New tax rules concerning non-deductibility of interest expenses, forfeiture of loss carry forwards, and tax on relocation of functions will require checking and/or rethinking of investment, financing, and group structures in order to avoid surprises at the level of German corporate tax. The legislative process on a draft law on venture capital activities should be monitored to keep abreast of the tax and regulatory framework for venture capital activities in Germany. Bottom line adverse effects may be avoided or mitigated if business/finance plans and structures are adapted in the light of the new law.
The recently enacted German Corporate Tax Law Reform 2008 will significantly affect private equity transaction planning, and business and group finance structures involving German companies. Most of the new law applies with effect as of January 1, 2008 and/or for fiscal years ending in 2008, respectively.
The main reason for the tax reform was to make German corporate tax rates competitive with other European countries’ rates. The German corporate tax rate is now reduced from 25% to 15%, resulting in an overall tax rate for corporations of approximately 29.8% (down from nearly 40%), including the municipal trade tax and the Western-Eastern Lander solidarity transfer surcharge tax.
Not surprisingly, this significant rate reduction comes with a drawback. To set off the loss of tax revenues resulting from the rate cut, among other things, the tax reform introduced less advantageous tax base calculation and depreciation rules and, particularly relevant for the private equity market, new interest deduction limits and the exclusion of loss carry forwards post-acquisition. Also note-worthy is a new tax on the relocation of company functions.
New interest deduction limits
Saying farewell to traditional debt-equity ratio rules, the German tax reform introduced an entirely new concept to limit the deductibility of interest expenses with a view to avoiding abusive financing structures. The new rules apply to both corporations and partnerships.
30% limit rule: The total “net interest expenses” after set off with interest income may only be deducted from the tax base to the extent they do not exceed 30% of EBITDA. EBITDA is to be calculated under the IFRS rules. There are three exceptions to the general rule:
(i) Basket amount: If the net interest expenses do not exceed EUR 1 million, they are fully deductible.
(ii) Independent company: The 30% limit does not apply if the company is not a member of, or is only partly a member, of a corporate group, and the company has not paid interest of more than 10% of the net interest expenses (a) to any shareholder holding directly or indirectly more than 25% of the share capital or (b) to any person related to such shareholder or (c) to a “harmful” third party lender having recourse against such shareholder or related person
(e.g. by way of guarantees).
(iii) Group debt-equity ratio comparison: The 30% limit does not apply if, as of the end of the previous fiscal year, the debt-equity ratio of the company is the same as, or not more than 1% higher than, the company’s group overall debt-equity ratio, and the foregoing threshold of 10% of the net interest expenses is complied with as regards any interest paid by any group entity to any qualifying (>25%) shareholder of any group entity (or related person or “harmful” third party lender, respectively) - i.e., roughly speaking, a qualifying shareholder may not have contributed more than 10% of the group’s loan financing.
Non-deductible interest is carried forward. The new interest deduction rules apply for the first time to fiscal years beginning after May 25, 2007 and ending not before January 1, 2008.
For most private equity transactions, due to the usual group context resulting from investing companies’ other holdings, the exemption item (ii), above, will not be available. Therefore, depending on the importance of the German investment, local and/or group-wide financing structures may need some adaptation in order to take advantage of one of the exemptions (i) (basket amount) or (iii) (group debt-equity ratio), respectively.
Exclusion of loss carry forward post-acquisition
Under previous law, loss carry forwards were forfeited where the economic identity of a company was changed significantly. This was generally presumed if at least 50% of the company’s share capital was transferred and the operations continued with predominantly new operating assets, a rather vague concept when applied in practice.
The new rules are clear cut, but result in an automatic forfeiture of loss carry forwards. Where more than 50% of a company’s share capital is transferred within a five-year period, losses can no longer be carried forward and are “lost” for tax purposes, regardless of whether there was or was not any change in the company’s operations. There is a limited pro rata loss carry forward if only 25-50% of the share capital are acquired within a five-year-period, whereas acquisition of less than 25% of the share capital during such period does not affect loss carry forwards.
More inventive (or circumventive) structures are also covered: any capital increase changing the respective participation ratios of shareholders is deemed a transfer of share capital for the purposes of the foregoing rules. Furthermore, apart from any direct or indirect transfer of share capital, the rules also apply to the transfer of other participation rights, voting rights and/or any similar fact patterns.
The new loss forfeiture rules, applicable to tax year 2008 and share transfers after December 31, 2007, will significantly affect venture capital transactions, which typically are made during a company’s loss phase. It is often difficult to keep VC-funding and share capital ownership below the new 25% or 50% thresholds for any 5-year period, particularly as the new interest deduction limitations (see below) may not necessarily permit a shifting to loan-based financing structures. Trustee-type shareholding arrangements that on its face would help to avoid exceeding the above thresholds might be viewed as a similar fact pattern or a circumvention arrangement covered by the loss forfeiture rules (although there is not yet any ruling directly on point).
Draft law on venture capital companies
In the light of the disincentive effect on risk capital investments, the government introduced a bill regarding venture capital companies that would, among other things, provide for a limited exemption from the foregoing loss carry forward forfeiture rules. The draft law’s usefulness for international transactions appears limited. It currently only applies to German-based venture capital companies which may not be part of a corporate group for more than five years after having obtained a German government license for venture capital activities (in accordance with new regulatory requirements such as minimum capital of EUR 1 million). Loss carry forwards would be maintained only up to the amount of the silent reserves of the target company, provided that the target is a non-listed corporation that has been established in the European Economic Area (EU plus EFTA countries) for no longer than 10 years and whose share capital is not in excess of EUR 20 million. The transfer of the shares to a third party during a four-year minimum holding period would result in a loss of the exemption and trigger forfeiture of such (limited) loss carry forward. The draft law is still pending at Parliament and it remains to be seen what will come out of the legislative process and whether broader regulatory requirements would ensue.
Tax on relocation of company functions
Restructuring plans for the post-acquisition phase will need to take account of the new German tax on the relocation of company functions. In an attempt to tax the relocated profit center potential, the tax reform introduced a tax on the intra-group outsourcing of company functions to a new location outside Germany to be determined on the basis of the (theoretically higher) value of the overall transferred package rather than only individual asset valuations. The details of this new tax regime are still unclear, but the German tax administration has announced that it intends to apply the new rules introduced by the tax reform even if requisite implementing regulations are not adopted in time. The new relocation tax regime has drawn substantial criticism, given its potential to create double taxation situations.