Federal Tax Court judgement: First ruling on the deduction ban under section 4i of the Income Tax Act

Deduction restrictions for interest expenses

For interest expenses to be deducted, under German income tax law either section 4(4) or section 9(1) of the Income Tax Act must first be satisfied – the expenses must constitute either business expenses [Betriebsausgaben] or income-related expenses [Werbungskosten]. In rare cases, interest expenses of natural persons may also be deducted in other situations that are subsidiary to business expenses and income-related expenses (e.g. the introductory sentence to section 12 of the Income Tax Act; e.g. as an extraordinary burden [außergewöhnliche Belastung], Explanatory Notes to the Income Tax Act [Einkommensteuer-Hinweise–EStH], H 33.1–33.4, “Zinsen” [“interest”]).

Outside these special cases, interest incurred in the business sphere must first satisfy the definition of business expenses. It is business-related, as is necessary (section 4(4) of the Income Tax Act), where the expenses are objectively connected with the business and are subjectively intended for the business (Federal Fiscal Court judgement of 18 Jan 2001, file ref. IV R 58/99, Federal Tax Gazette [Bundessteuerblatt–BStBl.] II 2001, p. 393, para. 17). Loans used to finance non-business purposes, particularly to finance withdrawals, are not business-related. Where, for example, a loan is not used to finance business expenses but is actually used to finance a withdrawal, that loan is non-business (Federal Ministry of Finance [Bundesministerium der Finanzen–BMF] Circular of 2 Nov 2018, Federal Tax Gazette I 2018, p. 1207 paras. 3, 4). 

After this hurdle has been cleared, many restrictions to deduction must be observed, particularly those of section 3c(1) and (2) of the Income Tax Act in an economic context for (partly or entirely) tax-exempt income. Specifically for interest expenses, the interest limitation rule of section 4h (for corporations, in conjunction with section 8a of the Corporation Tax Act) imposes restrictions in cases in which the net interest expense of the “business” exceeds EUR 3,000,000 (section 4h(2) sentence 1(a) of the Income Tax Act). Alongside this, letters (b) and (c) provide further “escape” options, which for corporations are in part again restricted by section 8a(3) of the Corporate Income Tax Act. The interest limitation rule — as a “temporary ban on the deduction of business expenses” (Federal Ministry of Finance Circular of 5 Dec 2024, Federal Tax Gazette I 2024, p. 1578, para. 126) — applies in principle to any “business” as defined by section 4h of the Income Tax Act and may therefore be applied to sole proprietorships, partnerships and corporations that generate income from agriculture and forestry, a trade or business, or from self-employment (Federal Ministry of Finance Circular of 12 Mar 2025, Federal Tax Gazette I 2025, p. 683, para. 1).

In addition, further deduction restrictions have developed for particular groups of taxpayers. Specifically for natural persons and partnerships, section 4(4a) of the Income Tax Act gives rise to risks for the full deduction of interest for tax purposes. Where there is an “excess withdrawal” [Überentnahme] as defined by that provision and above a specified base amount, the deduction of interest expense is denied on a lump-sum basis by way of an off-balance-sheet add-back. However, the frequent “interest expense for loans to finance the acquisition or production costs of fixed assets” is excluded by section 4(4a) sentence 5 of the Income Tax Act by way of a sectoral exception, while the interest limitation rule in section 4h of the Income Tax Act draws no such distinction.

Above EUR 200,000 of (gross) interest expense, restrictions arise for trade and businesses (section 2 of the Trade Tax Act) in respect of trade tax. To the extent that the allowance is exceeded, a quarter of the deduction is denied by way of an add-back. The add-back under section 8 no. 1 of the Trade Tax Act, as the “second step of determination” in determining trade income (Federal Fiscal Court judgement of 23 Nov 2021, file ref. I R 5/18, para. 17), thus operates as a partial deduction ban (Federal Fiscal Court judgement of 7 Jul 2004, file ref. XI R 65/03, Federal Tax Gazette II 2005, p. 102, II.1.). By its nature, this can capture only interest expenses that are contained in the initial “profit from trade or business” (section 7 sentence 1 of the Trade Tax Act), which is determined in accordance with the Income Tax Act or the Corporate Income Tax Act (“first step of determination”, Federal Fiscal Court judgement of 23 Nov 2021, file ref. I R 5/18, para. 17) (the opening sentence of section 8 of the Trade Tax Act; on the relationship between section 4(4a) of the Income Tax Act and trade income see Federal Fiscal Court judgement of 27 Sep 2023, file ref. IV R 8/21, Federal Tax Gazette II 2024, p. 110, para. 29).

Deduction restrictions on interest expense in a cross-border context

In addition, further restrictions on the deduction of interest arise in a cross-border context. In particular, section 4k of the Income Tax Act establishes a comprehensive deduction ban (or deduction restriction) for “expenses” (on the concept in tax law see Federal Fiscal Court judgement of 10 Oct 2017, file ref. X R 33/16, paras. 23 and following), but which is not confined in substance to interest expenses (Federal Ministry of Finance Circular of 5 Dec 2024, Federal Tax Gazette I 2024, p. 1578).

Under the additional deduction ban in section 4i sentence 1 of the Income Tax Act, expenses may not be deducted as special business expenses [Sonderbetriebsausgaben] to the extent that they also reduce the tax base in another state. Under the “special business concept” [Sonderbetriebskonzept] of German tax accounting law, a partner’s loan liabilities incurred to finance his contribution to the partnership qualify as necessary special business assets category II [notwendiges Sonderbetriebsvermögen II] (Federal Fiscal Court judgement of 16 Jul 2020, file ref. IV R 30/18, Federal Tax Gazette II 2021, p. 939, para. 35). The special business assets must also be recognised for trade tax purposes (e.g. Federal Fiscal Court judgement of 1 Feb 2024, file ref. IV R 26/21, para. 45). The resulting special business expenses reduce the aggregate profit of the partnership, as they do the trade income (e.g. Federal Fiscal Court judgement of 12 Oct 2016, file ref. I R 93/12, para. 11).

Under the Code of Procedure for the Fiscal Courts [Finanzgerichtsordnung–FGO], in which the Fiscal Court is the sole instance for findings of fact, it is for the court of first instance to rule on the reduction of the “tax base in another state”: foreign law is “binding in principle” on the Fiscal Court (Federal Fiscal Court judgement of 22 Mar 2018, file ref. X R 5/16, Federal Tax Gazette II 2018, p. 651, para. 23) and is to be established in exercising its proper discretion (Federal Fiscal Court judgement of 16 Jul 2025, file ref. I R 20/22, Federal Tax Gazette II 2026, p. 178, para. 32 with further references) (section 155 sentence 1 of the Code of Procedure for Fiscal Courts in conjunction with section 293 of the Code of Civil Procedure [Zivilprozessordnung–ZPO]). The Federal Fiscal Court may, however, on appeal review application of the findings to German law in full – in this case, reduction of the foreign tax base.

In its decision IV R 36/23, the fourth chamber of the Federal Fiscal Court has commented for the first time on the rule in section 4i sentence 1 of the Income Tax Act. A Dutch corporation was subject to limited corporate income tax liability in Germany because it held an interest as a limited partner in the claimant, a domestic limited partnership carrying on a trade or business (section 49(1) no. 2 (a) Income Tax Act). It had financed this interest through a loan from its Dutch parent, with which it had established a tax group under Dutch law. Under the Dutch rules, this resulted in “full consolidation”, in contrast to German law (section 14(1) sentence 1 of the Corporate Income Tax Act), under which the income of the controlled company, determined in accordance with tax rules, is attributed to the controlling company as third-party income (“attribution theory” Federal Fiscal Court judgement of 29 Aug 2012, file ref. I R 65/11, Federal Tax Gazette II 2013, p. 555, para. 18). The loan in the Netherlands was thus effectively negated.

No deduction of special business assets based on section 4i of the Income Tax Act

In the view of the fourth chamber, notwithstanding “full consolidation” within the Dutch tax group, the tax base in the Netherlands had been reduced for the purposes of section 4i sentence 1 of the Income Tax Act (on similar questions related to the “dual consolidated loss rule” in section 14(1) sentence 1 no. 5 of the Corporate Income Tax Act (rescinded), see Federal Fiscal Court judgement of 16 Jul 2025, file ref. I R 20/22, Federal Tax Gazette II 2026, p. 178). Section 4i sentence 1 requires neither an effective reduction of tax nor that the reduction of the foreign tax base occur to the same taxpayer to whom the deduction of special business expenses is attributable in Germany. According to the purpose of the rule (on the applicable methods of interpretation see Federal Fiscal Court judgement of 25 Mar 2026, file ref. II R 17/23, para. 22), namely to counter the double deduction of expenses in Germany and abroad, it is also to be applied to the fully consolidated Dutch tax base.

In the year in contention of 2017, section 4k—which applied for the first time to expenses arising after 31 December 2019 (section 52(8c) sentence 1)—did not yet play a role. On the one hand, the question arises as to its relationship with section 4i, which in the understanding of the tax authorities is to be decided by reference to which “of the relevant prohibitions on the deduction of business expenses goes further” (Federal Ministry of Finance Circular of 5 Dec 2024, Federal Tax Gazette I 2024, p. 1578, para. 125).

On the other hand, the question arises how “full consolidation” under foreign law affects section 4k (Federal Ministry of Finance Circular of 5 Dec 2024, Federal Tax Gazette I 2024, p. 1578, para. 76): “The foregoing principles also apply in the context of group taxation models, e.g. the group contribution model and profit-and-loss offsetting system. Expenses of a taxpayer taken into account in Germany which under the law of another state are attributed to a person subject to tax in that state are also taken into account in that other state as defined by sentence 1 of section 4k(4) where the expenses are negated as a result of the application of a foreign group taxation system in accordance with that state’s consolidation principles and the transaction does not lead to an increase in the group’s tax base.” The view of the tax authorities on section 4k(4) therefore coincides with that expressed by the fourth chamber on section 4i sentence 1.