Deduction of Business Expenses in the Event of Mismatches in Taxation

Deduction of Business Expenses in the Event of Mismatches in Taxation

The regulation of Section 4k of the German Income Tax Act (EStG) is based on the implementation of Articles 9 and 9b of the ATAD Directive of July 12, 2016 (Directive (EU) 2016/1164), as amended by Directive (EU) 2017/952 of May 29, 2017, and was introduced in Germany by the ATAD Implementation Act of June 25, 2021 (Federal Law Gazette I 2021, 2035) to avoid cross-border mismatches in taxation in connection with hybrid arrangements. This affects, for example, constellations in which business expenses are taken into account both domestically and abroad (so-called double-deduction-mismatches) or business expenses are only taken into account domestically, but the corresponding income is not taxable or only taxable at a low rate abroad (so-called deduction-/non-inclusion-mismatches). On December 5, 2024, the German tax authorities published the guidance on Section 4k EStG in which it clarifies definitions and controversial interpretation issues. We present the relevant contents.

Temporal Scope

The regulation of Section 4k EStG is to be applied for the first time to expenses incurred after December 31, 2019 (Section 52 (8d) sentence 1 EStG). A special rule applies to expenses based on a continuing obligation, such as interest, rent or license fees. These expenses, which were legally incurred before January 1, 2020, are considered to have been incurred after December 31, 2019, if they could have been avoided from that date without significant disadvantages, for example by terminating the contract. The regulation of Section 4k EStG is also not applicable to other expenses legally incurred before this date, which are therefore not based on a continuing obligation, if the reduction in income occurs after December 31, 2019.

Personal Scope

Recorded in accordance with Section 4k (6) sentence 1 EStG are first of all cases

  • between related parties within the meaning of Section 1 (2) of the German Foreign Tax Act (AStG),
  • between a (remaining) company and its permanent establishment located in the other jurisdiction, and
  • within the framework of structured arrangements.

It should also be noted that, according to Section 4k (6) sentence 2 EStG, a person who acts in coordination with another person is attributed the other person’s equity interest, voting rights and profit participation rights for the purposes of the regulation in Section 4k EStG. This creates a presumption of relatedness within the meaning of Section 4k (6) sentence 1 EStG.

A structured arrangement exists in accordance with Section 4k (6) sentence 3 EStG if the tax advantage from mismatches in taxation has been included in whole or in part in the terms of the contractual agreements or if these suggest that the parties to the arrangement could expect the tax advantage. Thus, the scope of Section 4k EStG is also opened to constellations between unrelated third parties.

Expenses incurred by a taxpayer are not subject to the restriction of deduction even in the case of a structured arrangement if, based on the external circumstances, it cannot reasonably be assumed that the taxpayer was aware of the tax advantage and, in addition, it can be proven that the taxpayer did not participate in the tax advantage (Section 4k (6) sentence 4 EStG). This exception may be applied in particular to structured arrangements involving bonds issued to third parties via a recognized stock exchange, provided that the interest rate is calculated in such a way that it is also attractive for investors whose interest income is taxed at the regular rate.

Material Scope

Mismatches in taxation caused by hybrid arrangements in the form of so-called deduction/non-inclusion-mismatches usually arise in cross-border cases involving hybrid financial instruments (Section 4k (1) EStG), hybrid entities (Section 4k (2) EStG) or, reversed hybrid entities (Section 4k (3) EStG), which are treated differently in the participating countries either with regard to their equity or debt capital character or with regard to their corporate form (so-called qualification or attribution conflict). Section 4k (2) and (3) EStG can also be relevant for permanent establishment issues with a profit allocation issue.

  • Section 4k (1) EStG restricts the deduction of expenses in connection with hybrid financial instruments such as convertible bonds, hybrid loans, typical silent partnerships, profit participation rights or shareholder loans, when the corresponding income is not taxed or is taxed at too low a rate abroad.

Non-taxation is to be understood as taxation at a rate of 0 %, the factual tax exemption of the income corresponding to the expenses, and the (pro-rata) waiver of the collection of a foreign tax. Low taxation of the income corresponding to the expenses is present if the income is subject to a lower effective tax burden than what would result from a qualification or attribution of the capital assets in accordance with German law. The German level of taxation on corresponding income is not relevant in this comparison. For example, a regulation comparable to Section 3 no. 40 EStG leads to lower taxation in the case of partial tax exemption of income.

The restriction of deduction pursuant to Section 4k (1) EStG only applies if the qualification conflict – usually with regard to the different treatment of the hybrid financial instrument as equity or debt capital – is responsible for the mismatch in taxation that has arisen. If there are other reasons for a non-taxation or low taxation of the income corresponding to the expenses that lie outside the scope of Section 4k EStG, such as the personal tax exemption of the creditor, the restriction of deduction pursuant to Section 4k (1) EStG does not apply. If the mismatch in taxation is likely to be eliminated in a future tax period and the payment terms are in line with an arm’s length comparison, the restriction of deduction pursuant to Section 4k (1) EStG does not apply either.

  • Section 4k (2) EStG restricts the deduction of expenses whose corresponding income is not subject to actual taxation in any jurisdiction due to a taxpayer’s different tax treatment (alternative 1) or due to a different tax assessment of presumed contractual relationships within the meaning of Section 1 (4) sentence 1 no. 2 AStG in matters relating to permanent establishments (alternative 2). Unlike the restriction of deduction pursuant to Section 4k (1) EStG, lower overall effective taxation of the corresponding income compared to the standard taxation abroad does not lead to a (pro rata) deduction restriction of the expenses.

The first alternative of the restriction of deduction pursuant to Section 4k (2) EStG includes expenses of taxpayers in Germany that are regarded as fiscally non-transparent but are regarded as fiscally transparent legal entities abroad – also based on options such as the US entity classification election rule or the check-the-box rule (so-called hybrid entities). These US structures are likely to be of particular relevance because they have often been used in the past to create mismatches in taxation due to the tax options available to companies in the US.

The verification of a possible existing qualification conflict is not limited to the jurisdiction of the creditor but can be extended to other jurisdictions if there is a justified causality of the qualification conflict. A different tax treatment of the legal entity may also be due to its inclusion in a foreign group taxation system, according to which it is considered to be fiscally transparent and, as a result, internal group service relationships are not taken into account for tax purposes.

The second alternative of the restriction of deduction in accordance with Section 4k (2) EStG requires a domestic reference in the form of a domestic company or a domestic permanent establishment, for which fictitious operating expenses or a corresponding exemption amount are taken into account. Consequently, from a German perspective, this does not apply to assumed contractual relationships between a foreign permanent establishment and the remaining foreign company.

The restriction of deduction pursuant to Section 4k (2) EStG is – like the restriction of deduction pursuant to Section 4k (1) EStG - only to be applied if the existing qualification conflict – now either with regard to the deviating tax treatment of the taxpayer or with regard to the deviating tax assessment of the assumed contractual relationships – is the sole cause of the mismatch in taxation that has arisen in the form of the actual taxation. If the expenses are offset by income of the same taxpayer that is actually taxed both in Germany and abroad (so-called double-counted income), the restriction of deduction pursuant to Section 4k (2) EStG does not apply. There are no legal provisions how to proceed if the mismatch in taxation is eliminated in a future tax period.

Furthermore, the non-application of the so-called fractional share treatment is regulated in Section 4k (2) EStG. This is based in particular on the case that a foreign asset-managing partnership is treated as fiscally non-transparent in its country of domicile. Payments made by it to its partner with unlimited tax liability in Germany are thus taken into account and reduce profits there. In principle, the partner does not have to report the income attributed to him/her in Germany due to the so-called fractional share treatment. Consequently, there is a mismatch in taxation that is eliminated by not applying the so-called fractional share treatment.

  • Section 4k (3) EStG restricts the deduction of expenses whose corresponding income is not subject to actual taxation in any jurisdiction due to a different tax allocation or attribution under the laws of other countries. As with Section 4k (2) EStG, lower effective taxation is irrelevant.

On the one hand, the restriction of deduction pursuant to Section 4k (3) EStG includes permanent establishment issues with a different allocation of profits between the individual cross-border parts of the company. On the other hand, it also includes payments to so-called reversed hybrid entities, which are treated as fiscally transparent in their state of residence, but as fiscally non-transparent in the state of their directly or indirectly participating shareholders.

The restriction of deduction pursuant to Section 4k (3) EStG applies only if the actual non-taxation of the income corresponding to the expenses is due to their allocation or attribution under tax law that differs from German law. Section 4k (3) EStG does not provide for an exception corresponding to Section 4k (2) EStG for income that has been taken into account twice. Similarly, there is no legal provision how to proceed if the mismatch in taxation is eliminated in a future tax period.

Using the restriction of deduction pursuant to Section 4k (4) EStG, mismatches in taxation resulting from the double deduction of expenses in both Germany and abroad (so-called double-deduction-mismatches) are neutralized.

In the case of a taxpayer with unlimited tax liability in Germany who is a shareholder of a legal entity based abroad, such multiple consideration is to be assumed even if the deduction of expenses is excluded abroad due to a regulation comparable to Section 4k EStG, Section 4k (4) sentence 2 clause 1 EStG. The domestic restriction of deduction is applicable in this case.

In Section 4k (4) sentence 2 clause 2 EStG, two exceptions to the principle described above are regulated:

  • If a corporation that is subject, without limitation, to corporate income tax in Germany is denied the deduction of the expenses in the state of its shareholder due to a regulation corresponding to Section 4k (4) EStG, the expenses are deemed not to have been taken into account in that other state. In this respect, there is no mismatch in taxation within the meaning of Section 4k (4) EStG, since the expenses have not been taken into account more than once. The expenses of the domestic corporation are therefore not subject to any deduction restriction pursuant to Section 4k (4) EStG.
  • Germany recognizes the refusal of a business expense deduction under a regulation corresponding to Section 4k (4) EStG by another EU state as having priority if the taxpayer is resident in two countries and the other EU state treats the taxpayer as not being resident in its state under the relevant double taxation agreement. In this case, the expenses are given priority in Germany.

The restriction of deduction pursuant to Section 4k (4) EStG does not apply if the taxpayer can prove that the expenses that have been taken into account twice are offset by the taxpayer’s own income that is actually taxed in Germany and abroad (Section 4k (4) sentence 3 EStG). The same applies in the case of a tax credit to avoid double taxation to the extent that the expenses reduce taxable income in Germany. However, if the expenses reduce income that is not subject to domestic taxation, this exception does not apply (Section 4k (4) sentence 4 EStG).

Section 4k (5) EStG restricts the deduction of expenses that do not directly lead to mismatches in taxation, but which are used to “import” a mismatch in taxation that has arisen between third countries into the domestic market. This is the case if the income resulting directly or indirectly from the domestic expenses again includes expenses – in particular, if there is a possibility of offsetting – and these expenses would be subject to the regulation of Section 4k EStG if these facts were realized in Germany and the mismatch in taxation is not neutralized by the relevant jurisdictions. The purpose of Section 4k (5) EStG is finally to prevent so-called back-to-back arrangements, i.e., multi-level financing with companies in countries without anti-hybrid rules, with a view to circumventing the restriction of deductions set out in Section 4k (1) to (4) EStG.

In the case of multi-tiered business relationships, a chain of service relationships is required between the legal entity bearing the harmful expenses and the German taxpayer. There is no need for a uniform economic connection between the taxpayer’s expenses and the foreign entity’s harmful expenses. This fairly wide interpretation by the German tax authorities can, in practice, lead to the application of Section 4k (5) EStG in a variety of ways.

With regard to the requirement of the realization of a constellation between related parties in accordance with Section 4k (6) EStG, the application of Section 4k (5) EStG requires the participation of at least three different legal entities in different jurisdictions. Two of the legal entities directly involved in a transaction must be related parties within the meaning of Section 1 (2) AStG.

The restriction of deduction pursuant to Section 4k (5) EStG does not apply if the mismatch in taxation has already been eliminated at another level of the legal relationship, e.g. by a corresponding foreign law.

Legal Consequence

If one of the restrictions of deduction mentioned in Section 4k (1) to (5) EStG is applied, the corresponding expenses are to be added in whole or in part to the off-balance sheet for tax purposes.


Notice:

The guidance on Section 4k EStG includes several welcome clarifications. Overall, the legal regulations introduced in 2021 still have to be consolidated in practice. Some points that have not been stringently implemented will certainly have to be clarified by case law in the next few years.