Deduction of Business Expenses in Case of Taxation Incongruence

In implementation of the requirements of Art. 9 and 9b ATAD, regulations were introduced in 2021 with Sec. 4k EStG to be applied retroactively, in order to neutralize taxation inconsistencies in connection with hybrid cross-border arrangements.

After a draft version was already available in July 2023, the BMF now addresses the application cases regulated in Sec. 4k EStG in its selectively changed, final application letter dated 5 December 2024. The BMF applies the letter to all open cases.

Personal Scope of Application

The personal scope of application of Sec. 4k EStG includes situations between related parties within the meaning of Sec. 1 (2) German Foreign Tax Act (AStG), between a company and its foreign permanent establishment, and within the framework of a structured arrangement. A relationship within the meaning of Sec. 1 (2) AStG is deemed to exist if, due to coordinated behavior, the participation, voting rights, and profit-sharing rights of another person are attributed. To explain when coordinated behavior is to be assumed, the BMF refers in the final letter to the explanations in the BMF letter of 22 December 2023 (also briefly AStG application letter) and thus provides clarity.

Taxation Incongruence Due to Hybrid Financial Instruments or Transfers

According to Sec. 4k (1) EStG, expenses are subject to a deduction prohibition if hybrid financial instruments, which lead to a different tax qualification, or hybrid transfers exist, which trigger a different tax attribution. Examples of hybrid financial instruments include convertible bonds, hybrid loans, typical silent partnerships, profit participation rights, and participating loans. A different attribution can result from securities lending or so-called repo transactions.

The deduction prohibition applies if the income corresponding to the expenses is not taxed or taxed lower than with the qualification or attribution corresponding to German law. With the final letter, the BMF states that it assumes taxation if the income is included in the tax base of an addition taxation. However, this does not include systems that allow cross-entity offsetting, as is the case, for example, with the global minimum tax.

The BMF also clarifies that in the case of lower taxation of income, the expenses are deductible in the amount of the percentage corresponding to a hypothetical taxation according to German regulations. A complete deduction prohibition thus only applies in the case of non-taxation of income.

Taxation Incongruence Due to Different Tax Treatment of the Taxpayer or Contractual Relationships

According to Sec. 4k (2) EStG, qualification conflicts regarding the tax treatment of legal entities are covered. This includes expenses of taxpayers considered fiscally transparent domestically, which are regarded as fiscally transparent legal entities abroad (hybrid entities). This also includes cases where a domestic taxpayer is treated as fiscally transparent or as a non-tax subject abroad due to the existing option there, as is possible, for example, with the check-the-box rule in the USA.

Here too, expenses are to be added back off-balance sheet in the amount of the non-taxation of the income corresponding to the expenses.

For the exception rule for double-considered income, if it can be proven that income of the same taxpayer corresponds to the expenses, which is also subject to actual taxation abroad, the BMF adds an equity rule with the final letter. Accordingly, for reasons of equity, it is regularly assumed that income is double-considered if the income of the taxpayer corresponding to the expenses, which is based on an intra-group service relationship and is subject to actual taxation domestically, does not lead to a consideration of the expenses corresponding to this income due to the different tax treatment of the taxpayer abroad (so-called "No-Deduction/Inclusion Incongruence").

Taxation Incongruence with Reverse Hybrid Entities and Allocation Conflicts with Permanent Establishments

As a catch-all provision for the preceding cases, Sec. 4k (3) EStG particularly covers services to reverse hybrid entities and permanent establishment situations with different profit allocation between company parts. Here, the BMF retains its explanations already contained in the draft letter. With regard to the catch-all provision, it should be noted that Sec. 4k (3) EStG does not contain an exception rule for double-considered income.

Taxation Incongruence Due to Double Deduction of Business Expenses

If expenses are considered twice and reduce the tax base both domestically and abroad, Sec. 4k (4) EStG provides for a prohibition on the deduction of business expenses. In the draft letter, it was still stated that consideration within the framework of an addition taxation would also lead to a double deduction of business expenses in this sense. In the final letter, this is explicitly denied. Likewise, as previously stated, there is no double consideration insofar as expenses are considered exclusively for the purposes of a negative progression reservation abroad.

Imported Taxation Incongruence

Finally, Sec. 4k (5) EStG provides for a deduction prohibition that applies subordinately if Germany is not directly involved in taxation inconsistencies, but these are transferred to the domestic territory via one or more transactions. The BMF has adopted the previous comprehensive explanations according to its draft letter unchanged.

Burden of Proof and Proof Obligations

Finally, it is explained who bears the burden of proof from the perspective of the tax administration and must provide evidence. The BMF assumes that the existence of the prerequisites for the application cases of Sec. 4k EStG is to be determined by the tax administration, but the taxpayer is subject to increased cooperation obligations due to the relevance of the tax treatment of the processes abroad. If the taxpayer does not meet his increased cooperation obligations, the tax administration can draw adverse conclusions for the taxpayer, even regarding facts that it is generally required to prove. Thus, as already stated in the draft, the BMF sees the taxpayer as obliged to procure and submit all documents necessary for the examination of the facts. Abstract representations are regularly considered insufficient. Rather, accounting documents of the involved foreign legal entities and information, tax assessments, or confirmations from foreign tax authorities related to the specific facts must be provided.