The Federal Tax Court’s landmark decision of 27 February 2019 will significantly change the way that the arm’s length principle is applied in Germany. The ruling affects the scope of the term ‘conditions’ in German transfer pricing rules and arm’s length requirements for shareholder loans. This case is of great practical relevance because shareholder loans are often granted without any collateral. From a bigger-picture perspective, the court decision could extend the reach of transfer pricing adjustments for all kinds of controlled transactions.
A Case Study on Shareholder Loans
A German parent maintained a settlement account for its Belgian subsidiary (debtor position). This was like a downstream loan from a controlling shareholder to its subsidiary. Both companies agreed to waive the claim with a debtor warrant for the part of the settlement account that was of no value. So the German parent wrote down this part of the receivable, decreasing its profits.
But as collateral was lacking for the loan, the German tax authorities rejected the write-down. They reasoned that the absence of collateral was not at arm’s length. The Federal Tax Court dismissed the plaintiff’s arguments.
Consequences of the Federal Tax Court Decision on Shareholder Loans
In the view taken by the court, it is normally not permissible for a German parent to reduce its profit by writing down an unsecured shareholder loan granted to its foreign subsidiary. This is because – the court argued – lack of collateral is incompatible with arm’s length behavior. As a result, this changes several aspects of case law:
- The court concluded that the mere absence of collateral does not justify re-characterizing a loan into equity. If a loan under civil law requires repayment, the tax treatment of the loan should be that of interest-bearing debt financing.
- The court denied the existence and value of any implicit group support, as a general principle. Arguably, a borrower may enhance its creditworthiness through implicit group support from passive association within a business group.
- The court is now of the opinion that the notion of ‘conditions’ in both domestic tax law and income tax treaties must be interpreted as permitting both an adjustment of the price for determining a taxpayer’s income and the alteration of other terms or conditions that were made or imposed between the related parties.
- So the court introduced a twofold arm’s length test for German tax purposes. The starting point for arm’s length prices is that the comparative analysis gives weight to conditions other than the price. While non-arm’s length prices will in principle be adjusted upwards or downwards, it is unclear – but of practical importance – how adjustments would be made for non-arm’s length conditions apart from the price.
- The court replaced the actually unsecured loan by a fictious recoverably secured shareholder loan on the grounds that independent enterprises would have made the granting of the loan dependent on the provision of recoverable security. But this observation is not necessarily the norm between independent enterprises in our experience. It also disregards the fact that an independent creditor may still be willing to bear the creditor risk of an unsecured loan if the risk is covered by a premium on the interest rate.
- The lack of actual collateral led the court to deny the tax deductibility of writing down the shareholder loan at the level of the German creditor.
- The court’s rebuttable presumption of secured loans, as a general rule, will presumably also have consequences for the determination of arm’s length interest rates. However, the court did not have to deal with those implications.
- The court reaffirmed that, in a tax treaty context, a transfer pricing adjustment cannot be justified merely due to the lack of legally effective, clear, and unequivocal agreements concluded before the transaction, regardless of whether the controlled transaction is set at arm’s length.
- Moreover, the disputed adjustment of the profit-decreasing write-down cannot be viewed as a breach of freedom of establishment pursuant to Article 49 TFEU in the court’s view.
Impact on Multinationals
All this could further extend the reach of transfer pricing adjustments. From a tax planning perspective, the latest view taken by the Federal Tax Court will limit the use of controlled transactions in order to justify the tax-efficient allocation of profits between related entities. In tax audits, it is expected that other terms and conditions of controlled transactions (apart from the price) will now be scrutinized more intensively. Due to this development, taxpayers should anticipate an increase and even greater complexity in tax disputes arising from German transfer pricing audits.
The court’s decision is discussed in more detail in Intertax 2019, Issue 12, pp. 1108-1120.