing. With the new reduced debt-to-equity ratios, it will become more likely that at least to a certain degree, any excess financing could still have been obtained from unrelated sources and thus will remain deductible.
To increase the level of equity, it is possible to forgive a portion of the outstanding shareholder debt as a contribution to the stated share capital, or to the capital surplus of the German subsidiary. Such a contribution to the stated share capital is a contribution in kind, which is subject to strict registration formalities to ascertain that the stated share capital is not overstated.
The increase in the stated share capital constitutes a change of the articles of association of the German subsidiary which has to be made by a notarial recording and subsequent filing for registration in the commercial register. The value of the forgiven receivable must generally be evidenced by a value confirmation to be given by a certified public accountant. The registration process is subject to review by the registration judge.
However, a contribution to capital surplus does not need to be registered and does not require the involvement of a certified public accountant. It thus proves to be less costly than the increase of stated share capital. To qualify as a contribution to capital surplus, it must be made certain that the forgiveness is made by the creditor in their capacity as a shareholder, and not as a creditor. The forgiveness of debt will qualify as a taxable gain if it can be construed that the forgiveness was made for commercial considerations rather than to strengthen the equity basis of the subsidiary.
If the debt was extended by a bank and qualifies as a shareholder debt under the German thin capitalization rules only because it was guaranteed by the ultimate parent company, a forgiveness of such debt does not constitute a contribution to capital unless the third party creditor has first transferred the loan receivable to the direct parent company.
Past losses requirement
A forgiveness of debt qualifies as a contribution to capital surplus only to the extent that the value of the loan principal has not been mitigated by past losses of the borrowing subsidiary. If the subsidiary has suffered losses and therefore is held not to be able to fully redeem the shareholder debt, the forgiveness of the valueless portion of the shareholder debt will constitute taxable income. In this case, a recapitalization of the borrowing subsidiary should be made by the injection of fresh cash. Such cash may subsequently be applied to redeem a portion of the shareholder debt.
If the net equity to be considered under the German thin capitalization rules is higher than the net equity revealed in the commercial accounts, because temporary losses are only deducted in the commercial accounts, but not for tax purposes, the cash injection will then wipe out the losses carried forward under accounting rules, but will not constitute excess cash available for a redemption of shareholder debt.
Even without changing the level of equity of the borrowing subsidiary, the deductibility of the interest can be preserved if the shareholder is transferring the shareholder debt to a German bank, even if thereafter the German bank continues to extend the shareholder debt to the German subsidiary on the basis of a guarantee by the ultimate parent company, as long as the bank loan is not collateralized by a back-to-back financing.
If the debt-to-equity ratio is not reduced and none of the above measures is taken, the consequence is more than the non-deductibility of the interest paid on the excess financing. Rather, the payment of such interest will be treated as a distribution of a constructive dividend.
While the tax due on a pure non-deductibility of an expense would be equal to the rate of the tax levied on such income, the treatment as a constructive dividend substantially increases the amount due.
In this case, the amount distributed is deemed to be an after-tax amount, which operates according to the German imputation tax system. Therefore, advance corporation tax may become payable on the assumed higher before-tax income. In addition dividend withholding taxes have to be paid on the amount of interest. Depending on the circumstances, the total tax burden on constructive dividends can thus equal up to 90% of the amount of the constructive dividend.
Consequently, such high penalties should be avoided, and the possibilities to adjust the equity or the shareholder
