Final guidance published by Germany’s Ministry of Finance on 5 December 2024 provides essential information on applying the anti-hybrid rules under Section 4k of the Income Tax Act (EStG). The lengthy decree clarifies definitions and controversial issues relating to the interpretation and practical application of the law and sets out the definitive position of the tax authorities. Draft guidance on the rules was originally released in 2023.
Section 4k is based on Germany’s implementation of Articles 9 and 9b of the 2016 EU ATAD Directive, as amended in 2017, via the 2021 ATAD Implementation Act. Hybrid mismatches exploit differences in the tax treatment of an entity or instrument between two or more countries, which can give rise to tax advantages or create mismatch outcomes. These differences can result in:
The anti-hybrid rules generally apply to expenses incurred after 31 December 2019, with a grandfather rule applying to expenses incurred under a continuing obligation, such as interest, rent or license fees before 1 January 2020.
As noted above, Germany’s anti-hybrid rules apply to D/NI mismatches, DD mismatches and imported mismatches. The rules are triggered in structured cross-border arrangements or where there are mismatches between associated parties or between a company and its permanent establishment (PE) in the other jurisdiction. Parties can be actually related for this purpose or be presumed to be related based on certain factors.
A structured arrangement exists if the tax advantage arising from a mismatch is included in whole or in part in the contractual agreements or if these suggest that the parties to the arrangement could expect the tax advantage. Thus, the scope of Section 4k could also apply to arrangements between unrelated third parties.
The expense deduction limitation can be avoided if the taxpayer can demonstrate that, based on external circumstances, it cannot reasonably be assumed that the taxpayer was aware of the tax mismatch advantage and the taxpayer did not benefit from the tax advantage.
D/NI Mismatch Outcome
Mismatches caused by hybrid arrangements in the form of a D/NI mismatch usually arise in cross-border cases involving hybrid financial instruments, hybrid entities or reverse hybrid entities, which are treated differently in the participating countries either with respect to their equity or debt capital or with respect to their corporate form. Section 4k can also be relevant in certain situations involving PEs.
The deduction disallowance in Section 4k(1) applies only if the qualification conflict—usually involving the different treatment of the hybrid financial instrument as equity or debt capital—is the cause of the mismatch. If there are other reasons for nontaxation or low taxation of the income corresponding to the expenses that lie outside the scope of Section 4k, the deduction restriction will not apply, nor will it apply if the mismatch in taxation is likely to be eliminated in a future tax period and the payment terms are at arm’s length.
The second alternative requires a reference in the form of a domestic company or a domestic business establishment for which fictitious operating expenses or a corresponding exemption amount are taken into account. Consequently, from a German perspective, this does not apply to presumed contractual relationships between a foreign business establishment and the remaining foreign company.
As under Section 4k(1), the Section 4k(2) deduction restriction applies only if the existing qualification conflict is the sole cause of the mismatch that has arisen in the form of no actual taxation. The disallowance does not apply if the expenses are offset by income of the taxpayer that is actually taxed both in Germany and abroad (i.e., double-counted income). There are no provisions for how to proceed if the mismatch is eliminated in a future tax period.
The Section 4k(3) deduction restriction applies only if the actual nontaxation of the income corresponding to the expenses is due to their allocation or attribution under tax law that differs from German law. Section 4k(3) does not provide for an exception corresponding to Section 4k(2) for income that has been taken into account twice and there is no guidance on how to proceed if the mismatch is eliminated in a future tax period.
Double-Deduction Mismatch Outcome
Section 4k(4) addresses mismatches resulting from the double deduction of expenses in both Germany and abroad. The guidance provides that the deduction restriction should apply where the expenses of a German taxpayer are deducted twice because the expenses are excluded under the controlled foreign corporation or similar rules in a foreign jurisdiction, subject to certain exceptions.
The deduction restriction in Section 4k(4) does not apply if the taxpayer can prove that the expenses that were taken into account twice are offset by the taxpayer’s own income that is actually taxed in Germany and abroad. The same applies in the case of a foreign tax credit to avoid double taxation to the extent the expenses reduce taxable income in Germany (but the exception does not apply if the expenses reduce income that is not subject to domestic taxation).
Imported Mismatches
Section 4k(5) restricts the deduction of expenses that do not directly lead to a mismatch, but which are used to “import” a mismatch that has arisen between third countries into the domestic market. This is the case if the income resulting directly or indirectly from the domestic expenses is income that arises from a legal relationship where the income is offset by the expenses and the mismatch is not neutralized by the relevant jurisdictions. The purpose of Section 4k(5) is to prevent back-to-back arrangements, i.e., multi-level financing with companies in countries without anti-hybrid rules with a view to circumventing Germany’s anti-hybrid rules in Section 4k(1)-(4).
In the case of multi-tiered business relationships, a chain of service relationships is required between the legal entity bearing the expenses and the German taxpayer. There is no need for a uniform economic connection between the taxpayer’s expenses and the foreign entity’s harmful expenses. This fairly broad interpretation by the German tax authorities can, in practice, lead to the application of Section 4k(5) in a variety of ways.
In addition, the application of Section 4k(5) requires the participation of at least three different legal entities in different jurisdictions, with two of the entities directly involved being related parties. The deduction restriction under this measure does not apply if the mismatch has already been eliminated at another level of the legal relationship, e.g. by a corresponding foreign law.
The guidance on Section 4K EStG includes several welcome clarifications about the rules, but overall, the regulations introduced in 2021 still have to be consolidated in practice. Some points that have not been stringently implemented will require further clarification by the courts.
Jan-Eike Eckardt
Winfried Feldhaus
Marina Leker
BDO in Germany
Section 4k is based on Germany’s implementation of Articles 9 and 9b of the 2016 EU ATAD Directive, as amended in 2017, via the 2021 ATAD Implementation Act. Hybrid mismatches exploit differences in the tax treatment of an entity or instrument between two or more countries, which can give rise to tax advantages or create mismatch outcomes. These differences can result in:
- Double deduction mismatches (DD mismatch) where a tax deduction is taken for the same payment in both countries;
- Deduction without inclusion mismatches (D/NI mismatch) where a tax deduction is taken for a payment in one jurisdiction without the inclusion in taxable profit in that jurisdiction; and
- Imported hybrid mismatches where the mismatch originates with foreign hybrid entities and are “imported” into an EU member state.
The anti-hybrid rules generally apply to expenses incurred after 31 December 2019, with a grandfather rule applying to expenses incurred under a continuing obligation, such as interest, rent or license fees before 1 January 2020.
Scope of the Anti-Hybrid Rules
As noted above, Germany’s anti-hybrid rules apply to D/NI mismatches, DD mismatches and imported mismatches. The rules are triggered in structured cross-border arrangements or where there are mismatches between associated parties or between a company and its permanent establishment (PE) in the other jurisdiction. Parties can be actually related for this purpose or be presumed to be related based on certain factors.A structured arrangement exists if the tax advantage arising from a mismatch is included in whole or in part in the contractual agreements or if these suggest that the parties to the arrangement could expect the tax advantage. Thus, the scope of Section 4k could also apply to arrangements between unrelated third parties.
The expense deduction limitation can be avoided if the taxpayer can demonstrate that, based on external circumstances, it cannot reasonably be assumed that the taxpayer was aware of the tax mismatch advantage and the taxpayer did not benefit from the tax advantage.
D/NI Mismatch Outcome
Mismatches caused by hybrid arrangements in the form of a D/NI mismatch usually arise in cross-border cases involving hybrid financial instruments, hybrid entities or reverse hybrid entities, which are treated differently in the participating countries either with respect to their equity or debt capital or with respect to their corporate form. Section 4k can also be relevant in certain situations involving PEs.
- Section 4k(1) targets mismatches arising where certain expenses relating to hybrid financial instruments such as convertible bonds, hybrid loans, typical silent partnerships, profit participation rights or shareholder loans, where the corresponding income is not taxed or is taxed at too low a rate abroad.
The deduction disallowance in Section 4k(1) applies only if the qualification conflict—usually involving the different treatment of the hybrid financial instrument as equity or debt capital—is the cause of the mismatch. If there are other reasons for nontaxation or low taxation of the income corresponding to the expenses that lie outside the scope of Section 4k, the deduction restriction will not apply, nor will it apply if the mismatch in taxation is likely to be eliminated in a future tax period and the payment terms are at arm’s length.
- Section 4k(2) restricts deductions for expenses (i) whose corresponding income is not subject to actual taxation in any jurisdiction due to a taxpayer’s different tax treatment, or (ii) a different tax assessment of presumed contractual relationships in matters relating to PEs. Unlike the restriction under Section 4k(1), lower overall effective taxation of the corresponding income compared to the standard taxation abroad does not lead to a (pro rata) deduction prohibition of the expenses.
The second alternative requires a reference in the form of a domestic company or a domestic business establishment for which fictitious operating expenses or a corresponding exemption amount are taken into account. Consequently, from a German perspective, this does not apply to presumed contractual relationships between a foreign business establishment and the remaining foreign company.
As under Section 4k(1), the Section 4k(2) deduction restriction applies only if the existing qualification conflict is the sole cause of the mismatch that has arisen in the form of no actual taxation. The disallowance does not apply if the expenses are offset by income of the taxpayer that is actually taxed both in Germany and abroad (i.e., double-counted income). There are no provisions for how to proceed if the mismatch is eliminated in a future tax period.
- Section 4k(3) disallows a deduction for expenses whose corresponding income is not subject to actual taxation in any jurisdiction due to a different tax allocation or attribution under the laws of other countries. As with Section 4k(2), lower effective taxation is irrelevant.
The Section 4k(3) deduction restriction applies only if the actual nontaxation of the income corresponding to the expenses is due to their allocation or attribution under tax law that differs from German law. Section 4k(3) does not provide for an exception corresponding to Section 4k(2) for income that has been taken into account twice and there is no guidance on how to proceed if the mismatch is eliminated in a future tax period.
Double-Deduction Mismatch Outcome
Section 4k(4) addresses mismatches resulting from the double deduction of expenses in both Germany and abroad. The guidance provides that the deduction restriction should apply where the expenses of a German taxpayer are deducted twice because the expenses are excluded under the controlled foreign corporation or similar rules in a foreign jurisdiction, subject to certain exceptions.
The deduction restriction in Section 4k(4) does not apply if the taxpayer can prove that the expenses that were taken into account twice are offset by the taxpayer’s own income that is actually taxed in Germany and abroad. The same applies in the case of a foreign tax credit to avoid double taxation to the extent the expenses reduce taxable income in Germany (but the exception does not apply if the expenses reduce income that is not subject to domestic taxation).
Imported Mismatches
Section 4k(5) restricts the deduction of expenses that do not directly lead to a mismatch, but which are used to “import” a mismatch that has arisen between third countries into the domestic market. This is the case if the income resulting directly or indirectly from the domestic expenses is income that arises from a legal relationship where the income is offset by the expenses and the mismatch is not neutralized by the relevant jurisdictions. The purpose of Section 4k(5) is to prevent back-to-back arrangements, i.e., multi-level financing with companies in countries without anti-hybrid rules with a view to circumventing Germany’s anti-hybrid rules in Section 4k(1)-(4).
In the case of multi-tiered business relationships, a chain of service relationships is required between the legal entity bearing the expenses and the German taxpayer. There is no need for a uniform economic connection between the taxpayer’s expenses and the foreign entity’s harmful expenses. This fairly broad interpretation by the German tax authorities can, in practice, lead to the application of Section 4k(5) in a variety of ways.
In addition, the application of Section 4k(5) requires the participation of at least three different legal entities in different jurisdictions, with two of the entities directly involved being related parties. The deduction restriction under this measure does not apply if the mismatch has already been eliminated at another level of the legal relationship, e.g. by a corresponding foreign law.
BDO Insight
The guidance on Section 4K EStG includes several welcome clarifications about the rules, but overall, the regulations introduced in 2021 still have to be consolidated in practice. Some points that have not been stringently implemented will require further clarification by the courts.Jan-Eike Eckardt
Winfried Feldhaus
Marina Leker
BDO in Germany