In recent years, transfer pricing case law has attracted increasing attention across Europe, where courts have ruled on cases dealing with intercompany loans. Local German tax courts have now done so, too.
The Local Tax Court of Münster ruled in its decision of December 7, 2016 that the cost-plus method is preferred to the external comparable uncontrolled price (CUP) method for transfer pricing when it comes to arm’s length analysis of intercompany loans between affiliated companies. It argued that a foreign financing company that grants intercompany loans cannot be regarded as a bank. The case is now pending at the Federal Tax Court. Interestingly, the German Federal Ministry of Finance is now also involved in the proceedings.
Most recently, the Local Tax Court of Cologne decided on the arm’s length nature of interest payments for a shareholder loan. This loan was granted by a Dutch company and two natural persons (via a German holding company) to a German subsidiary for the acquisition of another company.
A case study
Company acquisitions are often debt-financed by loans granted to the acquiring company. In a recent case, a German subsidiary acquired another company from a third-party seller, for which it received three types of loans:
- Shareholder loan (unsecured) with an interest rate of 8% p.a. The loan term was nine- and-a-half years and the loan was structured as a bullet loan,
- Seller’s loan (unsecured) with an interest rate of 10% p.a. The loan term was six years and the loan was structured as a bullet loan,
- Bank loans (secured) with an average interest rate of 4.8% p.a. The loan term was five years and the loans were redeemed in part by annuities.
During the tax audit, the German tax authorities decided that the interest payments for the shareholder loan were excessive and disallowed a significant portion of the interest expenses. The auditors concluded that an interest rate of 5% for the shareholder loan would be at arm’s length. Their reasoning was based on the application of an internal CUP for the bank loans. This was confirmed by the Lower Tax Court of Cologne in its decision dated June 29, 2017.
Court dismisses external CUPs for intercompany loans
The German borrowing subsidiary argued that transfer prices (interest payments) for the loan granted by its shareholder had been appropriately determined using the external CUP method. It also maintained that the application of the external CUP using a benchmark study based on publicly available databases was appropriate.
However, in line with the view of the tax auditors, the tax court found fault with the application of the external CUP to interest rates for the shareholder loan in the case at hand. It argued that an internal CUP (bank loan) takes priority over an external CUP. In addition, the court dismissed the benchmark study on the grounds that it was only prepared after the shareholder loan had been issued.
The tax court also found fault with the application of internal CUP based on the seller’s loan instead on the bank loans. The court did not agree with the borrowing company’s argument that the underlying conditions of the bank loans disqualify the bank interest rate as a comparable uncontrolled price. It rejected the higher interest payments for the seller’s loan as an internal CUP because those payments were allegedly agreed on strategic grounds. The court suspected a deferral on paying the purchase price or a compensation of a lower purchase Price. However, it did not substantiate this suspicion.
In the light of these arguments, the court concluded that it is reasonable to apply the bank loan-based internal CUP to the shareholder loan. This decision is now also pending at the Federal Tax Court.
Recommended action for MNEs
Despite the tax courts’ arguments, the external CUP must still be considered the most common transfer pricing method for benchmarking interest rates on intercompany loans. A benchmarking analysis typically uses information from publicly available databases such as Bloomberg, DealScan or Thomson Reuters LoanConnector, which provide information for third-party loans, or sometimes on yield curves. The German tax authorities generally accept this approach if it is well documented.
If an internal CUP is available, its comparability has to be balanced against the comparability of external CUPs, though there is no general priority of internal CUPs over external CUPs. German taxpayers have to prepare accurate transfer pricing documentation to demonstrate which third-party loans are sufficiently comparable to a shareholder loan, especially in terms of creditworthiness, terms/maturity, and loan amount. They should document any supposedly comparable third-party loans, whether they can be applied as internal CUPs or not.