On 10 February 2016 the German Federal Court of Finance (Bundesfinanzhof) published a decision to the effect that the German interest limitation rule 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 '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.

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.

It will be interesting to see 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. Also it will be important to understand whether a limitation rule under a possible EU Directive can be applied in Germany, if that rule is in breach of the German Constitution.