19.12.2014BFH rules on income adjustments under CFC rules
Germany’s Federal Tax Court (BFH) has ruled that a non-interest-bearing loan granted by a German taxpayer to a foreign subsidiary does not trigger an income adjustment under Germany’s CFC rules to the extent the loan is regarded as a loan similar to equity. The court also determined that the particular provision (Section 1 CFC Act) in German law generally is not incompatible with EU law.
Section 1 of the CFC Act allows income adjustments to be made to the income of a German company where a “business relationship” with a foreign related subsidiary is not on arm’s length terms. This rule has been subject to several legislative revisions, including a change in the definition of the term “business relationship” (these changes were not part of the case before the BFH). Questions also have been raised as to whether section 1 is compatible with EU law in transactions with EU subsidiaries.
In the case before the BFH, a German corporation granted a non-interest-bearing loan to a Belgium subsidiary. Relying on section 1 of the CFC Act, the tax authorities imposed an income adjustment on the German corporation to reflect an arm’s length interest rate. The taxpayer objected to the adjustment, arguing that the loan qualified as a loan similar to equity which cannot constitute a “business relationship” under section 1 CFC Act, since granting the loan was based primarily on the corporate relationship between the companies. The taxpayer also argued that no income adjustment could be imposed because it would infringe the EU freedom of establishment principle.
The BFH agreed with the taxpayer and held that an income adjustment could not be imposed to the extent the loan was regarded as a loan with equity features because to that extent it does not constitute a “business relationship”.
A portion of the loan was not regarded as a loan with equity features, and with respect to this portion, the BFH ruled that the income adjustment under section 1 CFC Act does not infringe EU law because the rule targets transactions that are not based on arm’s length terms. In the case, the income adjustment was a means to appropriately allocate income between EU member states which does not violate the freedom of establishment principle, according to the BFH.
The BFH decision generally is a welcome confirmation that transactions that are based on the corporate relationship between companies are not subject to income adjustments under section 1 of the CFC Act. Given, however, that substantial legislative changes to the definition of the term “business relationship” have been enacted, it is possible that the current version of the CFC rules could encompass such transactions.
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