On 11 December 2019, the German Draft Ministerial Bill on the implementation of the Anti-Tax Avoidance Directive (“ATAD”, together the “Draft Ministerial Bill”) was released, suggesting national regulations on cross-border IC financing transactions as part of a new § 1a of the Foreign Tax Act (“FTA”, together § 1a FTA-DRAFT), with a treaty override.
§ 1a FTA-DRAFT states amongst other things that 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 IC borrower.
§ 1 FTA allows for an adjustment of income for business relations with foreign entities. At the time of the publishing of the Draft Ministerial Bill, there was no consensus at an international level on how IC financing transactions should be treated. According to the explanatory memorandum, there had been no clear guidance on the interpretation of Article 9 (1) Organisation of Economic Cooperation and Development (“OECD”) Model Convention in the respective double taxation agreements for financial transactions. Specifically, the final OECD Guidance on Financial Transactions was only published in February 2020. Due to this presumed lack of guidance, the explanatory memorandum to § 1a FTA-DRAFT outlines that § 1a FTA-DRAFT contains clear instructions that apply regardless of a double taxation agreement in order to secure and make the German tax claim clear, thereby essentially introducing a treaty override.
While § 1a FTA-DRAFT aims to introduce a correction measure for instances where the German taxpayer’s income was reduced by cross-border IC financing relations, the explanatory memorandum to § 1a FTA notes that the arm’s length comparison for purely domestic financial relations does not differ from the one contained in § 1a FTA. In other words, the principles laid down in § 1a FTA may also be applicable for domestic cases.
The tax consequences, however, are different for purely domestic and cross-border cases as detailed in the following. For simplification purposes, it was assumed that the lender is the shareholder of the IC borrower.
In the domestic case, the interest expenses on the level of the German borrower qualify as a hidden profit distribution and, thus, increase the taxable income. On the level of the German lender, however, the corresponding interest income qualifies as dividend income for tax purposes, which is 95% tax-exempt. Hence, apart from the remaining 5%, a double taxation can be avoided by the corresponding adjustment on the level of the lender. Nonetheless, cash taxes may be involved, depending on the profit situation of the involved entities. Potential withholding tax on the dividend can be fully credited. In the case of a fiscal unity between lender and borrower, no adverse tax effects would occur at all.
In the cross-border case, the tax consequences are more severe. The interest expenses qualify as a hidden profit distribution which increases the borrower’s domestic taxable income. This generally triggers German withholding tax, unless the distribution can be taken from the borrower’s tax equity account or is covered by an exemption certificate. Such withholding tax may not (or only partially) be creditable or refundable. The explanatory note to § 1a FTA-DRAFT outlines that there should generally be an international unified understanding on the pricing of IC financial transactions, and apparently presupposes that such common approach would be in line with § 1a FTA-DRAFT. While the OECD Guidance on Financial Transactions, which was released in February 2020, in theory represents a consensus document among the OECD members on the pricing of financial transactions, the fact that it does constitute a consensus document inevitably allows taxpayers a certain scope of interpretation for an individually based arm’s length assessment. This stands in contrast to § 1a FTA-DRAFT which provides for a typification of the arm’s length principle in line with the view of the German Federal Ministry of Finance. Therefore, due to a missing corresponding correction in the country of the foreign lender, negating interest expense at the level of the German borrower as suggested in § 1a FTA-DRAFT might lead to double taxation on the level of the foreign lender in cross-border cases, which can generally only be eliminated by a mutual agreement procedure.
IC 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 in § 1a FTA-DRAFT are in several aspects similar to the OECD guidance. That said, they impose a certain typification of the arm’s length principle for financial transactions, which might lead to instances of double taxation in cross-border cases. This typification might also be applicable to domestic transactions. Tax consequences, if any, are usually less severe in domestic than in cross-border cases. It remains to be seen how the German legislator will react with updated and final law changes on IC financial transactions.
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