I. Background

BEPS stands for Base Erosion and Profit Shifting. The BEPS project was among others initiated by all OECD member countries and the G-20 with the aim of taking action against the harmful tax competition of countries and the aggressive tax planning scheme of internationally operating groups. On 5 October 2015 the OECD published the BEPS project’s results. Based on an action plan including 15 measures, concrete and feasible proposals were developed. This was followed by the publication of the EU BEPS regulation in July 2016.

The newly implemented § 4i EStG is related to action point 2 (Neutralising Hybrid Mismatch Arrangements) which contains suggestions for the prevention of non-taxation as well as for the double deduction of expenses regarding cross-border situations due to so-called hybrid arrangements. Hybrid Arrangements are characterised by the fact that two or more tax systems estimate one event or one legal entity differently, e. g. a company as “transparent” or “non-transparent” or a financial instrument as equity or loan capital. As a result the deduction of operating expenses may arise in one state without an equivalent taxation in another state or a “double deduction of operating expenses” may arise.

II. Specific problem

German partnerships are considered co-entrepreneurships in terms of tax law, which has led to problems in cross-border contexts. The reason for these problems is the two-stage determination of income. In the first stage the profit of the co-entrepreneurship is determined and attributed proportionally to its co-entrepreneurs. In the second stage expenses and revenues from so-called special operating assets (Sonderbetriebsvermögen) are attributed to the individual co-entrepreneurs. Difficulties usually occur because foreign tax regimes are not familiar with the institution of extraordinary operating assets. As a consequence expenses and revenues from special operating assets are not attributed to the profit of the co-entrepreneurship, but outside of this scope. As long as these expenses and revenues are attributed to the partnership in Germany, they are being taken into account “twice” in the end.

Example:
The foreign-based A-Limited, which is considered a corporation under German law, and Mr. B are shareholders of a commercially operating oHG (general partnership) based in Germany, each with a stake in the amount of 50 %. A-Limited is based in a country which has signed a Double Taxation Treaty with Germany. It refinanced its contribution in the oHG with a loan and pays an annual interest of EUR 25,000.00, which can be deducted as operational expenses in its country of residence.
In Germany A-Limited is subject to limited corporation tax on its domestic commercial revenues resulting from the participation in the oHG (§ 2 no. 1 KStG [German Corporate Income Tax Act] in connection with § 49 para. 1 no. 2 letter a EStG). According to the OECD Model Tax Convention (OECD-MTC), Germany is allowed to impose a tax on the profit of the oHG (article 7 para. 1, 2 OECD-MA). The profits are exempt from taxation in the other country subject to the progression clause (article 23A OECD-MTC). From a German tax perspective, the refinancing loan is considered passive special operating assets II (Sonderbetriebsvermögen II). In Germany the interests are deducted as special operational expenses (Sonderbetriebsausgaben) – in the second stage of the determination of the income of the co-entrepreneurship (§ 4 para. 4 in connection with § 15 para. 1 no. 2 EStG, § 50d para. 10 sentence 1 in connection with sentence 3, 2nd half of the sentence, EStG in connection with article 7 para. 1 page 1, 2nd half of the sentence, in connection with sentence 2 OECD-MTC). § 4i EStG prevents this deduction of interests as special operational expenses (Sonderbetriebsausgaben) from the assessment period 2017 onwards.

III. Regulatory content

Pursuant to § 4i sentence 1 EStG expenses of a co-entrepreneur cannot be deducted as special operational expenses to the extent that these expenses lower the tax base in another country.
The regulations under s§ 4i EStG became effective on 1 January 2017 and are applicable from the assessment period 2017 onwards and also in the case that the legal ground for the special operational expenses has arisen before 2017. That means that the prohibition on the deduction would also apply if A-Limited had obtained the refinancing loan in 2016.
§ 4i sentence 1 EStG requires a limited or unlimited income or corporate tax liability and revenues from an operating co-entrepreneurship pursuant to §§ 13, 15 or 18 EStG. The regulation includes partnerships under civil law and company-like legal groups (community of property/of joint heirs) as well as foreign companies if they can be classified as partnerships according to the so-called legal type comparison. Any expense of a shareholder is subject to this prohibition on deduction regardless of a connection with special business asset I or II.
§ 4i sentence 1 EStG does not include expenses which are already considered business expenses in the first stage of the determination of income of the co-entrepreneurship and such expenses which also lower the tax base in another country. This does not require an effective tax reduction. § 4i sentence 1 EStG also applies regardless of whether the expenses lower the tax base for any person or in any financial period (tax year, economic year, calendar year). So it could also happen that the financing costs in the example cannot be deducted as special operating expenses in the assessment period 2017 in Germany if the operational expenses are only deducted in A-Limited’s country of residence in 2018. The prohibition on deduction for domestic special operating expenses only applies to the extent that the expenses lower the tax base in another country. If the refinancing interest is partially excluded from the deduction of operational cost in A-Limited’s country of residence, the remaining amount will still be deductible as special operational expense in Germany.
The prohibition on deduction does not apply according to § 4i sentence 2 EStG if the non-deductible expenses pursuant to sentence 1 lower the revenues of the taxpayer which are subject to taxation both in his country of residence and abroad. Therefore it is sufficient that the revenues are taken into account in the tax base. This case does not require an effective tax burden. But then the exception under sentence 2 does not apply due to the lack of effective foreign taxation to the extent that the other country does not impose a tax on the revenues either for legal (lack of taxability, objective or personal tax exemption) or other reasons (taxation deficit). It is not required that the expenses and the revenues are related to the same subject matter. However, a reduction for the same taxpayer is – contrary to the regulation in sentence 1 – necessary. If the limitation of the deduction according to § 4i sentence 1 EStG applies, an allocation with double-counted (corresponding) revenues is possible. In this case the prohibition on deduction applies only to the amount of special expenses exceeding the revenues. Furthermore, § 4i EStG applies also to the trade tax.

IV. Outlook

By implementing § 4i EStG the legal authorities intend to close any taxation gaps which arise from the double consideration of special operational expenses in both the country of residence and abroad. In this regard the implementation of § 4i EStG is transparent and consistent. There is, however, doubt whether the legal authorities are working within the limits of the BEPS project’s guidelines which only affect hybrid arrangements. § 4i EStG may furthermore entail considerable difficulties in practice. For the future a multiple-period documentation of the taxation treatment of expenses and possible revenues abroad for multiple assessment periods and possibly for more than one taxpayer will be necessary.