Business Restructuring—Refinancing of Activities

As interest rates are low, refinancing an investment by leveraging equity is economically very profitable, even if this implies business risks. This article provides an overview of important German and Italian tax aspects to consider in a case of refinancing of activities, by considering an example, as well as recent legislative developments.

Example

The Italian company M-S.p.A. has two German subsidiaries, A-GmbH and B-GmbH, which hold German real estate. A-GmbH initially acquired the real estate with funds contributed by M-S.p.A. In order to repatriate these funds M- S.p.A has granted A-GmbH a loan.

In addition, A-GmbH wants to carry out substantial conversion procedures on the property. For this purpose a loan will be issued from another subsidiary of M-S.p.A—S-LLC—which is resident in the Seychelles. B-GmbH initially financed the acquisition of the real estate through a bank loan. Since it cannot obtain follow-up financing, M-S.p.A. grants B-GmbH a corresponding loan.

The managing directors of A-GmbH and B-GmbH are thinking about what has to be considered with regard to the tax treatment of the shareholder loans.

Tax Treatment under German Law

General Requirements

If a corporation has unlimited tax liability in Germany, the interest under the loan is in general deductible (subject to certain exemptions).

However, intra-group financings need to be documented in writing prior to the performance, conducted properly, and the conditions of the loan and the interest have to comply with the arm’s-length principle.

Such requirements have recently been tightened through the Deduction Tax Relief Modernization Act (Abzugsteuerentlastungsmodernisierungsgesetz). Instead of the previously codified hierarchy of transfer pricing methods, the new rules focus on the actual conditions of the respective business transaction (as opposed to the contractually agreed conditions) and determine the functional and risk analysis as the basis for the comparability of business transactions.

In addition, a so-called best method rule was introduced, which enables the reasoned selection of the most suitable transfer pricing method, taking into account the respective advantages and disadvantages and the data available to the taxpayer.

In the current example, the above formal requirements need to be met and it has to be proved to the tax authorities that the conditions of the loans and the interest comply with the arm’s-length principle. As only information objectively available at the time of the agreement of the business transaction may be used to determine the arm’s-length comparison, any transfer pricing analysis should be undertaken prior to the granting of the loan, in order to avoid a later challenge by the tax authorities.

Restrictions on Deductibility

Besides this, the deductibility of the interest is subject to certain general limitations. The most important one is the interest barrier rule (Zinsschranke) which applies for all kinds of compensation for debt (Vergütung für Fremdkapital), unless treated as construction costs for tax purposes.

Under the interest barrier rule, interest expenses are deductible up to the amount of interest income and beyond this amount (such exceeding amount is hereinafter referred to as “net interest expense”) only up to 30% of profit before interest, taxes, depreciation and amortization as for tax purposes (tax EBITDA).

However, there are several exemptions available. The most important exemption is the “threshold clause,” according to which interest expenses are deductible without any limitations if the net interest expenses are less than 3 million euros (about $3.4 million). Non-deductible interest expenses can be carried forward to the following fiscal years. Tax EBITDA not utilized for the calculation of the interest expense can also be carried forward up to five years.

Moreover, for German trade tax purposes, 25% of the deductible interest expenses (to the extent they exceed an available lump sum of 100,000 euros) are added back. However, the lump sum is only available once per year for several add-backs for trade tax purposes.

The deductibility of the loans granted to A-GmbH and B-GmbH might be limited under the above restrictions. However, in the case of A-GmbH, the interest for the property renovations might be capitalized and would therefore neither be considered for the interest barrier rule nor for the adding back for trade tax purposes.

Additional Limitations

In addition, several additional limitations have recently been introduced. Probably the most important are the so-called anti-hybrid rules which have been implemented with retroactive effect from Jan. 1, 2020 by the ATAD-Implementation Act (ATAD-Umsetzungsgesetz).

The anti-hybrid rules apply between related persons, between an enterprise and its permanent establishment, or in the case of a so-called structured arrangement. Roughly speaking, the rules will, inter alia, limit the deductibility of operating expenses with respect to the transfer of capital assets, if the corresponding income:

• is not taxed, or is taxed at a lower rate than under German law, and this is based on (i) a tax treatment, or (ii) allocation for tax purposes of the capital assets which differs from German law;
• is not taxed following a tax treatment of (i) the taxpayer, or (ii) a (deemed) relationship under the law of obligations between related parties which differs from German law;
• is not subject to taxation in any country due to its tax allocation or attribution under the laws of other countries, which differs from German law.

Besides this, the deductibility of operating expenses for the use or in connection with the transfer of capital assets shall be limited insofar as the expenses are also taken into account in another state. Certain exemptions apply.

In this example, the deductibility of the loans for German tax purposes should not be limited under the anti-hybrid rules as the interest income is already not recharacterized in other income (e.g., dividend income). Moreover, the interest is not deductible twice and there is also no imported mismatch.

Moreover, additional limitations (besides other restrictions and an extension of the limited tax liability and the additional taxation under the Foreign Tax Act) have been introduced by the law on the prevention of tax avoidance and unfair tax competition and on the amendment of other laws (Steueroasen-Abwehrgesetz, “StAbwG”) from 2022 onwards. They exclude the deductibility of expenses from business transactions related to tax havens from the fourth year the jurisdiction is qualified as a tax haven unless:

• the corresponding income is subject to unlimited or limited taxation under the German (Corporate) Income Tax Act or the StAbwG; or,
• on the basis of the income resulting from the expenses, an adding back of an additional amount under the Foreign Tax Act from so-called passive foreign income applies.

Although the Seychelles is regarded as a tax haven, the latter limitation will not apply. This is because the StAbwG also provides for a limited tax liability of S-LLC in Germany (and a corresponding withholding tax obligation on A-GmbH) in respect of the interest payments.

Tax Treatment under Italian Law

Tax Treatment of Interest Income Received from A-GmbH and B-GmbH

• IRES regime and transfer pricing requirements

Under Italian tax legislation, income derived by resident companies carrying on business activities is considered business income and, as such, is subject to corporate income tax (imposta sul reddito delle società, “IRES”) at a 24% rate.

The taxable base is generally the worldwide income shown on the profit and loss account prepared for the relevant fiscal year according to company law rules and adjusted according to the tax law provisions concerning business income, set out by Presidential Decree no. 917/86 (i.e., the Italian Income Tax Code, “IITC”).

In this respect, loan financing falls within those intercompany transactions which should comply with the arm’s-length principle set out in Article 110, paragraph 7 of the IITC and the transfer pricing guidelines issued by a Decree on May 14, 2018 (the Decree), enacting the OECD transfer pricing guidelines included in the base erosion and profit shifting (BEPS) project.

In light of the above, M-S.p.A. should receive remuneration for the loans borrowed by A-GmbH and B-GmbH compliant with the arm’s-length principle and then in line with comparable transactions among independent parties. Deviating from the arm’s-length principle, the burden of proof falls on the taxpayer, and therefore the parent company should provide grounded and detailed reasons, to avoid possible disputes with the Italian tax authorities.

A recent ruling of the Italian Supreme Court, no. 13850 of May 20, 2021, has reiterated the general rule of the arm’s-length principle stated by Article 110, paragraph 7, but it has also granted the possibility to deviate from this rule in case of particular “market reasons” that could be detected with reference to the loss-making situation of the subsidiary or its financial difficulties, to borrow money from third parties.

• IRAP regime

All income derived by Italian companies is also subject to the Regional Tax on Productive Activities (Imposta Regionale sulle Attività Produttive, “IRAP”) at the standard rate of 3.9% (different rates apply depending on the business activity and the region where the business is carried out).

IRAP is levied on the net value of production or gross profit. For holding companies (whose sole or main business purpose is holding share interest), financial income and financial expenses are also included in the taxable income.

Therefore, if M-S.p.A. qualifies as a holding company, the interest income deriving from the loans to A-GmbH and B-GmbH will be included in the IRAP base. The arm’s-length principle described above would apply as well.

Restriction on Deductibility of Interest Expenses

Italy has also implemented a set of rules aimed at countering profit shifting and the erosion of the taxable basis.

Such rules already applied before the enactment of the Anti-Tax Avoidance Directive, so its implementation into the Italian tax system has not introduced significant changes with respect to the deduction of interest expenses.

Currently, restrictions on interest deduction apply to the excess of interest expenses over interest income, including interest income carried forward from the previous fiscal years (“net interest”). Net interest is then deductible within a threshold represented by 30% of the company’s earnings before interest, taxes, depreciation and amortization or EBITDA (gross profit) calculated on the basis of the corporate income tax rules (“tax EBITDA”).

Net interest exceeding the 30% threshold may be carried forward and deducted in the following tax periods without a time limit, to the extent that the net interest accrued in the future years is less than 30% of the gross profit.

Similarly, any excess of interest income over interest expenses in a given fiscal year can be carried forward in subsequent fiscal years without limitation of time. Any unused amount of the 30% threshold may be used to increase the amount of deductible net interest in the following five tax periods.

If a company is part of a domestic tax consolidation regime, any excess of the net interest over 30% of the gross profit—and any net interest carried forward generated after inclusion in the tax consolidation—may be used to offset the taxable income of the fiscal unit up to the limit of:

• any excess of interest income, even carried forward from previous fiscal years, of another company, and
• the (30%) of another company’s tax EBITDA to the extent that the latter has not been entirely used to deduct its own net interest during the same tax period.

In our example, the interest income deriving from the loans granted to A-GmbH and B-GmbH will be used to deduct any interest expenses accrued by M-S.p.A. Any excess of interest income over interest expenses can be carried forward and be used in the following years to deduct net interest in those following years.

Notional Interest Deduction Implications

The notional interest deduction (Aiuto alla Crescita Economica) (“NID”) is an incentive introduced with the aim of encouraging Italian companies to strengthen their capital structures while mitigating the difference in tax treatment for income tax purposes between companies funded with debt and those funded with equity.

More precisely, NID provisions grant Italian companies a deduction from the taxable income corresponding to a deemed “notional return” on “qualified” equity increases accrued, starting from fiscal year 2011 onwards.

The notional return is calculated by multiplying the cumulated “qualified” equity increases for a specified interest rate (1.3% increased to 15% for fiscal year 2021 under certain circumstances).

The equity increases that qualify for the notional interest deduction are the following:

• (+) capital contributions in cash;
• (+) retained earnings;
• (-) distributions to shareholders.

The NID regulation includes specific anti-abuse provisions aimed at avoiding a duplication of the deduction with respect to the same equity increase.

In our example, the loan that M-S.p.A. granted to A-GmbH would in principle fall under one of the anti-abuse provisions (as potentially able to duplicate the NID base by means of multiple circular transactions within a group) and would reduce the qualifying equity increase accordingly.

However, M-S.p.A. could consider filing an advance tax ruling aimed at demonstrating that the funds transferred to A-GmbH under the loan agreement and transferred back as dividends distribution do not lead to a duplication of the NID incentive.

Planning Points

When taking up a new group financing, the taxpayer needs to consider the following with regard to the new rules:

• Is the loan subject to a domestic withholding tax, and can the withholding tax be avoided or reduced under the Interest and Royalties Directive or the tax treaty respectively?
• In this respect, does the lender meet the Interest and Royalties Directive and the tax treaty tests, including the beneficial ownership one?
• Is the loan documented properly and can it be proven to the tax authorities that the terms of the loan and the interest rate comply with the arm’s-length principles for transfer pricing purposes? Are there any specific exceptions available? For instance, for Italian tax purposes, could it be established that there are “market reasons” to justify an interest-free loan granted by an Italian parent company to its foreign subsidiaries? For German tax purposes, can it be proven to the tax authorities that for the determination of the interest rate the most suitable transfer pricing method was chosen, taking into account the respective advantages and disadvantages and the data available to the taxpayer?
• If the expense from an intra-group financing relationship has reduced German income, can it be proven to the tax authorities that the debt can be served and that the financing was economically necessary?
• Does the interest rate applied exceed an interest rate at which the group could finance itself externally? And if so, can it be proven to the tax authorities that this higher rate complies with the arm’s-length principle?
• Might the deductibility of the interest be limited under the anti-hybrid rules (e.g. because the interest is deductible twice or because the interest income of the lender is not taxed due to a mismatch in tax treatment of the loan/the involved parties or the allocation of the interest)?
• Is one of the involved parties tax resident in a tax haven and might the interest therefore not be deductible, for example under the German StAbwG Law?

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Björn Demuth is a Partner and Cornelia Wiendl is Counsel with CMS Germany; Carlo Gnetti is a Partner and Luca Vincenzi is Counsel with CMS Italy.

The authors may be contacted at: bjoern.demuth@cms-hs.com; cornelia.wiendl@cms-hs.com; carlo.gnetti@cms-aacs.com; luca.vincenzi@cms-aacs.com