In its recent decision dated December 6, 2016 (I R 79/15), the Federal Tax Court confirmed the availability of the banking privilege as stipulated in Section 19 Trade Tax Ordinance (TTO) to group finance companies (FinCo) in Germany. The so-called "banking privilege" limits the amount of non-deductible business expenses from interest to be added back to the trade tax base under Section 8 No. 1 lit. a Trade Tax Act or, in the best case, reduces it to zero. The add-back rules of the Trade Tax Act had for long been an obstacle to the use of German FinCos. German groups had to look out for alternatives and typically set up their FinCo in a foreign jurisdiction. Following the decision of the Federal Tax Court, the use of a FinCo in Germany may now represent a viable alternative to the establishment of a foreign FinCo, in particular in view of the ongoing BEPS developments.
Banking privilege under Section 19 TTO
Taxpayers in Germany are generally subject to Corporate Income Tax (CIT) at a rate of 15.825% (including solidarity surcharge) and, if they maintain a permanent establishment in Germany, Trade Tax (TT), the rate of which depends on the municipality (7 to 16%). The TT base is derived from the CIT base, except that certain expenses are partially added-back to the TT base and that certain income items are (partially or fully) deducted from the TT base. The TT add-back rules apply in particular to interest expenses, of which 25% are generally added-back as non-deductible expenses, thus increasing the effective tax rate.
The add-back rules in particular impact highly leveraged companies. For credit institutions as defined in Section 1 (1) of the German Banking Act (GBA) that are typically highly leveraged in the ordinary course of their business, Section 19 TTO provides for exemption from the interest add-back subject to certain requirements (so-called "banking privilege"). There was considerable legal uncertainty in the past as to whether the "banking privilege" can also be claimed by German FinCos.
Federal Tax Court decision
With its recent decision, the Federal Tax Court confirmed the applicability of the "banking privilege" to German FinCos. In the case at hand, a German FinCo exclusively granted loans to other group companies and took out loans for financing purposes. With respect to interest expenses paid on loans received, FinCo claimed the "banking privilege". However, the tax office in charge applied the add-back rules and rejected relief pursuant to Section 19 TTO. FinCo's court action against such assessment was successful in the first instance. Upon appeal by the German tax authorities, the Federal Tax Court confirmed the first instance decision based on the following line of arguments:
- FinCo is a credit institution as defined in Section 1 (1) GBA. According to this provision, financial institutions are undertakings which conduct banking business commercially or on a scale which requires commercially organized business operations. These requirements are met in the case at hand. The fact that FinCo had not first applied for and thus had not received a banking permit pursuant to Section 32 GBA from the Federal Financial Supervisory Authority (BAFIN) is irrelevant, according to case law of the Federal Tax Court (decision I R 23/02 dated 16.10.2002).
- Moreover, Section 2 (1) No. 7 GBA does not prevent the application of Section 19 (1) TTO. According to this provision, a company is deemed not to be a credit institution as defined in Section 1 (1) GBA if it conducts its banking business solely with a parent undertaking or with its subsidiaries or affiliated undertakings (Intragroup Exemption). However, this provision was held by the Federal Tax Court to be irrelevant for purposes of Section 19 (1) TTO. This results from the wording of the provision on the one hand which refers to Section 1 (1) GBA only and not to Section 2 (1) GBA, and from its purpose, on the other hand. According to the Federal Tax Court, the beneficial effect of the Intragroup Exemption would be thwarted if FinCos were generally to be excluded from the application of the "banking privilege". Such interpretation of the law does not contradict the ruling of the Federal Tax Court dated 16 October 2002 (I R 23/02). In this decision, the Federal Tax Court made reference to Section 2 (1) No. 7 GBA. However, this reference was not material to the final decision.
- The equal treatment of credit institutions that require a banking permit and those that do not is constitutionally required. There is no objective reason for justification of an unequal treatment. From an economic point of view, FinCos, same as other credit institutions, have a pass through position with respect to monetary and credit transactions and require a significant amount of borrowed funds. Both of these aspects were relevant for the introduction of the "banking privilege" in the first place.
Relevance for taxpayers
The decision of the Federal Tax Court offers tax planning opportunities: A German FinCo is eligible to benefit from the banking privilege and to avoid the non-deductibility of interest expenses for Trade Tax purposes according to the new case law of the Federal Tax Court. The German interest barrier, on the other hand, should likewise not pose an obstacle as long as FinCo’s net interest expense (interest expense in excess of interest income) is less than EUR 3 million. German taxpayers using debt financing within their group should consider outsourcing finance functions to a dedicated German company operating as a FinCo. This company would ideally be established in a municipality with a low trade tax rate. If properly structured, the establishment of a German FinCo can also offer an alternative to the establishment of a foreign FinCo. In contrast to foreign FinCos, the establishment of a German FinCo would mitigate the risk of the structure being considered established purely for profit shifting and tax avoiding purposes. However, it remains to be seen how the German tax administration will react to this decision of the Federal Tax Court.