German inbound investments – Increasing tax burden due to new interest deduction limitations?
What is it about & Who is affected?
Germany introduced new limitations regarding interest deductions at the level of taxpayers who are taxable in Germany in the case of cross-border intercompany financing. These new regulations target taxpayers who are part of a so-called “multinational group”, which are subject to
- limited tax liability (such as non-German entities generating taxable income in Germany from the operation of wind farms and solar plants or leasing of real estate, etc.) or
- unlimited tax liability (e.g., German resident entities).
Hence, these new regulations may particularly impact renewable energy, infrastructure or real estate investments in Germany.
Broad understanding of “multinational group”:
It is important to note that the term multinational group may be quite broad since reference is made to related parties in terms of the German Controlled Foreign Company taxation rules (German CFC Rules).
To qualify as such a related party, it is not necessarily required to hold a 25% stake in the share capital of another company or to exert controlling influence. For instance, to qualify two persons as related parties in terms of the CFC rules it may already be sufficient if one has a vested interest in the income realisation of the other.
A multinational group of companies could exist, for example, in relation to a German or non-German investment fund generating income from operating wind turbines in Germany through a Luxembourg holding company.
No grandfathering:
It should also be emphasised that the new rules do not provide for a grandfathering. The new (and additional) interest limitation rules may thus not only effect future loans/financing to be obtained but also existing loans, potentially restricting interest deductions in Germany for the fiscal year 2024 and subsequent years.
Practical effects:
a) General interest deduction limitation
Due to the new rules, interest expenses in the case of a cross-border intragroup financing can only be deducted if the taxpayer can credible evidence that:
(a) They could have satisfied the debt service (i.e., interest and principal) for the entire term of the financing from the outset (so-called Debt Capacity Test), and
(b) There was a business requirement to obtain the financing and the received funds were used for that business purpose (so-called Business Purpose Test).
If these requirements are not met, the interest deduction will be denied in full.
Furthermore, as an additional limitation, the interest deduction is only permitted at an interest rate payable by the company to non-related lenders (e.g., banks), applying the credit rating of the group instead of the rating of the single company, unless it can be demonstrated that a deviating rating, derived from the group rating, is at arm’s length.
b) Special interest limitation for on-lent financing?
In case obtained loans are passed on within a multinational group, the new rules provide for a rebuttable presumption that a low function and low risk service is carried out by the (intercompany) lender. Although the legal consequence of this presumption is not entirely clear yet, this new rule may limit any markup on intragroup loans by applying primarily the cost-plus method according to the explanatory notes of the legislator. Based on the explanatory notes, a markup of 5% to 10% of the directly allocable costs (excluding the financing costs) may be seen as a reference for the markup.
For example, if an Alternative Investment Fund (AIF) obtained third party debt at an interest rate of 3%, which is passed on to its subsidiary receiving German taxable income (e.g., a Luxembourg Sarl operating German wind mills, solar plants or real estate) at a rate of 6%, the deductible intragroup interest rate may be limited to 3%, plus a (slight) markup applying the cost-plus method (instead of 6%).
Recommendation for action:
Fund and asset managers, as well as investors, are urged to review their investment structures very carefully to determine whether the new rules might restrict (or even exclude) the interest deduction in Germany.
It is thus required to determine:
- Whether a “multinational group” exists,
- Whether cross-border financing transactions are in place.
In this regard, it must be considered that investors of a fund may also be part of the “multinational group” or may trigger the existence of a “multinational group” for German tax purposes.
Furthermore, any intergroup debt financing (or a similar transaction) should be thoroughly reviewed, and respective proof should be obtained and properly documented to ensure the interest deduction pursuant the new rules.
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