In 2002, the European courts declared German 'thin capitalisation' rules to be contrary to European law. The rules - which sought to protect German tax revenue by disallowing excessive interest payments on loans to companies made by non-German shareholders - did not apply to domestic shareholders (because there would be no net impact on German tax receipts). The court said that this discriminated against other EU members, and had to be changed. The impact of that ruling is just starting to be felt, and it could be dramatic for European buyout structures accorting to SJ Berwin. In Germany itself, there was a fundamental choice: to abandon the rules altogether, or to apply them to German shareholders as well as to foreigners. Perhaps unsurprisingly, the tax authorities chose the second option. But the changes have gone much further than they needed to. The new rules also reduce the 'safe' debt/equity ratio for holding companies, and now include loans to partnerships with corporate partners. Worse still, they include loans made by German banks within their ambit, if there is 'recourse' to a related person, such as a shareholder or subsidiary of the borrower. On a buyout, of course, the senior lender usually will have recourse to target companies - and the possibility that those structures are under attack has thrown the market into a state of shock.Although the German tax authorities are expected to issue a ruling in the next few months that will adopt a more restrictive view of the term 'recourse', and alleviate many of the concerns, nothing is certain. Meanwhile, the German buyout market is - once again - struggling with the uncertainty that the rule change has brought. And the problem is not restricted to Germany. Other European tax authorities have also been forced to react to the European court ruling. In the UK, where similar concerns about the legality of thin capitalisation rules exist, new rules come into force next month that could affect British buyout deals. The threat is a similar (but much less severe) one - where a company has borrowings which would be excessive when the company is looked at in isolation, but which are supported by guarantees from other group companies, there will have to be a reallocation of the interest relief. That could create problems for the guarantor companies and the group as a whole. Again, much depends on the way in which the rules are interpreted, which is hardly a satisfactory state of affairs. In many cases the net tax effect is likely to be neutral, but additional complexity and uncertainty is inevitable.The impact of a European court ruling in 2002 may be more significant than it seemed at the time, but the common theme is an over-reaction by tax authorities and unclear legislation. It is to be hoped that lobbying will lead to sensible clarification of these rule changes before too much damage is done. The news is not all bad, however. In Spain, the authorities took the other view, and abolished thin capitalisation rules altogether for financing coming from any EU country. There, at least, the European courts have done the buyout industry a favour.
