Federal Ministry of Finance publishes draft letter on anti-hybrid rules (§ 4k EStG)

On 13 July 2023, the German Federal Ministry of Finance ("BMF") published a draft letter on the so-called anti-hybrid rules of § 4k of the German Income Tax Act ("EStG") and sent it to the lobby groups for comments ("Draft"). The Draft is available here.

I. Introduction

§ 4k EStG was introduced by the Act Implementing the Anti-Tax Avoidance Directive (ATAD-Umsetzungsgesetz - ATADUmsG), in principle with effect after 31 December 2019. The purpose of the provision is to deny the deductibility of expenses in Germany to the extent that the resulting income is not taxed or is taxed at a low rate or deductions are made twice due to a hybrid mismatch (so-called deduction/non-inclusion, double deduction, imported mismatch).

The basic problem with the provision is that its application essentially depends on the tax treatment of the income and expenses in question abroad, so that determining and proving these foreign tax consequences is critical.

With the Draft, the tax authorities are now commenting for the first time on questions of interpretation and doubt. The Draft is rather descriptive and mostly only covers the basic structures with examples. It does not contain a complete overview of all issues relevant in practice, but this is difficult to achieve. In the following, we outline the most important statements of the Draft, which is more than 50 pages long (with reference to the marginal notes of the Draft).

II. General Aspects

Important general statements are:

Implementation of ATAD: The Draft emphasizes that § 4k EStG serves to implement art. 9 and 9b of ATAD (see mn. 1 et seq.). Without explicitly addressing it, we believe that this also means that, as a matter of principle, an interpretation in conformity with ATAD has to be applied.

Temporal scope of application: With regard to the temporal scope of application pursuant to § 52 (8c) EStG, the Draft differentiates between expenses from continuing obligations and other expenses (see mn. 3 et seq.). Expenses from continuing obligations are generally covered by § 4k EStG from 1 January 2020, even if the underlying contract was concluded before this date. According to the Draft, an exception shall only apply if the continuing obligation could not have been terminated without significant disadvantages. With these statements, the BMF reverses the rule-exception relationship provided for in § 52 (8c) sentence 2 EStG. In our view, however, the burden of proof remains with the tax authorities (see mn. 119). In the case of other expenses, on the other hand, there shall be no deduction prohibition if the expenses were legally incurred before 1 January 2020, even if the reduction in income does not occur until after 31 December 2019. The potential constitutional issues of an inadmissible retrospective effect are not addressed though.

Personal scope of application: § 4k EStG is applicable to both business and private income (§ 9 (5) sentence 2 EStG). The personal scope of application relates to situations between related parties, between companies and their permanent establishments located in other countries and in the context of structured arrangements (§ 4k (6) sentence 1 EStG). The Draft defines and explains the relevant terms (see mn. 7 et seq.).

Tax incongruence: In mn. 12 et seq. the Draft does not conclusively explain the concepts of taxation mismatches in the forms of deduction/non-inclusion (D/NI mismatch), double deduction (DD mismatch), imported mismatch and hybrid elements including sub-forms.

III. § 4k (1) EStG

The deduction prohibition of paragraph 1 relates to certain expenses in connection with financial instruments whose income is not taxed or is taxed at a lower rate due to a taxation mismatch pertaining to hybrid financial instruments (i.e. qualification conflicts) and to hybrid transfers (i.e. attribution conflicts) (see mn. 19). The following statements are made in the Draft:

Capital assets: For the concept of capital assets, the Draft refers to the identical concept of § 20 EStG (without taking into account § 20 (8) EStG and § 8 (2) of the German Corporate Income Tax Act ("KStG"); see mn. 20). The concept of expenses for the use of capital assets are to be understood accordingly (including accruals, i.e. an effective payment is not required); fees as well as compensation payments in the case of securities loans and repo transactions are to be considered as expenses in connection with the transfer of capital assets (these payments would generally be encompassed in § 22 no. 3 EStG, not in § 20 EStG; see mn. 21 et seq.). The concepts are thus broader than, for example, those of the interest barrier under § 4h EStG.

Non-inclusion: the Draft contains important statements on the concepts of non-taxation and low-taxation:

• Non-taxation occurs if the income corresponding to the expenses is not included in a taxable base. According to the legislative reasoning, also the inclusion under Controlled Foreign Company (CFC) rules constitutes taxation in this sense (cf. BT-Drs. 19/28652,  35). In our view, this applies accordingly to an inclusion under special CFC rules such as US Global Intangible Low-Taxed Income (GILTI). However, a specific statement from the BMF on this would be desirable. On the other hand, there is no non-taxation if, for example, there is no actual tax payment after offsetting against negative income, deduction of loss carry forwards, consideration of a basic allowance or alike, or crediting or deduction of foreign taxes (see mn. 27 et seq.).
• Low-taxation of the income corresponding to the expenses is deemed to exist if this income is subject to a lower effective tax burden abroad than that which would result if the capital assets were qualified or attributed in accordance with German law. The extent of the lower taxation should thus result from the difference between the actual taxation of the income abroad and the hypothetical taxation of the income abroad if the capital assets were qualified or attributed in accordance with German law (see mn. 30).

Causality: The Draft's emphasis on the causality between the taxation incongruence and the non-taxation or low-taxation. On this basis, § 4k (1) EStG can only be applied if a qualification or attribution conflict, alone - or together with another qualification and attribution conflict - is causal for the relevant taxation incongruence; other causes for non-/low-taxation – such as, for example, a personal tax exemption of the recipient of the income and, in our view a tax exemption with regard to an inclusion pursuant to the application of CFC rules – exclude the application of § 4k (1) EStG (see mn. 26). This also corresponds to an interpretation in conformity with ATAD (cf. art. 2 (9) subpara. 3 (e) sentence 2 ATAD).

IV. § 4k (2) EStG

The deduction prohibition of paragraph 2 relates to expenses in the case of a different tax treatment of a taxpayer as well as in the case of a different tax qualification of assumed debt relationships; this regularly concerns D/NI incongruencies. Important statements of the Draft are:

Expenses: The BMF clarifies that the term "expenses" is not limited to payments but covers expenses of all kinds (including accruals and depreciations) (see mn. 38 et seq.). Somewhat irritating is the statement that "expenses for the acquisition (e.g. purchase price payment)" are also considered expenses (see mn. 39) - however, the legal consequence in this case seem to be limited to the actual reduction of the profit (see mn. 51). In the case of such acquisition transactions, all expenses recorded by the purchaser are taken into account by the seller as "corresponding income". What the BMF means is that the proceeds from the sale are considered and therefore in particular no distinction is to be made for the prohibition of deduction according to whether or to what extent the seller does not pay tax on a capital gain (see mn. 41 in conjunction with example in mn. 63).

Deviating tax treatment: The concepts of a deviating tax treatment of a taxpayer or of an assumed debt relationships are explained and provided with examples in mn. 42 et seq.

Causality: Here, the Draft again emphasizes the requirement of sole causality ("solely causal") between the mismatch and the non-taxation (for § 4k (2) EStG, in principle, are low-taxation is not relevant; see mn. 49); however, it should be noted for § 4k (2) EStG that the BMF also extends causality to the treatment in other countries than that of the direct recipient of the income (see mn. 47).

Double-considered income: With regard to the exception for double-considered income under § 4k (2) sentence 3 EStG, there is discussion in particular as to the level at which the income must accrue in order to be considered income of the same taxpayer. In line with the legislative reasoning (cf. BT-Drs. 19/28652, p. 37), a tax group parent can also benefit from § 4k (2) sentence 3 EStG with respect to income attributed as income by tax group subsidiaries, provided that this income is also recognized abroad (see mn. 52). The income does not have to be related to the double-considered expenses. However, a double consideration/taxation requires, in addition to a domestic taxation, additional taxation in the country of the recipient, the partner (if the recipient is a partnership) or the other part of the enterprise (see mn. 53, also on a "carry-back" of income).

V. § 4k (3) EStG

The deduction prohibition of paragraph 3 relates to expenses whose income is not taxed due to a D/NI incongruence not already covered by paragraph 2. This covers, among other things, payments to reverse hybrid entities and allocation conflicts in the case of permanent establishments (including disregarded permanent establishments) (see mn. 63 et seq.). Noteworthy in this context is the complicated example 13, which deals with the coexistence of § 4k (2) and (3) EStG and arrives to the conclusion that an indirect tax incongruence in the context of the application of CFC rules can be a reason for the application of § 4k (3) EStG (see mn. 67 et seq.).

VI. § 4k (4) EStG

The deduction prohibition of paragraph 4 neutralizes DD incongruencies resulting from the double deduction of expenses, once in the domestic country and in at least one foreign country, without the need for a hybrid element. The expenses in another country do not have to be taken into account by the entity to be regarded as the taxpayer in Germany, but can also be taken into account by another entity. A double deductions presupposes a reduction of the taxable base (also an increase of a loss carry forward without taking into account local offsetting restrictions is encompassed), whereby also a reduction in the context of CFC rules shall be encompassed (but not the application of a negative progression proviso; see mn. 74). With regard to the double-considered income, reference is being made to the comments on paragraph 2 (see mn. 83 et seq.).

VII. § 4k (5) EStG

For imported mismatches, paragraph 5 provides for a deduction prohibition to the extent that the mismatch was not already eliminated by the paragraphs 1 to 4. Important statements of the BMF in this regard are:

Linkage: In this respect, the Draft states that the income resulting directly and indirectly from the expenses is income that arises from legal/tax relationships, without it being important that there is a uniform cause or economic connection. For example, the domestic expenses may be rental expenses, while the direct or indirect recipient pays e.g. - possibly harmful - royalty expenses to an indirect recipient (see mn. 94). Such income is "offset" by expenses if it is abstractly possible to offset the respective expenses against the income (see mn. 96).

Sequence of examination: In the opinion of the BMF, a certain sequence must be observed when examining expenses in multi-level chains. A hypothetical application of the paragraphs 1 to 4 must be carried out step by step from the direct recipient of income of the German taxpayer through the chain of indirect recipients (see mn. 103).

Double disallowance: If both Germany and another country deny a deduction of expenses at the same level under the rules for imported mismatches, the Draft provides for a pro rata application of the deduction prohibition (see mn. 115 et seq.).

VIII. Burden of proof

As already indicated above, the determination and proof of foreign taxation consequences within the scope of § 4k EStG is of central importance. Regarding the burden of proof, the BMF refers to the general principles.

Since the deduction prohibition is a tax-increasing fact, the burden of proof lies with the tax authorities; however, the taxpayer has an increased duty to cooperate pursuant to § 90 (2) of the German General Tax Code ("AO") (see mn. 119). The Draft mentions, among other things, accounting documents of the legal entities involved and rulings from foreign tax authorities on specific cases as possible information to be submitted; purely abstract descriptions of the foreign legal situation, on the other hand, are generally not regarded to be sufficient (see mn. 121). For the exceptions of § 4k EStG, in particular for a double-considered income, the taxpayer bears the burden of proof and must take precautions to provide evidence (see mn. 122 et seq.).

Against the background of the strict requirements, a de facto reversal of the burden of proof may occur.