Will the German interest deduction limitation rules be found unconstitutional? Action steps for taxpayers as the courts decide

by DLA Piper

In a decision dated December 13, 2013 but only published recently, Germany’s Federal Tax Court has suspended execution of a German corporate income tax assessment to the extent that it was levied on the basis of the application of the German interest deduction limitation rules.

The deductibility of interest expenses by businesses, in particular by corporations, is limited to 30 percent of German tax EBITDA (earnings before interest, tax, depreciation and amortization) under German tax laws.  Certain exemptions may apply, one of them being that interest may be fully deductible if the aggregate interest expenses fall below €3 million per year.  If interest expenses exceed such limit, then the interest expenses may only be fully deductible if the entity paying interest does not belong to a fully consolidated group or if certain equity ratios are met.  (The two latter exceptions also entail further detailed requirements.)

In the case decided by the German Federal Tax Court, the relevant interest expenses exceeded the threshold.  The corporation filing for suspension of execution of tax assessed belonged to a fully consolidated group and the relevant equity ratios were not met.  Therefore, the German interest deduction limitation rules applied.

The German Federal Tax Court held in a summary judgment, however, that there was a high likelihood that the German interest deduction limitation rules were unconstitutional.  In particular, it held that the ability-to-pay principle was violated.  That principle must be implemented consistently in German tax law.  Due to the limitation of the deductibility of interest payments, more than the net income may be subject to corporate income tax.

The court did not see any justification for this violation of the ability-to-pay principle.  In particular, the limitation of the interest deduction may not be justified on grounds of compensation for a statutory reduction of the corporate tax rate or on the basis of collecting additional taxes.  Also, anti-abuse considerations were not applicable because the rules apply to all kinds of financing situations.

Please note that the decision by the German Federal Tax Court is not a final decision of the case.  The case is still to be finally decided by the German Federal Tax Court; the suspension of execution is a mere summary judgment.  Please also note that the German Federal Tax Court may not finally decide on the constitutional law issues involved.  It seems very likely that the German Federal Tax Court will refer the case to the German Federal Constitutional Court, which will have the final say. 

To benefit from this decision and perhaps obtain a potential dismissal of the German interest deduction limitation rules, taxpayers subject to the German interest deduction limitation rules should do the following:

  • For tax returns that are still to be filed (for instance, for 2013): the position might be taken that the German interest deduction rules do not apply.  This position should be explained in an accompanying cover letter.  Should taxes nonetheless be paid on the basis of the application of the German interest deduction rules, interest would accrue on a future potential tax refund after having filed an objection.
  • Objections may be filed against tax assessments within one month after receipt.  The status of all tax assessments should be reviewed.
  • Should the one-month objection period already have lapsed, review whether tax assessments are preliminary or not.  If a tax assessment is marked as preliminary, the taxpayer can still make a motion to have the tax assessments amended.
  • Should tax assessments be subject to pending objection proceedings or to pending court proceedings, the assessments need to be reviewed on a case-by-case basis to determine to what extent motions for amendments can still be made.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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