Deduction of interest expenses with only indirect connection to tax-free income

According to Section 3c (1) of the German Income Tax Act (EStG), expenses that are directly economically related to tax-free income are excluded from deduction as business expenses or income-related expenses. If the expenses lack a concrete connection to a specific source of income, there may only be an indirect (causal) connection. In the decision of December 13, 2023 (case no. XI R 39/20), which was subsequently intended for official publication, the German Federal Fiscal Court (BFH) ruled on the deductibility of interest expenses from so-called pool financing when tax-free investment income is generated.

In the years 2012 to 2014, a credit institution received income from investments in special real estate investment funds within the meaning of Section 15 (2) of the German Investment Tax Act (InvStG 2004). For the acquisition of its respective shares in the investment fund, the credit institution regularly used so-called pool financing by using equity, collecting customer funds and general borrowing from other banks. The fund income distributed to the credit institution was partly attributable to rental income from properties located in other EU countries. These were exempt from German taxation due to the relevant double taxation agreements. The tax office recognized refinancing expenses attributable to the tax-free income from the funds as non-deductible operating expenses in accordance with Section 3c (1) sentence 1 EStG in conjunction with Section 8 (1) sentence 1 EStG. In contrast, both the fiscal court and the BFH recognized the interest expenses from the pool financing in question as deductible.

On the one hand, no income-related expenses or operating expenses of the unitholder can be taken into account when determining the income at the level of the investment fund in accordance with Section 3 InvStG 2004; these do not affect the amount of the distributed or distribution-equivalent income of the investment fund to be determined separately and uniformly. Contrary to the opinion of the tax office, the tax-free foreign income cannot therefore be attributed to the unitholder reduced by the income-related expenses or operating expenses incurred by the unitholder.

Secondly, in the case in dispute, there is an insufficient connection for the application of Section 3c EStG because the interest expenses in dispute are only indirectly related to tax-exempt income. This is particularly the case as the interest expenses were also, and not apportionably, related to non-tax-exempt income. On the other hand, a direct economic connection requires that the income and the operating expenses are caused by the same event. Accordingly, the interest expenses would have had to be inextricably linked to the tax-exempt income. The actual use of the loan taken out is decisive for the classification of financing costs under tax law. However, the credit institution had not specifically taken out loans to finance the acquisition of the fund units in question; there was no “direct refinancing of the investment”. In the opinion of the BFH, the fact that, as a result of the general borrowing by the bank, pro rata refinancing costs were incurred for the investment units in purely arithmetical terms is not sufficient for a prohibition of deduction pursuant to Section 3c (1) EStG.

Notice:

With this decision, the Federal Fiscal Court has specified the previous case law on the existence of a direct economic connection in the case of so-called pool financing and has also established potentially relevant criteria beyond this. However, in the version of the InvStG applicable from 2018, there are separate regulations on the treatment of expenses that are economically related to tax-free income from investment funds. Section 21 InvStG 2018 prohibits the deduction of expenses if they are economically related to income that is subject to partial exemption at investor level in accordance with section 20 InvStG 2018. The scope of application of section 21 InvStG 2018 is broader than that of section 3c (1) EStG, as an indirect economic connection is also sufficient. However, it has not yet been clarified by the highest court whether there is an economic connection with tax-exempt income from an equity, mixed or (foreign) real estate fund in the case of pool financing from a credit institution.