Tax court of Düsseldorf confirms restrictions on interest deductibility for partnerships in corporate groups

The local tax court of Düsseldorf recently published two decisions on a rule that disallows a deduction for interest at the level of a partnership in the case of so-called “excess withdrawals” from the partnership, even if the amounts are withdrawn from a limited partner belonging to a group controlled by a limited liability corporation and the amounts withdrawn remain in the group and are used for business purposes (case references 11 K 3720/08 and 11 K 2486/08).

The rule was added to the German Income Tax Act to eliminate the abusive shifting of interest expense from an individual taxpayer’s non-business sphere (where interest expense generally was not deductible) to the business sphere in the form of his share in a partnership (where interest expense generally was deductible). The rule is intended to prevent taxpayers from withdrawing cash from a partnership and soon thereafter obtaining a loan through the partnership to finance partnership investments. Interest expense on debt created this way should not be tax deductible.

The rule treats a certain portion of interest as nondeductible where there is an excess withdrawal. An excess withdrawal is presumed if the total withdrawals from a partnership in a fiscal year exceed the sum of profits of, and contributions to, the partnership in the same fiscal year. The nondeductible interest expense is calculated – in a simplified manner – with 6% of the excess withdrawals of a given fiscal year plus excess withdrawals of previous fiscal years and less deficit withdrawals (which result if profits and contributions exceed withdrawals) of previous fiscal years.

The rule not only prevents the abusive shifting of non-business related interest on debt into a business related sphere (e.g. of a partnership), but also presumes that (fictitious) interest spent to finance excess withdrawals always results from non-business-related activities and, therefore, is not deductible for tax purposes.

It was argued before the court that non-business related withdrawals cannot be made within a group controlled by a limited liability corporation, because corporations only perform business-related operations and, thus, the amounts withdrawn are used for business purposes.

In both cases, the court held that the wording of the underlying rule captures all kinds of withdrawals regardless of whether the withdrawal is used for business or non-business purposes. Therefore, and since the rule does not provide an escape clause for corporate groups, the fact that the amounts withdrawn remain in a group controlled by a limited liability corporation is irrelevant. The court pointed out that a limit on the scope of the rule based on its objective is not possible and that the judges do not have serious doubts about the constitutionality of the rule even though partnerships are treated in a different manner than corporations (which may generally deduct interest paid on loans obtained to finance dividends to individual shareholders). Appeals to the Federal Tax Court (BFH) are pending in both cases (case references IV R 22/10 and IV R 20/10).

For the time being taxpayers should consider that the rule remains fully applicable to partnerships even if controlled by a corporation and even if withdrawals are received only by a corporation. Hence, careful tax planning with regard to withdrawals is required to prevent excess withdrawals from the outset.

If you have any questions, please contact the authors of this article at  gtln@deloitte.de or your regular Deloitte contact.