Court backs CUP’s approach to business-to-business lending in Germany
On October 21, 2021, the German Federal Fiscal Court published its decision of May 18, 2021 IR 4/17. This will have important implications for the use of the comparable uncontrolled prices (CUP) method in determining interest rates for intercompany financing transactions.
Intercompany financing transactions are, along with post-merger restructurings and the valuation of intangible assets they involve, one of the hot topics of German transfer pricing (TP) audits.
German tax auditors often claim that intercompany lending is a routine service and lending should be remunerated on the basis of administrative cost plus. This view is supported by the revised German administrative principles published in July 2021.
Section 3.92 of the Administrative Principles states that if a group finance company provides capital to a taxpayer and the finance company does not have the capacity and authority to control or assume the risk of investing in a financial asset, it is entitled to consideration for lending only up to a risk-free rate of return.
Remuneration must be accounted for using the cost plus method on the basis of proven and directly attributable operating costs. As a general rule, refinancing costs should not be included in the cost base.
These administrative procedures are contrary to the common approach applied to the remuneration of intercompany financing transactions. Typically, comparable interest rates are identified through a database search for bond yields or comparable loan transactions.
However, German tax auditors often reject the CUP method by arguing that the transactions considered are not comparable, for example by arguing that the financing entity is not analogous to a bank (different function and risk profile) or that Bond transactions are not comparable to loan transactions, for example by arguing that bonds are subordinated to loans.
The decision of the Federal Tax Court rejected the expediency of the last German administrative procedure and supported the CUP approach, which is widely used in international transfer pricing practice (see OECD Transfer Pricing Guidelines 2022, section 10.90).
The court confirmed that the fundamental admissibility of the CUP method for the determination of arm’s length interest rates on loans results from the fact that the object of the service (provision of money for a certain period of time) is essentially homogeneous and objectively comparable and that many markets have information and analyzes for the underwriting and granting of credits (note 39).
What does this mean for taxpayers and what can they do?
Tax disputes over the appropriate pricing of B2B financial transactions will remain in Germany, as administrative principles oppose recent Federal Fiscal Court rulings and tax auditors focus on increasing taxable income, especially of subsidiaries of multinationals.
Taxpayers should be aware that decisions of the Federal Finance Court must be enforced by tax authorities in similar cases once they are officially published by the German Ministry of Finance, which has not happened until now. now.
In addition, the Federal Ministry of Finance is authorized to issue so-called non-application decrees, which prohibit the tax authorities from generally applying the decisions of the Federal Finance Court, except in the specific case of the decision. So far, such a decree of non-implementation has not been issued. Therefore, the uncertainties and risks associated with intercompany financing transactions always exist for taxpayers.
In practice, there are two main actions taxpayers should take to manage uncertainty and mitigate risk. First, produce proper TP documentation including a full function and risk analysis and second, obtain a credit rating indicating the borrowing entity’s creditworthiness. This must at least be requested externally by rating agencies or economic experts.
With respect to a full function and risk analysis, taxpayers should obtain/produce evidence that the financing entity is able to bear the risk associated with financing transactions (e.g. credit default risk , refinancing risks or the risk of interest rate fluctuations) and that it knows how and is able to carry out all the tasks and activities related to financing operations, including the proper management of risks.
As for rating on an autonomous basis, the Federal Finance Court has reinforced the arm’s length principle. Reviewing the creditworthiness of the lending entity on an individual basis may show that the interest rates taken for comparison would also have been agreed by independent third parties.
However, in practice, such a clear differentiation is difficult to ensure because other parameters, such as the degree of integration or implicit support within a group, cannot easily be neglected.
Finally, the better the documentation of the facts and circumstances of the underlying transaction, the more the taxpayer is able to provide information about the implicit support of the group (for example, the better an arm’s length interest rate can be determined and defended during tax audits).
If additional information about the underlying rating methodology can be provided, the taxpayer has likely fulfilled its obligations regarding qualifying TP documentation.
The authors have successfully applied this approach in numerous TP documents and tax audits and helped defend clients against unreasonable tax audit adjustments.
Managing Partner, NERA Economic Consulting
Associate Director, NERA Economic Consulting
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