Final Federal Ministry of Finance circular on Section 4k of the German Income Tax Act and US inbound structures

What are the German anti-treaty-shopping-rules?

Due to varying local tax law, cross-border service relationships and companies involved in them can be subject to differing tax treatment in the various countries. These so-called mismatches, can result in certain tax advantages, which can basically be broken down into two categories:

1. Deduction/non-inclusion mismatches (D-NI mismatch)
   A payment in Germany generates a deduction of operational expenses, while for the creditor the payment results either in non-taxable income or in income that is taxed too low owing to a mismatch.
2. Double deduction mismatch (DD mismatch)
   Operational expenses that are deductible in Germany are often counted twice, by them also reducing the tax burden in the other country at the same time. 

 Source: Grant Thornton Germany

In both cases operational expenses that reduce tax create tax advantages abroad at the expense of tax revenue in Germany. To prevent this, the rule contained in Section 4k of the Income Tax Act was introduced. This puts limits on the deduction of operational expenses for D-NI and DD mismatches in Germany.

The Section 4k rule is extremely complex and throws up many legal questions. On 13 July 2023, the Federal Ministry of Finance (BMF) published a draft circular on applying Section 4k (“draft version”), which met with heavy criticism. On 5 December 2024, the BMF published its long-awaited final circular (“final BMF circular”).

Important clarifications for hybrid mismatches 

As the BMF correctly states, the rule in Section 4k of the Income Tax Act is particularly important to German companies with US shareholders (“US inbound structures”). The background to this is that US tax law provides an option (known as “check-the-box election”) which allows companies either to be treated for income tax purposes as non-existent or as partnerships (disregarded or flow-through entities).

Since this option is frequently used, hybrid legal entities regularly come about for US inbound structures that cause mismatches. It is for these structures in particular that the final BMF circular contains important rules and clarifications.

1. Hybrid financial instruments

Section 4k applies to hybrid financial instruments if the corresponding income is subject to no or low taxation abroad. The decisive thing here is that the no or low taxation has to be caused by a mismatch in classification or allocation.

If, owing to such a mismatch, income abroad is taxed at a lower rate than it would be if it were classified or allocated under German tax law, the final BMF circular limits the deduction of operational expenses proportionately. To calculate the proportionate ban on deduction, the relationship between the actual taxation of the income abroad and hypothetical taxation on classification or allocation under German tax law is applied. The final BMF circular illustrates how this is calculated with an example.

However, simplified calculation methods are missing for cases on a progressive tax scale. There is also no restriction to the amount of foreign tax actually saved by applying different tax rates.

2. Actual taxation abroad

A further question about Section 4k that had been open until now was whether income only included under controlled foreign corporation rules and not subject to “regular” income tax should still count as taxed abroad. The final BMF circular has now cleared this up – the inclusion of income under controlled foreign corporation rules in the context of hybrid financial instruments is equated to actual taxation. This rule should also apply to the other situations covered by Section 4k. 

But the BMF has also made an exception to this principle – it is not counted as actual taxation if the income is only included in a “blending” regime. These kinds of regimes add together the income, losses and taxes of several or all the controlling companies, which allows them to be offset across borders and legal entities. We consider that this may particularly affect global intangible low-taxed income (GILTI) in the context of the US corporate foreign corporation rules. But there has not been a clear statement whether global minimum taxation is to be classified as actual taxation.

3. Easing of excess taxation on intercompany service relationships

On intercompany services, a literal application of Section 4k can lead to a considerable and inequitable higher tax burden. This particularly affects cases in which a German corporation counts as transparent from the US tax perspective due to check-the-box election and provides paid services to its foreign parent.

In such cases, the tax transparency of the German company may lead to double exploitation of losses in the USA. Section 4k lays down that the ban on deducting operational expenses only applies if there is no double taxed income (dual income inclusion escape). But owing to the German company’s tax transparency, the service charges from the intercompany service relationship are not taxed at the foreign parent in the USA. This results in the exemption not being applied, which can lead to a considerably higher tax burden.

Source: Grant Thornton Germany

The final BMF circular appears to address these issues and, in order to avoid this tax burden, stipulates that such income is to be taken into account “as a rule” “for reasons of equity”, which means Section 4k will not apply in these cases.

This clarification is to be welcomed. But it still remains unclear under what conditions deviations can be made from the application “as a rule” of this equity rule. The taxpayer also continues to remain obliged to submit evidence and supporting documentation in order to have Section 4k excluded.

4. (No) double exploitation of losses as part of foreign controlled foreign corporation rules 

The legislature has made unmistakably clear in the legislative process that there is no double exploitation of losses and that Section 4k is therefore not applicable if German losses are only taken into account under foreign controlled foreign corporation rules.

Source: Grant Thornton Germany

In the draft version, the BMF took the opposite view, however, which led to considerable uncertainty in practice. Fortunately, the BMF has adopted the legislature’s point of view in the final BMF circular. According to this, Section 4k does not apply if German losses are only taken into account under foreign controlled foreign corporation rules. This rule is also to apply to add-back regimes in which the income, losses and taxes of all or several controlled companies are added together (“blending”).

We think this particularly means that losses and operational expenses that are only taken into account for US GILTI taxation should not fall under Section 4k.

This clarification is very welcome, because otherwise US controlled groups with German subsidiaries would almost entirely have fallen within the scope of Section 4k.

5. (Incomplete) EU gatekeeper rules

Regarding the imported taxation mismatches under subsection (5) of Section 4k, the taxpayer is obliged to check and record whether the in/direct foreign shareholders have any taxation mismatches. Depending on the “chain of shareholdings” in question, this kind of checking and recording often turns out to be hardly practicable.

Since Section 4k of the German Income Tax Act is based on the EU Anti-Tax Avoidance Directive (ATAD), it can basically be assumed that similar rules to limit the deduction of operational expenses on mismatches will be introduced across the EU. According to the BMF, taxpayers with a parent company in the EU can basically rely on these kinds of mismatches being eliminated in the EU member state of the parent company, so that Section 4k(5) of the Income Tax Act will not apply.

Source: Grant Thornton Germany

This sensible simplification to the process and to evidence is, however, only of limited application in the final BMF circular because it only applies to the extent that the scopes of ATAD and Section 4(5) overlap. Since Section 4k goes beyond the minimum stipulations of ATAD, taxpayers with EU parent companies continue to remain obliged to fulfil their duties to check and record the existence of any imported mismatches.

Summary: important clarifications for practice, but issues remain open  

The final BMF circular on Section 4k of the Income Tax Act brings important clarifications and simplifications, particularly for practical issues related to hybrid mismatches and US inbound structures. 

But it remains vague on a number of important points. The BMF has also failed to give further details of the duties to calculate and record mismatches and particularly on introducing simplifications in terms of the procedure and evidence for US inbound cases. The requirements of the duties to provide evidence and supporting documentation thus remain high and taxpayers continue to have to make complex checks. 

Overall, however, the final BMF circular provides a helpful basis for the practical application of Section 4k, even if there is still some room for interpretation in some areas. We will be glad to answer your questions on Section 4k of the Income Tax Act and the final BMF circular. We’re looking forward to hearing from you!

This article was written by our experts Lukas Kawka and Julia Marie Koch.