Until recently, there was only limited guidance on transfer pricing of intercompany (I/C) financing relations. Following up on the BEPS project, on 3 July 2018 the OECD released the discussion draft on financial transactions. The discussion draft represented a non-consensus document, so it took a certain amount of time up until the final guidance was published in February 2020. In light of any missing OECD guidance on I/C financial transactions in 2019, the German Federal Fiscal Court revised a decade-long jurisprudence on I/C financing relations, and the German Federal Ministry issued suggested law changes with a treaty override as part of a Draft Ministerial Bill on the implementation of the Anti-Tax Avoidance Directive (“ATAD”). The following provides some highlights of the change in German jurisprudence regarding I/C finance relations, the suggested German law changes on I/C finance relations and the new Chapter X of the OECD Guidelines on financial transactions.
Recent Decisions of the German Federal Fiscal Court
In 2019 and continuing throughout 2020, the German Federal Fiscal Court revised a decade-long jurisprudence on I/C financing relations, as a result of a new formation of the Court. In a series of decisions, the German Federal Fiscal Court decided that implicit group support does not represent a valuable arm’s length security. In the underlying cases, a German company acted as a lender, whereas a foreign subsidiary was in poor economic shape and was no longer able to service the loan. The German lenders waived the receivable and de-recognised it, thereby reducing profit. Because the loans were not secured, the German Federal Fiscal Court disregarded the income reduction, arguing there would not have been any income reduction if the loans had been secured. Based on this line of argumentation, the German Federal Fiscal Court decided that a security represents a condition in the sense of § 1 Foreign Tax Act (FTA). Therefore, Article 9 (1) of the OECD Model Tax Convention no longer has precluding effect with regard to § 1 (1) FTA. Furthermore, the Court has been of the opinion that the income correction does not contradict the Hornbach-Baumarkt ruling of the EU Court of Justice. The German Federal Fiscal Court has not analysed in detail the appropriateness of the interest rate.
By neglecting the effect of implicit group support, this could imply from a transfer pricing perspective that the pricing of I/C financial transactions would have to be performed on a stand-alone basis of the borrower. This contradicts the 2017 OECD Guidelines, and also the new Chapter X of the OECD Guidelines suggests that the effects of passive group association shall be analysed and - depending on the facts and circumstances - considered. As detailed in the following, also the suggested changes to German law released in December 2019 place a certain emphasis on the group credit rating.
Although no rules have been provided in German law as of yet, the decisions of the German Federal Fiscal Court mark the current direction of German jurisprudence. However, consid-ering the suggested changes to German law, final OECD guidance and a further expected change of the German Federal Fiscal Court’s formation next year, it is possible that also German jurisprudence may change again soon in this regard.
Draft Ministerial Bill on the Implementation of ATAD
On 11 December 2019, the German Draft Ministerial Bill on the implementation of the ATAD was released, suggesting national regulations on I/C financing transactions with a treaty override. The draft bill was published at a time when a final version of the OECD guidance on I/C Financial Transactions had been awaited for some time but had not yet been published. The new rules on I/C finance transactions shall be governed in a new § 1a of the Foreign Tax Act (“FTA”). In line with final OECD guidance on Financial Transactions, which were published on 13 February, the suggested changes to German law introduce a substance test at the level of the borrower. Specifically, if it cannot be shown that (i) the principal payments for the entire duration of the financing relationship could have been repaid from the beginning and (ii) the financing is economically necessary and used for the purpose of the company; or if the interest rate payable by the German taxpayer for a cross-border financing relationship with a related party exceeds the interest rate at which the multinational enterprise group could be financed by third parties, then the interest expense shall be deemed to be non-deductible at the level of the I/C borrower. Additionally, the envisaged changes suggest limiting the compensation for low-function and low-risk financial activities such as mere intermediary of forwarding activities to a risk-free interest rate. It was envisaged that the changes would generally be applicable from 2020 onwards. An updated version of the German Draft Ministerial Bill on the implementation of the Anti-Tax Avoidance Directive is currently awaited, possibly with revisions also on I/C financing relations.
Final OECD Guidance on Financial Transactions
On 11 February 2020, the OECD finally released the final report on I/C financial transactions. It contains an addition to the first Chapter of the OECD Guidelines (Delineation) and an official new Chapter X solely concentrating on financial transactions. The new Chapter X of the transfer pricing guidelines deals with the classification of debt financing, treasury functions (intra-group loans, cash pools and hedging), financial guarantees and intra-group (captive) insurance. A considerable emphasis has been placed on the accurate delineation of the transaction. The distinction between equity and debt capital is tied to the borrower’s ability to (i) raise the capital on the financial market and to (ii) bear the relevant costs. Credit ratings are referred to as a suitable method for quantifying default risks within a group. Within this context, it should be analysed if and how implicit group support has to be considered for determining an arm’s length interest rate. Treasury functions such as loans, cash pool and hedging are generally to be considered as a support function, and a remuneration is correspondingly low. If the classification of the debt capital shows that the affiliated entity granting the financing does not bear any risks or does not carry out any decision-relevant activities, the latter should only be remunerated at most with a risk-free interest rate in order to reflect an appropriate remuneration. The guidance on guarantees is restricted to financial guarantees. Although Chapter X suggests that guarantee transactions shall be analysed both from the perspective of the guarantor and the guaranteed entity, the final guidance suggests that a borrower would usually only be willing to pay for a guarantee if the guarantee provides a benefit to the borrower.
Concluding Remarks
I/C financing transactions and their arm’s length nature are a frequently discussed topic in tax audits. The new Chapter X of the OECD Guidelines provides taxpayers with a set guidance. The suggested changes to German law are in several aspects similar to the OECD guidance but are also expected to be subject to further revisions. It remains to be seen how the German legislator will react with updated and final law changes in light of the recent developments.
