On August 13 2003 the German federal government approved a tax package which is now subject to further consideration in parliament. The proposal includes a number of new provisions that will influence future business with German borrowers in financing transactions. At the end of the legislative procedure regarding the Elimination of Tax Preferences Act earlier this year, the German federal government announced seven legislative measures (known as Basket II) to be enacted until the end of this calendar year. Some of the announced legislative measures already formed a part of the infamous so-called poison list published in November 2002 but fell through in the parliamentary procedures. Due to the aggravated Budget situation of all public bodies and their permanent search for additional revenue it is expected that the envisaged changes will have bipartisan support even though changes to certain aspects are to be expected.
The tax plans of the German federal government are split into three Bills that will pass parliament before the end of the year. The changes will be effective as from 2004. The most relevant proposals with an impact on financing transactions (that is, acquisition finance) are a radical extension of the statutory rule against thin capitalization. They are accompanied by certain elements of the suggested trade tax reform and new rules on the deduction of business expenses related to tax exempt dividends and capital gains.
Another element of the tax package is a severe limitation of the use of losses carried forward. A minimum taxation shall be introduced that works by restricting the availability of a loss carried forward. These provisions shall be applicable both to individuals and to corporate entities. According to current law, only the loss carried back (maximum ?511,500 ($587,000)) is limited, not the loss carried forward. The proposed legislation provides that losses remaining after application of a loss carried back can only be used to offset one half of the current profit for tax purposes. In order to assist small businesses, profits of up to ?100,000 are fully available for set-off against the loss carried forward. Pursuant to this rule, the current usefulness of a tax loss carried forward is reduced, but its availability will be extended into the future. The amended provision will be applicable to persons and corporate entities with resident and with non-resident tax liability to the extent of their German domestic income, such as income from German permanent establishments or interests in German partnerships. For this reason, tax consolidation structures should gain in importance. Existing group structures should be reconsidered, and it might be advisable to merge loss-generating entities into profitable ones in order to avoid that losses carried-forward accrue rather than being applied against current profits in the year they arise.
Under a recently introduced rule, losses derived by a corporation from a silent partnership interest in another corporation are ring-fenced and may only be set-off by profits derived from the same silent partnership. According to the general view this provision is not applicable where the silent partner corporation holds the silent partner interest indirectly through a partnership. This loophole shall now be closed. The new rule effects especially the financing in the German private equity market because public providers of funds usually invest through silent partnerships.
Thin-capitalization rules reinforced
The key provisions of Basket II clearly are completely revised rules against thin capitalization (section 8a of the Corporate Income Tax Act), which indeed are breath taking.
In 1993, Germany for the first time introduced rules against thin capitalization that disallowed a deduction for interest payable on debt provided or (economically) guaranteed by a non-German shareholder. The provision at that time clearly aimed at tax evasion in an international context. In December 2002 the European Court of Justice (ECJ) ruled in the Lankhorst-Hohorst case that the German rules against thin capitalization constitute a violation of the freedom of establishment to the extent they applied to EU-resident shareholders. German tax authorities already rendered general letter rulings to the effect that the existing rules must no longer be applied when EU-resident shareholders are concerned. Even non-EU shareholders can now avoid the rules against thin capitalization by interposing an EU holding company.
The draft Bill is now striving to reinforce the rules, broaden their scope and at the same time make them compatible with European law. The anti-avoidance provision is about to be transformed into a key provision of corporate taxation that applies to almost every debt financing within a group, and from a bank, when the debt is secured by a corporate shareholder or a corporate related party. This change is due to the expansion of the provision to corporate borrowers who are not resident in Germany but who are subject to German non-resident taxation. Foreign corporations maintaining a permanent establishment in Germany, as well as corporations who are renting real property in Germany and others will in principle be submitted to the new provisions. Further, the scope of application is expanded to domestic shareholders and domestic related parties. Under current law the rules only apply to corporations subject to German resident tax liability and to lenders who are not taxed on the interest earned.
If the rules are amended as proposed in the current draft Bill, interest payments would be re-characterized as constructive dividends if the underlying debt is provided or (economically) secured by a shareholder holding (either alone or together with related parties), that amounts to more than 25% of the shares in the borrowing corporation (qualifying shareholder) or a party related to a qualifying shareholder. This is as long as the interest:
is not expressed as a fraction of the principle, for example, it is contingent on the borrower's profits; or
in case the interest is expressed as a fraction of the principle, but the debt is more than 1.5 times the qualifying shareholder's share in the borrowing corporation's adjusted equity and the borrower is unable to show that it could have obtained the same funds at similar conditions from an unrelated party (arm's-length-test).
The adjusted equity is the equity from the corporation's statutory accounts after deduction of the book value of shareholdings in other corporations.
No adjustments will be made to the equity of holding companies but the enhanced safe haven for holding companies will be repealed and all entities will benefit from a safe haven of 1.5:1 (debt:equity). This change will require a review of all holding structures because it might under certain conditions be more beneficial not to qualify for the holding regime.
Under current interpretation of the existing rules against thin capitalization by the tax authorities, payments of interest to a third party (for example, a bank that has recourse against a foreign qualifying shareholder or a related party) are deductible if the third party is taxed on the interest in Germany and provided that there is no back-to-back financing. Since the thin-capitalization rules shall be expanded to purely domestic cases we conclude that this view would no longer apply under the amended rules.
Diagram 1: Base case partnership structure |
Bank may be replaced by a related party, that is, a subsidiary of a foreign corporation (without a right of recourse). |
Partnership structures
The rules against thin capitalization shall in future also apply to partnerships provided a domestic or foreign corporation, alone or jointly with related parties, holds an interest of at least 25% in the partnership. The relevant safe haven will be determined at the level of the incorporated partner in accordance with the pro-rated interest in the partnership's equity. This new rule explicitly aims at acquisition structures, which use partnerships as an acquisition vehicle funded with the acquisition loan. Mainly two acquisition structures involving partnerships currently are widely used to avoid the application of the rules against thin capitalization.
The basic structure provides that the foreign acquirer of a German target establishes a German corporation with limited liability (GmbH) which in turn forms a partnership with a subsidiary. This partnership will then be financed with the necessary debt to acquire the target. In this scenario the existing provisions against thin capitalization do not apply because the borrower is a partnership rather than a corporation. The structure also allows an optimized exit scenario because the foreign investor may dispose of German HoldCo GmbH tax free under the current capital gains taxation regime in Germany. In addition, the relevant case law of the German Federal Fiscal Court provides that there are no limitations as to the extent the partnership can be debt-financed by a partner or by a third party that has a right of recourse against the partners or related parties. Therefore, there currently are neither restrictions with regard to the amount of debt provided to a partnerships nor with regard to securities granted to the lending banks.
This commonly used structure will be affected by the proposed provisions against thin capitalization since the bank has, on the basis of a share pledge, recourse against the foreign shareholder of German HoldCo GmbH, which is detrimental. Whereas the pledge over the limited partnership interest held by German HoldCo GmbH in the Partnership GmbH & Co KG will not jeopardize the tax position even under the new law. The most obvious avoidance strategy for the parties would be not to take security over the shares in German HoldCo GmbH and to refrain from taking any collateral from parties related to German HoldCo GmbH. However, from a security perspective the position of the lending bank would in many cases be severely impaired when the shares of the top holding entity of the acquisition structure were not part of the security package.
It is questionable whether a guarantee or other security granted by Partnership GmbH & Co KG or by lower tier subsidiaries would fall under the related party concept. According to the definition of the term provided for in the German controlled foreign corporation rules, security granted by subsidiaries would also be relevant. However, this rather formal approach is apparently not covered by the intentions of the lawmaker and should not prevail. Unfortunately the draft legislation does not clarify this issue.
Another structure commonly used went even further by providing for a double dip of the interest expenses incurred. Under this structure the foreign acquirer lends the necessary funds to make the acquisition from a bank and provides the loan proceeds as an equity contribution to a German partnership in which it holds a limited partnership interest. Due to the particularities of German partnership taxation the interest incurred by the foreign limited partner is a deductible item at the level of the German partnership and thus reduces the partnership's and the partner's tax liability in Germany. In addition, the same amount of interest in principle is deductible at the level of the foreign limited partner in his home jurisdiction. Apparently, this structure did not work for all jurisdictions but it was tested for French partners and US partners (in the latter case dual consolidated loss rules need to be considered) in a German partnership. The existing rules against thin capitalization do not apply to this structure. Again, the Federal Fiscal Court backs the structure since it stated that the use of the particularities of partnership taxation in order to optimize the taxpayer's tax position is not abusive. However, this structure has the downside effect that the German partnership interest could not be disposed without triggering corporate income tax and trade tax on a capital gain made.
The new provisions against thin capitalization would apply to the structure because of the recourse of the bank against Holding SA. In order to avoid the application of the new provisions it would be necessary that the security package is less comprehensive and that the bank would not take collateral from the shareholders in French SA or parties related to this entity.
Diagram 2: Double-dip structure |
Bank may be replaced by a related party (that is, subsidiary of Holding SA (without a right of recourse). |
Diagram 3: Alternative structure |
|
Alternative structures
In this situation lenders and borrowers need to consider alternative structures to limit the impacts of the new rules against thin capitalization. Possible alternative structures should be based on the fact that the basic rule against thin capitalization provides that debt is provided to a corporation or, alternatively, to a partnership in which a corporation needs to hold an interest of at least 25% alone or jointly with related parties. Therefore the most promising avenue to reduce the impacts of the rules against thin capitalization is to use non-corporate entities. An obvious structuring alternative would be to use another layer of partnerships between the borrowing partnership and the holding corporation. This would allow the provision of a pledge over the interest in the top-level partnership in addition to a pledge over the interest in the borrowing partnership itself and to a pledge over the assets of the borrower.
This structure could avoid the application of the amended provisions against thin capitalization and would provide for a full security package. However, two-tier partnership structures often are difficult to handle from a tax accounting and compliance perspective. One might also consider replacing Partnership I GmbH & Co KG in the structure with an orphan entity that does not qualify as a corporation under German tax law such as a trust or a Dutch stichting. However, in that case careful structuring is required in order to avoid that such entity is considered to be a related party of German HoldCo GmbH.
A different way to avoid the application of the rules against thin capitalization would be to enter into securitization transactions or by using certain elements of securitization transactions.
In such a structure the German borrower will sell certain receivables to a lender, that is, a bank (with a right of recourse) or to a related financing party, and use the proceeds from the sale of the receivables to repay the loan. The purchaser of the receivables would then receive the payments made on the receivables' portfolio rather than interest and capital repayment from the borrower. The purchase price can eventually by refinanced by a securitization of the receivables. However, the granting of security by the German GmbH would be limited by the fact that such guarantee could impair the qualification of the sale of receivables as a true sale. In case of such reclassification the sales proceeds would be treated as an interest bearing secured loan and, consequently, the new rules against thin capitalization would apply. This apparently limits the cases in which this structure can be applied to intra group financing.
Diagram 4: Securitization |
|
Debt pushdown
The proposed amendments to the rules against thin capitalization also include a new rule concerning especially the debt financing of the inter-company transfer of shares. According to the new provision, interest payable on shareholder financing is reclassified into a constructive dividend if the financing was made available for the acquisition of shares in a corporation from the shareholder of the acquiring corporation or from a related party. This technique often was used for the purposes of a debt pushdown in inter-company reorganizations. The provision shall also apply in case a related party made the financing available and/or the shares were acquired from a related party.
Under the proposed legislation the interest paid by the acquirer to the shareholder or to a related party shall not be deductible irrespective of an available safe haven or an arm's length test to be passed. Even more frightening, the provision is drafted in a way that it also can be applied to any acquisition financing outside a group of companies when the financing is provided by a third party (that is, a bank) with a right of recourse against a shareholder or a related party and/or when the seller is a third party with a such right of recourse.
It is not hard to imagine that this situation might well arise in a number of M&A transactions when the purchaser is an acquisition vehicle without any other business activities beside entering into the share purchase agreement and the loan agreement. In this case the seller and the financing bank will ask for shareholder guarantees or other securities. Since the draft does not provide for a grandfathering rule it will apply to any acquisition financing already in place from 2004 onwards.
Do the proposals heal the violation of European law?
Technically, the rules against thin capitalization do not work as a simple disallowance of a deduction, but deem the interest as well as lease rentals or royalties as a constructive dividend. As a result of this re-characterization, the interest received by a German incorporated parent is treated as a dividend and, hence, tax-free (or 95% tax-free if the rules are amended as discussed below). By contrast, non-German parents receiving interest re-characterized as dividends for German tax purposes may not find themselves in a similar position. Even if the foreign country in which the parent is resident allows a participation exemption or similar benefits for foreign source dividends, it is uncertain whether this preference will apply to interest payments that are re-characterized under German tax law. The EU Parent Subsidiary Directive in principle covers both the transfer of profits of a subsidiary to its parent by a profit distribution based on a shareholder resolution and a transfer of profits by means of a constructive dividend. Nevertheless, it cannot be excluded that not every member state takes the same view of this topic especially since the proposed German legislation unilaterally expands the scope of application of the Directive to the detriment of other member state's revenue. Bearing in mind the ECJ's decision in Lankhorst-Hohorst, it appears doubtful whether the preference granted to German parents is inline with European law. If this were not the case the new rules would not apply to German corporations with EU shareholders.
Trade tax reform
The tightening of the rules against thin capitalization is accompanied by amendments to the Trade Tax Act. Trade tax, which shall be renamed municipal business tax (MBT or Gemeindewirtschaftsteuer), will also be subject to a fundamental reform, which will have an influence on financing transactions in two respects.
First, thin-capitalization rules will for the first time also be applicable to trade tax. Consequently, any amount treated as constructive dividend under the revised thin-capitalization rules will also be treated as taxable income for trade tax purposes, which has not been the case under current law.
Further, the infamous rule on the add-back of 50% of the interest paid on long-term debt (basically debt exceeding a term of 12 months) will be removed from the MBT Act. At the same time a new rule shall be enacted targeted at inter-company financing. This new rule provides that interest shall be added back to the income subject to MBT when it is paid by a domestic corporation to a shareholder, to a related party or to a third party with the right of recourse against the shareholder or a related party. The add-back shall not apply if the amount of interest is subject to trade tax at the level of the recipient. The provision therefore aims at international inter-company financing structures and will especially have an impact on inter-company cash pooling arrangements. Since the proposed provision makes a distinction between domestic cases and cases involving a foreign lender it is apparent that the provision is highly problematic from a European law perspective.
Dividends received in capital gains from sale of shares to be taxable
Under the current rules, dividends received and capital gains derived form the sale of shares in a corporation are generally tax exempt if received by a corporate tax payer. In the case of a shareholding in a domestic corporation, expenses relating to the shareholding, for example financing costs, are deductible only to the extent that they exceed the dividends received from that company in the same year. If the shareholding is in a foreign corporation all expenses are deductible but 5% of the dividends must be included in the taxable income. This distinction between capital gains and dividends on the one hand and domestic and foreign shareholdings on the other would be repealed.
The proposed new rule would subject 5% of all dividends received and 5% of all capital gains realized to tax. Given a compound tax rate of 40% for corporations, the new rule would impose a 2% tax on capital gains from the sale of shares and dividends received. The new rule may adversely affect groups with multiple tiers of corporations where earnings must be distributed through several incorporated entities before they are available at the parent level. Unless the requirements for group taxation under the Organschaft rules are met, the 2% tax would be levied at every tier if a dividend distributed from a lower tier company up to the parent.
Diagram 5: Acquisition finance |
|
Less room for sensible tax structuring
The current draft legislation will bring some important changes for German borrowers and for German and foreign institutions lending into Germany. Even though there most likely will be amendments to the draft in the forthcoming weeks, it can be expected that the provision discussed above will be enacted without much changes. The room for sensible tax structuring will further be reduced, however there still are planning opportunities to avoid some of the negative effects of the proposed legislation which are worth considering in more depth in each individual case.
Martin Bünning (martin.buenning@allenovery.com), Frankfurt
