Unconstitutionality of the Interest Limitation? Evidence from Germany: Adequate amount of interest expense in an enterprise and interest coverage ratio

Abstract

The tax deductibility of interest expenses is an issue for companies. However, the interest limitation rule may restrict the tax-effective deduction for interest expenses of a business to 30% of the EBITDA. The German Supreme Tax Court (BFH) has submitted the interest limitation to the German Federal Constitutional Court to examine its constitutionality (BFH I R 20/15; 2 BvL 1/16). Since the interest limitation has been introduced by European secondary legislation (Art. 4 ATAD; Anti-Tax-Avoidance Directive) in all EU Member States, and the German rule corresponds exactly to Art. 4 ATAD, the decision of the German Federal Constitutional Court (BVerfG) will have a great signaling effect. The unconstitutionality of the interest limitation rule may prevent important tax policy goals of limiting tax-related debt financing of businesses and corporations from being achieved. According to the BFH, the German Federal Bar Association and the predominant opinion in the German literature, the interest limitation rule violates the ability-to-pay principle under Article 3 (1) of the German Basic Law. However, the existing analysis falls short. An economic and legal analysis of the interest limitation shows that it does not violate constitutional law. Under constitutional law, the legislator may limit the amount of the tax-effective deduction of business expenses to interest expenses that are customary in the market. In doing so, the legislator can use recognized financial ratios, such as the interest-coverage ratio (ICR) that stands behind the 30% EBITDA limit. Constitutional law does not provide for an unlimited tax deduction of interest expenses.