German Supreme Tax Court allowed for the deduction of interest payments on a loan used to finance the acquisition of shares even after the shares are contributed into another corporation

Implications: The heading of this article is phrased as if there where no deduction of interest payments on loans used to finance the acquisition of shares possible under German jurisdiction. But that is not the full story. As it is often the case when it comes to German tax law, things appear to be tricky. That is also true in the case discussed in the article. It has to be admitted that there is a restriction on such but nevertheless under certain conditions interest payments on loans used to finance the acquisition of shares are deductible even after the shares moved into another corporation. This analysis discusses the courts ruling and identifies the necessary conditions.

Analysis: On March 27, 2007, Germany’s Supreme Tax Court (Bundesfinanzhof, BFH) heard a case regarding the deduction of interest payments as capital income-related expenses. In the case under consideration, a taxpayer originally held 50% of the shares of a corporation (GmbH 1). The taxpayer provided a guarantee for GmbH 1 which later drew on the guarantee. In order to finance the guarantee payment, the taxpayer took out a loan of 700,000 EUR.

The taxpayer was also shareholder of another corporation (GmbH 2), into which he contributed the shares of GmbH 1. In return for the contribution he received approximately 30,000 EUR which were charged against existing loans.

In his income tax return, the taxpayer claimed a deduction for the interest payments on the loan. The tax authorities denied the deduction arguing that there was no direct connection between the interest payments and any kind of income. The loan had originally been taken out in order to finance the guarantee for GmbH 1 but after contributing the shares of GmbH 1 to GmbH 2, the taxpayer no longer had direct income from it but rather this income flowed to GmbH 2.

The Supreme Tax Court basically agreed with the tax authorities but referred to prevailing case law stating that in the case of the sale of an asset which has been used to achieve taxable income, interest payments arising on the financing of the assets remain deductible if the sale profits are reinvested into another asset which also generates taxable income.

The new aspect of the case considered was that the shares were contributed to another GmbH rather than being sold. The Court regarded this process as comparable to an exchange and therefore as in return for payment stating that it made no difference that there was no cash payment but only the charging against loans.

According to the Court, however, the deduction of interest payments is restricted to the amount which corresponds to the reinvested profit. Since the taxpayer received only 30,000 EUR which he could reinvest, but paid interest on a loan of 700,000 EUR, the interest payment could only be deducted proportionately.