Basic types of contract arrangements
Contracting parties are generally able to freely draw up their loan contracts how they wish and to agree whatever loan terms they want to include. Yet, tax law will override civil law if there is a risk of abusive structures; in such cases
- either the loan relationship under civil law will then, in principle, be negated and for, tax purposes, equity capital will be assumed instead of debt capital along with all the consequences of this (1st level)
- or the agreements concluded under civil law will then be adjusted for tax purposes and instead of the agreed amount of interest only an appropriate amount of interest will be permitted as a business expense deduction (2nd level).
The notional benchmark here is always the ‘arm’s length comparison’, thus the terms that a ‘prudent and diligent managing director’ would agree. What is relevant is whether or not the loan amount and loan term as well as the debtor’s collateral and creditworthiness are in accordance with what is usual for third parties dealing at arm’s length. Although, this will take different forms because a distinction has to be made between
- loan relationships that are entered into on a purely national basis with no international connection (more on this in section 2) and
- cross-border transactions that are usually subject to more far-reaching and stricter requirements (more on this in section 3).
Please note: In the following discussion we do not go into the thin-cap rules (the so-called ‘interest barrier’ under Section 4h of the Income Tax Act [Einkommenssteuergesetz, EStG]) and the tax consequences of loans that are completely interest-free (Section 6(1) No. 3 EStG).
In the case of (purely) national transactions, the loan relationship has to be judged simply on the basis of the criteria of a hidden capital contribution or a hidden profit distribution.
At the 1st level, the recharacterization of the full amount of a loan that has been granted as the provision of equity capital is indeed restricted to rare cases where repayment is not at all wanted. The Federal Fiscal Court (Bundes-finanzhof, BFH) has largely rejected the recharacterization of a loan, granted by shareholders to a company, as a hidden capital contribution (BFH ruling from 11.7.2017, case reference IX R 36/15). Even those loans granted to, or left in a company during a crisis would not cause the loan relationship to be negated ‘downstream’ under tax law. At the 2nd level, in the case of such a constellation, there are normally different opinions with respect to the appropriate interest rate. If a corporation is paying its shareholders too much in interest, then this would be deemed to constitute a hidden profit distribution. However, interest payments to shareholders that are too low are not a problem any more than cases where the shareholders pay their subsidiary an inflated interest rate.
Recommendation: In a national transaction, the ‘downstream’ situation will be treated differently from the ‘upstream’ situation. That is also interesting in terms of structuring if, for example, for the purposes of making use of loss carry-forwards or withholding tax credits, conditions are agreed that deviate from those usual for third parties dealing at arm’s length.
Rules in cross-border cases
In cross-border cases the national rules are supplemented by Section 1 of the Foreign Transactions Tax Act(Außensteuergesetz, AStG). Accordingly, all loans that have been granted have to stand up to an arm’s length comparison without any distinction being made between ‘upstream’ or ‘downstream’. There is widespread agreement that here, up to now, Section 1 AStG has taken effect only at the 2nd level, i.e., the amount of the interest rate.
Please note: The rule that applies when setting transfer prices is that higher risks are associated with higher interest rates. However, in the case of intra-group loans, where the agreements frequently include subordination, flexible maturities but no collateral, this results in a paradox that has remained unsolved to date, namely, the more closely the structure of the intra-group loan resembles equity, the higher the interest rate should be.
Yet, this problem also illustrates that, in many cases, it will be very difficult to subject the interest rate for an intra-group loan to an arm’s length comparison, particularly as intra-group loans are frequently also related to matters under company law. In some cases, external financing is then hardly possible any more on account of the economic situation. The ECJ has recognised this and in the Hornbach case (judgement of 31.8.2018, case reference C-382/16) explicitly acknowledged that, within a group, non-arm’s-length agreements should also be permitted for tax purposes if a commercial justification can be provided for this.
Since then, the BFH, in a high-profile ruling from 27.2.2019 (case reference: I R 73/16), has established new principles. In the event of a default, the BFH does not want to allow a profit-reducing deduction; this would be tantamount to an adjustment at the 1st level and thus ultimately, in effect, a recharacterization of the loan relationship as an equity injection. It would then at least be logical, at the 2nd level, not to require interest payments for tax purposes either. However, the BFH has not drawn this conclusion.
The BFH wants the above-mentioned legal consequences to apply to all non-arm’s-length loan agreements. In this case, it is focussing particularly on unsecured loans.
Please note: Interestingly, the BFH has scarcely dealt with the issue of whether or not its ruling is compatible with the arguments put forward by the ECJ in the Hornbach case; recently, in an unusual step, this was criticised by the Federal Constitutional Court in its ruling from 4.3.2021 (case reference: 2 BvR 1161/19).
Planned changes for cross-border cases
By introducing a Section 1a AStG the aim is to do away with these unclear rules in cross-border cases. The new rules are admittedly no longer included in any current governmental draft, however, the implementation will in any case be postponed. According to the intention of the legislator, the new rules here will be based on the OECD requirements (Art. X of the OECD TPG).
Within the framework of such new rules, at the 1st level, to begin with, it would have to be demonstrated that the debtor is generally able to service the debt and that it needs the financing for commercial purposes. Otherwise, already in principle, the interest may not be deducted; for transfer pricing purposes this implies recharacterizing debt capital as equity capital. At the 2nd level, thus when assessing the interest rate, besides other factors (such as, e.g., the purpose of the loan, the regulatory frameworks, maturity, currency risks or the loan volume), the borrower’s credit risk has to be taken into account, in particular, since this can significantly affect the interest rate. Here, the creditworthiness of the entire group of companies is generally relevant and not that of an individual company.
Recommendations: Cross-border intra-group loan relationships should stand up to an arm’s length comparison. This applies not only to the interest rate level but also to the other constituent parts of the loan agreement, especially with respect to collateral. We would recommend that you determine the interest rates on the basis of the appropriate benchmark comparisons.
Groups with cross-border financing, in particular, should keep a close eye on the planned changes in the legal situation and, if necessary, examine existing agreements now already with a view to a potential need for amendments.