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Granting loans to partnerships – Controlling influence precludes favourable withholding tax rates

Taxpayers that enter into a loan arrangement with another person will be able to take advantage of a tax rate differential, which is mostly very pronounced, between withholding tax on capital gains and the taxpayer’s normal rate of income tax. However, it is imperative to be mindful of the closeness of the relationship with the persons in question.

To take advantage of the tax rate differential, person A could, for example, take out a loan, for the purchase of a rental property, with a different person B. This would mean that Person A could claim the debt interest as allowable deductions for costs in relation to their income from letting and, in this way, reduce the amount of income that is taxed at a normal rate. Person B however will only have to pay tax at a rate of 25% on the interest payment received. 

The German tax legislator has identified such tax structuring options and issued rules according to which the withholding tax rate of 25% would be precluded in cases where loan arrangements are between persons who are closely related to each other, insofar as the borrower is able to claim a deduction for the interest that is paid, as business expenses or as allowable deductions for costs in relation to their domestic (German) income. 

The Federal Fiscal Court (Bundesfinanzhof, BFH) recently considered who would be deemed to be “persons who are closely related to each other” within the meaning of this exclusion rule and set this out in its ruling of 28.9.2021 (case reference: VIII R 12/19). In the case in question, a married couple had issued a loan to a limited partnership [Kommanditgesellschaft, KG] and had wanted to pay tax on the resulting interest income at 25%. What proved to be problematic was the fact that the married couple had held a partnership interest in the KG when the loan commitment was given; however, this was no longer the case when the interest was paid because they had transferred their partnership interests to a family foundation. The local tax office assumed that there was a close relationship between the creditors (the married couple) and the debtor (the KG) and taxed the interest income at the normal rate.

Nevertheless, the BFH now allowed the married couple to pay at the rate for withholding tax and ruled that the relationship that had existed had not been sufficiently close. A close relationship could be presumed if, among other things, one of the persons involved was able to exert a controlling influence over the other person, or such influence from the outside affected both persons. In a partnership, a partner would only able to exert a controlling influence if their share of the voting rights that had been agreed for partner resolutions enabled them to outvote their co-partners. Furthermore, ‘de facto control’ could also be sufficient in that a partner could actually exert the respective pressure on other partners so that they would submit to this particular partner’s will. 

Result: In the case in question, in view of the position of the partners, there was no controlling relationship since the married couple no longer held partnership interests in the KG when the interest was paid. Admittedly, the married couple had transferred their partnership interests to a family foundation. In the opinion of the court, however, in view of the regulations at the foundation, this step had not resulted in direct control either. 

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