Impact of the 2008 German Business Tax Reform on Financing Structures
The 2008 German Business Tax Reform (GBTR), which took effect on 1 January 2008, has a substantial impact on existing and future financing structures. The main objective of the GBTR is the creation of incentives for companies to do business in Germany. This is mainly achieved by a significant reduction of the overall tax burden levied on corporate taxpayers from approximately 42% to 30%. Due to budget restraints, this tax relief is to a large extent counter-balanced by a broadening of the tax base. With respect to financing structures, the GBTR provides for several limitations to the deduction of financing expenses. In many cases, such limitations will over-compensate for the relief brought by the reduction of the overall tax rate.
The so-called interest barrier (Zinsschranke) is a newly introduced earnings-stripping restriction that generally limits the tax deduction of net interest expenses to 30% of a company’s annual (taxable) EBITDA (earnings before interest, taxes, depreciation and amortisation). This directly affects industries that depend on high levels of debt financing (e.g. leveraged buy-outs). In particular, the new interest barrier and the additional tax burden it can create threaten the parlous financial state of distressed companies.
Even in those cases where debt financing complies with the interest barrier, there is an additional add-back of interest, lease and license expenses and similar expenses to the taxable basis for trade tax purposes, effectively resulting in trade tax being imposed on expenses. Instruments such as leasing and asset-backed securitisations are particularly impacted by the trade tax add-backs. It is those changes to the add-back of certain business expenses for German trade tax that now have a significant impact on the securitisation of assets by German originators.
Under both the previously applicable thin capitalisation rules and the new interest barrier, all business operations in Germany are hit comparatively hard. However, in comparison to the new interest barrier, the former thin capitalisation rules made it easier to predict whether interest expenses would actually be deductible for tax purposes. Under the new rules, the deduction of interest depends on the profit and loss vagaries of the current financial year. For trade tax purposes, the changes regarding the add-back of interest and equivalents abolish the previously available tax benefits gained by funding a business operation through selling its receivables.
Under the previous tax legislation, 50% of interest expenses deductible for corporate income tax purposes were added-back to the trade tax base if the interest was owed on debt that served the acquisition, expansion or improvement of an operation or which strengthened the operating capital on a long-term basis (long-term debt). German trade tax generally aims to tax a business irrespective of its particular individual financing activities, whether by use of equity or leverage. For this reason, even the prior concept of adding back only 50% of interest payable to income subject to trade tax was not in line with the fundamental basis of the legislation. A full add-back would be the only consistent solution; however, the new rules do not close this gap.
Under the new tax legislation, the add-back also includes discounts on the sale of bills of trade and other cash receivables by reference to their interest equivalent character (Section 8 no. 1 lit. a Trade Tax Act). This expansion was introduced because discounts usually granted when selling long- or medium-term receivables are an economic equivalent to interest otherwise payable on loan financing. As a result, this will abolish previously available tax benefits of financing without trade tax add-back through the sale of receivables (e.g. factoring, asset-backed securitisation).
Although the general aim of the new tax legislation seems to be clear (equal tax treatment of economically equivalent financing alternatives), some of the details necessary for practical implementation of the new rules are still unclear (by way of example, the legislation does not define the term ‘discount’). Factoring deductibles are referenced in the legislative motives of the GBTR, but it remains unclear which specific components of the usual discounts (financing costs, risk factors, administrative costs) are caught by the add-back.
It would be inappropriate in view of the intention to tax interest equivalents if all factors driving the purchase price of a receivable below its face value should be made the basis for assessing the interest component of such sale. The calculation principles to be applied must ensure that only the portion of the discount granted for the cash advance compared to cash on maturity of the respective receivable will qualify as the interest component for trade tax purposes. For example, when selling a portfolio of loan receivables, including performing and non-performing loans, the discount factor will largely be influenced by the credit rating of the portfolio itself. Therefore, the discount will be owed partly to the cash advance (loan equivalent) and partly to the value adjustment of the receivable to its recoverable value (risk equivalent). Objective measures to determine the add-back of interest-equivalent financing expenses will be necessary in applying the new rules. Unless such points are resolved, it will be very difficult to base transaction financing on solid ground in terms of the overall tax burden.
The German tax authorities recently published a draft circular for discussion purposes on the interpretation of the new add-back rules. This interpretation substantially deviates from the understanding as outlined above. Tax authorities argue that, due to the strict wording of the law, all discounts agreed when selling receivables must be taken into consideration when calculating the necessary add-back. In their view, the wording of the legislation requires the full difference to be added back between the face value of the receivables and the purchase price. Accordingly, tax authorities argue that there is no room for interpreting specific elements of the discount as not equivalent to interest.
It is now up to advisors and their clients to structure securitisation transactions without discounts, other than narrow financing components. Risk factors or administrative expenses should now be separated from the purchase price calculation and they should be invoiced to the German originators separately. It remains up to the creativity of structuring whether the strict interpretation of the tax authorities might even be used to the advantage of originators by converting financing expenses other than narrow interest into different forms of settlement, therefore largely avoiding the sale of receivables at a discounted value.
This article was originally published in Baker & McKenzie’s Securitisation & Structured Capital Markets Newsletter – Edition 7, July 2008.