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Court backs CUP approach to intercompany loans in Germany

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Decision IR 4/17 will have significant implications for the use of the CUP method

Yves Hervé and Jens Rubart of NERA Economic Consulting explain why a Federal Fiscal Court decision regarding intercompany financing will have significant implications for taxpayers in Germany.

On October 21 2021, the German Federal Fiscal Court published its May 18 2021 decision IR 4/17. This will have significant implications for the use of the comparable uncontrolled price (CUP) method with regard to the determination of interest rates for intercompany financing transactions. 

Intercompany financing transactions are, together with post-merger restructurings and the involved valuation of intangibles, one of the hot topics in German transfer pricing (TP) audits.

German tax auditors often argue that providing intercompany loans is a routine service and that the loan provision should be remunerated on an administrative cost-plus basis. 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 financing company provides capital to a taxpayer and the financing company does not have the ability and authority to control or bear the risk of investing in a financial asset, it is entitled to consideration for providing loans only up to the amount of a risk-free rate of return.

Remuneration is to be recognised using the cost-plus method on the basis of proven and directly attributable operating costs. Generally, refinancing costs are not to be included in the cost base. 

These administrative proceedings are contrary to the common approach applied to remunerating intercompany financing transactions. Typically, one identifies comparable interest rates via a database search for comparable bond yields or loan transactions.

However, German tax auditors often reject the CUP method by arguing that the considered transactions are non-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, e.g. by arguing that bonds are subordinate to loans. 

The Federal Fiscal Court’s decision rejected the appropriateness of the latest German administrative proceedings and supported the CUP approach, which is widely used in international TP practice (see OECD TP Guidelines 2022, section 10.90).

The court confirmed that the basic 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 there are numerous markets with available information and analyses for taking out and granting loans (note 39).


What does it mean to taxpayers and what can they do?

Tax disputes involving the appropriate pricing of intercompany finance transactions will remain in Germany, as the administrative principles oppose the recent Federal Fiscal Court decisions and tax auditors are focused on increasing the taxable income, particularly of subsidiaries of multinationals.

Taxpayers should be aware that Federal Fiscal Court decisions have to be applied by the tax authorities in similar cases once they are officially published by the German Ministry of Finance, which has not occurred so far.

In addition, the Federal Ministry of Finance is authorised to issue so-called non-application decrees, which prohibit the tax authorities from generally applying Federal Fiscal Court decisions, except in the specific case of the decision. So far, such a non-application decree has not been published. Therefore, the uncertainties and risks regarding intercompany financing transactions still exist for taxpayers.

In practice, there are two main actions taxpayers should undertake to manage uncertainties and mitigate risks. First, produce proper TP documentation including a comprehensive function and risk analysis and, second, secure a rating showing the creditworthiness of the loan-taking entity. At least the latter has to be requested externally by rating agencies or economic experts.

Regarding a comprehensive function and risk analysis, taxpayers should procure/produce evidence that the financing entity is able to bear the risk related to financing transactions (e.g., credit default risk, refinancing risks or risk of interest rate changes) and that it has the know-how and ability to perform all tasks and activities related to financing transactions, including proper risk management. 

As for the rating on a standalone basis, the Federal Fiscal Court strengthened the arm’s length principle. Considering the creditworthiness of the loan-taking entity on a standalone basis can show that the interest rates taken for comparison would also have been agreed upon by independent third parties.

However, in practice, such a sharp differentiation is difficult to provide because other parameters, such as the degree of integration or of 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 equipped the taxpayer is to provide information about implicit group support (e.g. the better an arm’s length interest rate can be determined and defended in tax audits).

If additional information on the underlying rating methodology can be provided, the taxpayer has likely met their obligations regarding admissible TP documentation.

The authors have successfully applied this approach in numerous TP documentations and tax audits and helped defend clients against unreasonable tax audit adjustments.

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