United States: New Circular of German Ministry of Finance Regarding Thin Capitalization Rules

By Dr. Ingo Kleutgens, Heiko Penndorf and Dr. Patrick Sinewe

Originally published August 2005

The Federal Ministry of Finance has given further guidance on the interpretation of German thin capitalization rules in a Circular dated July 22, 2005 ( "the Circular"). The Circular follows a previous Circular of the German Federal Ministry of Finance, dated July 15, 2004, which was released after the new thin capitalization rules came into force on January 1, 2004. The Circular contains comments on current open cases relating to several banks involved in debt financing.

German thin capitalization rules as set out in section 8a of the German Corporate Income Tax Act ("CITA") relate to shareholder loans /related party loans and provide that the borrower does not get an interest deduction if the loan is in excess of 1.5 times the equity of the borrower. Under section 8a paragraph 1 sentence 2 CITA the thin capitalization regime also applies to third party debt if the lender can take recourse against the (substantial) shareholder or a related party of the shareholder. In practice such third party loans are usually made by banks. Under the rules such bank loans become subject to thin capitalization rules if the bank is secured by share pledges, guarantees or other forms of collateral granted to it by the shareholder or another party related to the shareholder.

Shortly after the new thin capitalization rules were introduced in 2004 it became apparent that the tax effects of the new rules went beyond the purposes originally intended. For instance, in the case of a bank loan which is subject to the thin capitalization rules the lending bank, if taxable in Germany, would have to pay taxes on the interest earned from the loan in Germany. At the same time the thin capitalization rules had the effect that the borrower would not get a tax deduction for the interest expense with the further consequence that his taxable gain was increased or his net operating losses were reduced.

Given that the interest payments are characterized as dividend payments to the shareholder and – where the shareholder is a corporation – 5% of such dividend payments are subject to corporate income tax, the overall tax burden arising from the taxation of the interest payments was increased compared to the situation where the interest payments are fully deductible at the borrower’s level and are subject to income tax at the level of the bank only.

For this reason the German Ministry of Finance acknowledged in the previous Circular that a restrictive interpretation of the thin capitalization rules was necessary. It was therefore decided that only in a so-called "back-to-back" situation should third party loans become subject to the thin capitalization regime.

Under a back-to-back arrangement the shareholder or a related party makes a capital contribution to a bank by way of a loan and the bank "turns around" and lends this money to a subsidiary of the shareholder/related party. A bank loan which is backed up by a contribution by the shareholder to the bank will be subject to the thin capitalization rules if the bank has a recourse right against the shareholder in respect of that bank loan. Following the limitation of the thin capitalization rules to back-to-back arrangements it is only that portion of the interest which the shareholder generates through its capital contribution to the bank which is disregarded for interest deduction at the subsidiary’s level and, instead, characterized as a dividend distribution to the shareholder of the borrower. In other words: to the extent a back-to-back situation does not exist the thin capitalization rules do not apply to third party loans.

Although these clarifications were well received in the banking industry some questions remained open. In particular, the position was unclear where the shareholder and the subsidiary were using two banks, i.e. one bank to which the shareholder made his capital contribution and a second bank which financed the subsidiary. On a literal interpretation of the above clarification it seemed that by using two banks the shareholder was able to secure the bank loan made to the subsidiary without taking the risk that interest paid under the bank loan was not deductible.

Tax experts soon decided that a back-to-back arrangement could also exist under the "double bank concept", i.e. if the financing bank could obtain recourse against the bank where the shareholder was keeping his deposit, this could be regarded as the shareholder using just one bank for both keeping his deposit and financing the subsidiary. As the thin capitalization rules also required the financing bank to have a right of recourse against the shareholder it remained an open question whether such recourse rights needed to relate to all of the shareholder’s assets (e.g. through a guarantee) or if the recourse needed to specifically relate only to the claim of the shareholder against the deposit bank. The problem was that if a general guarantee qualified as a back-to-back arrangement, that would probably undermine the limitation of the thin capitalization rules set out in the previous circular.

In the latest Circular the German tax authorities have now decided to clarify the latter position, so that a general recourse right of the financing bank does not suffice to qualify for a back-to-back agreement. However, the German tax authorities have taken the position that if the shareholder accepts any limitation of his right to dispose of his claim for his deposit against the bank in favor of the bank financing his subsidiary such agreement will be regarded as a back-to-back arrangement with the lending bank. In the Circular the tax authorities have also specified different situations where such limitation of the right to dispose over the claim for the deposit exist:

As mentioned any pledge over a bank account made in favor of the bank financing the subsidiary/related party of the shareholder is regarded as harmful under the thin capitalization rules.

Example (taken from the Circular):
Bank A makes a loan to a German GmbH. The shareholder of the GmbH maintains a bank account (interest bearing) with Bank B and pledges this bank account to Bank A. Under the Circular a tax-ineffective third party loan is given and the interest paid under the third party loan is not deductible to the extent that the shareholder receives interest from Bank B.

A back-to-back arrangement also exists if the shareholder or a related party has a claim against the deposit bank and the shareholder or the related party has agreed for the benefit of the third party lender a limitation of his right to demand repayment of his deposit.

Example (as mentioned in the Circular):
Bank A grants a loan to a German GmbH. The shareholder maintains a savings deposit account with Bank B and guarantees the repayment of the third party loan. If the shareholder enters into an agreement with Bank A according to which the shareholder will not dispose of the savings deposit until the repayment of the loan, a harmful recourse right under the German thin capitalization regime is given and the interest paid under the shareholder loan is (partly) non-deductible.

Following this example the tax authorities also presume arrangements to be harmful for purposes of the thin capitalization rules under which a shareholder is free to make disposals over his bank account held at Bank B but has given a guarantee in favor of Bank A together with the right for Bank A to realize the assets of the shareholder if the subsidiary (i.e. the borrower) does not meet its payment obligations.

The Circular clarifies the interpretation of "recourse" for German thin capitalization purposes. From the view of the banking industry the most important effect of the Circular of July 22, 2005 is the certainty that it is not just any kind of security which can trigger the application of the thin capitalization rules but only security which is specifically legally related to the deposit held by a bank other than the bank which has made the loan to the subsidiary.

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