by Dr. Alexander Vögele, KPMG Frankfurt
For editorial cut-off date, disclaimer, and notice of copyright see end of this article.
On p. 17 of German News no. 2/2001 (article no. 225), we reported on a lower court decision rebuffing attempts by the tax authorities to attribute the income earned from investing the proceeds of an intra-group interest-free loan to the lender instead of the borrower (Munich Tax Court decision of 29 August 2000 – DStRE 2001, 138).
On appeal, the Federal Tax Court (FTC) has now affirmed the lower court decision (judgement of 17 October 2001 – I R 97/00).
Simply put, the facts of the case are as follows:
X-AG, the sole parent of Y-GmbH, both domestic corporations, grants Y an interest-free demand loan in an amount of DM 90 million.1 Y has loss carryforwards of DM 20 million. Y entrusts the loan proceeds to X for investment in the name and for the account of Y. Y earns interest of DM 20 million from the loan, which it offsets against its loss carryforwards on its tax return. It is then merged into another subsidiary of X. Under the merger law of the time, the loss carryforwards would not have survived the merger.
The tax authorities challenged the interest free loan above all under the general anti-avoidance provision of §42 AO (Tax Procedure Act). This section reads in pertinent part as follows:
The tax laws may not be circumvented by abuse of legal structuring possibilities. In case of [such] abuse, the tax claim [of the tax authorities] is the same as that arising under a structure appropriate to the economic transaction.
The FTC affirmed the holding of the Munich Tax Court that interest-free loans are not "abusive" in the sense of §42 AO as long as the recipient of the loan is not a shell corporation without independent economic function. In the case at hand, Y was a company with economic substance that had amassed its loss carryforwards attempting to develop certain solar energy technologies. The court could discern nothing abusive about granting Y an interest-free loan so as to neutralise loss carryforwards resulting from a legitimate business activity.
The FTC noted that the result would be different in the event of a cross-border loan from X to a subsidiary in a foreign jurisdiction. Such situations would fall under the general international transfer pricing clause in §1 AStG (Foreign Transactions Tax Act), a provision inapplicable to a transaction between two domestic corporations. The court regarded the existence of a special provision for cross-border transactions as evidence that purely domestic transactions should be recognised for tax purposes.
The court ignored the fact that it seriously doubts whether §1 AStG is compatible with the law of the European Union (see German News no. 1/2002 p.10 = article no. 240). Hence, §1 AStG may be unenforceable as regards cross-border interest-free loans between EU residents.
The FTC also noted that the interest-free loan could not be challenged on the grounds that the income earned by Y on investment of the proceeds should be treated as a contribution of funds from X to Y increasing X's basis in its stock in Y. If this approach were possible, then the income that X forewent by failing to charge an arm's length rate of interest on the loan would accrue to X, and Y's taxable income would be reduced accordingly under the rule of §4 (1) EStG. However, as the FTC points out, a combined chamber of the Federal Tax Court held in 1987 that the mere use of an asset (e.g. cash) could not be contributed by a parent to its subsidiary (ruling of 26 October 1987 – GrS 2/86 – BStBl II 1988, 348).
1 In 1999, sec. 6 (1) no. 3 EStG was amended to require non-interest-bearing liabilities not maturing within 12 months to be discounted for tax accounting purposes to their present value, assuming an interest rate (discount rate) of 5.5%. This affects interest free loans to domestic commercial taxpayers in that the difference between the nominal and discounted value of the loan is treated as income in the year of the loan. However, the annual increases in the discounted value of the loan are interest expense. Over the term of the loan, net income is zero.
Editorial cut-off date: 31 August 2002
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