The German Tax Reform 2008 — Impact on Leveraged Transactions

July 11, 2007

On July 6, 2007, the German Corporate Tax Reform 2008 passed all German legislative bodies and will become effective January 1, 2008. The Corporate Tax Reform 2008 does not provide for any grandfather rules for current transactions. For structures involving German entities with deviating fiscal years, the changes might already have impact on fiscal years starting in 2007. The German Corporate Tax Reform 2008 can be divided into two key elements: i) the intended reduction of an overall tax rate for corporations (corporate and trade tax) from 38.6% to slightly below 30%; and (ii) a new general interest deduction limitation rule ("New Rule") which will have a significant impact on leveraged transactions in Germany.

The New Rule abolishes the current German thin cap rules under which interest paid to related parties is deductible as long as the debt/equity ratio of 60% to 40% is complied with. With respect to third party bank debt, the current thin cap rules specifically require that there be no harmful back-to-back financing in place, which can be ensured through a proper structuring of the security package. If a back-to-back financing is excluded, third party bank debt is deductible without further restrictions. Under the New Rule, interest expenses on shareholder loans and third party bank debt are only deductible in an amount equal to the interest income of the German entity and, above that, up to 30% of the EBITDA. The interest expense and interest income definitions are broad and include payments on all instruments where the holder is entitled to either any return of capital or a return on capital. Income or expenses from discounted instruments are treated as interest in this context.

The Corporate Tax Reform 2008 provides for three exceptions to the New Rule: i) the New Rule does not apply to interest expenses (in excess of interest income) less than EUR 1 million p.a. (threshold). If the threshold is exceeded by only EUR 0.01, the total interest expenses are subject to the 30% rule; ii) the New Rule also does not apply if the German entity does not belong to a group for accounting purposes. The German entity is considered to be part of a (global or domestic) group for accounting purposes if it is or could be part of a consolidated group under the relevant accounting standard or is factually controlled by another entity; and iii) the most relevant exception to the New Rule refers to the equity ratio of the German entity. The deduction of all interest expenses may be allowed if the German entity can prove that its equity ratio is higher or equal to the group’s equity ratio as reflected in the IFRS balance sheets at the end of the preceding fiscal year of the German entity and the consolidated group. For purposes of computing the equity amount of the German entity, the book value of shares in subsidiaries (outside a fiscal unit) must be deducted. Even if such proof can be provided, the exception to the New Rule does not apply if 10% or more of the interest payments are made to related parties or third parties having a recourse right against the related party and the related party does not belong to the relevant group. Pure intra-group interest on shareholder loans is not taken into account. Neither do upstream, downstream and cross-stream securities within the group lead to a harmful recourse. However, even if one member of the group (irrespective of its domicile) receives a harmful shareholder financing from outside the group, the exception to the New Rule is not applicable and the interest expenses of the German entity are only deductible up to 30% of the EBITDA. Any interest expenses not deductible in a fiscal year will be carried forward to the subsequent fiscal years when the net interest expense is below the 30% threshold, provided there is no change of control in the German entity as a result of mergers, contributions or similar transactions.

The New Rule also impacts tax treatment at the level of the financing shareholder. Under the current German thin cap regime any interest payments on shareholder loans which exceed the relevant debt/equity ratio are re-qualified as constructive dividends and are subject to German withholding tax of 20%. Foreign shareholders must rely on an applicable tax treaty or on the European Parent/Subsidiary Directive to reduce German withholding tax. Under the New Rule, interest payments on shareholder loans remain fully taxable without any re-qualification at the level of the financing shareholder. That means, in essence, that non-deductible interest expenses are taxed twice, at the level of the German entity and at shareholder level. However, a foreign shareholder who wishes to highly leverage the German entity (at arm’s-length interest rates) may benefit from the New Rule if he structures the debt financing through the interposition of a low-taxed entity. Interest income generated by a foreign low-taxed entity is not subject to German taxation or withholding tax, even though the lender is not treaty-protected unless the loan is secured by German real property. 

In short, under the New Rule related party debt and third party bank debt will no longer be treated differently. The related party debt will only play a role in determining whether the German entity can apply for the exception to the New Rule.

What can be done to mitigate the effect of the New Rule? One alternative is to increase the interest income of the German entity. Only interest expenses net of interest income are subject to the New Rule, if the interest expenses (in excess of interest income) exceed the threshold of EUR 1 million p.a. Under the current German thin cap rules the threshold amounts to EUR 250.000 and applies to interest payments on shareholder loans without considering any interest income.

An increase of the German entities’ equity and/or a decrease of the non-German entities’ equity may help to fall under the exception clause. Besides customary capital measures (e.g., capital contribution or capital reduction), this can be achieved by a restructuring of the group or by creating a fiscal unit. Since the equity amount of the German entity will be reduced by the book value of shareholdings in other group companies, the shareholdings of the German entity can be transferred to other group companies or subsidiaries transformed in permanent establishments. For purposes of the calculation of the equity ratio under the New Rule, German parent company and German subsidiaries are viewed as one entity if they create a fiscal unit. A fiscal unit is possible with a consolidated German corporation. Shareholdings within a fiscal unit do not reduce the equity amount of the German parent company.

Another alternative is to avoid interest expenses at the German entities’ level. Existing debt may be transferred to other non-German group entities or replaced by other financing instruments. Off-balance sheet or sale-and-lease back structures may reduce the need for additional debt in the German entity. The New Rule only refers to interest payments in cash. Lease rents or royalties do not fall under the New Rule (exceptions exist for trade tax purposes). 

It is therefore expected that the New Rule will lead to the implementation of alternative financing instruments for German entities and the reorganization of existing intra-group financing structures in order to secure interest deduction in Germany.


Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work or Hans Martin Schmid (+49 89 18933-189, mschmid@gibsondunn.com) or Christian Schmidt (+49 89 18933-189, cschmidt@gibsondunn.com) in the firm’s Munich office.

© 2007 Gibson, Dunn & Crutcher LLP

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