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On 25 June 2021, the Federal Council adopted the Anti-Tax Avoidance Directive ("ATAD") (ATAD Implementation Act). It was published in the Federal Law Gazette on 30 June 2021. With the Act, the ATAD from the European Union was implemented into national law. In particular, the national regulations on exit taxation, on CFC (controlled foreign company) taxation and on the avoidance of hybrid mismatches were adapted.
In the following first part of our three-part series on the ATAD Implementation Act, we look at the new rules for avoiding taxation mismatches in relation to hybrid arrangements.
The new section 4k German Income Tax Act (Einkommensteuergesetz, EStG) shall avoid the deduction of business expenses in case of hybrid structures between related parties or between persons "with coordinated behavior". The idea is to avoid structures in which it comes to a double deduction of business expenses or a deduction without taxation of corresponding business income. The regulations are structured as a treaty override, so that double taxation treaties do not have to be observed. The application of these regulations is mandatory for all expenses incurred after 31 December 2019. Expenses that were legally incurred before 31 December 2019 may be assumed to have been incurred after 31 December 2019 under certain conditions.
In detail, the following cases are covered:
Section 4k (1) EStG covers operating expenses in connection with hybrid financial instruments (forms of lending) and from the transfer of capital assets. In case the income (corresponding to the business expenses) is not taxed in the other state or is taxed at a lower rate than in Germany, a deduction of business expenses will be not permitted. This may be the case, for instance, if income is qualified as non-taxable dividends abroad, but can be deducted as interest expense in Germany. Provided that the mismatches are eliminated in future taxation periods and the at arm's length principle (Fremdvergleichsgrundsatz) has been considered a deduction should be possible.
Section 4k (2) EStG extends the restriction to payments from services (e.g., interest, rent and license payments, etc.) which are not taxed in the state of the service recipient due to different qualification of the services or the legal entities involved (only non-taxation, not low taxation). Such cases can be possible in permanent establishment structures or in the case of different classification of hybrid entities (non-transparent classification in one state and transparent classification in the other state).
A double deduction of operating expenses (e.g., in the case of so-called double-dip structures) is restricted by section 4k (4) EStG. A deduction remains possible if corresponding income is taxed in both states.
Section 4k (5) EStG is intended to prevent the deduction of operating expenses for structures in which the income in the other state is offset by expenses that would not be deductible in Germany under section 4k (1) to (4) EStG if they were incurred in Germany. Such constellations may be possible in the case of multi-level financing structures with the use of hybrid financial instruments, in which, for instance, the interest payments and interest income at the individual levels usually balance out, but at the top level, for instance, there is no taxation of the interest income due to a hybrid financial instrument.
Entities with cross-border relations (e.g., financing, shareholding or other service agreements) should keep an eye on the regulations of section 4k EStG (applicable retroactively as of 1 January 2020). Such cross-border structures should be also reviewed from a tax perspective to mitigate potential tax risks.
