Limited deduction of business expenses for hybrid arrangements

Why is the deduction of business expenses limited for hybrid arrangements?

In principle, expenses incurred due to the business operations of a company based in Germany reduce the profit that is subject to income tax in Germany as operating expenses. However, arrangements between related parties in which financial instruments or companies are treated differently for tax purposes in different countries (so-called hybrid arrangements) can lead to expenses being deducted for tax purposes in one country but the corresponding income not being taxed in another country. To prevent the abusive exploitation of such tax mismatches, Germany has introduced a specific deduction restriction for business expenses in hybrid structures in line with the OECD's recommendations to combat base erosion and profit shifting (BEPS) and in implementation of the EU Anti-Tax Avoidance Directive (ATAD) of 12 July 2026.

How the restriction on the deduction of business expenses works

The restriction on the deduction of business expenses (Section 4k EStG) applies in cross-border situations

• between related parties for tax purposes, e.g. in the case of an equity interest of at least 25 %,
• between a company and its foreign permanent establishment or
• in the case of structured arrangements, e.g. if the desired tax advantage was included in the contractual agreements.

Note: On 5 December 2024, the German tax authorities (BMF) submitted the long-awaited letter for Section 4k EStG. It addresses the application cases regulated in the provision and explains in particular who bears the burden of proof and must provide evidence.

This particularly affects cases of "deduction/non-inclusion", in which expenses are deducted in Germany but the corresponding income is not taxed or taxed at a reduced rate abroad. The provision is also intended to prevent the double deduction of business expenses in the case of a "double deduction", where the business expenses are recognised for tax purposes in two countries. The provision also applies to imported tax mismatches. This refers to cases in which the income directly or indirectly resulting from domestic expenses abroad is in turn offset by expenses abroad, the deduction of which would be denied to the creditor, another creditor, or another person if the above principles were applied accordingly.

Typical applications for the limitation of the deduction of operating expenses are:

• Hybrid financial instruments: If a German company grants profit participation rights to a sister corporation domiciled abroad, the associated payments to the sister corporation in Germany must be classified as interest expenses. If, on the other hand, the profit participation rights are categorised abroad as similar to equity investments and the payments therefore constitute dividends, no operating expenses may be deducted by the German company.
• Hybrid companies: If a partnership domiciled in Germany opts for corporation tax in Germany, it will continue to be treated as fiscally transparent abroad. This means that the managing director's salary of a partner resident abroad is qualified as a profit share abroad, but is not taxed there due to the DTA exemption for permanent establishment profits. In Germany, the company opting for corporate taxation is therefore denied the deduction of operating expenses for the managing director's salary.

The restriction on the deduction of business expenses applies irrespective of the provisions of double taxation agreements. Affected companies can therefore not invoke treaty protection.

The limitation on the deduction of business expenses under Section 4k EStG has generally applied since the 2020 assessment period. In our view, the issue of deducting business expenses is therefore currently being increasingly addressed in the context of tax audits. Particularly in the case of continuing obligations covered by Section 4k EStG that were already established before 2020, the question then arises as to the extent to which the limitation on the deduction of business expenses applies. This is because its application is limited to expenses that could have been avoided from 2020 without significant disadvantages or if the continuing obligation was significantly changed from 2020.

How we support you

In the case of cross-border situations with related parties that are potentially treated differently for tax purposes in Germany and abroad, it should be checked at the latest when filing tax returns whether the deduction of business expenses is not possible or only possible to a limited extent due to the regulation. The complexity of the regulation, with its numerous exceptions and exceptions to the contrary, regularly requires a detailed examination of the individual case. We are happy to support you

• in examining your individual circumstances and analyse how you can avoid potential tax disadvantages.
• In the event of tax audits, we are at your side as part of our defense and enforcement advice relating to the limitation of the deduction of business expenses.
• To optimise your tax planning, we will also keep you up to date on legal changes and application regulations from the tax authorities regarding the deduction of business expenses for hybrid structures.