German Federal Court of Finance questions constitutionality of German interest limitation rule

Publication February 2016

German Federal Court of Finance questions constitutionality of German interest limitation rule

On 10 February 2016 the German Federal Court of Finance (Bundesfinanzhof) published a decision dated 14 October 2015 (I R 20/15) in which it took the view that the German interest limitation rule (Zinsschranke) is in breach with the German Constitution because it violates the principle of equality. The Federal Court of Finance has accordingly stayed the proceedings and referred the matter to the German Federal Constitutional Court (Bundesverfassungsgericht) to decide whether it is.
The decision is noteworthy because the German interest limitation rule is one of the measures Germany proposes internationally to fight international tax avoidance through base erosion and profit shifting (BEPS). The rule has already been copied by Italy, Spain (and the UK is looking at it) and it has become part of the draft EU Anti-Tax Avoidance Directive (read our Tax Briefing 'European Commission proposes an Anti-Tax Avoidance Directive').


Under the German interest limitation rule a taxpayer’s interest expenses are only fully tax deductible to the extent that interest income is generated. The interest expenses that exceed the interest income (net interest expenses) are generally only tax deductible in the amount of up to 30% of the current year’s taxable EBITDA (and any unused EBITDA from previous fiscal years, if any). Non-deductible interest expenses may be carried forward.

There are three exemptions from this interest limitation rule:

  1. The net interest expenses remain below EUR 3 million p.a.;
  2. the taxpayer is not part of a group of companies (stand-alone exemption); and
  3. the taxpayer can demonstrate that the equity ratio of the taxpayer is equal to or higher than the equity ratio of the group he belongs to (so called escape clause), with a 2% variance being tolerated.

However, the stand-alone exemption and the equity ratio exemption are only available, if not more than 10% of the interest expenses are related to debts to parties outside the group which – directly or indirectly – own more than 25% in the taxpayer or have a recourse to such parties.

Specific case

In the specific case, the taxpayer (a German limited liability company) formed part of a domestic group of companies in the real estate sector. Under the interest limitation rule the company was not able to deduct all of its interest expenses. The carried forward interest expense was forfeited due to a reorganization.

The Federal Court of Finance held that the German interest limitation rule violates the objective net income principle under the German Constitution which in principle allows for the deduction of all expenses which are effectively connected with a taxable activity. The court held that there is no justification for that violation; in particular the court held that in the specific case the interest limitation rule could not be justified as an anti-avoidance measure since the specific case concerned a purely domestic structure not involving any financing from outside Germany; i.e. there was no risk that any tax revenue was shifted from Germany to another jurisdiction.

Implications for taxpayers

From a domestic German perspective, the decision on the constitutionality now lies with the Federal Constitutional Court. Until the decision of the court has been taken, the relevant assessment periods need to be kept open. That is, to the extent those assessments are not issued as preliminary, it may be advisable to file an objection against such assessments. It may also make sense to apply for a suspension of execution (Aussetzung der Vollziehung) in order to suspend the payment obligation. However, in this case there will be a risk of  interest if  the Federal Constitutional Court confirms the interest limitation rule as constitutional.

Interest Limitation Rule as Anti-BEPS measure

It will also be important to follow the impact this decision may have on the OECD and EU BEPS initiatives against international tax avoidance. The European Commission published on 28 January 2016 its proposal for a new EU Anti-Tax Avoidance Directive which – inter alia – contains an interest limitation rule that is generally structured like the German interest limitation rule (i.e. limitation of deductibility of net interest expenses to 30% of EBITDA, subject to exemptions). Italy, and Spain have already previously introduced a similar interest limitation rule. The UK is considering whether to do so.
It remains to be seen if and how the decision of the Federal Court of Finance and / or the Federal Constitutional Court will influence the discussions at the EU level, in particular, whether it may be appropriate to include an escape clause for taxpayers if they evidence that the interest deduction is not part of a tax avoidance scheme. Also it will be important to understand whether a limitation rule under a possible EU Directive can be applied in Germany, if that rule breaches the German Constitution.

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