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October 21, 2021
German Federal Fiscal Court ruling contradicts position of German Ministry of Finance on Guidance on Financing Structures
The German Ministry of Finance (MoF) issued the Administrative Principles regarding Transfer Pricing (AP TP) in July 2021. This guidance provides, among others, that for loans to German borrowing group affiliates the acceptable interest margin for a foreign financing company is limited to the current risk-free market return unless the financing company is “able and authorized” to control the financial investment and bear the corresponding risks.
To the extent interest payments out of Germany result in higher compensation at the level of the foreign financing company, they are not deductible according to the position of the MoF. For background, see EY Global Tax Alerts, German Ministry of Finance issues new guidance on financing structures, dated 23 July 2021 and German Ministry of Finance issues new Administrative Principles regarding transfer pricing, dated 23 July 2021.
The German Federal Fiscal Court (BFH) contradicted the position of the MoF as set out in the AP TP in a ruling published on 21 October 2021 regarding the calculation of an arm's-length interest rate on intercompany loans (BFH, ruling dated 18 May 2021, I R 4/17). According to the ruling, the interest rate should be based on the economic circumstances of the borrower (and not the lender). Further, the comparable uncontrolled price (CUP) method is to be applied with priority over the cost-plus method. The priority of the CUP method should also apply if (comparability) adjustments are required and appropriately performed. Essentially, the decision stipulates that the appropriate interest rate is the rate the borrower would have to pay to a third-party lender and that there is no restriction to a risk-free interest rate for certain intercompany lenders - as opposed to the view set forth by the MoF in the AP TP.
In rec. 3.92 of the AP TP, the MoF sets forth the position that the interest of a financing company is limited to a risk-free return based on a cost plus method if a financing entity provides funds to a related party but does not have the capability and authority to control the financial investment and to bear the associated risks. Accordingly, the deductibility of interest charged to a German taxpayer is limited to such a risk-free return.
In the case underlying the ruling of the BFH, a German corporation received a large number of loans from its Dutch sister (financing) company. The German tax authorities asserted that the Dutch lender does not actually bear the financing risk and therefore only provides a service. Consequently, based on their approach, they applied the cost plus method to calculate the appropriate remuneration of the lender and treated the interest payments as constructive dividends to the extent they exceeded this amount.
The BFH positions itself clearly in contrast to the position of the German tax authorities held in this case and also set forth in the AP TP. According to the court, the arm’s-length analysis for the provision of funds from a lender to a borrower including the determination of risks is solely to be based on the actual transaction and the direct contracting parties. In the opinion of the BFH, the CUP method is to be applied with priority over the cost plus method, inter alia referring to the Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines on Financial Transactions (Inclusive Framework on Base Erosion and Profit Shifting (BEPS) - Actions 4, 8-10 of February 2020).
Moreover, the BFH held that any potential financial group support for the lender by the parent entity is not relevant for the arm’s-length analysis of the actual transaction between the borrower and the lender, but rather constitutes a separate transaction between the lender and the parent entity in line with the OECD’s view (see example in OECD Transfer Pricing Guidelines on Financial Transactions, para. 10.25).
Since the MoF guidance is considered a clarification of the arm’s-length principle by the tax authorities, it is applied retroactively in all open cases and is binding for the tax authorities (e.g., within tax audits). Therefore, the positions set forth by the MoF are of significant practical importance for taxpayers.
In light of the background of the contrary BFH ruling, it now remains to be seen whether the tax authorities will revise their view and adjust the AP TP. In the most unfavorable case for taxpayers, the tax authorities could react with a non-application decree. In this case, the BFH ruling would not be applicable beyond the individual case decided, even though it would still indicate how the court would decide in similar cases. Until certainty is achieved, taxpayers should disclose any nonconformity from the official guidance when filing their tax returns.
For additional information with respect to this Alert, please contact the following:
Ernst & Young GmbH
Ernst & Young LLP (United States), German Tax Desk, New York
Ernst & Young LLP (United States), EMEIA Transfer Pricing Desk, New York