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The German thin capitalisation rules introduced in 1994 as sec. 8a KStG (corporation tax act) have now been in effect for slightly more than four years (see article no. 4). This span of time is too brief for court resolution of the numerous controversies surrounding what some consider to be a poorly drafted piece of legislation. The disputed matters range from fundamental challenges based on EU and tax treaty law to mechanical intricacies such as the proper treatment of multiple shareholder loans at different interest rates. Given the wide array of opinions in the literature and the hard line taken by the tax authorities in their 1994 directive on many, though not all, doubtful issues, it may be assumed that there is a lot of litigation "in the pipeline."
After a brief introduction to the thin capitalisation rules (sections 1 - 2), this article summarises various aspects of the rules which are positive from a taxpayer perspective (sections 3 - 6) and reports on the first known tax court decision on the thin capitalisation rules (section 5.4 ). Means of circumventing the thin capitalisation rules are discussed in section 7. Section 8 calls attention to selected issues which are likely to be the subject of litigation in the next couple of years.
1. Introduction
The thin capitalisation rules have not driven the foreign shareholders of German corporations to desperation. On the contrary: they set up safe havens which are generous by international comparison and permit accurate, flexible, and relatively risk-free planning to use these to full advantage. Furthermore, various exceptions allow shareholders to exceed the safe haven limits. While there is no shortage of ideas as to how to circumvent the rules entirely, many foreign shareholders find it simpler to comply with them.
Generally speaking, the thin capitalisation rules apply to loans to German corporations from foreign shareholders with capital stakes in excess of 25 % or from foreign related parties. Loans by unrelated third parties (e.g. banks) are also covered if the third party has recourse against a 25+ % shareholder or a related party. The meaning of "recourse" and the precise scope of the thin capitalisation rules are disputed. Compensation paid or accrued for debt capital which is "impermissible" under the rules is treated as a constructive dividend for corporation tax purposes, but not under the trade tax. The thin capitalisation rules thus requalify interest on excessive shareholder loans as dividends without requalifying the underlying debt as equity. The rules operate in addition to the basic requirement that loans from shareholders and related parties be at arm's length and supported by a clear and unambiguous agreement entered into in advance and performed in fact.
2. The incentive for foreign shareholder loans
German domestic tax law in general only taxes interest received by foreign lenders from German debtors when the debt claim belongs to a German permanent establishment or is secured by German real property (other exceptions may also apply). Interest paid is, on the other hand, deductible as a business expense for a German corporate debtor. The German tax on dividends paid by a German corporation to a foreign shareholder ranges from about 44 % (with zero withholding tax) to well over 50 % (assuming 15 % withholding) depending on the local trade tax rate. Since the average OECD income tax rate is only about 37 %, foreign shareholders have an obvious interest in debt financing for their German subsidiaries. The incentive for foreign shareholder loans increases if the shareholder's domestic tax regime permits accumulation of income in a low-tax jurisdiction. Finally, even German-based corporate groups may seek to reduce their German tax burden by establishing offshore financing companies to provide German group members with debt financing (see section 8.7 below).
3. The safe havens
The thin capitalisation rules distinguish two types of loans: those for which the compensation paid for the use of debt capital is defined solely as a fraction of the principal amount (hereinafter referred to as "conventional" loans) and all other types of loans. Fixed and variable rate interest loans (e.g. LIBOR + 2 %) belong to the former category; loans paying a share of profits or turnover fall under the latter.
For conventional loans, a "safe haven" debt-to-equity ratio of 3-to-1 applies. Interest on arm's length loans will only be challenged to the extent this ratio is exceeded. The safe haven rises to 9-to-1 for conventional loans to a qualified holding company.
For loans earning e.g. a share of profits or sales, the applicable ratio is only 0.5-to-1. If this safe haven is used, that for conventional debt is reduced proportionately.
The lender need not have tax treaty protection to enjoy the safe havens.
4. Holding companies
The 9-to-1 safe haven for conventional loans to German holding companies constitutes a major planning option. To qualify as a holding company, a corporation must have direct "participations" (generally 20+ % minimum) in at least two other corporations, domestic or foreign. Shares in corporations without any business function do not count. Furthermore, the corporation must either derive 75 % of its earnings from debt or equity holdings in its direct and indirect subsidiaries or more than 75 % of its assets must consist of participations in other corporations. In applying the 75 % asset test, debt claims against direct or indirect subsidiaries are disregarded because the test could otherwise scarcely ever be met.
A German corporation with a single German subsidiary (plus at least one foreign subsidiary) can thus qualify as a holding company and receive triple the normal safe haven. Necessarily, the German companies under the holding have no safe haven of their own, hence the safe haven of the holding must suffice for the entire group. Since this arrangement is not optional, situations are conceivable in which a holding structure, despite its higher nominal safe haven ratio, would be less advantageous than direct financing of the subsidiaries (because "equity of the German subsidiaries x 3" yields a higher figure than "equity of the holding x 9"). This problem can be avoided by ensuring adequate capitalisation of the holding. Furthermore, the arm's length exception discussed below remains available for conventional direct loans to holding
5. Exceptions to the safe-haven limits
The safe havens are not the exclusive means to avoid reclassification of loan remuneration as constructive dividends. The following exceptions exist in addition:
5.1 Arm's length exception
With respect to all conventional loans, the possibility exists to show that the borrowing company could have obtained the same debt capital on the same conditions from an unrelated third party. If this burden of proof can be met, the loan is "permissible" even if in excess of the safe haven. While the details of this exception are controversial, it is clear that the borrower's creditworthiness is the key element to be proven. This involves analysis of the security which the borrower could have offered for a loan. A firm credit offer from a bank, preferably not one with which the borrower or its group does regular business, is considered strong evidence, as is a formal credit analysis. The arm's length exception is also open to corporations which have no safe haven because they are part of a domestic holding group.
5.2 Domestic third party lender exception
Third party loans fall under the thin capitalisation rules if the third party lender has recourse on the loan against any person whose direct loan would have been subject to the thin capitalisation rules. However, there is an exception for recourse loans from third party lenders who are taxable in Germany on the interest or other compensation received on the loan. As a rule, third party lenders will be banks. The exception also applies to loans by the German branches of foreign banks as long as the loan is attributable to the German branch. For the exception to apply, the borrower must show that the interest paid on the loan has not been siphoned off by means of a back-to-back loan arrangement (e.g. foreign parent lends money to German bank, German bank in turn lends to German subsidiary). Written assurances by the lending bank are thought to be sufficient for this purpose.
5.3 Banking transactions exception
Conventional loans incurred to finance "normal banking transactions" are not subject to the thin capitalisation rules. This exception is generally thought to apply to banking transactions within the meaning of bank regulatory law engaged in by borrowers licensed to do business as a bank. In addition, the tax authorities require that the loan proceeds not be used to finance "group dependent companies" which are not themselves banks, e.g. by means of loans, factoring, or leasing (see item 70 of the thin capitalisation tax directive of 15 Dec. 1994, hereinafter the "thin capitalisation directive"). This requirement is controversial.
5.4 Short-term and current account debt exception
The thin capitalisation rules do not apply to "short-term" debt (items 47 - 49 of the thin capitalisation directive). The tax authorities restrict this exception to short-term credit extended within the context of a normal trading relationship. Whether trade credit is short-term depends in their view on what is customary in the trade, with a six-month limit applying in general. Furthermore, they require a supplier-customer relationship to exist between the lender and the borrower and refuse to allow current account credit of any sort to qualify for the exception.
However, the Munich tax court recently held that this restrictive interpretation is subject to "serious doubt" (EFG 1998, 67 - 30 July 1997). The court appeared inclined to apply the distinction between long-term and short-term debt for trade tax purposes to the thin capitalisation rules as well.
The trade tax draws the general dividing line between long-term and short-term debt at twelve months instead of six. It is also more generous in its treatment of current account debt. Not only is current account debt not ipso facto long-term, but the long-term amount of current account debt is determined with regard to its minimum balance over a period of at least one year. Furthermore, loans taken out to finance regular business transactions (e.g. the purchase of current as opposed to fixed assets) do not constitute long-term debt for trade tax purposes no matter what their duration, as long as this is normal in the trade.
The lower court's ruling relates solely to a motion to stay collection of the tax. The tax authorities have appealed to the Federal Tax Court.
6. Fine-tuning the debt-equity ratio
The safe havens under the thin capitalisation rules are calculated by comparing a shareholder's pro rata share of equity at the close of a given fiscal year with the amount of shareholder debt throughout the year to follow. Capital added during the year in progress does not "count" until the following year. If the safe haven has been fully exploited, any loss incurred during a fiscal year would in principle trigger constructive dividends in the year to follow unless capital is injected before the end of the year in progress, which is highly impractical. However, the statute contains a liberal loss adjustment provision: reductions in equity due to operating losses are disregarded as long as the loss is restored by the end of the third succeeding fiscal year. Losses may be restored either by subsequent profits earned or by contributions of capital. With three years in which to react to dips in equity, shareholders can easily make maximum use of the safe havens at all times.
7. Ways around the thin capitalisation rules
7.1 Operating in partnership form
The thin capitalisation rules apply only to loans to corporations, not to partnerships. They can thus be side-stepped by doing business in Germany in partnership form, e.g. as a GmbH & Co. KG. While the choice of such a structure poses other issues, these appear manageable.
German partnership tax law (sec. 15 (1) no. 2 EStG) for instance treats interest paid by a partnership on loans received from its partners as partnership profits specially allocable to the partner-lender. Interest on such loans is thus allocable to the partnership's German permanent establishment and subject to German taxation (sec. 49 (1) sent. 1 no. 2 (a) EStG - see also article no. 77, section 9.5). It therefore appears advisable for the German operating partnership to receive its debt capital from a foreign group company which holds no partnership interest, e.g. from a foreign financing subsidiary.
Whether this is really necessary is debatable, however, if the foreign partner is located in a tax treaty country. The Federal Tax Court has held in recent years that interest paid by a partnership to its foreign partner falls under the interest article of a typical tax treaty, not under the business profits article, as the domestic provision assimilating such interest to partnership profits might lead one to expect. This should effectively prevent German taxation of such interest.
Any profits earned by a foreign corporation from the domestic operations of its German partnership will be taxed at the rates applicable to the German branch of a foreign corporation. These are explained in the subsection which follows.
7.2 Operating through a German branch
The thin capitalisation rules apply to loans to corporations subject to tax in Germany on their worldwide income. Loans to the German permanent establishment of a foreign corporation are therefore outside of the scope of the provision. However, the taxation of domestic branches of foreign corporations is less favourable than that of domestic subsidiaries (42 % corporation tax rate as opposed to 30 % + withholding tax on distributed earnings). The advantage of a higher debt-to-equity ratio may compensate for the generally higher rates at which branches are taxed, however. While avoidance of the thin capitalisation rules is relatively easy, such structures must be planned with general transfer pricing principles in mind as well.
7.3 Lease and license agreements instead of loans
Likewise not covered by the statute are non-cash transactions such as lease or license of tangible or intangible property. In many cases, such arrangements can substitute for money loans.
7.4 Avoidance structures
The literature has also generated a number of circumvention models which employ interposed partnerships or branch establishments to permit the continued operation of the actual business entities in corporate form. These structures are aggressive and more vulnerable to attack under Germany's general anti-abuse provisions than the simple decision to do business in partnership form.
One of the oldest and simplest proposals involves a three-tier structure consisting of a foreign parent, its domestic partnership, and a domestic operating corporation wholly owned by the domestic partnership. The foreign parent borrows money from a foreign lender, e.g. a bank, and re-lends the loan proceeds to its domestic partnership. The partnership then contributes the loan proceeds to the operating corporation as equity. The corporation pays dividends to the partnership. Even assuming that the interest paid by the partnership will not be exempt from taxation (which may not be the case; see section 7.1 above), the interest paid by the foreign parent to the foreign lender will be treated as a business expense allocable to the interest income. The partnership in turn sets off the interest paid against dividends received and is furthermore entitled to the corporation tax credit. The structure is outside of the thin capitalisation rules because it does not involve a loan to a German corporation. The structure is, however, subject to challenge under Germany's general anti-abuse provision, sec. 42 AO. Probably the most important factor in avoiding such a challenge would be to show that the domestic partnership was not established purely for tax purposes.
Modifications of the same basic idea are also possible. A foreign group financing company can loan funds directly to the domestic partnership, which in turn contributes the funds to the operating corporation as equity. Or the foreign parent can borrow funds from a foreign group financing company and contribute these to its domestic partnership, which in turn lends them to the operating corporation. The interest on the funds borrowed by the parent to fund its contribution to the partnership will be deductible from the parent's distributable share of partnership profits. These will consist primarily of interest received from the operating corporation. The interest paid to the group financing company will in effect neutralise the interest received by the domestic partnership on its loan to the operating corporation.
Instead of a domestic partnership, the foreign parent can establish a domestic permanent establishment. Interest on loans made to the domestic permanent establishment by a foreign group financing company will be deductible from the profits of the permanent establishment. The permanent establishment can then contribute the loan proceeds as equity to a domestic operating corporation, the shares of which are part of its business assets. The permanent establishment can set off the interest paid on the loan against dividends received and is furthermore entitled to the corporation tax credit on such dividends.
7.5 Atypical silent partnership
A silent partnership is defined in sec. 230 ff. HGB (German Commercial Code) as an arrangement by which the silent partner makes a contribution to the capital of a commercial business in return for a share of the profits and losses of the business. The arrangement is an internal one in that the business continues to function as before and the silent partner remains completely in the background. The statutory silent partner has few of the rights typically enjoyed by partners in a general or limited partnership. Arrangements which adhere closely to the statutory model are referred to as "typical" silent partnerships and the "typical" silent partner's investment is treated as a capital investment for tax purposes. The share of profits received is a deductible expense for the business entity and subject to a 25 % withholding tax. For trade tax purposes, the deduction is allowed only if the profits received by the silent partner are subject to trade tax in his hands. (This provision of the law (sec. 8 no. 3 GewStG) may violate EU law, however, under the principles discussed in article no. 102.)
An "atypical" silent partnership is one in which the parties by agreement alter the statutory model so that the silent partner, in his internal relationship to the business entity, enjoys the rights and shares the risks typical of a normal partner. The silent partner's income from such arrangements is treated as business income like that of any partner in a commercial partnership. The business entity and the silent partner each derive a distributive share of profits from the arrangement. From the standpoint of the business entity, this is much the same as if the silent partner's profit share were deductible expense (except for trade tax purposes). There is no withholding tax on the silent partner's distributive share.
It is argued that the contribution of an atypical silent partner to a partnership constitutes "equity" for tax purposes and is therefore outside of the scope of the thin capitalisation rules, which only apply to "debt" incurred by domestic corporations (Walter DStZ 1994, 113, 115).
Walter proposes to avoid the thin capitalisation rules by having a foreign shareholder in a domestic holding company (GmbH) enter into an atypical silent partnership with the GmbH. The share of profits paid to the foreign shareholder by reason of this arrangement would escape sec. 8a KStG because the contribution would constitute equity, not debt.
However, the profit share of the foreign silent partner would normally be treated as business income attributable to the foreign partner's deemed domestic permanent establishment and hence be fully subject to German taxation. Walter suggests that this result can be avoided if the GmbH is engaged only in passive asset management. In this case, the foreign silent partner might derive income from capital and so escape taxation. He points out that the tax authorities contend that the silent partner of a domestic GmbH invariably derives taxable business income. As a fallback, Walter suggests using funds borrowed abroad to finance the contribution of the silent partner so as to be able to deduct the financing charges from the profit share, in the event this proves to be taxable.
Oho/Schneider/Behrens (DB 1996, 2516) propose using an atypical silent partnership in combination with tax treaty law. Under their model, the foreign shareholder in a domestic GmbH would also be its atypical silent partner and at the same time its creditor. Because of the silent partnership, they contend that the loan principal would constitute equity for tax purposes and hence fall outside of the thin capitalisation rules. This leaves the problem of German taxation of the interest on the loans as business income attributable to the permanent establishment (which the shareholder is deemed to have by virtue of the atypical silent partnership). Citing a decision of the Federal Tax Court on tax treaty law (BStBl II 1995, 683 - 31 May 1995; see section 7.1 above), the authors contend that interest cannot be assimilated to the profits of the partnership for tax treaty purposes and must instead be taxed under the interest clause of the applicable tax treaty. Typically, this would mean the interest is exempt from German taxation.
8. Selected thin capitalisation issues
Numerous aspects of the thin capitalisation rules are controversial. The following list deals briefly with several of these disputed issues. (Issues covered by article no. 4 are not duplicated below.)
8.1 Challenges under EU law
It is something of a simplification to say that the thin capitalisation rules apply to loans to German corporations from qualified foreign shareholders. Specifically, the law refers to loans to domestic corporations by "shareholders not entitled to the corporation tax credit." These shareholders are defined in sec. 50 KStG. Besides foreign shareholders, domestic tax exempt entities (e.g. charitable organisations, public corporations) fall into this category. While foreign persons are entitled to the corporation tax credit if they hold the shares in the distributing corporation in a domestic business, including a partnership, a special anti-avoidance provision of the thin capitalisation rules provides in effect that entitlement to the corporation tax credit on these grounds is disregarded for thin capitalisation purposes.
The thin capitalisation rules thus limit the ability of foreign persons and certain domestic persons (e.g. charitable organisations) to fund their corporations with debt as opposed to equity capital. On the other hand, no limits are imposed on loans by non-tax-exempt domestic persons to their corporations (as long as such loans are not routed through offshore financing companies - see section 8.7 below).
Critics attack this regime as incompatible with the principle of free establishment of businesses throughout the European Union (Article 52 of the EEC Treaty). They see the thin capitalisation rules as essentially imposing limits on non-German EU residents which are not imposed on German residents. The defenders of the thin capitalisation rules call attention to the large group of domestic persons covered (i.e. tax exempt organisations, public sector corporations) and state that, as far as is known, such domestic persons account for half of all shareholders not entitled to the corporation tax credit. Furthermore, they state that the thin capitalisation rules ensure, within limits, that domestic profits are subject to domestic taxation, and that this is a legitimate goal under EU law.
8.2 Challenges under tax treaty law
It is sometimes assumed that Germany's tax law gives international treaties priority over domestic law and thus precludes treaty overriding. While this is not true, the intention of the German legislature in enacting sec. 8a KStG was not to override existing treaty law.
In case of incompatibility of the thin capitalisation rules with the provisions of a tax treaty, it is therefore the tax treaty which will prevail.
Various authors have examined tax treaty issues posed by the thin capitalisation rules and in many cases expressed doubts on at least certain aspects of the new statute. Even those who believe that the requalification of interest as dividends under sec. 8a KStG is itself permissible under typical German tax treaties admit that problems may arise in securing a corresponding adjustment in the foreign taxpayer's country of residence.
The conclusions reached on tax treaty issues by Portner in a lengthy two-part article (IStR 1996, 23 and 66) are as follows:
The provisions of sec. 8a KStG are invalid if incompatible with the arm's length principle (cf. Article 9 of the OECD Model Treaty).
With respect to conventional loans paying remuneration defined as a fraction of loan principal, the rules of sec. 8a KStG are consonant with the arm's length standard, in no small measure because of the arm's length exception to the rigid quota for such loans (see section 5.1 above).
The rules with respect to other loans (e.g. profit-linked loans, hybrid financing) violate the arm's length standard. However, certain German tax treaties already treat at least certain types of hybrid financing (e.g. "typical" silent partnerships) as dividends.
Most German tax treaties lack terms which compel the foreign taxpayer's state of residence to make a corresponding adjustment in response to the German requalification of interest under sec. 8a KStG. A few tax treaties are, however, worded so that the source country's definition of "dividends" is binding on the other treaty state. For the tax treaty with the U.S., such an intention is expressed in the German Explanatory Report on the treaty. However, in most cases the treaty definition of dividends is not broad enough to cover deemed dividends under sec. 8a KStG, in part because the theory of the law is a requalification of the payments without requalification of the underlying debt as equity.
When a loan covered by the thin capitalisation rules is made by a foreign affiliate of the direct shareholder, interest paid on the loan should be governed by the interest article of the tax treaty, not the dividend article. Any withholding tax imposed on such payments would therefore be refundable since Germany's tax treaties typically exempt interest from taxation in the source country.
8.3 Conventional loans and other loans
A 3-to-1 debt-to-equity ratio applies to loans if the payment for the use of capital is defined as a fraction of the principal amount ("conventional loans"). The ratio for all other loans (e.g. loans linked to profits or sales - "non-conventional loans") is only 0.5-to-1. Furthermore, the arm's length exception (see section 5.1 above) and the increased 9-to-1 ratio for holding companies (section 4 above) are only available for conventional loans.
There are a number of cases in which the categorisation of a loan as conventional or not is disputed. Notably, item 55 of the 1994 directive issued by the tax authorities interpreting the thin capitalisation rules states that an agreement to defer payment of interest in loss years will cause an otherwise conventional loan to become non-conventional. This view is contradicted by a number of articles in professional journals, including that by Janssen (FR 1997, 333, 335/2). Janssen argues that a loan does not become non-conventional merely because the time of payment of accrued interest is defined with respect to e.g. profits. The same applies if payment is deferred until profits are earned.
8.4 Conditional waiver of loans
Waiver of debt claims is frequently subject to a clause providing that the loan shall be reinstated or revived if a certain condition subsequent is fulfilled, for instance, if the debtor's financial situation improves and he re-enters the profit zone (so-called waiver with recovery agreement - Besserungsschein). Such agreements between shareholders and their corporations have been sanctioned by the Federal Tax Court with the added proviso that reinstatement of the loan can lead to reinstatement of interest for the period of the waiver as well. There is dispute in the literature as to whether such reinstated interest falls into the conventional or non-conventional category (e.g. Herlinghaus DStR 1994, 1830, 1831: conventional; Janssen FR 1997, 333, 336: non-conventional). Obviously, a great deal can turn on the answer to this question. It appears virtually certain that the tax authorities will seek to treat such retroactively reinstated interest as paid with respect to a non-conventional loan and hence subject to the reduced safe haven of 0.5-to-1.
Conditional waiver of loans raises other issues as well, however. Waiver of a loan by a shareholder results in an increase in equity in the commercial accounts of the debtor corporation. Since the debt-to-equity ratio for thin capitalisation purposes is calculated with respect to the commercial accounts, this ratio is reduced by the waiver, which both lowers debt and raises equity. If there are several shareholders, the pro rata share of equity of the waiving shareholder may not increase by the full amount of the waiver, however. Leaving this aside, two questions arise when the condition subsequent is fulfilled and interest is retroactively due for the period of the waiver:
What account is to be taken of the waiver in calculating the safe haven for the reinstated interest? Specifically, should the safe haven during the years for which the interest is retroactively due also be retroactively recalculated as if the waiver had never occurred?
If so, is this recalculation also appropriate with respect to shareholder debt which was not waived?
Herlinghaus (DStR 1994, 1830, 1833/1) answers both questions in the affirmative. To use his example: A domestic corporation with equity of DM 1 million owes a debt of DM 6 million with interest at 10 % to its sole shareholder, a foreign corporation. At the end of Year 01, the sole shareholder waives DM 1.8 million of the debt claim subject to a reinstatement clause. This causes equity to increase to DM 2.8 million and debt to fall to DM 4.2 million, yielding a debt-to-equity ratio of 1.5-to-1. Interest is paid on the remaining DM 4.2 million of the loan in Years 02 and 03. In Year 04, the condition subsequent is fulfilled and the waived portion of the debt (DM 1.8 million) reinstated. The corporation pays back interest for Years 02 and 03 (DM 180,000 for each year).
According to Herlinghaus, the debt-to-equity ratio should be recalculated for Years 02 and 03 upon retroactive reinstatement of the loan, leading to a debt-to-equity ratio of 6-to-1. Both the retroactive interest on the waived portion of the loan and a portion of the regular interest on the portion which was not waived (i.e. interest on DM 1.2 million for each year) are requalified as constructive dividends under sec. 8a KStG.
It is again noted that the reinstated interest might well be subject to the reduced 0.5-to-1 safe haven for non-conventional loans. If this assumption is added to the approach advocated by Herlinghaus, retroactive reinstatement of interest leads to requalification of virtually all interest paid for the Years 02 and 03. Interest on the retroactively reinstated loan (DM 1.8 million) is allowable only in an amount of DM 50,000 (10 % of DM 500,000) for each year (debt-to-equity ration 0.5-to-1 or DM 500,000-to-DM 1 million). Since the safe haven for non-conventional debt has been exhausted, no safe haven at all exists for conventional debt (see section 3 above), hence all remaining interest for Years 02 and 03, retroactive and regular, is requalified as a constructive dividend.
8.5 Requirement of 25+ % shareholding
The thin capitalisation rules only apply to debt financing of a domestic corporation with respect to which some shareholder holds an interest, measured by stated capital, which exceeds 25 %. Attribution rules apply in calculating the shareholding.
The prevailing opinion is that crossing the 25 % threshold is in itself sufficient to bring the thin capitalisation rules into play. Janssen (IStR 1998, 11 and 43) argues, however, that crossing the 25 % threshold merely establishes a rebuttable presumption that the shareholder in question can exercise "significant" or "determining" influence (massgeblicher Einfluss) on the corporation in question.
The premise behind Janssen's argument is that requalification of interest as a constructive dividend is only justified, and only intended, if there is reason to suppose that the creditor had sufficient influence over the debtor corporation to induce it to accept excessive debt financing. Consequently, Janssen further argues that indirect shareholdings in the debtor corporation are only of significance if the person to whom they are attributed holds a 25+ % interest in each of the intervening entities. Otherwise, Janssen points out that the indirect shareholdings are of no consequence because they do not add up to significant influence over the debtor corporation.
Example
Foreign Shareholder S holds a 7 % interest in Z-GmbH. He also holds 20 % of the shares in X-GmbH, which in turn holds the remaining 93 % of the shares in Z-GmbH.
According to Janssen, Shareholder S does not hold a 25+ % share in Z-GmbH because his stake in X-GmbH is too small to warrant attributing to him a pro rata share of the stake of X-GmbH in Z-GmbH. Under the majority view, which is also that of the tax authorities, a pro rata attribution to Shareholder S is always possible no matter how slight his stake is in the other entities in the chain of attribution (20 % x 93 % = 18.6 % + 7 % = 25.6 %).
On the other hand, Janssen concurs with the tax authorities (item 12 of the thin capitalisation directive) in attributing all of the shares held by an intervening entity in the debtor corporation to the indirect owner if the indirect owner controls the intervening entity. "Control" (Beherrschung) represents a higher degree of influence compared with "significant" or "determining" influence and hence justifies attribution in full.
Example
Foreign Shareholder S holds a 60 % stake in X-GmbH which in turn holds 45 % of Z-GmbH. Shareholder S is a related party of X-GmbH because its stake in X-GmbH is 25 % or more (sec. 1 (2) AStG). The stake of S in Z-GmbH is 45 % for thin capitalisation purposes. The stake of the intervening corporation is attributed in full to S because S controls this corporation.
8.6 Relationship to standard constructive dividend rules
Constructive dividends under the thin capitalisation rules are less costly for the shareholder than "normal" constructive dividends because the requalified interest payments remain deductible expense for trade tax purposes, subject to the standard trade tax denial of one half of interest paid on long term debt.
The tax authorities (item 3 of the thin capitalisation directive) and the majority opinion regard the normal constructive dividend rules as having priority over those of sec. 8a KStG in all cases. This is to say, payments constituting constructive dividends under both sets of rules will be treated as normal constructive dividends, which is more costly to the taxpayer.
Janssen (DStZ 1997, 180) challenges this view with regard to sums paid on non-conventional loans (e.g. profit-linked loans), for which the thin capitalisation rules should in his opinion take precedence over the normal arm's length constructive dividend principles to the extent the capital loaned is outside of the safe haven. His reasoning mirrors that of Koester (RIW 1994, 310, 312). In general, the legislative history indicates, under their reading, that the thin capitalisation rules were intended to take precedence to the extent the safe havens were exceeded. However, for conventional loans the arm's length exception applies in addition to the safe haven. The exception will generally apply for conventional loans at rates of interest exceeding the safe haven because an unrelated third party would have been willing to make the loan at the higher rate of interest. The non-applicability of sec. 8a KStG in such cases permits the general rules to apply. For non-conventional loans there is no arm's length exception, however. Hence the thin capitalisation rules, not the standard rules, apply to non-conventional loans which exceed the safe haven and which are at an inflated rate of interest or remuneration.
8.7 Offshore financing of German-based groups
Item 19 of the thin capitalisation directive provides that the statute applies to loans made by foreign related parties of domestic shareholders (shareholders entitled to the corporate tax credit) as well. This is intended to bring loans by offshore financing subsidiaries of German companies within the scope of the thin capitalisation rules.
Example 1
German Parent Corp. holds 100 % of German Sub and 100 % of Offshore Financing Sub. Offshore Sub loans money to German Sub.
Example 2
German Parent Corp. holds 100 % of German Sub which in turn holds 100 % of Offshore Financing Sub. Offshore Sub loans money to German Sub (i.e. to its own parent).
Depending on how one interprets the statute, the situations in the examples may fall outside of the scope of the thin capitalisation rules because they do not involve loans by a foreign party related to a foreign shareholder. Instead, the loans come from a foreign party related to a domestic shareholder.
The examples are drawn from Ammelung DB 1996, 600. The chances nevertheless appear good that the courts will uphold the tax authorities' reading of the law because it is in keeping with the legislative intention of preventing domestic profits from escaping domestic taxation. With respect to this goal, it makes no difference whether the ultimate owners of the profits are domestic or foreign persons.
9. Summary
After four years of operation, the German thin capitalisation rules are still riddled with unsettled questions. However, these relate mostly to marginal issues. The regime established by the rules has proven to be a fairly gentle one. Most taxpayers prefer to conform to the rules rather than intentionally venture into their grey areas. The safe havens established are generous in international comparison and permit considerable profits to be shifted from Germany to a lower tax jurisdiction. Furthermore, there are a number of exceptions which taxpayers may be able to exploit. Finally, alternative structures exist which circumvent the thin capitalisation rules entirely, albeit in some cases with a certain measure of risk.
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