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Court Expresses Doubts on German Interest Barrier Rules
A recent ruling of Berlin-Brandenburg tax court implies that the German interest barrier rules are not in line with the constitution and therefore violate the so-called ability-to-pay principle. This statement was sufficient for the Court to suspend the enforcement of a corporate income tax assessment notice. Taxand Germany assesses the outcome of the Berlin-Brandenburg court's ruling in light of the contradiction with a previous ruling of the tax court in Munich.
The case at hand affected a Luxembourg company owning real estate in Germany. The company was partly financed with debt for which it had to pay interest. According to the German interest barrier regulations, unlimited deduction of interest expense is allowed up to the amount of interest income and above that up to 30% of the tax EBITDA (taxable income + interest expenses - interest income + depreciation and amortisation). These restrictions however do not apply if (i) the net interest expense of an entity is less than three million Euro in a tax year, and (ii) the entity does not belong to a group or its equity ratio is not lower than the equity ratio of the whole consolidation group (2% deviation is accepted).
In the tax Court's ruling, the company achieved a positive taxable profit after the application of the interest barrier rules even though it actually suffered losses from its business activities. Taxes were assessed on this profit.
The tax Court was of the opinion that these regulations violate the ability-to-pay principle - one of the basic principles of taxation - because the company needed to pay taxes on "virtual" profits although it suffered losses. Interest expenses which have arisen due to normal business activities were not allowed to be deducted from the income. Therefore, the rules might be not in line with the constitution. Subsequently the court criticised that the interest barrier rules can also be applied retroactively which means that investment decisions made before the introduction of these limitations are affected because the regulations apply already for fiscal years which start after May 25, 2007 and do not end before January 1, 2008. This issue should have been avoided by appropriate transition regulations.
The reason for introducing the interest barrier rules was for the prevention of abuse of shareholder debt financing and transfer of taxable profits abroad. However, due to European law these rules also cover inland interest payments. This includes interest payments to shareholders as well as to unrelated third-party banks. As a result all companies are affected, including those that, due to their course of business, have a high equity ratio but do not fulfil the EBITDA requirements.
The tax court recognised these doubts of the constitutionality of the addressed regulations and the clear breach of the principles of meritocratic taxation, i.e. taxation of the actual financial performance as reason enough to suspend the enforcement of the tax assessment notices until these uncertainties are fully clarified.
The opinion of the tax court in Berlin-Brandenburg is in contradiction to decisions of the Munich tax court and the final decision from the Federal Fiscal Court still needs to be announced. This new decision opens the possibility for all companies being subject to German taxation for filing appeals against tax assessment notices. An appeal can be filed within one month after receiving the tax assessment notice. If the appeal was not successful a claim at the proper tax court is possible, also within one month after the decision regarding the appeal has been delivered. Should the decision of the tax court be sustained, a case for the Federal Constitutional Court might arise which might have severe implications on German taxation. If a company fails to file an appeal or a claim within the statutory deadline it might only profit from a possible positive decision of the Federal Constitutional Court if the assessment notices were issued with reservation to a future review or are issued as preliminary assessment with respect to this issue. As the tax assessment notices are currently not issued preliminary, an appeal should be the best way to keep the assessment open.
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