July 18, 2023
German Federal Ministry of Finance publishes draft decree regarding the application of anti-hybrid rules
The German Ministry of Finance has published a draft decree regarding the application of German anti-hybrid rules. The rules were enacted in 2021 through the European Union (EU) Anti-Tax Avoidance Directive (ATAD) Implementation Law. The anti-hybrid rules generally apply to all expenses accruing after 31 December 2019 focusing on a potential whole or partial denial of deductibility for expenses in Germany to the extent the resulting earnings are not taxed at all or — in the case of financing transactions — are "low taxed" due to a hybrid-mismatch or deductions taken twice (Deduction/Non-Inclusions, Double-Deductions, Imported Mismatches).
The draft decree does not provide detailed guidance on all currently unclear issues. The examples it provides mostly cover basic structures, but do not include a comprehensive overview on the tax authorities' view on questions that are highly relevant in practice (e.g., for certain disregarded US-outbound structures).
Grandfathering for recurring transactions entered into before 1 January 2020
The legislative process for the introduction of the anti-hybrid rules was initiated with the government draft on 24 March 2021, but covers all expenses accruing after 31 December 2019. For expenses legally caused before 1 January 2020, but accruing thereafter, the law provides an exception from the rules' application (e.g., amortization of an asset acquired in 2019). For recurring expenses (e.g., from lease agreements, loans, etc.), the grandfathering also requires the underlying agreement to not be substantially amended and that the expenses resulting from such agreement could not have been avoided without significant disadvantages.
The draft decree does not define the term "without significant disadvantages" beyond the wording of the law but states that disadvantages are to be considered significant if the costs associated with the change or termination of the recurring obligation (e.g., early repayment penalty for the termination of a loan agreement) exceed the tax benefit from the existing hybrid element. According to the decree, the burden of proof lies with the taxpayer in this regard.
German anti-hybrid rules cover different types of scenarios, including the following.
Expenses for financing transactions are not tax deductible to the extent the income is subject to a relevant non- or lower taxation at the recipient level due to a mismatch of either instrument qualification or asset allocation.
According to the draft decree, a relevant non-taxation or lower taxation of a financing transaction occurs if the corresponding income is not included in the recipient's tax base. A tax rate of nil percent, a (partial) tax exemption of the income and a (partial) waiver of the tax by non-German tax authorities are considered relevant non-taxation or lower taxation events (however, a hybrid mismatch must cause the non-taxation or lower taxation in addition for a denial of the expense). Taxation in a specific jurisdiction (e.g., the jurisdiction of the recipient) is not required. Said differently, an income inclusion in another jurisdiction (e.g., within applicable controlled foreign corporation (CFC) rules) is relevant when determining the rule's non-taxation or lower taxation.
Moreover, the non-taxation or lower taxation must be caused by a hybrid mismatch. In this regard, the decree indicates that the application of the rule requires either a hybrid financial instrument or a hybrid (transfer) transaction (e.g., a reposession transaction). Hence, the rule for financing transactions should not apply absent such a transaction (i.e., where neither a hybrid financial instrument nor a hybrid transfer of a financial asset is involved).
If the non-taxation or lower taxation at the recipient level is just temporary and the transaction is structured at arm's length, the rule generally does not apply. The draft decree includes that the capitalization of interest (i.e., a deferral of interest payments) that a third-party lender would not agree to does not meet the arm's-length principle and, therefore, excludes the application of the exception for temporary mismatches.
Any deduction/no-inclusion scenario in which 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 the US entity classification principles) falls under the restrictions. The draft decree explicitly refers to the principles of the United States (US) check-the-box election in this respect. Furthermore, the application of the rule does not require that an entity classification mismatch exist between the jurisdictions directly involved in the transaction; a deviating entity qualification in another jurisdiction (e.g., in the jurisdiction of a direct or indirect shareholder) suffices to create relevant hybridity.
According to the draft decree, the expenses covered by the rules generally include all types of expenses, regardless of their nature. This includes all cash and non-cash expenses (e.g., by way of amortization or impairment of assets).
An exception is granted where there also is dual-inclusion income in the payee's jurisdiction. Under this exception, expenses remain deductible even in the case of a relevant mismatch if, and to the extent that, these expenses only offset income that is subject to taxation in both Germany and the jurisdiction of residency of the recipient of the corresponding income. A link between the hybrid transaction's expenses and the double included income is not required. Moreover, the dual inclusion income must not necessarily be included in the taxable income of the direct recipient of the payment (e.g., in case a tax consolidation applies and the income is included in another entity's taxable income). Vice-versa, income of the German payor's tax consolidated subsidiaries can be considered. However, the dual-inclusion income must be taxed in the jurisdiction of residency of the recipient of the payment. Said differently, taxation in a third jurisdiction (e.g., due to applicable CFC rules) is not sufficient for the dual-inclusion income exception. The guidance also indicates that a dual-income inclusion generally requires actual inclusion of the income in taxable income in the other jurisdiction but does not provide any further details for cases in which the income taxed in Germany corresponds to an expense in the other jurisdiction that is effectively obscured due to the hybridity of the German entity (e.g., payments from a US shareholder to its disregarded German subsidiary). Economically, such cases should give rise to dual-inclusion income but would not result in an "actual inclusion of income" in the tax base in the other jurisdiction.
Reverse hybrid entities
Any deduction/no-inclusion scenario in which the absence of an inclusion as taxable income is due to a mismatch in the qualification of the recipient entity (e.g., reverse hybrids; transparent under local law, but nontransparent from owner's perspective) or a branch income inclusion mismatch, lead to German nondeductibility of relevant expenses. The draft decree does not provide for notable clarifications in this regard.
Any double-deduction scenario — for example, due to expenses incurred by a hybrid entity (non-transparent locally, transparent at shareholder level) — would result in a denial of the expense, unless coupled with the double inclusion of (positive) income. Moreover, the guidance provides that a deduction within a foreign CFC regime (e.g., at the level of an indirect shareholder) generally also constitutes a double deduction in the meaning of the rule.
The dual-inclusion income exception explained above also applies in double-deduction scenarios.
Moreover, an exception applies if the taxpayer demonstrates that there is no effective double deduction due to the application of a foreign anti-hybrid rule. The compliance effort for hybrid mismatches with other EU jurisdictions is simplified in this regard due to harmonized ATAD implementation. Absent any indications to the contrary, it is assumed that the mismatch is already addressed in the other EU jurisdiction. A hybrid mismatch with a third country (e.g., the US), must be analyzed on a case-by-case basis.
Imported hybrid mismatches
The imported mismatch rule applies in scenarios where there is no mismatch at the level of the direct recipient of the expense but a mismatch occuring at another level directly or indirectly results from the expense (e.g., due to a back-to-back structure).
As per the draft decree, an economic nexus between the different income and expense streams is not required to give rise to an imported mismatch. Rather, according to the tax authorities, it is sufficient that the income is offset against an expense that would be nondeductible under German anti-hybrid rules. (For example, if a German taxpayer has expenses from lease payments, any expenses at the level of the payment recipient could give rise to an imported mismatch (meaning there is no limitation as to the number of parties that can be involved for an imported mismatch).) The guidance does not provide any practical considerations on how this could be implemented or monitored in practice.
Where the double deduction is already resolved in another jurisdiction due to similar rules, the expense remains deductible in Germany. The simplification mentioned above, allowing assumptions to be drawn where other EU jurisdictions are involved, absent any indication to the contrary, applies in these cases as well. However, the guidance caveats that this cannot be assumed where the German anti-hybrid rules go beyond the ATAD minimum standard.
The guidance provides one example that is of high practical relevance, clarifying that cost of goods sold in a distribution company scenario is generally not considered "expense" in the sense of the anti-hybrid rules and hence cannot be denied as a deduction (unless the distribution activity leads to a loss, which would be a rare event in the typical "limited risk distributor" setups encountered in practice).
Burden of proof
Even though the draft decree acknowledges that the tax authorities bear the burden of proof, it also refers to taxpayers' increased obligations to collaborate in international matters. In the view of the tax authorities, this means that the taxpayer is obliged to provide detailed information and documentation regarding the foreign entities and tax law, potentially including confirmations from foreign tax authorities and similar documents (even if a treaty regarding mutual assistance in tax matters exists with the other jurisdiction). The information and documentation provided by the taxpayer must be sufficient to unequivocally exclude the applicability of the anti-hybrid rules. If the taxpayer does not meet these requirements, the guidance mentions that the tax authorities can make estimates and assumptions where required. Effectively, this shifts the burden of proof to taxpayer.
The guidance further allocates the (full) burden of proof to the taxpayer wherever a taxpayer seeks to apply an exception (e.g., dual-inclusion income exception).
Priority of rules
Lastly, the guidance confirms that the anti-hybrid rules do not generally take priority over other rules denying the deduction of expenses, but that the different rules apply in parallel. However, the anti-hybrid rules are to be applied with priority over the German interest deduction limitation rules as well as the German dual consolidated loss rules. On the other hand, the rules around constructive dividends take priority over the anti-hybrid rules. The anti-hybrid rules are generally viewed as in-line with double tax treaties, however the draft decree clarifies that the rules would take priority over a treaty, even if there were a perceived conflict.
Once issued, a final decree will be applicable in all open cases. For comments on the draft decree, the MoF has set a deadline of 10 August 2023.
For additional information with respect to this Alert, please contact the following:
Ernst & Young GmbH, Germany
Ernst & Young LLP (United States), German Tax Desk, New York
Ernst & Young Solutions LLP, German Tax Desk, Singapore
Published by NTD’s Tax Technical Knowledge Services group; Carolyn Wright, legal editor