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TAX IMPLICATIONS OF ACQUISITION FINANCING
Post-Acquisition Debt Consolidation and
Interest Deduction Limitations in Germany in Comparison to the United States and France
A thesis submitted to the Bucerius/WHU Master of Law and Business Program in partial fulfillment of the requirements for the award of the Master of Law and Business (“MLB”) Degree
Dominik Pavlik July 22, 2011
14.227 words (excluding footnotes)
Supervisor 1: Florian Lechner Supervisor 2: Prof. Dr. Deborah Schanz
I
TABLE OF CONTENTS
LIST OF ABBREVIATIONS ............................................................................ III
LIST OF DIAGRAMS ...................................................................................... IV A ACQUISITIONS, FINANCING & TAXATION – AN INTRODUCTION .............. 1 I Relationship Between Acquisitions and Taxation – Empirical Evidence .... 1 II The Acquisition ................................................................................................ 3 III Financing an Acquisition ............................................................................... 4
1 Cash Financing .............................................................................................. 5 2 Equity Financing ............................................................................................. 7
IV Scope of the Following Chapters .................................................................. 8 B GERMANY ...................................................................................................... 10 I Debt Consolidation ......................................................................................... 10
1 Mergers ........................................................................................................ 10 2 Tax Consolidation ........................................................................................ 12 3 Debt Push-Down .......................................................................................... 12
II The Interest Barrier ....................................................................................... 14 1 Business Tax Reform 2008 .......................................................................... 15 2 Background .................................................................................................. 15 3 The New Interest Barrier .............................................................................. 17
a Group Independence ............................................................................................ 19 b Escape Clause ..................................................................................................... 20
4 Impact on Acquisition Financing .................................................................. 20 5 Efficient Structuring in Light of the Interest Barrier ....................................... 21
a Realization of Hidden Reserves ........................................................................... 23 b Variable Interest Expenses and Debt-to-Equity Swap ......................................... 24 c Accounting Measures ........................................................................................... 25
C UNITED STATES ............................................................................................. 26 I Debt Consolidation ......................................................................................... 26
1 Mergers ........................................................................................................ 26 2 Tax Consolidation ........................................................................................ 27 3 Debt Push-Down .......................................................................................... 28
II Earnings-Stripping Rules ............................................................................. 29 1 Background .................................................................................................. 30 2 Application .................................................................................................... 31 3 Impact on Acquisition Financing .................................................................. 35 4 Efficient Structuring in Light of the Earnings-Stripping Rules ....................... 36
a Debt-to-Equity and Adjusted Taxable Income Optimization ................................. 36 b Debt Push-Down .................................................................................................. 37
D FRANCE .......................................................................................................... 38 I Debt Consolidation ......................................................................................... 38
1 Mergers ........................................................................................................ 38 2 Tax consolidation ......................................................................................... 40 3 Debt push-down ........................................................................................... 41
II
II Thin Capitalization Rule ................................................................................ 41 1 Background .................................................................................................. 43 2 Application .................................................................................................... 44 3 Impact on Acquisition Financing .................................................................. 47 4 Efficient Structuring in Light of the Thin Capitalization Rule ........................ 48
E CONCLUSION ................................................................................................. 50
Bibliography ................................................................................................. 53
III
LIST OF ABBREVIATIONS AG Aktiengesellschaft (Germany)
CGI Code Général des Impôts (France)
CIT Corporate Income Tax
DTT Double Tax Treaty
EBITDA Earnings Before Interest, Taxes, Depreciation and Amortization
EC European Community
EEA European Economic Area
EStG Einkommensteuergesetz (Germany)
EU European Union
GewStG Gewerbesteuergesetz (Germany)
GmbH Gesellschaft mit beschränkter Haftung (Germany)
HGB Handelsgesetzbuch (Germany)
IFRS International Financial Reporting Standards
IRC Internal Revenue Code
IRS Internal Revenue Service
KStG Körperschaftsteuergesetz (Germany)
PIT Personal Income Tax
Sec. Section
SEC Securities and Exchange Commission
TT Trade Tax
UmwStG Umwandlungssteuergesetz (Germany)
U.S. United States
U.S.-GAAP United States Generally Accepted Accounting Principles
WHT Withholding Tax
IV
LIST OF DIAGRAMS Diagram 1: Acquisition Scenario p. 8
Diagram 2: Interest Barrier Applicability Test p. 22
Diagram 3: Earnings-Stripping Rule Applicability Test p. 32
Diagram 4: Thin Capitalization Rule Applicability Test p. 44
Diagram 5: Back-to-Back Arrangements and Secured
Third Party Loans p. 45
1
A ACQUISITIONS, FINANCING & TAXATION – AN INTRODUCTION
I Relationship Between Acquisitions and Taxation – Empirical
Evidence
Tax optimization plays an important role for organizations. Hence, it also plays
an important role in relation to M&A transactions.1 Furthermore, empirical
studies point to to the importance of considering taxes when planning M&A
transactions.2 On one hand, taxes can be beneficial in a tax environment,
allowing tax savings and thereby a decrease in the acquisition price. On the
other hand, where no such benefit is provided by the relevant legislation,
taxes increase the total cost of the transaction, limiting the potential economic
advantage, and may even jeopardize the actual transaction.
For the acquirer, the most important tax consideration in relation to
acquisitions is the possibility of deductible expenses – deduction of the
acquisition price and the financing costs.3 The target, on the other hand, aims
to compensate its tax burden by increasing the sales price. As a result, taxes
may create challenges and even hinder the deal from going though. This is
particularly the case in acquisition scenarios where the tax burden of the
seller and the potential for tax savings of the acquirer are not in equilibrium.4
In such cases, the motivation of the acquirer to compensate the seller’s tax
burden by paying a higher price is likely to be limited, unless the acquisition is
based on other more valuable intentions.
Most of the empirical studies conducted in this area focus on the U.S.
market.5 All of the studies concentrate on three aspects of the relationship
between taxes and acquisitions: First, the relationship and effect of taxes on
1 See Schreiber & Ruf, p. 435. 2 See Desai & Hines; Becker & Fuest 3 See Schreiber and Ruf, p. 437. 4 See Schreiber and Ruf, p. 438. 5 See Schreiber and Ruf, p. 435.
2
the acquisition price; second, whether taxes hinder economically useful
acquisitions or may be a reason for acquisitions to take place; and third, the
aim to prove the existence of a relationship between tax planning activities
and acquisitions. 6
One important finding regarding the effect of tax on the acquisition price was
that the acquirer, in most cases, is not able to compensate its tax burden by a
lower price, whereas the seller can.7 An additional study in this area of
research proves that sellers will increase the acquisition price if they face an
increasing tax burden by having to pay capital gains tax.8 Thereby this study
supports the findings of the previous one on the effect and relationship
between tax and price.9
Empirical studies have proven that the existence of taxes deter economically
useful mergers and acquisitions. Ayers, Lefanowicz and Robinson performed
one of the most convincing studies in this area in 2007.10 Their analysis
focused on the number of taxable M&A transactions in times of low and high
taxation on capital gains. The results showed a decrease in the number of
M&A transactions in times of high capital gains taxes.11 In combination with
previously performed studies12 there is convincing evidence “that taxes inhibit
economically useful transactions”13.
Studies concentrating on tax planning activities in relation to acquisitions
found that the likelihood of debt financing increases if the acquirer faces a
higher tax rate since the tax savings grow.14 Other researchers who extended
the study by analyzing 167 acquisitions found that the lower an acquirer’s
possible tax deduction rate, the lower the level of debt financing.15 Further
6 See Schreiber & Ruf, p. 438. 7 See Henning, Shaw & Stock (2000). 8 See Schreiber & Ruf, p. 440. 9 See Ayers, Lefanowicz & Robinson (2004). 10 See Schreiber & Ruf, p. 447. 11 See Ayers, Lefanowicz & Robinson (2007). 12 See Scheider & Ruf, pp. 444 ff. 13 Schreiber & Ruf, p. 447 (autor’s translation). 14 See Erickson (1998). 15 See Dhaliwal, Newberry & Weaver (2005).
3
studies came to the conclusion that acquisitions are not limited to tax efficient
structuring. In addition, acquisitions provide long-term tax savings if they are
used as a means of tax planning.16
II The Acquisition
The acquisition of a company can take place in two ways: by means of an
asset or a share deal. In an asset deal, the acquirer receives the title to the
targeted assets after consideration has been given. Where a transaction is
performed as a share deal, instead of title to the assets the acquirer receives
the target’s shares after consideration has been given.
From a tax perspective, an asset deal is generally advantageous for the
acquirer because of the possibility of an accounting step-up. The higher tax
basis allows an increase in the depreciation and amortization expenses which
can be used as a deduction measure to lower the tax base and thereby the
future tax burden. Consequently, in cases where the target has many
undervalued assets in its balance sheet, an asset deal may be the right form
of acquisition.
On the other hand, the asset deal has two disadvantages for the acquirer.
First, transfer taxes may be applicable to all or specific types of transferred
assets. To limit the additional costs resulting from transfer tax, the acquirer
should analyze to which assets transfer tax is applicable and whether a share
deal may be more favorable, taking future tax savings due to a potential step-
up into account. Another possibility is to negotiate with the seller who pays the
applicable transfer taxes. Second, tax credits resulting from the target’s past
net operating losses may not be carried forward. Accordingly, in cases of
targets with high tax credits, an acquisition by means of a share deal may be
preferable to the acquirer.
From the seller’s perspective, these tax credits are the main advantage of an
asset deal as “such tax considerations remain with the holders of the target
16 See Schreiber & Ruf, p. 444.
4
firm’s stock”17. In other words, if the target continues operating after the asset
sale, the tax credits can still be used.
The tax disadvantage of an asset deal for the seller is the taxation on gains
arising from the sale. Thus, the lower the book values in comparison to the
current market values, the higher the taxable gains of the target. This may
create conflicts between the acquirer and the target as the acquirer may favor
an asset deal in cases which allow a high post-acquisition step-up, while the
target is likely to prefer a share deal in such cases. Furthermore, if the target’s
shareholders intend to liquidate the business after the transaction, depending
on the legal form of the entity, they might even be subject to double taxation.
The sales gain will be taxed on the level of the business, and the
shareholders’ capital gain will be taxed.
Besides the form of the acquisition, the acquirer and the target have to agree
on all the other structural aspects of the transaction. These include their goals
and future plans, the amount of risk they are willing to take, the price they are
willing to pay / to accept, the exact stake in the company they are willing to
acquire / to give up, and whether or not approval will be needed to go forward
with the transaction. When each of the parties has found a clear position on
all of these aspects, including the form, the parties must reach consent to
finally structure the acquisition. Doing so, an in-depth evaluation of each
aspect – taking into account the overall transaction – is of great importance as
“decisions made in one area affect other aspects of the overall deal
structure”18. This includes additional costs due to a higher tax burden resulting
from the chosen acquisition structure.
III Financing an Acquisition
The first and most important decision in relation to the financing of the
acquisition is to choose the right type of currency for the payment of the
17 DePamphilis, p. 464. 18 DePamphilis, p. 444.
5
acquisition price.19 The two basic currencies available are either the acquirer’s
stock or cash. A third option is to use a combination of the two.20 Other
instruments which can be used to finance an acquisition are convertible debt,
real property, rights to intellectual property, royalties, earn-outs and
contingency payments.
When choosing the currency, four characteristics have to be taken into
account.21 First, in relation to the necessity of taking additional debts in order
to use cash, the acquirer’s capital structure, debt capacity and cost of capital
have to be analyzed. Second, how will the ownership structure be affected? In
the case of cash, the acquirer will control the target, while a payment in
shares will change the overall ownership structures and may limit the
acquirer’s and its shareholders’ level of control.22 Third, “who will bear the risk
of the enterprise going forward”23? When cash is used, it will be the acquirer
that bears all the risks, whereas in the case of shares being used, the risk will
be split between acquirer and target.24 The fourth aspect is the tax liabilities in
relation to the chosen form of financing.
1 Cash Financing
If cash is used to finance the acquisition, the necessary amount can be
obtained by several methods. The most liquid form of cash is retained
earnings. Debt is another relatively liquid form of cash, whereas the level of its
liquidity and the acquirer’s access to debt depends on its cost of capital. If the
cost of capital is too high, debt financing might not be an option. Additionally,
using debt to gain the necessary level of cash increases the risk of bankruptcy
for the acquirer.25 Another possibility and frequently used method of
increasing the level of cash is the sale of “either the acquirer’s existing assets
19 See Thompson, p. 17. 20 See Thompson, p. 17. 21 See Thompson, p. 18. 22 See Thompson, p. 20. 23 See Thompson, p. 18. 24 See Thompson, p. 20. 25 See Thompson, p. 18.
6
or some of the target’s assets that won’t produce synergies with the
acquirer”26.
In terms of taxation, the use of cash may be the preferred form of payment for
the acquirer. Since the interest payments are deemed to be expenses, they
are tax deductible. However, as most jurisdictions limit the level of interest
that can be deducted from an entity’s taxable income, the benefits are limited.
In other words, the tax benefit is lost as soon as the optimum leverage level of
the organization is reached.27
From the seller’s point of view, being paid in cash is unfavorable in terms of
tax, as the capital gains of the target’s shareholders are subject to immediate
taxation.28 It has to be borne in mind that the tax base and tax rate on the
capital gains are exempt due to certain criteria such as the holding period of
the shares or a tax-free level of capital gains.29 In many cases, this may limit
the tax disadvantages of a cash transaction for the shareholders of the target
company.
As the previous illustration shows, the taxation of a cash transaction may
create differing interests between the acquirer and the target. A common
reaction by the seller in cash transactions is to require a higher purchase price
in order to compensate for the tax disadvantage.30
Cash “is the most commonly used means of acquiring shares or assets”31.
Besides the potential tax advantages for the acquirer, another reason for this
is the simplicity of collecting the necessary cash in comparison to the issuing
of sufficient shares to undertake the acquisition. Depending on the regulatory
environment and the shareholder structure, the “process can take months
longer than a similar deal in which the currency is cash”32.
26 See Thompson, p. 17. 27 See Thompson, pp. 18 and 71. 28 See DePamphilis, p. 451. 29 See Thompson, pp. 70 – 71. 30 See Thompson, p. 71. 31 DePamphilis, p. 451. 32 Thompson, p. 18.
7
2 Equity Financing
Issuing sufficient shares requires a series of preconditions. In cases where
there is no or too little authorized capital, a shareholder meeting needs to be
held in order to obtain the shareholders’ approval on the share increase.
Moreover, the shareholders have to withdraw their pre-emption rights in
regard to the new shares, which are given to shareholders in most
jurisdictions. In addition to the shareholder resolution, jurisdictions may
impose specific disclosure rules for the issue of new stock (e.g. SEC
disclosure rules in the U.S.).33
Issuing new shares also creates a variety of costs for the acquirer. The most
obvious and - to some extent controllable – expenses are the organizational
costs, e.g. costs incurred by the shareholder meeting, and the transaction
costs. The more dangerous costs, in the case of publicly traded acquirers,
stem from the risk of the share price decreasing due to the share increase.
Empirical studies show that the price of existing shares decreased in many
cases where companies issued new shares. This may be a result of the
investors’ “belief that the newly issued shares will result in a long-term dilution
in earnings per share”34 or due to the market interpreting the acquisition by
shares as the management signaling a current overvaluation of the shares35.
In some jurisdictions like the U.S. and Germany, reorganizations are treated
favorably in terms of taxation. In order to benefit from those tax advantages,
certain preconditions have to be met by the reorganization. A share
transaction, for example, qualifies as a reorganization in many cases. Thus
the share transaction is likely to be treated favorably in terms of taxation.36
An acquisition using shares is much more favorable for the seller than using
cash from a tax perspective. In many cases, a potential cpaital gain by the
target occurring through a share purchase is not considered to be income for
33 See Thompson, p. 18. 34 DePamphilis, p. 451. 35 See Thompson, p. 18. 36 See Thompson, p. 19.
8
tax purposes. Hence, there is no tax liability for the seller until it realizes a
capital gain on the sale.37
IV Scope of the Following Chapters
The analysis made in the following chapters on Germany, the U.S., and
France is based on the acquisition scenario outlined below:
Diagram 1: Acquisition Scenario
The acquirer in the given scenario is a holding company with no income other
than dividends. This is a typical case for acquisition vehicles.38 Since the
acquirer only has limited taxable income, as dividends received by corporate
shareholders are partially tax exempt – in Germany and France 95% of
dividend income is tax exempt. In the U.S. between 70% and 100% of
dividend is tax exempt depending on a corporate shareholder’s interest in the
37 See Thompson, p. 71. 38 See Gröger, p. 352.
9
distributing company. The taxable income of the acquirer is not sufficient for
the deduction of interest expenses incurred by the acquisition financing.
Hence, to have sufficient taxable income to offset against the interest
expenses arising, the first step after the acquisition is to perform a debt
consolidation.
In acquisition scenarios, the limited deductibility of interest expenses incurred
via the acquisition financing, which may be due to limited income on the level
of the acquirer, as mentioned above, requires the performance of post-
acquisition debt consolidation measures to create a tax shield against the
interest expenses. These tax shields aim to concentrate the taxable income
and the acquisition expenses on one level in order to reduce one by the
other.39 In other words, the objective is to use the interest expenses to reduce
the tax base and thereby decrease the tax burden. Three possible
mechanisms that can be used to consolidate the debt on the level of the
target or another entity of of any given group are a merger, tax consolidation
or a debt push-down. These will be analyzed in respect of each country in the
following chapters.
Following this analysis, the countries’ regulations in regard to a limitation of
the potential deductibility of interest expenses – the interest barrier
(Zinsschranke) in Germany, the earnings-stripping rule in the U.S., and the
thin capitalization rule (règles de sous-capitalisation) in France – are
examined.
The tax implications of these regulations for acquisition financing, i.e. external
or internal financing or a combination of the two, will be examined.
Furthermore, optimization measures to counteract these regulations will be
introduced. For the case of Germany, which is the main focus of this thesis,
several accounting mechanisms, which allow the acquirer to decrease
negative tax effects due to the interest barrier, will be discussed.
39 See Gröger, p. 360.
10
B GERMANY
I Debt Consolidation
The following description of a merger, tax consolidation and debt-push-down
transaction as a means of debt consolidation illustrates the necessity of an in-
depth evaluation of the overall situation. Due to each method’s advantages
and disadvantages, which may have a greater or lesser effect on the
individual group situation, the appropriate method has to be chosen on a
case-by-case basis. Particularly, an evaluation has to demonstrate whether
the individual tax advantages of one method outweighs its disadvantages,
taking into account the same analysis of the other available methods for the
given case.
1 Mergers
In the case of a merger, the acquirer has two options – to perform an
upstream or a downstream merger.
Upstream merger means the target (one level below the acquirer in the
organization’s chart) is merged into the acquirer. According to sec. 11(1) and
(2) KStG, the merger can take place at book value.40 In other words, hidden
reserves will not be realized (no step-up). The performance of the upstream
merger without the realization of hidden reserves requires an application to,
and acceptance by, the tax authorities. Usually, the acceptance of the
application is unproblematic. The only requirements by the tax authorities are
that the merged target will remain a tax resident of Germany and no
compensation is given.41
The advantage of this scenario is that as no capital gains arise and no taxes
are triggered. On the other hand, if the acquisition took place shortly before
and in the form of an asset deal, the value of any hidden reserves is likely to 40 See Gröger, p. 360. 41 See Gröger, p. 360.
11
be relatively low. Even though there will be no taxation on capital gains, a
potential merger gain may be taxed at a rate of 5% of CIT and TT according
to sec. 8b(3) KStG. In most mergers, the accrual of a merger loss is more
likely than a merger gain. So, no taxes will be levied in most cases.42 The
downside of the merger loss, on the other hand, is that it does not offer any
tax advantage as provided by sec. 12(2) sentence 1 UmwStG. The loss
cannot be used in order to reduce the taxable income of a given entity.
Another tax disadvantage of the merger may exist when the target has
valuable tax credits or accounts carried forward. These are canceled in the
case of the merger as defined by sec. 12(3) in conjunction with sec. 4(2)
sentence 2 UmwStG.43 Bearing this in mind, as those losses were already
canceled due to the acquisition – except EBITDA carry forwards – the
potential disadvantage is limited.
A downstream merger is the exact opposite - the acquirer merges into the
target. Before any downstream merger, the merging entities have to ensure
that corporate law does not prohibit the merger. Especially in post-acquisition
mergers, as is the case in this analysis, conformity with corporate law is an
important issue. That is because the high debt of the acquisition financing on
the level of the acquirer may reduce the target’s equity level considerably.
Primarily in cases of limited liability corporations (GmbH) and stock
corporations (AG) this is an important principle which may be violated through
the performance of a downstream merger.44
In terms of taxation, a downstream merger is treated in the same way as an
upstream merger. Generally, there is no tax advantage or disadvantage. One
exception may apply to any post-acquisition merger. As the acquirer’s
accounts carried forward were not canceled by the acquisition, their loss due
to a downstream merger may be more significant in comparison to a loss of
the target’s accounts carried forward in the upstream merger.
42 See Gröger, p. 361. 43 See Gröger, p. 362. 44 See Gröger, p. 363.
12
2 Tax Consolidation
Tax consolidation (Organschaft) means that the profits and expenses of all
consolidated companies (Organgesellschaften) which participate in the tax
group are consolidated and taxed on the level of the dominant enterprise
(Organträger). Besides the financial integration of the target, it is necessary to
conclude a profit and loss transfer agreement with a minimum duration of five
years for the purposes of tax consolidation.45 In addition, the dominant
enterprise needs to own the majority voting rights of each consolidated
company since the beginning of the consolidated company’s fiscal year.46
This is unlikely in the year of the acquisition. To overcome the potential tax
disadvantage in the year of the acquisition, the acquirer can apply to the tax
authorities for a change of the target’s fiscal year as provided by sec. 7(4)
sentence 3 KStG. Where this is done, it is later necessary to bring forward the
end the target’s fiscal year (Rückumstellung) before the end of the acquirer’s
fiscal year in order to offset the target’s profits against the acquirer’s interest
expenses. This backward adjustment can be performed under the same
conditions as the previous change of the fiscal year through an application to
the tax office. Usually, the tax office does not challenge such applications.47
These modifications of the target’s fiscal year enable the target to benefit from
the tax consolidation as soon as the acquisition is performed.
While, in cases of merger, tax credits and accounts carried forward are
canceled, they are frozen and therefore cannot be used for the duration of the
tax consolidation.48
3 Debt Push-Down
A debt push-down is performed through a payment by the target to the
acquirer. The cash generated by the acquirer through these inflows will be
used to repay or reduce the loan it has taken out to finance the acquisition.
Hence, no more interest expenses arise on the level of the acquirer. 45 See Gröger, p. 364. 46 See Gröger, p. 365. 47 See Gröger, p. 365. 48 See Gröger, p. 365.
13
The payment by the target to the acquirer can either be made by means of
external or internal financing. If the target has sufficient cash from retained
earnings, these can be used. Alternatively, the target can take out a bank loan
to pay the acquirer.
The mechanisms available to the parties to effect the payment are a refund of
contributions (Einlagenrückgewähr), a payout of dividends (Ausschüttung) or
the redemption of an investor’s stake (Anteilsrückkauf). A further option is the
use of an assumption of debt (Schuldenübernahme). This option is not
beneficial for consolidating the debt since the acquirer would still be paying
the interest on the loan. In other words, as the interest expenses would still
arise on the level of the acquirer, these cannot be deducted from the target’s
earnings. The assumption of debt may only be advantageous and a tax
beneficial debt-consolidation measure in combination with tax consolidation or
a waiver of the contribution claim. In order to waive the contribution claim, the
target needs suficient capital to secure the refund of debt.49 Where this is not
the case, the assumption of debt should not be considered an alternative.
Anyway, as the formation of a tax group would be necessary, which already is
a beneficial debt-consolidation method on its own, an assumption of debt is
no true alternative.
When evaluating the tax advantages and disadvantages of the debt push-
down, an analysis in relation to each of the available debt-push-down
mechanisms needs to be performed. Furthermore, the risk of taxes being
levied on capital gains needs to be taken into account. If the level of taxable
capital gains – usually this should not be the case shortly after the acquisition
– is high, the payout of dividends may be a more appropriate solution as
dividends are 95% tax-exempt.50 Another aspect which should be considered,
even though it might not be an issue shortly after an acquisition, is the target’s
accounts carried forward. In the case of a change in the ownership structure,
they are canceled accordingly.
49 See Gröger, p. 367. 50 See Gröger, p. 368.
14
If the group owns more operating businesses in Germany besides the target,
the other businesses could be included in the debt push-down. In such a
situation, the acquirer can sell the target’s shares to those businesses in the
group and offset these inflows against the outstanding loan. Obviously such a
scenario is only beneficial in the case of businesses with sufficient income
that the interest expenses can be offset against.
II The Interest Barrier
In general, interest expenses related to the financing of the acquisition are tax
deductible according to sec. 4(4) EStG.51 Besides this general regulation, the
level of deductible interest expenses may be limited due to the interest barrier,
discussed in section III of this chapter. A further limitation on the level of
deductible interest expenses is applicable in relation to trade tax. Unlike in the
case of CIT and PIT, for which 100% of interest expenses can be deducted,
only 75% of interest expenses exceeding the exemption level of €100,000 are
deductible for TT purposes, according to sec. 8 (1)(a) GewStG.52
After the implementation of the 2008 business tax reform, which is briefly
introduced in the next subsection, the interest barrier, governed by sec. 4h
EStG in conjunction with sec. 8 KStG, limits the interest deductibility granted
by sec. 4(4) EStG.53 By introducing the interest barrier, the government aimed
to control and limit the level of any financing activity by undertakings of all
legal forms.54 Therefore the interest barrier limits the level of interest payment
on any form of financing which may be deducted from an undertaking’s
income as an expense. In consequence, there is a limit to the benefit of a tax
advantage due to a decrease in the tax base resulting from the deductibility of
interest expenses. In other words, the level of tax advantages due to financing
activities is restricted to a certain level, as illustrated in detail by subsection 3.
51 See Gröger, p. 344. 52 See Gröger, p. 346. 53 Gröner, p. 344 (author’s translation). 54 See Schult, p. 37.
15
Another aspect intended by the government was to improve interest
deductibility for mid-sized companies, while increasing the tax advantage to
large multinationals. Unfortunately, as research already proves, while the
effect on multinationals is rather limited, the interest barrier is highly
disadvantageous for mid-sized companies.55
1 Business Tax Reform 2008
As part of the coalition agreement made between the CDU, CSU and SPD on
11 November 2005, the parties agreed to reform the German business tax
system by 2008.56 The coalition agreed that the reform had to cover all legal
forms, i.e. both corporations and partnerships.57 The coalition intended to
achieve five goals by means of the reform. Its first and primary goal was to
create a business tax system which was more attractive and capable of
competing on the international level while at the same time being appropriate
for the needs of the EU, and to abolish future conflicts with the European
Court of Justice.58 An additional benefit for undertakings was intended to be
easier tax planning.59 In a last point, the reform also had to guarantee the
“sustainable security of the German tax base”60.
The reform came into force on 1 January 2008 and included numerous
changes to many aspects of business taxation. One of these was the
introduction of the interest barrier. Overall, the governing coalition intends to
make Germany more attractive for undertakings and thereby eliminate tax
evasion.61
2 Background
The first limitation of external financing was implemented by the German tax
office in 1987 and was applicable solely to debt financing by foreign
55 See Prinz (2008). 56 See CDU, CSU & SPD, p. 69. 57 See CDU, CSU & SPD, p. 69. 58 See CDU, CSU & SPD, p. 69. 59 See CDU, CSU & SPD, p. 69. 60 CDU, CSU & SPD, p. 69 (author’s translation). 61 See Schult, p. 36.
16
shareholders. This regulation, as did many of the following regulations
implemented until 2002, aimed to limit the corporation’s possibility to transfer
profits to its shareholders abroad in the form of interest payments and
amortizations, without triggering WHT liability.
This regulation was ruled to be invalid by the Federal Finance Court on 05
February 1992.62 In a first reaction to the judgment, the tax office annuled the
regulation and passed the responsibility of implementing a new regulation to
the legislative authority.
The legislative authority did so and implemented a new regulation in 1994 as
part of the Location Protection Act (Standortsicherungsgesetz). The act was
the first government legislation which limited the deductibility of interest
expenses in Germany. It is important to know that the limitation only applied to
interest payments on loans provided directly or indirectly by shareholders who
had an interest of more than 25% in the undertaking and were not subject to
German CIT.63 In particular, similarly to the previous regulation by the tax
office, the legislative body “intended to limit interest payments of national
undertakings to foreign shareholders” by introducing this limitation.64 In order
to achieve its aim, the legislature limited the deductible amount of interest
expenses to a specific ratio between equity and debt – the so-called “safe
haven”. The equity/debt ratio for holding companies was 1:9 (holding
privilege), 1:0.5 for loans with a variable interest rate and 1:3 for loans with a
fixed interest rate.65 In 2001, those ratios were further reduced to 1:3 for
holdings; 1:1.5 on fixed interest and the “safe haven” on variable interest was
abolished.66 All interest expenses on debt trapped by the regulation
exceeding the ratio – the safe haven – were not deductible.
In 2002, the European Court of Justice found the legislation to violate the
freedom of establishment. Hence, the regulation only applied to foreigners of
third countries and was not applicable to interest payments to EU and EEA
62 See Köhler, Vogel & Adolf, p. 655. 63 See Köhler, Vogel & Adolf, pp. 655-656. 64 Köhler, Vogel & Adolf, p. 655 (author’s translation). 65 See Köhler, Vogel & Adolf, p. 656. 66 See Köhler, Vogel & Adolf, p. 656.
17
members anymore.67 Furthermore, a tax exemption of €250,000 was
implemented in 2004 which was applicable to all shareholders.68
In terms of M&A transactions, a high level of uncertainty existed in relation to
the previously described regulations. In consequence, finding the appropriate
structure and performing effective tax planning for the transaction were
challenging and created a high level of uncertainty.
3 The New Interest Barrier
Unlike the previous regulations that were implemented to limit an
undertaking’s level of external financing, the newly introduced interest barrier
applies to undertakings of any legal form and any form of financing. In order to
stimulate a more intense use of retained earnings or other internally available
cash, the interest barrier limits the level of deductible net-interest payments to
30% of the EBITDA.69 Interest expenses exceeding the deductible level can
be brought forward for an unlimited period. Whereas this results in an
increased level of interest expenses in future years, profits will not be affected
by the carry forward.70 Hence, an interest carry forward can only be exercised
in the case of a future decrease in the ratio of net-interest expenses to the
EBITDA. Furthermore, the ‘real’ value of the interest carry forward is limited
since it is canceled in certain restructuring scenarios and in cases of
significant changes in the ownership structure.71
On the other hand, when the EBITDA exceeds the interest expenses, the
EBITDA can be carried forward (EBITDA-Vortrag) and increases the level of
net-interest deductibility.72 The EBITDA carry forward is limited to five years.
Interest expenses include all payments on financing activities. These include
interest payments based on “fixed and variable interests, typical silent
67 See Köhler, Vogel & Adolf; p. 656. 68 See Köhler, Vogel & Adolf; p. 657. 69 See Gröger, pp. 344-345 and Schult, p. 37. 70 See Gröger, p. 344. 71 See Reiche & Kroschewski, p. 1331. 72 See Gröger, pp. 344-345.
18
partners, participation rights and share of profits such as commission”73.
Besides these expenses, tax authorities even deem several other non-interest
expenses which are directly related to the financing activity to be interest
expenses. An example of these are fees charged by a creditor in relation to a
loan.74
In order to support small and medium-sized businesses, the interest barrier
was introduced with an exemption for interest expenses up to a specific
amount. At its introduction in 2008, interest expenses of up to €1 million were
exempted from the interest barrier and fully deductible. In 2009, the
exemption was increased to €3 million by the Citizens’ Relief Act
(Bürgerentlastungsgesetz) – initially meant for a limited time period.75 The
time limitation was abolished in 2010 through the Growth Acceleration Act
(Wachstumsbeschleunigungsgesetz).76
Regarding the exemption level, it is of crucial importance to know that the
exemption is not a general tax-free amount. In other words, the exemption of
€3 million only applies to cases where the undertaking’s total interest
expenses do no exceed the exemption level. As soon as this level is reached
(e.g. interest expenses exceeding € 2,9999,999.99) the total amount is
subject to the interest barrier.
From this point on, undertakings whose interest expenses exceed the
exemption level slightly and which are unsure whether these expenses
exceed 30% of their EBITDA should try to reduce their interest expenses
below the €3 million threshold in order to create a tax benefit by avoiding the
application of the interest barrier. In a corporate group scenario, as the
interest barrier applies to each autonomous business, the allocation of interest
expenses throughout the group may provide a solution to the non-applicability
of the interest barrier. Potential ways which help to structure the financing in
such a way as to avoid tax disadvantages due to the interest barrier are
introduced in section 5.
73 Gröger, p.345 (author’s translation). 74 See Gröger, p. 345. 75 See Gröger, p.345. 76 See Köhler, Vogel & Adolf, p. 658.
19
Two other options provided by legislation which may result in the non-
applicability of the interest barrier are group independence (Konzern-
unabhängigkeit) according to sec. 4h(2) sentence 1(b) and sec. 4h(3)
sentences 5 and 6 EStG and the escape clause provided in sec. 4h(2)
sentence 1(c) EStG.
a Group Independence
The group independence exemption applies to “undertakings which are not or
only proportionally part of a group”.77 In relation to the interest barrier, the
definition of a group is extended. According to German regulations, an
undertaking is considered part of a group if it can be consolidated with other
undertakings by means of the IFRS, the US-GAAP or according to any other
accounting legislation of an EU member state.78 Alternatively, in cases where
the financial and business policies of a group can be controled by, or are
equal to those, of another undertaking, the prerequisites for being considered
part of a group are satisfied.79
Besides the necessity to satisfy the previously mentioned prerequisites, a
business entity may not provide so-called “harmful shareholder financing”
(schädliche Gesellschafterfremdfinanzierung).80 Harmful shareholder
financing occurs when more than 10% of the total net-interest expenses are
paid to shareholders whose interest in the company exceeds 25%. This
includes interest on loans provided by any related party to those
shareholders, or a third party which is capable of having recourse
(steuerlicher Rückgriff)81 to the shareholder or also a related party to it.82
Consequently, any undertaking which has a diverse ownership structure, has
no subsidiaries, and where less than 10% of interest expenses are a result of
harmful shareholder financing, is implicitly considered to be independent and 77 Reiche & Kroschewski, p. 1332. 78 See Reiche & Korschewski, p. 1332 and Gröger, p. 346. 79 See Reiche & Korschewski, p. 1332. 80 See Sinewe & Witzel, p. 317 and Schult, p. 42. 81 See Sinewe & Witzel, p. 319. 82 See Sinewe & Witzel, p. 318.
20
free of a group. In connection with this exemption, it is crucial to note that the
ownership structure and financing situation of the previous fiscal year are the
determining factors.83 Therefore, a target previously independent of the group
which satisfyies the requirements of this exemption according to its status in
the prior fiscal year can be exempted from the interest barrier in the fiscal year
of the acquisition.
b Escape Clause
Undertakings which are members of a group and are therefore not able to use
the group independence exemption can use the escape clause to be
exempted from the interest barrier. This exemption takes effect in cases
where the equity capital ratio84 of a group’s undertaking does not surpass the
group’s equity capital ratio by more than 1%.85
In order to be exempted due to the applicability of the escape clause, also the
requirements in regard to harmful shareholder financing described in the
previous paragraphs have to be fulfiled [sec. 4(2) sentence 1(c) EStG]. In
relation to the harmful financing of groups, it is important to know that “internal
group financing is harmless in relation to the interest barrier and the harmful
shareholder financing”86.
4 Impact on Acquisition Financing
Since the implementation of the interest barrier, the annual level of the
interest expenses’ deductibility – for those cases in which the exemption level
of €3 million is reached – is limited to 30% of the EBITDA of a given year.
Where the debt is consolidated by means of a merger, the EBITDA of the
combined undertakings is of relevance; in the case of tax consolidation, it is
the EBITDAs of all consolidated companies and the dominant company.
When debt-push-down measures are used, the EBITDA of the undertaking to
83 See Sinewe & Witzel, p. 317. 84 The relationship of equity to the balance-sheet total. 85 See Reiche & Korschewski, p. 1332; Gröger, p. 346 and Sinewe & Witzel, p. 320. 86 Sinewe & Witzel, p. 321 (author’s translation).
21
which the debt has moved – and therefore where the interest expenses
appear – is the significant figure.
All excess interest expenses have to be carried forward until either the
interest expenses of a future year decrease or the EBITDA becomes high
enough to allow the deductibility of the current interest and the interest
expenses carried forward. Other than would have been the case for the
previous regulations, since the introduction of the interest barrier, the form of
acquisition financing – external (e.g. bank loan) or internal (e.g. debt provided
by the foreign parent company) – does not play a role in relation to the
deduction limitation. In other words, whereas the previous regulation only
applied to specific types of financings by foreign shareholders, the choice of
acquisition financing became subordinated in terms of interest deduction
because the interest barrier applies to all financing activities.
Nevertheless, in the case of internal financing, two conditions have to be
considered. First, the acquirer has to ensure that the underlying conditions
meet arm’s length requirements. Where this is not the case and arm’s length
is exceeded, interest payments are only considered interest expenses up to
the arm’s length level. Expenses above this level are considered constructive
dividends and are not tax deductible. Second, if the application of the escape
clause may be an option, it should be ensured that the undertaking using the
escape clause – acquirer, target or the combined entity after a merger – does
not provide any harmful shareholder financing.
5 Efficient Structuring in Light of the Interest Barrier
In order to allow the acquirer to perform appropriate tax-planning activities
and reduce the potential tax disadvantages due to the applicability of the
interest barrier, the first step is to examine the individual likelihood of its
applicability.
In comparison to other interest barrier applicability tests that solely consider
the applicability of the exemption level, group independence or escape
22
clause87, the applicability test shown in diagram 2 takes other structuring
approaches into account. Furthermore, whereas the other tests are limited to
the current fiscal year as net-interest expenses and EBITDA change, the
scheme above aims to provide a long-term planning approach by taking
business plans and other forecasts into account. For undertakings which may
not be able to use any of the exemption methods, the introduction of business
forecasts in the tax planning activities regarding the interest barrier provides
an idea of whether or not the 30% burden may be exceeded in the future.
Hence, in such a case the undertaking can try to use a structuring method in
order to avoid tax disadvantages due to the interest barrier.
Diagram 2: Interest Barrier Applicability Test
Overall, a proactive long-term approach to avoid the interest barrier offers
numerous benefits in comparison to a reactive approach based on the fiscal
year. Nevertheless, certain additional reactive activities according to the
circumstances in a particular fiscal year have to be considered.
87 Cf. Sinewe & Witzel, p. 315; Braun, p. 77 and Bird & Bird Germany, p. 4.
23
A previously formed tax group may already be beneficial and decrease the
likelihood of negative tax effects due to the interest barrier.
Under this arrangement, all entities participating in the consolidation are
treated as one undertaking [sec. 15(3) KStG] for tax purposes.88 As a result,
the EBITDA of the tax consolidation refers to that of all consolidated
companies and the dominant enterprise, and all interest expenses are
consolidated on the level of the dominant enterprise. Hence, the consolidated
companies with high net-interest expenses benefit from the high EBITDA
contributed by others, while those companies with high profits and low
expenses benefit from the deductibility of the others’ expenses.
The same also applies for a merger. The positive effect may be especially
advantageous where more businesses than only the acquirer and target are
consolidated or merged.
Another, but similar, option in the case of a group is available for cases where
debt push-down is used as the measure of debt allocation: The interest
expense is distributed in such a way that the individual taxable unit’s interest
expenses remain below the exemption level of three million euros. Such a
scenario may already be created before the acquisition takes place by using
more than one acquisition vehicle89. Bearing in mind if the acquisition vehicles
are mere holding companies, the advantage is limited because a minimum
amount of taxable income is involved.
Besides these structuring opportunities going hand in hand with the debt
consolidation, German law provides for further accounting-related
opportunities to improve the deductibility of interest expenses.
a Realization of Hidden Reserves
One restructuring option to increase the level of deductible interest expenses
is the increase in the tax EBITDA through the realization of hidden reserves.
In the case of a target acquired in an asset deal, this alternative may not be
88 See Gröger, p. 364 89 See Reiche & Korschewski, pp. 1333-1334.
24
available after the acquisition. Nonetheless, hidden reserves of the acquirer or
other group undertakings may be available; it may be possible to realize them.
Those undertakings could ultimately be used for a debt push-down.90
Before beginning to realize available hidden reserves, an in-depth analysis of
the potential benefit in terms of the interest barrier is as important as for any
other structuring activity. In relation to the realization of hidden reserves, the
evaluation should explicitly concentrate on the potential tax payments on
capital gains created by the realization of hidden reserves. If they exist, they
have to fall below the realized tax advantages in comparison to the interest
barrier. Otherwise the realization of hidden reserves is not advantageous.
b Variable Interest Expenses and Debt-to-Equity Swap
Two other options, in most cases likely to be exclusively available to internal
financing, are the payment of variable interest91 and a debt-to-equity swap.
Agreeing on the payment of variable interest in relation to any given fiscal
year’s EBITDA allows the acquirer to ensure that its interest expenses on the
acquisition financing will be fully deductible and not exceed the 30%
threshold. Obviously, when more than the one loan is taken out, the interest
barrier can become an issue due to the other loans. To avoid or limit this risk,
the interest on all other loans and an EBITDA forecast should be taken into
account when the variable interest rate is negotiated.
A second option is to use a hybrid loan in a similar manner. For the hybrid
loan to be advantageous in terms of the interest barrier, the creditor and
acquirer have to conclude an agreement including the possibility of a shadow
interest carry forward (Schattenzinsvortrag). Such an agreement may be
formulated as follows: “In the case of a low cash-flow and limited deductibility
of interest, no interest will be paid and carried forward until cash-flow has
increased again”92.
90 See Liekenbrock, p. 312. 91 See Liekenbrock, p. 287. 92 Liekenbrock, p. 288 (author’s translation).
25
For any agreement on the payment of variable interest between related
parties, attention must be given to the possibility that the interest rate exceeds
arm’s length terms. In such a case, the interest expenses in excess of arm’s
length are not deductible.
In the case of a debt-equity swap, any possible risks of the interest barrier are
canceled. As the former creditor becomes a shareholder and receives
dividends which are not triggered by the interest barrier, no more interest
payments are made.
c Accounting Measures
A corporate group could try to improve its equity capital ratio by means of
accounting. To achieve such an improvement, the change to IFRS accounting
is advantageous. IFRS offers such an advantage due to the possibilities of
performing time-value accounting on certain assets, the allocation of goodwill
to so-called cash-generating units and the right to elect the type of valuation
(Bewertungswahlrecht).93 In terms of the interest barrier, the improvement
measures have to focus on the individual business’s balance sheet rather
than the group balance sheet to allow the employment of the escape clause.
A second available accounting measure is limited only to very few and
specific acquisitions provided by sec. 255(3) sentence 2 HGB. According to
the section, interest expenses which can definitely be assigned to the
production process can be treated as production costs.94 As this rule is also
applicable in terms of tax accounting, a tax advantage is created in relation to
the interest barrier.
Even though the application of this measure cannot be applied to most
acquisitions, in some cases – such as that of a previous subcontractor
involved in the production process – the use of this option allows the acquirer
to account for the interest expenses of the acquisition financing as production
expenses. Hence, the interest barrier is not applicable and the interest
expenses, being considered production costs, are fully deductible.
93 See Liekenbrock, p. 314. 94 See Liekenbrock, p. 313.
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C UNITED STATES
I Debt Consolidation
Any debt-consolidation method performed has to consider potential threats by
the step transaction doctrine, often applied to post-acquisition reorganizations
by courts. According to U.S. tax law, reorganizations have to be borne by a
general business purpose and on economic grounds.95 Reorganizations
performed solely for tax optimization reasons can therefore be challenged by
the courts and may result in unpredicted negative tax consequences. To avoid
such tax disadvantages, it is crucial to take reasonable and justifiable
business purposes and economic grounds into account when determining
restructuring measures in relation to post-acquisition debt consolidation.
1 Mergers
Sec. 355 of the IRC is applicable to tax-free mergers in the U.S. In order to
perform a tax-free merger as defined by Sec. 355 IRC, six requirements have
to be fulfiled. These include “a five-year business history”96, a minimum 80%
interest by one shareholder, and the continuity of the business after the
merger, such as a business purpose being the reason for the merger.
In relation to a post-acquisition merger as a means of debt consolidation,
where the business history requirement or any other requirement cannot be
met, a tax-free merger according to sec. 355 IRC is not an option. In such
cases, a merger can be performed at book value or as a statutory merger
under sec. 368(a)(1)(A) IRC. For the statutory merger to be tax neutral
several statutory and non-statutory (case law) requirements such as the step
transaction doctrine and the continuity of the business after the merger need
to be fulfilled.
95 See Taxand, p. 367. 96 Chip, p. 1.
27
When the merger is performed at book value, it may be advantageous for tax
purposes to perform an upstream merger as hidden reserves on the level of
the target may already be realized during the acquisition. This is especially
true if the acquisition was performed by means of an asset deal. However,
according to sec. 338 IRC, under certain conditions a share deal may also be
treated as an asset deal for income tax purposes.97 Where this is possible,
the acquirer should elect this option in order to limit capital gains arising from
a post-acquisition merger.
2 Tax Consolidation
The single requirement for forming a tax group in the U.S. is a direct interest
of 80% by the dominant company in one of the consolidated companies. If
more than the acquirer (e.g. dominant company) and the target (e.g.
consolidated company) are joining the tax group, it is sufficient if any
consolidated company other than the dominant company holds an interest of
at least 80% in one of the other consolidated companies.98
When those requirements are satisfied, a tax group can be formed by means
of a consolidation election under sec. 1501 IRC.
Alternatively, the tax consolidation can either be performed by “checking the
box” or through the establishment of a partnership for tax purposes.
By using the “checking the box” option, each consolidated company becomes
a division of one single undertaking – the tax group.99 Since this conversion is
considered to be a liquidation for tax purposes, it may trigger built-in gains. If
the assets causing the gain are kept in the U.S. business for less than ten
years, those gains are subject to taxation.100
Where the tax group is formed by means of a partnership for tax purposes, no
new entity will be established, and assets will not be moved. The shifting of
assets may give rise to taxable gains. To establish the partnership, it is
sufficient that all participating businesses conclude a profit and loss pooling
97 See Taxand, p. 361. 98 See Deloitte (Highlights U.S.), p. 3. 99 See Chip, p. 2. 100 See Chip, p. 2.
28
agreement. This agreement has to contain wording such as the following:
“Neither party may sell business assets without the other’s consent, each
party indemnifies the other for business-associated liabilities, each party
agrees to ’true up’ disproportionate losses, businesses are to be carried on
under a single trade name, new assets are acquired in the name of the joint
venture and the businesses are accounted for as a joint venture”101.
3 Debt Push-Down
In terms of taxation, the distribution of dividends may be an attractive option
for performing a debt push-down. This is especially the case where a member
of the same group holds an interest of 100% in the distributing business. In
this case, dividend income is 100% tax exempt.102
Since the maximum possible level of dividend distributions may not be
sufficient to push down all debt incurred by the acquisition from the acquirer to
the target, additional measures such as a distribution of the target’s assets
may be necessary. In relation to such a transaction with other affiliated
companies, it is crucial to take potential tax consequences created by the
realization of capital gains into account.
A third method frequently used in the U.S. as a means of debt push-down is
to combine the acquirer and the target in a newly established holding
company.103 For tax purposes, such a transaction – which is somewhat similar
to a merger – can be performed as a share deal to minimize tax implications
due to the realization of hidden reserves.
Additionally, a carry forward is not lost proportionally in the case of such
restructuring. This is a significant advantage in comparison to Germany.
101 Chip, p. 2. 102 See Deloitte (Highlights U.S.), p. 1. 103 See Chip, p. 2.
29
II Earnings-Stripping Rules
As in Germany, interest expenses incurred due to acquisition financing can
generally be offset against taxable income. Besides this general principle,
certain exceptions exist under which the level of deductibility is limited. The
most important exceptions are the question whether financing is classified as
debt or equity in accordance with the principles of economic import [sec. 385
IRC], IRS standards and judicial principles.104 Classification as debt is the first
necessary prerequisite for allowing any interest deduction. Mainly in cases of
shareholder loans not granted at arm’s length [sec. 482 IRC] or debt secured
by a related guarantor – who may be considered the primary borrower by the
tax authorities – interest payments are treated as dividends and are therefore
not deductible.105
Another limitation applies when discounted securities are the financing
instrument used. If a foreigner holds a security instrument, where the issuer
did not pay the original issue discount, the discount is not deductible.
Likewise, the deduction can be limited or disallowed, “if the debt instrument is
treated as an applicable high yield discount obligation”106.
When the acquisition is financed or the financing is secured by a related party,
the interest deductibility may also be limited under the earnings-stripping rule.
The earnings-stripping rule governed by sec. 163(j) IRC, limits the
deductibility of interest payments by U.S. corporate enterprises when the
financing is conducted by a related party abroad, underlying a back-to-back
arrangement, or is provided by a third party where the agreement includes a
disqualifying guarantee and no WHT is levied on the interest payments. If the
interest payment is not taxed or taxed at a rate below 30%107 in the U.S., the
deduction of the interest expenses is limited. In the case of a WHT rate below
30%, the interest deduction is limited in accordance with the level of WHT
levied (e.g. 10%) and the statutory rate of 30%. A more detailed analysis in 104 See KPMG (U.S.), p. 7 and Bohn, pp. 153-154. 105 See KPMG (U.S.), p.7. 106 KPMG (U.S.), p. 9. 107 30% being the total level of withholding tax levied in the U.S.
30
relation to the application of the earnings-stripping rule is provided in
subsection 2.
If a corporation’s financing includes disqualified interest expenses108 – in
cases with excess interest expenses – the deductibility of the expenses may
be limited. The limitation only occurs when the debt-to-equity safe harbor of
1.5:1 and the cash-flow safe harbor, being 50% of the adjusted taxable
income109, are exceeded.110
Once the interest expenses of one fiscal year exceed both safe harbors, not
all interest expenses will be deductible. Non-deductible interest expenses can
be carried forward for an unlimited time.111 In addition, if the interest expenses
are below 50% of the adjusted taxable income, the excess portion of this 50%
– the excess limitation – can be carried forward. This can be carried forward
for a maximum of “three years and added to the 50% of the adjusted taxable
income to increase the threshold”112 of the following years.
1 Background
The earnings-stripping rule was primarily introduced by means of the
Omnibus Budget Reconciliation Act in 1989. With its introduction, the U.S.
government intended to generate equal taxation for all U.S. businesses, by
limiting the tax structuring opportunities of U.S. businesses with foreign
undertakings. While they were able to create tax advantages by shifting profits
abroad, purely domestic businesses had a tax disadvantage.
In addition, by implementing the earnings-stripping rule, the U.S. government
was able to limit a further decrease in its tax revenue.113
Initially, the regulation only applied to direct financing activities by a related
party and back-to-back transactions. In 1993, as part of the Revenue 108 Interest expenses on financing activities falling under the earnings-stripping rule (see PWC (2004), p. 1). 109 Adjusted taxable income = taxable income + net interest expense+ net operating loss deduction + depreciation, amortization, depletion. (See BDI & KPMG, p. 23). 110 See PWC (2004), pp. 1-2 and BDI & KPMG, p. 20. 111 See Deloitte (U.S.), p. 11. 112 PWC (2004), p. 2. 113 See BDI & KPMG, p. 20.
31
Reconciliation Act, the application was extended to third party debt with
recourse authority.
In the early 2000s two proposals, the “Thomas Bill” 114 of 11 July 2002 and the
“Bush Proposal” 115 as part of the 2004 budget, were introduced aiming to
modify the earnings-stripping rule.
Both proposals suggested a reduction of the adjusted taxable income safe
harbor from 50% to 35%, a limitation on disallowed interest carried forward to
a maximum of 5 years, and the elimination of the excess limitation carry
forward.116 While the Thomas Bill proposed the elimination of the debt-to-
equity safe harbor, the Bush Proposal intended to replace the 1.5:1 ratio with
a debt-to-asset test.117 Furthermore, in cases where “the U.S. group is more
heavy levied than the rest of the group”118,the Thomas Bill aimed to disallow
disqualified interest of such groups, while the Bush Proposal suggested
disallowing the interest either completely or only partially. This was to apply to
U.S.-based and foreign-based multinational groups. Neither of the two
proposals has been enacted and come into force to date.
2 Application
The earnings-stripping rule only applies to U.S. businesses which are
considered members of a group. To be deemed a member of a group, an
interest of at least 80% must be held directly or indirectly by another corporate
entity.119 Especially when a corporate parent holds a significant interest in two
or more U.S. businesses, those businesses are considered members of a
group.120
For partnerships, the earnings-stripping rule is not applicable – at least on the
level of the partnership. In the case of a corporate partner, the earnings-
stripping rule may apply proportionally to its interest in the partnership –
114 Named after the representative William Thomas, who chaired the House Ways and Means Committee. 115 Named after the U.S. president at that time, whose administration advanced the proposal. 116 See PWC (2004), p. 3. 117 See PWC (2004), p. 3. 118 PWC (2004), p. 3. 119 See Ernst & Young LLP, p. 43. 120 See BDI & KPMG, p. 25.
32
subject to the existence of disqualified interest expenses on the partnership
level. In cases where the partnership is the related party (e.g. parent
partnership) of a U.S. business, the decision whether the earnings-stripping
rule applies will be made on the level of the partner. The partners may only be
considered related parties and fall under the earnings-stripping rule if their
interest in the partnership is 10% or more.121
Diagram 3: Earnings-Stripping Rule Applicability Test
As diagram 3 illustrates, in line with the application of the earnings-stripping
rule, the classification of the form of capital is significant. More precisely, it is
significant whether the capital provided is considered to be internal or external
in relation to federal income taxation.
Sec. 385(b) IRC provides that, in order to determine the form of capital, the
interest rate, the type of underlying interest (fixed or variable) and the
121 See BDI & KPMG, p. 26.
33
creditor’s ranking in comparison to other creditors are of vital importance.122
Financing activities providing an inappropriate interest rate – in comparison to
the market rate - demand the payment of variable interest rates, or in the case
of a subordinated creditor’s ranking, the financing is deemed to be internal.123
Internal capital is treated as an equity investment for tax purposes. Hence,
interest payments are considered as dividend payments and not deductible.124
On the one hand, when the interest rate is appropriate and fixed, and the
creditor’s ranking equals those of similar creditors, the capital is categorized
as external. This makes the deductibility of interest expenses generally
possible, whereas the level of deductibility may be limited. In addition to the
requirements set out in the IRC, a great deal of case law handed down by
U.S. federal courts exists in connection with the classification of financing.
According to these decisions, “the overall intention of the parties, the terms
and conditions of the loan, the history of the actual dealings of the parties
(e.g. payment history), and the hypothetical ability of the borrower to obtain
similar financing from an unrelated party”125 are criteria which should be taken
into account.
Where the financing has been classified as external, the next step is to
analyze whether the creditor belongs to one of the three groups / financing
parties to which the earnings-stripping rules apply. As previously mentioned,
these three groups include related parties abroad which do not pay or pay a
U.S. WHT below 30% on the interest, back-to-back arrangements and third
party debt (e.g. bank loan) which is secured by a disqualified guarantee and
on which interest payments no WHT is levied.
Whether a creditor is considered a related person has to be analyzed by
applying the criteria provided by sec. 267b and sec. 707b(1) IRC.126
According to these provisions, the creditor has to satisfy one of the following
three criteria: natural persons holding an interest of above 50%, “corporate
122 See BDI & KPMG, p. 20. 123 See BDI & KPMG, p. 20 and Ernst & Young LLP, p. 46. 124 See KPMG (U.S.), p.7. 125 Ernst & Young LLP, p. 46. 126 See BDI & KPMG, p. 21.
34
enterprises of the same affiliated group having a parent-subsidiary
relationship or being corporate sisters holding an interest of above 50% on
each level”127, or partnerships having an interest of above 50% in the
corporate entity or vice-versa.128 For both cases, the interest can either be
owned directly or by adding the interest of family members of others. In
general terms, a creditor not dealing at arm’s length is considered to be a
related person.129
Back-to-back arrangements involve the use of an unrelated party – such as a
bank – as an intermediary between the related person abroad and the U.S.
corporate entity. Instead of granting a loan to the corporate entity, the related
party grants a loan to the bank on condition that the loan is passed on to the
corporate entity by the bank. In consequence, even though the corporate
entity pays interest to the bank, the interest payment is deemed to be an
indirect payment of interest from the corporate entity to its related party as the
bank pays interest to the related party. The deduction of such indirect interest
payments is also limited by the earnings-stripping rule.130
The third category of financing affected by the earnings-stripping rule is third
party loans that satisfy certain requirements. These requirements are the
guarantee of repayment by a related person and that no WHT is levied on the
interest payment. According to IRS standards and the evolution of the
legislative process in the U.S., the guarantee requirements are not solely
limited to disqualified guarantees. In principle, any form of credit support by a
foreign related party can fulfill the requirement.131 The WHT prerequisite is
only based on the guarantor. Thus, even when the financing bank is based
and located in the U.S. and therefore subject to U.S. taxation, the earnings-
stripping rule applies if the guarantor is not subject to U.S. WHT.132 In other
words, if WHT were not levied or WHT were imposed below 30% in the
127 BDI & KPMG, p. 21 (author’s translation). 128 See BDI & KPMG, p. 21. 129 See Ernst & Young LLP, p. 44. 130 See BDI & KPMG, p. 21. 131 See BDI & KPMG, p. 22. 132 See BDI & KPMG, p. 22.
35
hypothetical case of a direct interest payment to the guarantor, the earnings-
stripping rule would be applicable.
3 Impact on Acquisition Financing
The illustrations in the previous section show under which conditions the
deductibility of interest might be limited. As the introduction to this section
described, certain forms of financing such as discounted securities and
financing subject to underlying conditions that lead to its classification as
internal capital are not tax deductible in general. Hence, such forms of
financing should be avoided when choosing the appropriate financing method.
Furthermore, other forms of financing provided or secured by related persons
may be disadvantageous due to the possible applicability of the earnings-
stripping rule.
The earnings-stripping rule can be compared to the German legislation prior
to the introduction of the interest barrier in 2008. Moreover, the previous
German regulations and today’s environment in the U.S. are more
advantageous in terms of deducting interest expenses incurred due to
acquisition financing. Overall, this advantage is based on the fact that the
earnings-stripping rule is applicable only to a specifically defined set of
financing methods including those provided by a foreign related party whose
WHT rate is below 30%, back-to-back arrangements, and third party financing
secured by those related parties. Considering the earnings-stripping rule and
its underlying applicability requirements, an acquirer, given its costs of capital
allows it to use external (e.g. bank) financing, may have little difficulty in
choosing a form of financing that does not trigger the earnings-stripping rule.
Given that, there will be no or only very few limitations in regard to the
deductibility of such interest expenses.
In Germany, only choosing a specific form of financing where no related party
is involved does not exclude the application of the interest barrier as it applies
to all financing activities.
36
4 Efficient Structuring in Light of the Earnings-Stripping Rules
The primary and best optimization measure, as explained above, is to exclude
financing activities involving related parties wherever possible. Still, as there
are cases where the available forms of financing are limited, the earnings-
stripping rule cannot be avoided by means of the ‘right’ form of financing.
Hence, other measures are necessary to limit or counteract a limitation of the
deductibility of disqualified interest expenses.
In comparison to Germany, these structuring opportunities are limited.
Nevertheless, there are several measures that allow an acquirer to improve
the level of deductible interest expenses. Possible optimization measures are
increasing one or both safe harbors. This may be achieved by means of tax
consolidation, as introduced in section 1. Another optimization measure may
be provided by a debt push-down.
a Debt-to-Equity and Adjusted Taxable Income Optimization
As already stated, one option to achieve such an optimization is the
introduction of consolidated taxation since the accounts payable and
receivable of each group enterprise are consolidated on the group level,
including those accounts inbetween the group’s entities. Such accounts may
not be considered in the case of non-consolidated taxation.133 Hence, by
performing consolidated taxation, the overall debt-to-equity ratio may be
improved considerably. Ahead, in the case of any tax consolidation, the
applicable 50% cash-flow-based safe harbor is determined according to the
consolidated group’s adjusted taxable income.
Ultimately, the performance of consolidated taxation is more than likely to
improve both safe harbors of the group. Thereby, the deductibility of
disallowed interest expenses increases, while the potential tax disadvantage
due to the earnings-stripping rule decreases.
Excess interest expenses or excess limitation are carried forward on the level
of the group.
133 See BDI & KPMG, p. 25.
37
b Debt Push-Down
In certain scenarios, a post-acquisition debt push-down is a valuable option to
avoid the applicability of the earnings-stripping rule. This applies to cases
where the acquisition financing on the level of the acquirer falls under the
earnings-stripping rule. Provided the debt push-down is financed by means of
external financing on the level of the target or another affiliated U.S. business,
an advantage is only created in cases where the refinancing does not
stipulate disallowed interest expenses.
One example of a situation in which a debt push-down may be advantageous
is when a U.S. acquisition vehicle is used whose only function is to acquire
the target. Under such circumstances, the financing costs are most likely to be
classified as disallowed interest expenses as it is unlikely that the acquisition
vehicle will be granted an unsecured loan by a U.S. bank. An unsecured bank
loan to the target is more likely.
For these reasons, a debt push-down from the acquirer to the target, where
the target uses internal funding or a loan not including a related party, creates
a tax advantage in connection with the earnings-stripping rule.
38
D FRANCE
I Debt Consolidation
The following description demonstrates that mergers performed shortly after
an acquisition tend to be a secondary option for debt consolidation as they
might be challenged by the tax authorities. Also, the formation of a tax group
may be a secondary choice as the consolidated company has to be controled
by the dominant company for 12 months in order to perform the tax
consolidation. In consequence, pushing down a debt may be the best and
least controversial option for performing immediate post-acquisition debt
consolidation.
1 Mergers
As in Germany, a merger can either be upstream or downstream and can also
be performed at book value. Hence, no taxation would be levied due to capital
gains.
Still, from a taxation point of view, there is one disadvantage in a post-
acquisition downstream merger. The losses carried forward by a holding
company are canceled when it is merged into the target. In the opposite
scenario of an upstream merger, this is not the case. Before being merged
into the holding company, the target can take its loss carry forward into the
merged entity after approval by the tax authorities. For such approval to be
granted, the only condition is that the merged entity is maintained for a
minimum of three years.134 Under these circumstances, essentially in cases of
a holding company with a high loss carry forward, the target should be
merged into the acquirer, and not vice-versa.
In addition, so-called “quick mergers” (“fusions rapides”) – mergers performed
shortly after the acquisition – are not well received by the French tax
authorities. Pursuant to the theory of abuse, the merger can be challenged if it
134 See Taxand, p. 109.
39
is fictitious or performed solely for tax reasons.135 As the post-acquisition
merger is likely to be performed for tax reasons, this poses a substantial
threat to the merger. Furthermore, the quick merger may also be challenged
by means of the abnormal act of management.136 This is breach in cases
where “the merger cannot be deemed to be performed in the interest of the
relevant company”137. In other words, if the target has no advantage due to
the merger and the merger is only advantageous for the acquirer, a breach
has occurred.
Even though it is theoretically very likely that the quick merger will be
challenged on any of these grounds, almost all of the existing case law is in
favor of the taxpayer.138
According to these rulings – mainly by the Supreme Administrative Court and
Regulations 41-2-00 from the year 2000 – tax authorities have to take other
favorable decisions and whether such decisions exist into account before the
merger may be challenged.139 In addition, the time between the acquisition
and the merger, the amounts of equity and debt on the level of the acquirer,
and whether the acquirer’s activity in the target went beyond the mere
shareholding, have to be evaluated and taken into consideration for a decision
whether or not the merger is acceptable.140
In order to avoid the merger being challenged by the tax authorities, an in-
depth analysis and evaluation, taking into account the facts, circumstances
and the overall situation, has to be performed. Additionally, it should be
considered whether other options are not preferential for the debt
consolidation given the potential uncertainty.
One way to avoid a potential challenging of the quick merger is available due
to a 2007 ruling of the French tax authorities.141 According to this ruling, a
quick merger between two holding companies by means of a secondary
leveraged buyout – where neither of these holding companies has a minority
135 See Cotty Vivant Marchisio & Lauzeral, p. 2 and Assouline, p. 46. 136 See Cotty Vivant Marchisio & Lauzeral, p. 2 and Assouline, p. 46. 137 Cotty Vivant Marchisio & Lauzeral, p. 2. 138 See Cotty Vivant Marchisio & Lauzeral, p. 2. 139 See Cotty Vivant Marchisio & Lauzeral, p. 2. 140 See Assouline, p. 46. 141 See Assouline, p. 46-48.
40
shareholder – may not be challenged. Unfortunately, for the given scenario
this structuring measure does not provide any advantage in terms of the debt
consolidation. To be advantageous, a tax group would have to be formed
including the holding company and the target. As a tax group itself is sufficient
for the purpose debt consolidation, there is no necessity to perform an
additional merger between the acquirer and a new holding company.
Furthermore, as a company may not finance its own acquisition according to
the French Commercial Code, more debt could be necessary to perform this
restructuring.142 Thereby the risk of non-deductible interest expenses may
even increase.
2 Tax consolidation
The requirement to establish a tax group is a direct or indirect interest of a
minimum of 95%143 [Art. 223(A) f. FTC] in the consolidated company for a
period of 12 months144. In addition, the consolidated entities’ accounting
periods need to be equivalent.145 When these requirements are fulfiled for the
performance of the tax consolidation, it is sufficient if the acquirer makes the
formal decision to be consolidated with the target.
If tax consolidation occurs after an acquisition in order to consolidate the
acquirer’s interest expenses with the target’s profits, these requirements are
detrimental. Due to the 12-month holding period, in particular, interest
expenses incurred in the first year after the acquisition may only be offset
against the limited income of the acquirer. Even though the likely loss can be
carried forward on the level of the acquirer, its tax advantage is limited
because the loss cannot be transferred to the tax group.
142 See Taxand, p. 110. 143 See Assouline, p. 44. 144 See Cotty Vivant Marchisio & Lauzeral, p. 1. 145 See Cotty Vivant Marchisio & Lauzeral, p. 1.
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3 Debt push-down
The most common measures for performing a debt push-down in France are
a dividend distribution or the relocation of the target’s assets.146 Both
measures can be financed by a loan where no retained earnings are
available.
As a distribution of dividend is limited by the company’s distribution capacity, it
might be necessary to increase its distribution capacity in accordance with the
accounting rules before the dividends are distributed to the acquirer. One
option for increasing the distribution capacity without triggering high taxation
on capital gains is “the straight sale of shares benefiting from the participation
exemption regime”147. For such transactions, the effective tax rate levied is
1.7%. The participation exemption regime exempts 95% of the taxation on
capital gains on shares held for more than two years and on dividends where
the recipient holds an interest of at least 5% for a minimum of two years.148
In consequence, the effective tax rate of 1.75% may also be applicable to the
relocation of the target’s assets and the payout of a dividend to the acquirer.
Furthermore, in the case of an asset sale to an affiliate within the same tax
group, which may be the case if the target has subsidiaries with which it
formed a tax group before the acquisition, the transaction can be performed at
book value and therefore be tax neutral.149
II Thin Capitalization Rule
In France, interest expenses are generally tax deductible. This is true as long
as the interest payment is borne by a loan in the interest of the company –
loans not resulting from an abnormal act of management.150 Another
exception applies to loans where related parties (entreprises liées) are 146 See Taxand, p. 109. 147 Taxand, p. 109. 148 See Deloitte (Highlights France). 149 See Taxand, p. 106 and pp. 109-112. 150 See Taxand, p. 107.
42
involved. The deduction of interest expenses on such loans can be limited by
the thin capitalization rule as defined under Art. 212 CGI.
The level of deduction of such disqualified interest expenses – interest falling
under the thin capitalization regime – is limited according to a three-step test:
a 1.5:1 debt-to-equity ratio test, 25% of the adjusted ordinary income151, and a
related party interest test152.153 The possible deduction level is based upon the
higher level of any of these tests. Hence, when the debt-equity test result is
100, 25% of the adjusted ordinary income is 150, and the related party
interest test’s result is 80, disqualified interest expenses of up to 150 can be
deducted.
In addition, a safe harbor allows further deduction of disqualified interest
expenses of up to €150,000 above the deductible level. In the case of
disqualified interest expenses exceeding the safe harbor, they can be carried
forward for an indefinite period.
Even though the carry forward period is unlimited, its value decreases over
time. In particular, the full amount carried forward can only be offset against
the adjusted ordinary income of the following two fiscal years. When this is not
possible, the interest carry forward is deducted by 5% annually.154
Another exemption, similar to the escape clause under the German interest
barrier, is provided for members of groups. Where the stand-alone debt-to-
equity ratio is equal or below the group’s debt-to-equity ratio, the business is
exempted from the thin capitalization rule.155 This rule may provide a second
safe harbor to companies whose disqualified interest expenses exceed the
safe harbor of €150,000.
In addition, the deduction of disqualified interest expenses on financing
activities involving related parties may be limited if the interest rate exceeds
151 adjusted ordinary income = annual income before tax + net related-party interest + depreciation and amortization + lease expenses. 152 The level of interest income from related parties compared to interest expenses to related parties. 153 See Linklaters, p.1. 154 See Taxand, p. 108 and IBFD (France), sec. 10.3. 155 See IBFD (France), sec. 10.3.
43
the market rate. As a general principle, the interest rate may not exceed the
interest rate “determined by the French tax administration”156. Whenever the
interest rate is above this level, the interest expenses are only deductible if
the company can prove that the interest rate meets arm’s length
requirements.
1 Background
“French tax law is famous for its permanent evolution”157. This also applies to
the thin capitalization rule. Since its implementation in 1990, the thin
capitalization regime has undergone several reforms. Consequently, it is
important to remain up to date regarding the current scope and limitation of
the rule.
Originally, the thin capitalization rule only applied to financing provided directly
by foreign related parties. Two rulings handed down by the French Supreme
Administrative Court on 30 December 2003, similarly to what also happened
in Germany, found the thin capitalization rule to contradict Art. 43 of the EC
Treaty (freedom of establishment) and the French/Austrian DTT, by only
applying to foreign related parties. 158 In a reaction by the tax administration
on 12 January 2005, the applicability of the thin capitalization rule was
narrowed. Thereafter, it only applied to related parties situated outside the
EU, countries lacking a valid DTT with France or a DTT not including an anti-
discrimination clause and those countries explicitly providing for the
application of the French thin capitalization rule.159
Two years later, in 2007, its application was reformed again. Since then, the
thin capitalization rule has applied to all financing by related parties, whether
the related party is situated abroad or in France.
The last evolution of the thin capitalization rule came into force in 2011. The
scope of the French thin capitalization rule was extended similarly to that of
156 Taxand, p. 108. 157 Assouline, p. 44. 158 See IBFD (France), sec. 10.3 159 See IBFD (France), sec 10.3.
44
the U.S. earnings-stripping rule. Hence, in addition to direct financing granted
by related parties, from now on it also applies to third party financing which is
secured by a related party – including back-to-back arrangements.160
2 Application
Diagram 4: Thin Capitalization Rule Applicability Test
The French thin capitalization rule applies to all French businesses, including
those which belong to foreign group. In other words, it also applies to
financing activities involving a French parent or sister company.161
The thin capitalization rule applies when the financing is provided by related
parties or by third parties in cases where a related party secures the financing
in person or in rem.162
In regard to secured third party financing, the value of the security given by
the related party has to be taken into account for the determination of the level 160 See Linklaters, p. 1 and Robert, p. 1. 161 See IBFD (France), sec. 10.3. 162 See Linklaters, p. 1.
45
of disallowed interest expenses. Where the value of the security is below the
value of the financing provided by the third party, only a portion of the
financing, in proportion to the value of the security, falls under the thin
capitalization rule.163 When the third party provides a loan of €100 which is
secured by a related party of the debtor with assets in the value of €20, only
interest payments on €20 are deemed to be disallowed interest expenses.
As previously mentioned, the French thin capitalization regime also applies to
back-to-back arrangements. In comparison to the U.S., where back-to-back
arrangements and third party financing are considered separately, French
legislation treats back-to-back arrangements as secured third party financing.
To avoid any confusion, a short illustration is provided below:
Diagram 5: Back-to-Back Arrangements and Secured Third Party Loans164
Diagram 5 illustrates the differentiation between a secured third party loan
and the view of a back-to-back arrangement taken in the U.S. As shown
above, even though the starting point of the two scenarios is the same, the
difference is the location of the third party – the bank. For the purpose of the
163 See Linklaters, p. 2. 164 See BDI & KPMG, pp. 21-22.
46
French thin capitalization rule, all of these scenarios fall under the category
“secured third party loan”. In France this would even be the case when all the
parties – debtor, bank, and the related party – are located in France.
Whether a creditor or guarantor is considered a related party is defined under
Art. 39(12) CGI.165 According to this provision, a party with an interest of 50%
or more, or one with de facto control over the debtor, is related. Alternatively,
a third party may also be classified as related if it “has a direct or indirect
minimum holding of 50% in the capital of the two companies or exercises
control de facto over the two companies”166. Where any of these two
conditions are met by the creditor or guarantor, the deductibility of interest
expenses on such financing is limited according to the above-mentioned
limitations.
Certain legal entities and individuals are exempt from the thin capitalization
rule, even though they might be classified as related parties according to Art.
39(12) CGI. One of these three groups is cash pooling centers which have no
other core activity besides the pooling of the group businesses’ cash. The
other two are finance leasing establishments (établissements de crédit-bail)
and financial institutions (e.g. banks).167
Besides these exceptions considered in relation to the business’s activity,
certain financial instruments are excluded from the thin capitalization rule as
well. These are publicly offered bonds, loans secured by the debtor’s shares,
and “loans contracted with a view to repaying an existing debt which became
repayable due to the takeover of the borrower up to the amount of capital
reimbursed”168.169
In regard to tax groups, specific rules apply to the deductibility of disallowed
interest expenses. As a first measure, the value of non-deductible interest
expenses must be determined on the level of the consolidated company.
165 See IBFD (France), sec. 10.3. 166 IBFD (France), sec. 7.3. 167 See IBFD (France), sec. 10.3. 168 Clifford Chance (2010), p.2. 169 See Clifford Chance (2010), p.2 and Linklaters, p.2.
47
Whether and to what extent those disqualified interest expenses are tax
deductible on the level of the tax group has to be considered in light of the
following equation:
(A + B) – [ 25% * (C + D – E)] = F; where “A” is interest payments by the
consolidated company to non-consolidated affiliates, “B” is disqualified
interest “incurred prior to joining the tax group and deducted in the relevant
fiscal year”170, “C” is the tax group’s adjusted ordinary income, “D” is interest
payments incurred by the tax group to non-consolidated affiliates, “E” is the
dividend income of consolidated companies received by other consolidated
companies, and “F” is the maximum amount of deductible disqualified
interest.171 Disqualified interest expenses exceeding the maximum can be
carried forward under the same conditions applicable to non-consolidated
companies described before.
3 Impact on Acquisition Financing
The French thin capitalization regime is comparable to the German regime
before 2008 – a conclusion already drawn in relation to the U.S.’s earnings-
stripping rule. This is not remarkable since the previous analysis
demonstrated that, mainly in regard to its applicability, the French thin
capitalization rule has many parallels to the U.S. earnings-stripping rule.
Insofar, the implications of this rule are also comparable to those already
mentioned in regard to the earnings-stripping rule in the previous chapter.
In consequence, unlike the case for the German interest barrier, where it is
not possible to minimize the tax impact on the acquisition financing by
choosing the ‘right’ financing method, the tax implications can be influenced
by the choice of financing in France. Where the acquirer is able to use only or
mostly non-related party secured financing from third parties, there are likely
to be no negative tax implications due to the thin capitalization rule.
An alternative solution to avoid falling under the thin capitalization rule would
be the use of financing provided by a group’s cash pooling unit if this meets
170 Clifford Chance (2011), p. 5. 171 See Clifford Chance (2011), pp. 5-6
48
the requirements for being exempt. Also, the use of those financing methods
which are exempt from the rule - publicly offered bonds or debt secured by the
debtor’s shares - is an advantageous alternative from a tax perspective.
4 Efficient Structuring in Light of the Thin Capitalization Rule
Unlike in Germany, where a tax group may be beneficial in light of the interest
barrier, the advantage may be limited due to the special treatment of tax
consolidation under the French thin capitalization rule. In certain cases, the
effect on the deductibility of disqualified interest expenses may even be
negative in comparison to taxation on the level of the individual business.
Therefore, potential negative effects caused by the thin capitalization rule in
comparison to other positive tax aspects have to be analyzed before making a
choice in favor of or against tax consolidation. In addition, already at the stage
of choosing an appropriate debt-consolidation method, the effect of each
available method in regard to the thin capitalization rule has to be taken into
account.
In comparison, a merger – where the likelihood of the merger being
challenged by the tax authorities can be excluded or is low – may have a
positive effect on the deductibility of interest. Besides, as the post-merger cost
of capital in comparison to the individual’s pre-merger costs of capital is likely
to be lower, also decreasing the access to non-related party secured
financing, the possibility of obtaining third party financing, which does not
trigger the thin capitalization rule, increases.
A further optimization measure, also available in Germany, is an optimization
of the individual business’s debt-to-equity ratio in order to become exempt.
This outcome can be achieved by debt restructuring measures such as a debt
push-down or debt push-up. In the case of a purely French group with no
businesses abroad, the positive effect is limited, as the exemption of one
business may result in the applicability of the thin capitalization rule on the
level of the other businesses. This possibility has to be taken into account
when evaluating such an optimization strategy for a purely French group.
49
Where a French group has businesses in foreign countries or in cases such
as the one used for the purpose of this thesis – a foreign group with
businesses in France – an exemption of the French businesses created by
means of debt restructuring is likely to have a much more positive tax effect.
This is considerable when the debt is pushed to a company abroad. In such a
situation, the major factors to be taken into account are the potential interest
deduction limitation of the foreign country to which the debt is moved, and
taxes levied in France (e.g. WHT) or tax implications in foreign country due to
the debt restructuring.
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E CONCLUSION
The analysis of the tax implications of acquisition financing outlined in this
thesis includes a description of the possible negative tax effects such
financing may have. This adverse impact applies to taxes levied on post-
acquisition debt consolidation measures and the non-deductibility of certain
interest expenses incurred by the acquisition financing due to interest
deduction limitations.
In any of the three jurisdictions analyzed – Germany, the U.S., and France –
debt consolidation can theoretically be performed by means of a merger, the
formation of a tax group, or a debt push-down. Nonetheless, due to the
diverging supplementary taxes triggered by these procedures in the given
jurisdiction and the varying difficulties involved in conducting one procedure in
comparison to another, different measures are preferred in these jurisdictions.
While the formation of a tax group may be preferential in Germany and the
U.S., debt push-down is more favorable in France. It has to be borne in mind
that this may change according to the individual case. In any case, the
evaluation of the appropriate debt consolidation measure for a given scenario
has to consider potential advantages and disadvantages in terms of the
respective interest deduction limitation.
Furthermore, this analysis addresses the issue of the additional tax triggered
by the interest deduction limitation – the German interest barrier, the U.S.
earnings-stripping rule and the French thin capitalization rule. While it is
relatively simple to avoid tax disadvantages in the U.S. and France provided
the acquirer can access external financing, the situation is less favorable in
Germany. As all kinds of financing fall under the interest barrier in Germany,
tax disadvantages can only be minimized through optimized structuring
measures to enable the acquirer to benefit from any applicable exemptions.
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When comparing the tax implications of acquisition financing in these three
jurisdictions, it can be stated that the U.S. earnings-stripping rule has the least
impact since it only applies to financing activities by foreign related parties to
which no or a WHT of below 30% applies. The tax effect is somewhat greater
in France, where the applicable thin capitalization rule only limits the
deduction of financing involving foreign and domestic related parties. In
Germany, the interest barrier affects any financing activity.
Therefore, it can be concluded that of all three systems the German interest
barrier has the strongest impact in terms of tax on acquisition financing. In the
long run, this may result in decreasing foreign investments in Germany.
Considering the given scenario, if the acquirer is not able to reduce its tax
implications by any of the available optimization measures, Germany may be
disadvantageous for its investment from a fiscal point of view. Especially if the
economic climate in one of the other countries is similar, the acquirer is likely
to prefer an investment there.
A likely alternative, which was not considered in this thesis but may become
an increasingly popular measure in the case of a German acquisition by
foreign companies, could be the use of acquisition vehicles located in other
EU member states or further countries having a favorable DTT with Germany
where no WHT is levied on dividends and the acquirer is capable of
consolidating its debt with a non-German business.
While the German and the French regimes were regularly modified over the
years, the U.S. earnings-stripping rule underwent fewer changes within the
same time frame. However, it can be assumed that this may change soon. As
the two proposals dating from 2002 and 2004 already implied a reduction of
the deductible level of disqualified interest, it can be assumed that such a
reduction may come in the near future, the deduction level will come closer to
that available in France, and the earnings-stripping rule will be extended to
domestic corporations.
In any case, it is to be hoped that neither the U.S. nor France implements a
new regulation similar to the German interest barrier. In contrast, Germany
52
will hopefully realize that the interest barrier does not favor the deductibility of
interest expenses of midsized companies, as originally intended. In this case,
it would mean progress to return to the former regime.
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