Tax risks regarding foreign currency loans to domestic or international group companies
Resident taxable entities that issue foreign currency loans to domestic or international group companies can be exposed to tax risks if changes in exchange rates result in an impairment of the loan. Losses arising from such loans are subject to a ban on loss deduction if the loan was granted to corporations in which the lender holds a direct or indirect investment of more than 25%. The wording of the legal provision actually intended for credit quality-related impairment losses also includes all other events leading to an impairment, thus also exchange rate-related losses on loans.
While the law allows for counterevidence for lending relationships arranged on an arm's length basis, how this is specifically to be provided and whether uncollateralised loans can be covered by the exception at all is still unclear and can be answered in different ways. It is also unclear whether the law at this point would rather have to be restrictively interpreted in accordance with its purpose and whether exchange rate losses have to be exempted from the ban on deduction.
The deductibility of such exchange rate-related loan losses has already been denied by tax authorities in tax audits in some cases.
The problems are aggravated for domestic lenders if they, as is typically the case, hedge the foreign exchange risks arising from loan positions using structured derivative financial instruments as an offset. In the case of such hedges linked to lending transactions, both commercial and tax balance sheet hedges are recognised. As a result, the underlying transaction (loan) and the hedging instrument are considered as a unit (valuation unit). The nature and purpose of the valuation unit is to cancel out opposing changes in value arising from the underlying transaction (hedged item) and the hedge in respect of the presentation in the income statement and balance sheet. In the commercial balance sheet this is either managed in such a way that the gains or losses from the hedged item and hedging instrument are not recognised at all over the entire duration of the loan in the income statement (net hedge presentation method) or gains and losses arising from the hedged item and hedging instrument are recognised in the income statement in each case by setting aside the realisation principle (gross hedge presentation method). Provided hedging is sufficient, both methods ultimately result in an earnings effect of 0.
The tax authorities consider it necessary to deviate from this when determining the tax result. Significant in this regard is that the tax authorities always prefer to take an isolated view of the realised gains or losses in the case of hedge reversal.
The aforementioned ban on deduction for loan losses comes into play in this regard. If – when viewed in isolation – an exchange rate-related impairment of the loan arises, in certain circumstances these losses are not deductible from a tax perspective. However, there is no corresponding provision for the isolated view of a gain arising from the hedge. The gain would be taxable under this approach. In the overall view, unrealised gains would be subject to income taxation (dry income taxation).
Although this surprising tax consequence can be countered by a series of arguments (e.g. lending relationship on an arm's length basis), the tax authorities remain to some extent intransigent and follow up on these cases as part of tax audits. Until there is clarification on the treatment of foreign exchange losses arising from group loans by the highest court, there should be consideration of potential hedging arrangements. Where possible, loans could be issued in EUR and hedged against changes in value in respect of the country currency taken out in the country of the borrower.
Overseas legal systems are mostly not affected by the existing problems for hedges in Germany. In addition, loans can be issued via international finance companies, which at the same time avoids the restrictions on deductibility for refinancing expenses for trade tax purposes in place in Germany. Finally, it is necessary to ensure as a minimum that adequate documentation of the arm's-length nature of the loan terms is in place for cases of doubt.
Source: KPMG Corporate Treasury News, Edition 80, May 2018
Author: Autor: Dr. Dirk Niedling, Partner, International Tax, firstname.lastname@example.org
© 2019 KPMG AG Wirtschaftsprüfungsgesellschaft, ein Mitglied des KPMG-Netzwerks unabhängiger Mitgliedsfirmen, die KPMG International Cooperative (“KPMG International”), einer juristischen Person schweizerischen Rechts, angeschlossen sind. Alle Rechte vorbehalten.