Business Tax Reform 2008: New Earning Stripping Rules

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1 Newsletter Tax July 2007 Business Tax Reform 2008: New Earning Stripping Rules The upper house of the German parliament (Bundesrat) has passed the Business Tax Reform 2008 Act (Unternehmenssteuerreform 2008) on 6 July 2007 and has, therefore, concluded the ongoing discussions on the proposed amendments to the German tax regime for partnerships and corporations, providing further restrictions of the use of interest deductions and loss carry forwards. The Business Tax Reform Act will come into force from 1 January Among other changes, the Act replaces the current thin capitalisation regime and introduces new interest deduction limitation rules ("earning stripping rules"). In the following, we have outlined the new earning stripping rules which will have an important impact on domestic and cross-border debt financing of German investments. I. Deductibility of Interest Expenses In general, interest expenses deductible under German GAAP are also deductible for both German corporate income tax and trade tax. However, German tax law has provided several restrictions on the tax deductibility of interest expenses which have been subject of substantial amendments over the last few years. Unlike the current thin capitalisation regime which sets out limitations for related party loans (e.g. shareholder or shareholder guaranteed loans), The new interest deduction rules are applicable for all debt financing (including bank financing) of a German tax paying company. The new rules apply to German or n-resident companies irrespective of whether such borrowing companies generate business or n-business (e.g. rental) income in Germany. In particular, The new rules may affect n-resident corporate special purpose vehicles which invest in German real property and which leverage these investments by bank financing. As a general rule under the new earning stripping rules, business expenses are tax-deductible to the extent that the total interest expenses do t exceed the total interest earned in the same fiscal year (interest balance). Moreover, the deduction of interest expenses exceeding the interest balance is generally restricted to 30% of the taxable EBITDA. EBITDA within the meaning of the earning stripping rules is the aggregate amount of domestic taxable income, domestic depreciations and interest expenses less interest earnings. Calculation of taxable EBITDA for German tax purposes taxable profit 900 plus depreciation 100 plus interest expense less interest income -100 Calculation of n-deductible interest expenses overall balance of interest % of EBITDA (2.000) 600 Non-deductible (but subject to an interest carried forward) 400 Taxable income EBITDA 2.000

2 II. Exceptions to the Earning Stripping Rules However, the new law provides for several exceptions under which the borrowing company can deduct (subject to arm's length conditions) all of its overall interest expense. (1) De minimis tax threshold The earning stripping rule is t applicable to the extent that net interest expenses of the borrowing company amount to less than EUR 1 million. (2) Non-group entities If the borrowing company is t a member of a consolidated group (Konzern) the interest deduction ceiling is, as a rule, t applicable provided that there is "harmful debt financing" (as described in more details below). The borrowing company is part of a consolidated group if it is or can be included in that group's consolidated financial statements prepared according to IFRS, local GAAP or US GAAP or if the company's finance and business policy is jointly managed by shareholders. In particular, a consolidated group within the meaning of the earning stripping rules can be assumed if an individual holds shares in at least two controlled corporations. (3) Escape clause The new law stipulates an escape clause for companies that are members of a consolidated group. Under this exception, the earning stripping rule is t applicable to the extent that an "equity ratio" comparison test is met and that there is harmful debt financing. This means, that a borrowing company does t fall within the scope of the interest deduction limitations if its "equity ratio" is t less than 99% of the "equity ratio" of the consolidated group. The equity ratio is the ratio of equity (calculated under the applicable GAAP) to its balance sheet total. Certain adjustments, such as elimination of interests held in other group companies, have to be considered in determining the equity percentage of the company. Generally, the determination of the equity ratios of the company and the group is based on the financial statements provided under IFRS or, in default of such information, under local GAAP. This exception is only applicable if the borrowing company can demonstrate that there is "harm-ful debt financing" for tax purposes. This can be assumed if more than 10% of the net interest expenses of one of the domestic or foreign group companies (i.e. t only the net interest expenses of the German tax paying company) is paid in respect of related party debt (including shareholder, related party and shareholder/related party guaranteed loans). However, such shareholders' financing shall only be harmful if, in addition to the 10% threshold, a loan is granted by a shareholder/related party who is t part of the consolidated group, or if a guaranteed loan by a third party lender is secured by a shareholder/related party who is t part of the consolidated group.

3 III. Comparison of the current thin capitalisation rules and the new earning stripping rules Unlike the current thin capitalisation rules n-deductible interest expenses only affect the borrowing company and are t regarded as constructive dividends. current thin capitalisation rules (FY 2007) new interest deduction limitation (FY 2008 ) advantage of new rules borrower's position n deductible interest corporate/trade tax rate approx. 40% approx. 30% tax burden of borrower domestic corporate shareholder's position corporate/trade tax rate 2 % (constructive dividend, 40% of 5%, add. subject to domestic refundable WHT) approx. 30% (interest income) tax burden of domestic corporate shareholder overall tax burden (borrower & lender) foreign corporate shareholder's position German corporate/trade tax rate 21,1 % (WHT - may reduced by DTC) 0 % ( domestic WHT) tax burden of foreign corporate shareholder 21, ,1 overall German tax burden (borrower & lender) 61, ,1 IV. Restructuring of debt financing The reduction in the combined corporate and trade tax rate in Germany to 29.83% from FY 2008 compared favorably with many other European jurisdictions (e.g. France (34%), Belgium (35%) and Spain (37.3%)). When combined with the new earning stripping rules which seek to shift profits under German taxation there could be both winners and losers in Germany. Potential tax-optimized Measures * Increase of taxable EBITDA of borrowing company * Increase of equity portion of borrowing company * Avoidance of a consolidated group * Uniform repartition of the equity portion within the group * Financing of OpCos instead of HoldCos * Collaterals only be granted by group companies for third party debt

4 If the foregoing exceptions to the new earning stripping rules cant be met, different planning measures may be available to obtain any tax benefits or to mitigate any tax disadvantages which may arise as a result of the changes. For example, taking measures to increase the taxable EBITDA of the borrowing company (e.g. by adopting a more aggressive transfer pricing policy) could lead to a higher interest deduction ceiling. Furthermore, it may be necessary to consider changing the financing structure of German companies to shift deductible interest payments to tax regimes with less stringent thin capitalisation rules and/or to avoid taxable interest income being generated with corresponding tax deduction in Germany. At a glance * Interest paid by a borrowing company is tax-deductible as a business expense provided that the total interest expenses are t more than total interest earned in the same fiscal year (interest balance). * Interest expenses in excess of interest earnings are only deductible up to a maximum of 30% (interest deduction ceiling) of the EBITDA (as calculated under tax law) of the borrowing company. * Non-deductible interest expenses are subject to an interest carry forward. An interest expense carry forward may cease to apply, however, following a reorganisation or any substantial change of ownership (e.g. if more than 50% of the shares in a corporation are transferred to one recipient). * The new rule provides for exceptions: (i) de minimis tax threshold of EUR 1 million; (ii) n-group entities and (iii) escape clause. interest expenses - interest earnings interest balance 0 interest balance < 1 Mio limitation on interest deduction interest balance 30% taxable EBITDA n-group or escape-clause (equity ratio comparison) and 10% of harmful shareholder loans limitation on interest deduction limitation on interest deduction interest ceiling: limitation of interest deduction to 30% of taxable EBITDA

5 Tax Contacts Bird & Bird Germany Patrick Sinewe Skyper, Taunusanlage Frankfurt a.m. Germany Tel.: +49 (0) Fax: +49 (0) patrick.sinewe@twobirds.com Bird & Bird France Anne Quenedey Centre dáffaires Edouard VII 3 square Edouard VII Paris France Tel: +33 (0) Bird & Bird UK Mathew Oliver 15 Fetter Lane London EC4A1JP UK Tel.: +44 (0) Bird & Bird Sweden Christian Luthman Norrlandsgatan 15 Box 7714 SE Stockholm Sweden Tel.: +46 (0) Bird & Bird The Netherlands Pieter Camps Van Alkemadelaan AW The Hague P.O. Box GH The Hague The Netherlands Tel.: +31 (0) Bird & Bird Tax Memoranda provide comments on new developments and issues of interest to our clients and friends. These memoranda do t purport to provide comprehensive coverage of the subject matter and are t intended to provide legal advice. Readers should seek specific legal advice before taking any action with regard to the matter covered. Brussels The Hague Dusseldorf Frankfurt Hong Kong London Lyon Madrid Mailand Munich Paris Peking Rom Stockholm