Challenges Inherent in Addressing Debt and Equity Financing - And How Germany Went Over the Top

• Author: Christian Dorenkamp
• Position: LL.M. (NYU Int?l Tax), Attorney at Law.
• Pages: 1-20

European Tax Studies 1/2010

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Challenges Inherent in Addressing Debt and Equity Financing

– And How Germany Went Over the Top

Christian Dorenkamp1

1. Introduction

Financing a company with either equity or debt provides for an entirely different tax

burden at both the investor level and the company level. Consequently, it is not

surprising that the choice between debt and equity is an important issue in everyday’s

tax practice, and also occasionally in abusive schemes. To identify the tax policy

needs resulting therefrom is an essential concern of this article.

Particular attention is given to cross-border debt financing. Here, specifically, tax rate

differentials provide for tax planning opportunities that can, in the absence of

defensive legislation, also be used in an abusive manner. In particular this holds true

for the so called thin capitalization and fat capitalization schemes, i.e. the under-

capitalization of domestic subsidiaries of foreign corporate groups on the one hand

(thin cap) and the over-capitalization of foreign finance subsidiaries of domestic

corporate groups on the other hand (fat cap).

Latter-mentioned schemes, however, are to be clearly distinguished from the straight-

forward capitalization of a domestic group with both domestic and foreign subsidiaries

facing financing needs regarding both its domestic and foreign business activities. The

so called interest barrier (Zinsschranke), an internationally unprecedented2 instrument

recently introduced by the German legislative bodies in order to limit the tax

deductibility of interest expenses, needs urgent repair in this respect3. Unfortunately,

1 Dr. Christian Dorenkamp LL.M. (NYU Int’l Tax), Attorney at Law.

2 See, however, for a similar set of rules in Italy § 96 of the Italian Income Tax Consolidation Act (30%

EBITDA plus 5 year carry forward).

3 See also the Coalition Agreement dated October 26, 2009 between CDU, CSU and FDP, page 11

(“modifying the equity escape and making it applicable to German corporate groups”).

European Tax Studies 1/2010

© Copyright Seast - All rights reserved

2

the so-called equity escape (being in theory designed to provide unlimited interest

deduction to corporate groups that finance their German operations with at least as

much as equity as the overall group average) has not yet been adjusted to eliminate

the devastating effects of the so-called book value reduction

(Beteiligungsbuchwertkuerzung).

This holds true notwithstanding the fact that it is well known even within the German

tax administration that virtually no German-based corporate group can avail itself of

the aforementioned equity escape. Accordingly, virtually all German-based corporate

groups are denied the full interest deduction even though presumably the vast

majority of them provide for a well above-average equity financing within their home

country. A modification of § 4h of the German Income Tax Act4 (ITA,

Einkommensteuergesetz) thus remains one of the most urgent tasks of corporate tax

policy in Germany.

2. Distinguishing Debt and Equity in Germany

To distinguish between either equity or debt financing for purposes of the German tax

law is rather simple. This is because the tax law in this respect generally follows the

German Commercial Code (Handelsgesetzbuch5) providing for straight-forward and

consistent debt equity rules (compared, for instance, to the United States, where the

tax courts apply a numerous factor test for this purpose6).

The relevant characteristics for equity are subordination (behind debt in case of

insolvency), sustainability (no right of cancellation and thus open-ended commitment)

and participation in losses and profits of the company7.

A specific tax regime is provided only by § 8(3)(2) of the Corporate Tax Act8 (CTA,

Körperschaftsteuergesetz). According to this provision, payments are deemed to be

4 § 4h ITA.

5 HGB.

6 See William T. Plumb, The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a

Proposal, 26 Tax Law Review 369, 1971

7 See with respect to the application of these criteria to different types of legal entities Wolfgang Schoen

e.a., Debt and Equity – What’s the Difference – A Comparative View, B.III.1, Social Science Research

Network (SSRN).

8 § 8(3)(2) CIT.