Germany: Arm's length interest on intercompany loans (court decisions)
Three recent judgments from the German Federal Tax Court (BFH)
German Federal Tax Court (BFH) set out the arm's length principles for intercompany loans
The German Federal Tax Court (BFH) in three recent judgments set out the arm's length principles for intercompany loans.
Judgment I R 4/17: Finance company
In the first case, a Dutch finance company (FinCo) granted an interest-bearing unsecured loan to its German related or associated company. At the same time, the German company took out loans from banks which, although bearing lower interest than the intercompany loan, were secured by guarantees. The tax office considered the interest rate on the intercompany loan to be non-arm's length (that is, too high) and reduced the interest payable in Germany. In the opinion of the tax office, the FinCo would not be considered a bank, but an agent. The service nature of forwarding loan funds is to be regarded as the primary focus. The interest, therefore, must be determined on an arm's length basis using the cost-plus method.
The BFH disagreed. According to the court:
- The basic method to be used for determining arm's length lending rates is the comparable unrelated price method (CUP).
- The comparison with the bank loans was to be rejected, not only because the bank loans were secured (internal arm's length comparison).
- It could not be ruled out that the effect of the security provided on the interest rate can be quantified and eliminated.
- The external arm's length comparison was found not to fail because of the FinCo's structure, which typically has less resources than a bank.
- Corporate bonds could also be used for comparison.
- The group affiliation itself did not prevent application of the CUP method but, however, could affect the credit rating and the interest rate. The credit rating of the borrower must be on a stand-alone basis and not a group rating. A rating agency's credit rating could be used for that purpose (in this case, the S&P).
Judgment I R 62/17: Shareholder loan
In the second case, a German company acquired shares in a company. This was financed by the following loans:
- Unsecured subordinated shareholder loan (interest rate 8%)
- Secured bank loan (interest rate 4.78%)
- Unsecured loan from the seller of the shares (interest rate 10%)
The tax office considered the interest rate on the shareholder loan too high and only granted a tax deduction of the interest payable of 5% (comparison with bank loan).
The BFH disagreed. The court found that:
- The comparison with the bank loan was flawed—the bank loan was (contrary to the shareholder loan) secured and senior. An unrelated party would not grant a subordinated and unsecured loan at the same "price" as a secured and senior loan.
- The statutory subordination of shareholder loans was irrelevant for arm's length determination.
- The "close relationship" between the shareholder and the subsidiary was to be "disregarded,” meaning that the lender was not acting as a shareholder, and thus statutory subordination did not apply or compensation would be required for "voluntary" subordination of the loan.
- As a result, for arm's length comparison, actual agreements with unrelated parties (in this case, the secured senior bank loan) would first have to be adjusted mathematically to compensate for any special circumstances at affiliated companies (and again in this case, no collateral, subordinated) before they can be used.
Judgment I R 32/17: Write-down of receivables
In the third case, a domestic company granted shareholder loans to its foreign subsidiaries. Most of the loans were fixed interest. For one of the loans, annual participation in net profit was agreed as compensation in lieu of a fixed interest rate. The loans were unsecured.
In the year under dispute (2005), the German company wrote off its receivables against profit. The tax office took the position that the loan terms were not at arm's length and added the write-downs back to profit (pursuant to Section 1 of the German External Tax Relations Act [AStG] – profit adjustment in the case of cross-border business relationships between associated companies at non-arm's length conditions).
The BFH held that the lack of loan collateral falls under the "conditions" within the meaning of Section 1 AStG which, in the overall analysis, could lead to the business relationship (related-party transaction) being considered non-arm's length. The same applies to Article 9 of the OECD Model Tax Convention, so that Article 9 of the OECD Model Tax Convention has no precluding effect on the unilateral adjustment of profit under Section 1 AStG.
Whether an unsecured intercompany loan is considered arm's length depends on whether an unrelated party would have granted the loan under the same conditions—taking into account compensation for potential risks where applicable. Not only banks, but also other lenders could be considered "unrelated parties" if there is a market for the specific financing in which such lenders are active. Even the collateral itself does not always need to be "customary in banking.” Moreover, full collateralisation cannot always be assumed.
When determining the market for the agreed loans, all circumstances of the individual case must be considered, i.e., in addition to the borrower's credit rating, other circumstances such as the corporate group's conduct in lending to unrelated parties, the economic benefits of potential collateralisation in the specific individual case, alternatives to non-collateralisation, loan amount and term, the purpose of the loan and the business strategy of the lender. It is therefore possible, according to the BFH, that an unrelated party on this market would be willing to compensate for the increased credit risk arising from non-collateralisation—for example, through agreement of an interest rate premium. Accordingly, the lack of a single "condition" (in this case, the lack of collateral) does not immediately lead to the profit adjustment pursuant to Section 1 AStG being applied.
The BFH referred the case back to the lower court with instruction to expand its findings on arm's length transactions. If the lower court were to come to a conclusion that arm's length "conditions" were agreed in general, a profit adjustment pursuant to Section 1 AStG would be precluded. If the examination were to show that the agreed conditions were not at arm's length, even when taking into account a so-called risk compensation, an adjustment of the write-down to fair value (of the loan amount) pursuant to Section 1 AStG would also be precluded. However, the profit adjustment would be limited to the difference between the actually earned and the arm's length interest income if there is such a market for the agreed loans.
Read a November 2021 report [PDF 355 KB] prepared by the KPMG member firm in Germany
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