In a series of rulings in 2019 and 2020, the German Federal Fiscal Court has abandoned its decades-long ruling practice on implicit group support and the blocking effect of para. 9 OECD Model Tax Convention. It was ruled that (i) the so-called implicit group support is not considered as an arm's length (valuable) security and (ii) the missing security of a loan is generally a condition as defined by Sec. 1 Foreign Tax Act (FTA) and not at arm's length. The BFH explained that this decision is based on the "standard banking" behaviour related to the securitisation of financial transactions. However, in its rulings of 18 May 2021 (Case No. I R 4/17 and Case No. I R 62/17) and 9 June 2021 (Case No. I R 32/17), the German Federal Fiscal Court has now relativised its case law from 2019 and 2020, provided some practical guidance on determining and reviewing interest rates for intra-group loans and remitted all the decisions to the relevant lower courts. The following presents the highlights of the respective rulings.
Ruling of 18 May 2021 (Case No. I R 4/17)
According to the German Federal Fiscal Court, there will often not be "the" arm's length price, but a range of prices. In such a case, the most favourable price for the taxpayer is to be used. Contrary to the opinion of the tax office and the lower tax court, the arm's length nature of the agreed interest rate for an IC loan must first be determined using the comparable uncontrolled price method, with differences being eliminated by adjustment calculations if necessary. This also applies to unsecured IC loans. It is only if this is not feasible that the cost plus method can be applied, pursuant to which the lender's costs are to be determined and increased by an appropriate profit mark-up. Accordingly, the credit rating relevant for the interest rate is not the average credit rating of the entire group, but the credit rating of the borrowing group company ("stand alone" rating) under consideration of the implicit group support. Implicit group support is only to be considered if the credit rating assigned to the group company by a third-party lender exceeds the stand-alone credit rating of this company.
Ruling of 18 May 2021 (Case No. I R 62/17)
The German Federal Fiscal Court stated that without evidence to the contrary, it cannot generally be assumed that a third party would, acting as a prudent and conscientious business manager, use the interest rate for a secured and senior loan as a basis for determining the interest rate for a subordinated and unsecured loan. Instead, the group relation should be "ignored": Thus, a lender would then not be an affiliated company but a third party, and its claim would not be subject to any statutory reduction in rank in the event of insolvency. The lower tax court's reference to the statutory subordination of shareholder loans, which may not be undermined by securitisation and consequently cannot justify a risk surcharge, is therefore irrelevant. The imaginary third party would presumably only accept such a reduction in rank voluntarily in return for corresponding financial compensation. Compensation would also be at arm's length if - as in the case in dispute - the borrower had sufficient substance to provide security for the repayment of the loan. This is because a third party would take into account not only the current financial situation, but also future economic developments when determining the terms and conditions of the loan. Thus, a third party would demand corresponding compensation due to the subordination and lack of security of the loan. If, in addition, the lower tax court finds that there is a market for subordinated loans, this market would provide the appropriate benchmark for any external price comparison. Against this background, it also does not seem far-fetched that third parties on this market are willing to grant unsecured subordinated loans against payment of a higher "price", i.e. of an interest surcharge to compensate for a higher default risk. Consequently, such loans would also be recognised in the relationship between the company and its shareholders. Since the third parties on this market are not "traditional banks", the usual behaviour of (comparable) third parties is decisive and not that of banks.
Ruling of 9 June 2021 (Case No. I R 32/17)
In the view of the German Federal Fiscal Court, the objective factual requirements of Sec. 1 FTA are met in connection with the partial write-off in the domestic market. Contrary to the plaintiff's perspective, the income reduction as defined by Sec. 1 (1) FTA may also have occurred due to ("as a result of") the lack of securitisation. In this respect, Article 9, para. 1 DTT USA 1989 and Article 9, para. 1 DTT France do not have a blocking effect on Section 1, para. 1 FTA.
At the same time, in the view of the German Federal Fiscal Court, the lower court had not sufficiently analysed whether the lack of securitisation was a non-"arm's length" condition in the present case. The question regarding the arm's length nature of the absence of a collateral for a given IC loan - and, therefore, of the arm's length nature of a given IC loan - should be answered based on all specific circumstances of the given case (including the creditworthiness of the borrower, realistically available option related to the absence of securities, etc.). Since this had not been sufficiently analysed by the relevant lower court, the decision was remitted.
Recommendations for action
In general, existing transfer pricing guidelines for intra-group financial transactions and existing intra-group loans (incl. loan agreements) related to German group companies should be checked and, if necessary, adjusted. The focus should also be on analysing the functional and risk profiles of the companies involved.
Originally Published 05 May 2022
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