Hybrid financing instruments in international tax law – Part 1: Outbound structures
The tax treatment for borrowers will be determined by the requirements of tax law in the foreign country. It is therefore not possible to make general statements; in fact, it is usually necessary to consider individual cases in coordination with foreign consultants. Nevertheless, for income tax purposes it is possible to make a distinction between two typical cases.
- The capital is classified, for tax purposes, as the equity of a corporation. The remuneration paid on this capital is then usually non-tax deductible but, instead, is frequently considered to be a dividend and taxed accordingly. In many cases, the foreign corporation’s state will then feel entitled to levy withholding tax on such returns, although this could possibly be limited by double taxation agreements (DTA) or other rules.
- The capital is classified, for tax purposes, as debt. Notwithstanding something like special rules on the recognition of debt financing for tax purposes (e.g. so-called thin capitalisation rules), remuneration paid on this capital then generally reduces the profits of a foreign corporation. At the same time, the foreign country will frequently tax the remuneration to a German capital provider as, or like interest payments, so that the foreign country might feel entitled to levy withholding tax, which perhaps is limited by DTAs or other rules.
Taxation in Germany
Based on an overall consideration, the respective financing form would be assessed In accordance with the principles of German tax law. If the alternative of a partnership stake (e.g. atypical silent partnerships) is ignored then the following (put simply) applies.
- If the capital is subsequently, in Germany, classified as equity then the remuneration for lending this capital would thus primarily be income from capital assets; depending on the circumstances of the individual case, for the investor this income could in principle, under German tax laws, be subject to a preferential form of taxation, such as for example, the partial income method, or an exemption from corporation tax and/or trade tax. However, in order to avoid the uncoordinated combined effect of foreign and domestic (German) tax laws in terms of potential under-taxation, the partial income method or an exemption from corporation tax would not apply if the remuneration at issue had reduced the profit of the corporation abroad (so-called correspondence principle).
- By contrast, if the capital constituted debt under German fiscal law then the regular returns would be considered to be interest and, depending on the individual circumstances and according to German tax regulations, would either be subject to withholding tax or “standard taxation” with income tax or corporation tax, the solidarity surcharge, church tax, if applicable, as well as trade tax.
Some German DTAs include explicit rules for the taxation of specific hybrid forms of financing. However, beyond the scope of application of these special rules, at the latest, in some cases, there is still considerable legal uncertainty as regards the application of DTAs. For example, the Nuremberg tax court, in a ruling from 30.1.2018 (case reference: 1 K 655/16, Tax Court Decisions in 2019 p. 214) classified the returns from special preference shares of a US American company as interest not only according to domestic (German) assessments but likewise under the USA DTA; nevertheless, it itself admitted that a Federal Fiscal Court ruling would be needed to achieve uniformity of taxation. The outcome of the appeal proceedings (case reference: I R 12/18) is therefore highly anticipated.
Recommendation: The business appeal of hybrid forms of financing frequently lies in the possibilities arising from the flexible structure that can thus be adapted to individual requirements. However, the optimal use of such financing instruments in cross-border constellations is usually complicated in terms of tax and, in some cases, is subject to legal uncertainty. In the past, it was possible to generate, to some extent, low-taxed income using cross-border hybrid financing instruments. However, these possibilities were already previously limited by the correspondence principle and the planned changes in the ATAD Transposition Act are likely to diminish them considerably once again.