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July 16, 2021
2021-1363

Germany enacts EU ATAD Implementation Law including anti-hybrid rules

Executive summary

On 30 June 2021, Germany published the European Union (EU) Anti-Tax Avoidance Directive (ATAD) Implementation Law, which includes the new anti-hybrid rule (Sec. 4k Income Tax Act), in the German Federal Gazette. This concludes the final step of the legislative process after the approval by the Federal Parliament (see EY Global Tax Alert, German Parliament advances several tax proposals, dated 25 May 2021), the Federal Council and the signing of the law by the Federal President on 25 June 2021. Accordingly,  the law is now enacted and in force.

The new anti-hybrid rules focus on a potential whole or partial denial of deductibility for expenses in Germany to the extent the resulting earnings are not taxed or are low taxed due to a hybrid-mismatch or that deductions are taken twice (Deduction/Non-Inclusions, Double-Deductions, Imported Mismatches).

As expected, the anti-hybrid rules apply to expenses accruing after 31 December 2019. Therefore, the provisions generally apply retroactively. As the only exception to this rule, the law specifies expenses which were (legally) caused before 1 January 2020 unless these expenses are recurring (e.g., lease agreements, loans) and could have been avoided without significant disadvantages. Since the legislative process was initiated in 2021 and the law was enacted in 2021, an application for the tax period 2020 is a retroactive change for an already completed tax assessment period causing a controversial discussion.

The retroactivity further raises the question as to when and how the tax effects from the anti-hybrid rules would have to be considered for a potential recognition within tax provisions in the annual or quarterly financial statements. Since the ATAD Implementation Law was published in the Federal Gazette on 30 June 2021, the law entered into force on 1 July 2021 (the day following the publication). However, the law was approved by the Federal Council and signed by the Federal President on 25 June 2021. Publication in the Federal Gazette is, insofar, a mere formality. Hence, the new rules likely have to be considered for accounting purposes for financial statements as of 1 July 2021 at the very latest, but earlier consideration might be mandated by applicable accounting standards since the approval by the Federal Council and the signature by the Federal President on 25 June 2021 essentially made the enactment of the law a certainty.

Moreover, tax positions recognized for earlier reporting periods may have to be revisited due to the retroactive applicability of the rules for expenses accruing after 31 December 2019.

Detailed discussion of the anti-hybrid rules

Germany already has a wide range of rules that are intended to counter undesired tax outcomes due to the mismatch of rules in an international context. However, most of the existing rules deal with German-outbound situations only; there were only limited rules that tie the tax treatment of intra-group expenses to the tax treatment at the recipient level (a significant exception being the royalty limitation rule, which since 2018 partially or wholly denies royalty deductions to non-Organisation for Economic Co-operation and Development (OECD)-compliant preferential tax regimes).

The implementation of far-reaching general anti-hybrid rules with the ATAD Implementation Law changes this. The rules are still broadly based on the OECD Action 2 proposal and the ATAD I and II wording. They notably do not cover cases where the foreign non- or low taxation is not triggered by a hybrid mismatch, but due to the general rules applied in the recipient jurisdiction. Overall, the rules cover the following situations:

  • Financing transactions where due to a mismatch of either instrument qualification or asset attribution the income is subject to no or lower taxation at the recipient level than without the mismatch (e.g., hybrid loans/equity instruments; certain stock lending- or REPO-transactions). If the non- or low taxation at the recipient level is just temporary and the transaction is structured at arm’s length, the rule does not apply.
  • Any deduction/no inclusion scenarios where the absence of an inclusion as taxable income is due to a mismatch in the qualification of the paying entity (e.g., disregarded transaction under United States (US) entity classification principles). This rule is not limited to financing transactions, but also covers any other payments which are in principle deductible (immediately or over time, e.g., by way of amortization); it also covers “dealings” between a permanent establishment (PE) and the relevant headquarters. An exception is granted where there also is dual inclusion income at the level of the foreign recipient, and thus the income is effectively taxed despite the mismatch. Initially, this exception was deemed inapplicable if there was a theoretical possibility for a foreign tax credit, however this limitation was eliminated within the discussion of the rules in Parliament. Further, the inclusion of the income due to an “equivalent” controlled foreign corporation taxation is considered as effective taxation and thus would turn off the anti-hybrid rule.
  • Any deduction/no inclusion scenario, where the absence of an inclusion as taxable income is due to a mismatch in the qualification of the recipient entity (reverse hybrids; transparent under local law, but non-transparent from owner’s perspective) or a branch income inclusion mismatch.
  • Any double deduction scenario, e.g., due to expenses incurred by a hybrid entity (non-transparent locally, transparent at owner level), unless coupled with the double inclusion of (positive) income; an exception applies if the taxpayer demonstrates that there is no effective double deduction due to the application of a foreign anti-hybrid rule.
  • Imported mismatch scenarios, i.e., scenarios, where there is no mismatch at the level of the direct recipient of the expense, but where there is a mismatch in income taxation at any level other than the direct expense recipient, which is directly or indirectly resulting from the expense (e.g., due to a back-to-back structure). According to the explanatory notes to the law, an economic nexus between the different income and expense streams is not required and the mere fact that the income is offset against an expense is sufficient to give rise to an imported mismatch. However, this rule would generally not apply if the taxpayer demonstrates that, due to the application of a foreign anti-hybrid rule at any direct or indirect recipient level, there is no effective mismatch.

In all of these cases, the German deduction is wholly denied (in the case of financing transactions, potentially only partly, if the mismatch only results in “lower” taxation, but not in a non-taxation). The rules apply to all related-party transactions (including persons acting in concert) as well as “dealings” between headquarters and PEs and also to structured arrangements involving third parties, where it is apparent from the contractual documentation or otherwise that a tax advantage resulting from a mismatch was intended. Only where it is reasonable to assume that a taxpayer which is party to an arrangement with a third party was not aware of any tax mismatch advantages and the taxpayer can demonstrate that he/she actually did not benefit from the tax mismatch, no structured arrangement would be assumed.

Even though the legislative process was initiated with the government draft on 24 March 2021 only and the law was finalized in 2021, the final law provides that these rules are to be applied on expenses accruing after 31 December 2019. As the only exception to this rule, the law specifies expenses which were (legally) caused before 1 January 2020 (e.g., amortization on assets acquired prior to 1 January 2020) unless these expenses are recurring (e.g., from lease agreements, loans) and could have been avoided without significant disadvantages or if the underlying arrangement was changed significantly after 31 December 2019. A disadvantage is deemed significant if the costs to avoid the expenses in question would have exceeded the tax benefit from the hybrid arrangement, even though it is unclear why the tax benefit should be an appropriate measure for the significance of a disadvantage. Essentially, this mechanism would “punish” taxpayers for not being willing to at least spend an amount equal to the tax benefit on avoiding the tax benefit. Since the legislative process was initiated and completed in 2021, it is obvious that an application for the tax period 2020 is a retroactive change for an already completed tax assessment period and the question of the retroactive application is already discussed controversially. It will have to be seen whether the fact that anti-hybrid rules were mandated by EU directives will be sufficient to convince courts that this retroactivity is acceptable in this case. At least where the effect of the German implementation of these rules exceeds the effects of the ATAD minimum standards this is at least doubtful. This includes that rules concerning reverse hybrids, which are only mandated from 1 January 2021 by the ATAD II Directive, would not be supported by this position.

The law also includes a new provision on reverse-hybrid structures within the catalogue of income subject to Germany nonresident taxation (Sec. 49 para. 1 nr. 11 Income Tax Act). Essentially, this rule provides that income earned via German (reverse-hybrid) partnerships is subject to German nonresident taxation if the income is not taxed in the jurisdiction in which the partner is resident because this jurisdiction treats the German partnership as opaque for tax purposes. The rule further generally requires that the partner owns more than 50% in the German partnership directly or indirectly together with related parties and is applicable as of 2022. This rules implements Art. 9a of the ATAD II into German law.

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For additional information with respect to this Alert, please contact the following:

Ernst & Young GmbH

Ernst & Young LLP (United States), German Tax Desk, New York

 

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