Recognition of the arm’s length value (application of Section 1 AStG)
If a taxpayer’s income is reduced due to a foreign business relationship with a closely related person as a result of the use of conditions that are not consistent with the arm’s length principle then the income should not be recognised at the agreed conditions but rather at the arm’s length value (Section 1 AStG). On 27.2.2019, the BFH stated its opinion on the application of this provision for three constellations.
(1) To begin with, the BFH, in its first ruling (case reference: I R 73/16), viewed the costs arising from the writeoff on the loan of a domestic (German) parent company to its foreign subsidiary together with the costs related to the derecognition of the loan as being non-tax deductible because the loan was not characterised by the usual market terms and conditions, e.g. no collateral was provided. In this ruling, the BFH changed its previous opinion in this respect; according to its earlier decisions, a provision in a DTA equivalent to Art. 9 OECD MTC prohibited the above-mentioned application of Section 1 AStG beyond a transfer pricing adjustment (so-called “blocking effect of Art. 9 of the OECD MTC”). The BFH thus now shares the opposite view of the German fiscal authority. The reason that the BFH gave for this was that this precisely did not constitute a transfer pricing adjustment within the meaning of Art. 9 OECD; in fact, the entire loan would never have been granted by an unrelated third party without collateral; this case was about a substantive adjustment that had to be made via Section 1 AStG.
(2) In two further rulings (case references.: I R 51/17 and I R 81/17) on inter-company receivables and guarantees, the BFH highlighted that so-called group support merely expressed that within a group of companies it was usual to grant loans without collateral. Yet, group support cannot be equated with loan collateralisation. That is why it can neither replace such collateral nor exclude the possibility that a loan receivable between associated enterprises could be of no value. What is notable here is the BFH’s relativisation with respect to the question of whether or not the lack of collateral or inadequate collateral for a receivable is consistent with the arm’s length principle. In the ruling mentioned under (1), the BFH was still describing such agreements simply as “not arm’s length circumstances”; however, the BFH referred the latter cases back to the tax courts on the grounds that the necessary investigations had not been carried out in order to ascertain whether or not the lack of collateral for the payment claim corresponded to what an unrelated third party would have agreed (ex ante).
Interim conclusion: In summary, despite the latterly described uncertainties, new hurdles have emerged for the tax deductibility of expenses related to cross-border business relationships with closely related parties.
Tight limits for the Hornbach ruling
Furthermore, you should bear in mind that the BFH has placed tight limits on the application of the, basically favourable, ECJ judgement in the matter of “Hornbach“. The contentious matters in the cases of the inter-company loans and guarantees, which were mentioned under (2), were thus not comparable with the guarantees and comfort letters that had been at issue in the ECJ’s Hornbach ruling. In addition, the BFH established that for cases that involve third countries, at all events, the free movement of capital could conflict with the application of Section 1 AStG, although there could be no objection to the restriction through the German AStG due to the so-called “standstill clause”. According to this clause, a restriction on the free movement of capital through national measures would (still) be allowed if these measures (like Section 1 AStG) had already existed on 31.12.1993.
Recommendation: If your objective is to enable expenses to be tax deductible, for example, the costs relating to impaired loans or other claims against closely related foreign parties (or drawdowns under a guarantee) then you should review your existing cross-border business relationships with a view to the need for amendments on the basis of the new ruling. It is advisable to structure future business relationships in accordance with the new requirements.