German Thin Capitalisation Rules: Potential Effects on German LBOs
In 2004, Fitch observed a number of German leveraged buyout (LBO) transactions with security packages for lenders that have been weaker than those typically seen in German LBOs. This weakening of security has been triggered by uncertainty over the new German thin capitalisation (“thin cap”) tax rules that came into force in January 2004. The new rules limit the tax-deductibility of shareholder debt, including bank debt that has recourse to shareholders. Uncertainty over the definition of “recourse” has caused concern in the German LBO community that secured debt could potentially be subject to the thin cap rules.
In May 2004, the German Finance Ministry issued a draft decree which provided some guidance on its intended meaning of recourse and Fitch’s understanding is that the new rules are not intended to capture secured debt typically used to finance LBO transactions. A final decree is expected in July but until this has been issued and the law has been tested in practice, it is possible that security packages of existing and new LBO transactions could be diluted to avoid secured bank debt being considered recourse.
Fitch has considered the impact of any reduction in security on the recovery prospects for senior and mezzanine lenders and notes that it may be reflected in reduced notching potential for these instruments. Furthermore, irrespective of the final treatment of secured debt, the new rules are likely to reduce the free cash flow generation of some LBO issuers, as they will restrict the tax deductibility of interest on shareholder loans. For LBO issuers whose cash flow is already strained, the impact may be significant and could even result in a lower Issuer rating.
This report examines the potential ratings impact of the new laws and takes a brief look at thin cap rules in other European jurisdictions.
In common with several other European jurisdictions, Germany had thin cap rules in place to restrict the tax-deductibility of interest payments to foreign shareholders. In December 2002, the European Court of Justice declared German thin cap rules to be contrary to European Law. As the laws only applied to shareholder loans from foreign shareholders but not German shareholders, the rules were deemed discriminatory against other EU members and hence had to be changed.
In December 2003, the Bundesrat approved a number of changes to German tax law as part of the 2004 Tax Reform Acts. Among these were the revised thin cap rules which came into effect on 1 January 2004. As the new rules contain no “grandfathering” provision, they will affect both new and existing LBO transactions.
What is “Thin Capitalisation”?It is often more tax efficient to finance a cross-border acquisition with shareholder debt rather than equity. This is because interest on debt is generally deductible for tax purposes, whilst dividends and other distributions in respect of equity participations are not tax-deductible. This enables the tax charge to be shifted from the jurisdiction where the investment is made to the jurisdiction of the investor, allowing more flexible tax planning, and, often, a tax rate arbitrage. This may lead to the shareholder debt representing a high proportion of the target company’s total capital, with a corresponding reduction in the equity injected by the shareholder. Hence the term “thin capitalisation”. When the shareholder and the target company are both subject to tax in the same jurisdiction, there will usually be little tax advantage stemming from thin capitalisation. The interest will be tax-deductible for the target company but taxable income for the shareholder, generally at the same rate. However, when the shareholder is tax-exempt or located in a jurisdiction with a lower tax rate, then a tax advantage can be gained. It has therefore been common for European revenue authorities to adopt thin capitalisation rules limiting the tax-deductibility of shareholder debt from foreign or tax-exempt shareholders in an attempt to protect their tax revenues. |
| Previous Rules | 2004 Rules | |
|---|---|---|
| Borrowers subject to rules: | German Corporations | German Corporations German Partnerships |
| Limitations on: | Debt from foreign shareholders1 Debt from foreign affiliates of shareholders1 Debt from third parties “with recourse” to foreign shareholders1 |
Debt from foreign or domestic shareholders1 Debt from affiliates of shareholders1 Debt from third parties “with recourse” to shareholders1 |
| “Safe Haven” Ratio: | 1.5:1 for operating companies 3.0:1 for holding companies |
1.5:1 for all companies |
| Implications for “excess shareholder debt”: | Loss of deductibility for Corporate Tax purposes | Loss of deductibility for Corporate Tax and Trade Tax purposes 20% dividend withholding tax |
1 Shareholders holding > 25% of equity
Source: Fitch Ratings and public information
Previously, German thin cap rules only applied to interest on funding from foreign shareholders and distinguished between interest paid by holding companies (safe haven ratio of 3:1) and operating companies (ratio of 1.5:1). The new rules have been extended to apply to funding from, or with recourse to, both German and foreign shareholders. The rules will also apply to the funding of partnerships, which were previously exempt. The lower safe haven (ratio of 1.5:1) will now apply to both operating and holding companies. Finally, whereas the old rules applied only to the deductibility of interest for corporate tax, the new rules will apply to both corporate tax and trade tax.
It is important to note that the safe haven ratio does not test the entire capital structure of a company but merely the shareholder funding. For example, a company that is financed with EUR75m bank debt, EUR15m shareholder debt and EUR10m equity is not considered to be thinly capitalised under German law as the shareholder debt: equity ratio is only 1.5:1. Furthermore, the ratio is calculated using the book equity figure from the beginning of the relevant year.
The changes that are most relevant to LBO transactions are summarised in Table 1.
The new thin cap rules have two potential effects on German LBOs:
In German LBOs, security available for secured debt typically includes a pledge of the shares of the operating companies, mortgages over fixed assets and pledges and assignments of the current assets and, in most instances, upstream and downstream guarantees.
Since secured lenders in a LBO structure typically have recourse to the operating subsidiaries of a borrower (which are affiliates of the shareholder), there has been concern among market participants that interest on secured debt could become subject to the new thin cap rules.
A number of German LBO issuers have been working with tax consultants and lawyers on restructuring alternatives, while others have even considered negotiating a release of some security, in order to avoid losing the tax-deductibility of the interest on secured debt. Moreover, Fitch has noticed that a number of new German LBO transactions in recent months have been structured with somewhat weakened security to avoid falling foul of the new rules. For example, Fitch recently reviewed a German transaction where the cross guarantees were excluded from the senior lenders’ security package specifically because of potential thin cap implications. Another recent transaction addressed the uncertainty over the new rules by initially offering a limited security package with a mechanism for automatic expansion of the security if the thin cap rules allowed.
On 12 May 2004, the German Finance Ministry published a draft decree to clarify several aspects of the new laws. Various parties have been invited to comment on the draft and a final decree is expected to be issued in July 2004.
The draft decree provides some guidance as to what the Ministry of Finance intended recourse debt to encompass by suggesting that the thin cap rules should only apply to bank debt in cases of back-to-back financing, i.e. a “funded guarantee”, where the shareholder has put funds on deposit with the lender. While LBO financing structures have not been specifically addressed in the draft decree, Fitch believes that the thin cap rules are not intended to capture secured bank debt and that interest on debt in an LBO financing which is supported by an “unfunded guarantee” is likely to remain fully tax-deductible. The draft decree states that borrowers will need to provide proof that guarantees from shareholders or affiliates are unfunded but Fitch believes that this should be a relatively straightforward procedure.
Issuer and Issue Long Term CreditRating Fitch assigns a Long Term Credit Rating (LTCR) to both Issuers and Issues. The exercise of assigning a rating to any debt instrument is a two-step process. Step One: Assign Issuer LTCRThe Issuer Long Term Credit Rating, also known as an entity or default rating is a senior unsecured rating which focuses primarily on the probability of default. The Issuer LTCR is derived through traditional credit analysis. Step Two: Notch the Debt Instrument Rating Up or Down from the Issuer LTCRThis reflects the relative position of the debt instrument in the capital structure and therefore the agency’s view as to likely recovery rates in a distress situation. The main areas of focus include the capital structure of the transaction, collateral and covenant package and the applicable insolvency regime. Senior secured loans and mezzanine facilities in most instances benefit from a position at or near the top of the capital structure, and are generally secured, the latter on a second secured basis. Therefore, there is potential to notch the senior secured and mezzanine ratings up from the Issuer LTCR. By way of contrast, European high-yield bonds are generally notched down from the Issuer LTCR to reflect their structurally subordinated position. Fitch is in the process of reviewing its rating definitions and the manner in which they reflect default probability and predicted recovery rate. |
Fitch’s Current Notching Methodology for Senior Secured Loans and Mezzanine Facilities in GermanyFitch considers Germany to be a relatively creditor-friendly regime. The German insolvency regime favours the taking of security (share pledges, mortgages over fixed assets; pledges and assignments of current assets) and, through the rights of separate satisfaction, allows senior secured lenders reasonable control over restructuring or insolvency proceedings.
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Until the final decree is published and the definition of “recourse” finalised, there is still a chance that secured bank debt could be treated as shareholder debt for the purposes of assessing thin capitalisation, thereby resulting in the interest becoming non tax-deductible. As mentioned previously, this will either have a detrimental effect on the free cash flow of LBO issuers or, more likely, issuers will seek to convince lending banks to accept a weaker security package to avoid the debt being treated as recourse to shareholders.
In this event, Fitch would expect to see a continued weakening of senior and mezzanine lenders’ security packages in new German LBOs as issuers try to retain tax deductibility of interest. For existing transactions, a combination of corporate restructuring and/or renegotiation of security may occur.
The weakening of security is unlikely to have an impact on the Issuer rating. However, any weakening of security packages may affect the likely recoveries for senior and mezzanine lenders in a distress scenario, thereby potentially reducing the number of notches assigned between the Issuer rating and the Instrument rating.
While the potential impact of the new thin cap rules on the tax-deductibility of interest on secured debt remains unclear, the situation is more certain for shareholder debt. Under the new rules, when debt from any major shareholder (>25% shareholding) exceeds the book equity of that shareholder, the interest on the excess debt will be considered a constructive dividend and lose its tax-deductibility.
Fitch has attempted to estimate the size of the potential increase in the tax burden (see Table 2). While a standalone company’s effective tax rate and annual tax charge depends on a myriad of other factors, the calculation below attempts to quantify the increased liability in order to put the effect of the new rules into perspective.
Investor acquires 100% of the equity of Target for EUR1,000m. Both Investor and Target are German companies.
The acquisition is financed as follows:
Senior Debt EUR500m
Shareholder Loans EUR400m
Equity EUR100m
Total EUR1,000m
Table 2 shows the tax charge of Target before and after the introduction of the new thin cap rules (2003 and 2004 respectively), assuming that the final decree does not treat senior secured debt as being recourse to shareholders.
Since Investor is a German company, the thin cap rules would not have applied in 2003 and therefore all of Target’s interest would have been deductible for corporate tax purposes and 50% deductible for trade tax. In 2004, the thin cap rules apply and some of the interest on shareholder debt is deemed non-deductible. Since only EUR150m is within the safe haven (1.5:1 shareholder debt: equity ratio), the interest on the further EUR250m is deemed non-deductible.
The incremental tax charge for Target in 2004 is therefore EUR6.6m. While this represents only 6.6% of EBIT, it may have an adverse impact on the free cash flow generation of the issuer if it is already experiencing liquidity pressure.
NB – The calculation below is based on several simplifying assumptions and is merely intended to illustrate the potential magnitude of the cash-flow impact of the application of thin cap rules to shareholder debt from German shareholders. The example does not address the issue of withholding tax on constructive dividends.
| Rate (%) | EURm | ||
|---|---|---|---|
| 2003 | 2004 | ||
| Excess Shareholder Debt | 0 | 250 | |
| EBIT | 100.0 | 100.0 | |
| Interest on Senior Debt | 8.0 | 40.0 | 40.0 |
| Interest on Shareholder Loans | 8.0 | 32.0 | 32.0 |
| EBT | 28.0 | 28.0 | |
| Notes | |||
| Interest on “Excess” Shareholder Debt | 20.0 | ||
| Taxable Profits for Trade Tax1 | 64.0 | 74.0 | |
| Taxable Profit for Corporate Tax2 | 16.2 | 34.4 | |
| Trade Tax3 | 18.4 | 11.8/16.2 | 13.6/14.4 |
| Corporate Tax4 | 26.4 | 4.3 | 9.1 |
| Net Income | 12.0 | 5.3 | |
| Incremental Tax Charge in 2004 | 6.6 | ||
1 Only 50% of interest on debt is deductible for trade tax purposes
2 Trade tax is deductible when calculating corporate tax
3 Trade tax rates vary by municipality in Germany
4 Corporate tax rate includes solidarity surcharge
Source: Fitch Ratings
Fitch will consider the impact of the new thin cap rules on issuers’ cash flow profiles on a transaction-by-transaction basis. Issuers capitalised with a high proportion of shareholder loans will be most affected. While, in many cases the negative cash flow impact may not be material, for issuers where cash-flow is already strained, the extra tax burden could exacerbate the situation and thus result in downward pressure on the Issuer rating.
Thin cap rules exist in different forms in many European jurisdictions. Several countries have had to amend their laws in recent months to comply with EU non-discrimination rules. Below is a summary of the current rules in some other major LBO markets:
As of 1 April 2004, UK thin cap rules have been extended to cover loans from domestic as well as foreign shareholders. Interest on debt from, or guaranteed by, a shareholder which exceeds a UK company’s “arms length borrowing capacity” is non-deductible. The Inland Revenue does not use safe haven ratios, relying instead on case-by-case determinations of arms-length borrowing capacity. To reduce the risk of double-taxation, the Inland Revenue has stated: “Every adjustment to the taxable profits of one party to a transaction will be matched by a compensating adjustment for the other party, to ensure that both are taxed on a consistent basis. Special rules for loan guarantees and accrued interest will ensure that normal commercial lending arrangements will not be disturbed”.
The flexible definition of arms-length and the compensating tax adjustments mean that the UK thin cap rules should have little effect on issuers’ cash flow or lenders’ security.
The French tax authorities have not yet amended their thin cap rules to comply with EU non-discrimination rules. The current rules state that interest paid to a controlling foreign shareholder on debt that exceeds a debt: equity ratio of 1.5:1 is non-deductible. It is not yet clear whether the French authorities will extend the rules to include domestic shareholders (as Germany and the UK have done), apply the rules only to non-EU shareholders (as Spain has done), or pursue an alternative solution.
If France chooses to apply its thin cap rules to domestic shareholders, the potential impact on lenders’ security will depend on the tax treatment of interest on debt guaranteed by shareholders or affiliates.
The Netherlands introduced thin cap rules for the first time on 1 January, 2004 to replace previous laws that were also deemed discriminatory. Under these new rules, interest on “excess debt” payable to related entities is non-deductible. Excess debt is defined as debt exceeding a debt: equity ratio of 3:1, or exceeding the overall group’s debt: equity ratio, if this is higher. Third-party debt guaranteed by a related entity may in certain circumstances be treated as related-entity debt.
Despite their potential treatment of guaranteed debt as related-party debt, the impact of Dutch thin cap rules should be limited by the fact that issuers can use the group debt: equity ratio as a safe haven.
Italy has also introduced thin cap rules as part of its recent tax reform. From 2004, interest on loans from, or guaranteed by, a qualified shareholder (>25% ownership) will be non-deductible to the extent a shareholder debt: equity ratio of 4:1 is exceeded (5:1 for 2004).
While the broad definition of “guarantee” used in the Italian Law could include some typical senior debt security, the relatively high safe haven ratio should limit the impact of the new rules.
Spain amended its thin cap rules in December 2003. Rather than extending the rules to include Spanish shareholders, Spain has stated that they will not apply to any shareholders resident in the EU. Interest payments to non-EU shareholders will continue to be non-deductible to the extent a debt: equity ratio of 3:1 is exceeded.
The Spanish decision to extend the exemption to all EU shareholders means that thin cap rules should not impact Spanish LBOs.
Note: Co-authors of this report were Sharon Westley and Karsten Frankfurth. This report was first published by Fitch on 15 June 2004.