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No all-clear for foreign currency loans in groups

No all-clear for foreign currency loans in groups

Recognition of tax loss still uncertain

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Nils A. Bothe

Partner, Audit, Finance and Treasury Management, Finance Advisory

KPMG AG Wirtschaftsprüfungsgesellschaft

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foreign currency loans

Review

As we have already reported (see our newsletter article from edition 80: Tax trap for intragroup loans denominated in foreign currency?), the German tax authorities in their currently ongoing tax audits do not allow loss deduction of negative changes in value for intragroup loans caused by movements in exchange rates. 

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; in the opinion of the German tax authorities, this also means 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.

As profits and losses are treated inconsistently, the ban on deduction already violates basic principles of fair and consistent taxation. There will be disproportionate consequences if the lender uses the typical approach of currency forwards to hedge their foreign exchange risks arising from lending. The absence of corresponding tax exemption for hedging gains arising from these transactions combined with the non-deductibility of loan losses could result in profits being taxed that never materialised ('dry income taxation').

Current developments

Although we received signals from the legislator at the end of last year indicating that support will be provided for this unsystematic and unreasonable tax consequence, there is currently no sign of any legal amendment or of the tax authorities issuing a standard regulation applicable across Germany.

On the contrary, the Lower Saxony State Office for Taxes issued a decree dated 21 April 2020 officially confirming the tax authorities' hard line. According to this administrative instruction, foreign exchange losses are to fall under the non-deductibility rule. In the state office's opinion, offsetting income from hedging transactions cannot be recognised as a netting mechanism in such cases. According to the decree, hedging foreign exchange risk alone does not allow the counterevidence option of arm's length loan hedging. Overall, this first administrative interpretation published will lead to taxation of profits not economically generated, which under certain circumstances will have significantly negative consequences for the respective company's effective tax rate (ETR).

However, a recent ruling of the German Federal Tax Court (BFH I R 20/16) on a comparable matter is in opposition to the comments of the Lower Saxony tax authorities. The BFH had to decide on how to tax profits from foreign currency hedges entered into to hedge foreign exchange risks from investments in cases where the investment is sold. As investment gains are generally tax-exempt but currency forward gains are taxable, a decision had to be given on whether and under what circumstances hedging gains are to be included in the tax-exempt gain on disposal.

According to the BFH ruling, gains on currency forwards that are caused by the sale of shares and can be attributed to these must be taken into consideration as part of the selling price when determining the tax-exempt gain on disposal. As losses from currency forwards (as selling costs) reduce the gain on disposal, the court decided that gains from foreign currency hedges likewise increase the gain on disposal. The required connection between the sale of shares and hedging transaction is seen by the BFH as existing only if the exclusive purpose of the currency forwards is to minimise foreign exchange risk related to the specifically expected proceeds from the sale ('micro hedges').

Based on our practical experience, the tax authorities have not yet transferred the principles of this ruling to foreign currency loans and the associated hedging transactions. Due to the identical context of rules and the comparable systematic background, however, there is an argument for tax treatment to be consistent. Overall, this would lead to the possibility of offsetting loan losses against gains from the hedging transactions and would avoid capital-based taxation.

Consequences of unexplained legal situation

As it cannot currently be foreseen how the lower tax courts will ultimately treat exchange rate-related loan losses and associated hedging transactions, taxable entities must find ways of identifying the tax risk and making it manageable. In this regard, it should be noted the scope of the non-deductibility rule does not just cover foreign-currency receivables obviously classifiable as loans – it can also include legal transactions economically comparable with loans (for example trade receivables not settled on time, or receivables from agreed dividend payments and from foreign-currency cash pools).

Strategies to avoid the tax risk could include moving parts of the critical financing function to other jurisdictions, moving the currency risk to the foreign group company with local hedging or intragroup netting of the risk positions at the foreign group companies.

Source: KPMG Corporate Treasury News, Edition 102, June 2020
Author: Dr Dirk Niedling, Partner, International Tax, dniedling@kpmg.com

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