The Supreme Tax Court has held that a loan from a domestic shareholder to a domestic subsidiary to fund a foreign PE is not a foreign transaction open to income adjustment under the transfer pricing rules.

Two local residents jointly held the share capital of a GmbH as well as that of a Swiss company. In the course of a reorganisation, the business of the Swiss company was sold to the GmbH which funded the transaction with loans from its shareholders. The business acquired was continued by the GmbH in its own name as a Swiss permanent establishment. The loans were granted informally, that is without written agreements. Interest was charged at 1% above the Bundesbank's prime rate, but only for the first year. Thereafter, it was waived altogether. The tax office maintained that the shareholders had no arm's length reason not to charge interest at the going rate and imputed additional income to them. There was no corresponding expense for the GmbH as its interest costs would have been attributable to its Swiss permanent establishment and so were not a matter for German taxation.

The Supreme Tax Court declined to deal with the substance of the case. Rather, it took the view that the transfer pricing rules calling for all transactions between related parties to be at arm's length were founded on Sec. 1 of the Foreign Tax Relations Act and so did not apply to transactions between two domestic parties. Here, lender and borrower were both domestic parties, and the fact that the borrower intended to use the loan to fund the purchase of assets for its foreign permanent establishment was not the concern of the lender. At any rate, it did not make the GmbH a "foreign" borrower.

This case may well have wider implications than immediately apparent, particularly in view of the not infrequent attempts by tax officials to apply the transfer pricing rules by analogy to domestic transactions. Interest income is not considered to be a "contributable asset", so there was no reason here for the tax authorities to try interpreting the transfer pricing rules as an abstract definition of "hidden capital" in the hope of founding a profit shift on domestic law. The same consideration applies, though, to the provision of most other services.

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