Despite its initial aim to encourage foreign investment the German government's new tax legislation now appears to discriminate against foreign funds investing in Germany, as Uwe Stoschek, Sven Behrends and Christina Foth explain
In May the draft German 2008 Tax Reform bill passed the Bundestag (Lower House) while final approval by the Bundesrat (Upper House) is expected in July.
The 2008 Tax Reform initiated by the Grand Coalition aims to decrease the tax burden in Germany to around 30% in order to achieve competiveness with other European countries. However, this tax relief contrasts with extensive counter-financing measures so as to avoid significant tax losses resulting from the tax reform.
One of the most far-reaching measures in this respect is arguably the proposed limitation of interest deduction for German tax purposes. The earning stripping rules were initially presented in the German government's white paper in November 2006 as an anti-abuse provision, the earning stripping rules are now supposed to generate significant revenue.
Despite the expectation of significant lobbying by German banks and financial institutions, the German government has not changed, still less abandoned, its plans as regards the interest limitation rules. A little success was achieved shortly before passing the Lower House when EBITDA (earnings before interest, tax, depreciation and amortisation) instead of EBIT was introduced as the basis for the limitation; in particular, this might provide relief for real estate investments.
In general, only a part of the interest borne by a German business will be deductible. Accordingly, so-called net interest expenses (interest expenses less interest earnings) will only be deductible by up to 30% of the relevant tax EBITDA (EBITDA adjusted for tax purposes). Any excess interest expenses, however, must be carried forward. Such amounts carried forward may be deducted in following years provided the 30% threshold of the tax EBITDA is not then exceeded. Remarkably, in contrast to the current rules all interest expenses - ie, on shareholder, related party and bank loans - would be affected by this new interest limitation rule.
Typically for German tax law, there are some exemptions to this general rule.
First, the German lawmaker has proposed to apply the new interest limitation rules only if annual interest exceeds a threshold of €1m.
Alternatively, non-controlled corporations (companies which do not form part of a consolidated group) are generally released from the new interest limitation rules. But in the case of a corporation's interest payments to a substantial shareholder (defined as having a shareholding of more than 25%), related parties, or even third parties such as banks having recourse to a substantial shareholder or to its related parties, the earning stripping rules will still apply if the interest exceeds 10% of the net interest expenses.
Lastly, a third escape clause has been introduced that might be relevant for real estate funds most of all. The interest deduction for a company running a German business will not be limited if the leveraged company forming part of a consolidated group can prove that it is not more highly leveraged than the group it belongs to. A tolerance of 1% is acceptable. However, this escape clause does not apply if the interest payments to substantial shareholders, their related parties or third parties having recourse to substantial shareholders or to their related parties exceed 10% of the net interest expenses. Interest payments only count in terms of the 10% threshold if the respective liabilities are shown in the consolidated accounts of the group and the security/recourse is not solely provided by a member of the consolidated group.
Usually, investors participate in a real estate fund vehicle via subscription of units/shares, via equity investment. Furthermore, such funds have generally implemented a multi-tier holding structure whereby the fund forwards its monies to the German business in the form of shareholder loans as far as is permissible. Additionally, bank loans are obtained to leverage the investment efficiently.
Notably, existing fund investments are usually structured in compliance with German rules governing what is known as thin-capitalisation (the state of having a capital structure heavily weighted towards debt rather than equity). Companies holding German property are therefore leveraged at around 80-95% (thereof around 12-20% shareholder loan on a loan-to-value basis). Thus the funds' financing structures currently show a high leverage of the investing companies compared with the fund vehicle, which itself is often only provided with equity by investors.
Taking into account the proposed German earning stripping rules, almost all the described financing structures originally drawn up to benefit from the relief ("safe haven") provided by the current thin-cap law will likely collapse unless they are restructured before 1 January 2008.
Although the planned new rules would also provide for escape clauses, these would hardly offer a real escape for foreign real estate funds with existing German investments.
Typically, only the third escape clause (group clause) described above might be applicable. This is because interest expenses borne by the investing company will likely not remain below the €1m annual threshold. This threshold is already reached when financing an amount of €20m with an applicable interest rate of 5%. The second escape clause (non-group clause) of not having the investing company consolidated (in theory!) should only become applicable in very specific cases. After all, if a real estate fund basically has to rely on the third escape clause, in a first step the equity ratio comparison would have to be met where the investing company's equity ratio would in principle have to be equal to or exceed that of the consolidated group.
Assuming the fund vehicle as head of the consolidated group, the consolidated accounts would provide, roughly speaking, for an equity ratio of 100% minus the bank loan. In the case of existing shareholder loans, therefore, the property company would always show a lower equity ratio and consequently fail the equity test according to the third escape clause. Accordingly, the third escape clause actually established for group companies also fulminates for foreign funds with German investments.
Even if no shareholder loans have been granted it is somewhat likely that German property companies will not have uniform external leverage. In practice, therefore, the equity test would be met by some companies but not by all. Property companies which were more successful in obtaining bank loans will fail and will have to rely on the general 30% rate of interest deduction.
Whereas the initial intention of the German lawmaker may have been to disburden companies from German taxes and increase Germany's attractiveness as an investment location, the upshot is that the opposite might actually be true for foreign real estate funds investing in Germany.
In the case of funds investing from outside Germany, an additional tax leakage might apply. This will have an impact on rental yields (after tax) and therefore also on bid prices. New German real estate investments will have to take the proposed rules into account. Difficulties may arise in case of existing investments where discussions with investors and banks may become necessary.
Uwe Stoschek is partner, and global real estate tax leader, Sven Behrends is manager and Christina Foth is an associate at PriceWaterhouse Coopers in Berlin