MOF issues transfer pricing guidance for intercompany financing arrangements in final version of administrative principles

Final version of administrative principles transfer pricing guidance provides details about the application of new TP rules included in the Growth Opportunities Act that was introduced in March 2024.

On 12 December 2024, the German Ministry of Finance (MOF) issued a decree revising and supplementing chapter J of the 2023 administrative regulations on transfer pricing principles (see GTLN dated 6/27/23), which includes guidance for intercompany financing relationships. The decree is based on the newly introduced provisions governing the arm’s length principle for financing transactions between related parties as introduced in sections 1 (3d) and (3e) of the Foreign Tax Act (FTA) by the Growth Opportunities Act earlier this year. The new rules generally are effective as from 1 January 2024. A draft version of the decree was published on 14 August 2024.

The decree includes guidance, in particular, related to the arm’s length nature of the financing relationship itself (section 1 (3d) sentence 1 no. 1 FTA), the determination of an arm’s length interest rate (section 1 (3d) sentence 1 no. 2 FTA), and the classification of financing relationships as low function and low risk, i.e., routine services (section 1 (3e) FTA). Additional related guidance is contained in the 2023 decree providing “Administrative Principles regarding Transfer Pricing” (“2023 decree”).

The highlights of the decree are summarized below.

Debt capacity and business purpose test

In order to treat interest expense as being deductible for German tax purposes, a taxpayer must credibly demonstrate that (i) they could have served the debt for the entire term of the financing arrangement from the inception and (ii) the debt is economically needed and used for the purpose of the company. The test is primarily aimed at the debt capacity of the borrower and the intended use of the debt.

The conditions that are needed to qualify under the debt capacity and business purpose test are specified in more detail in the decree. With regard to the ability to service debt, it needs to be examined in particular whether “sufficient assets or cash flows can be expected from the outset.” This explicitly includes, among others, the assets acquired by the additional debt. Relevant indicators include the existence of a fixed repayment date, obligation and modalities for the payment of the interest, right to enforce the repayment of the principal, and payment of the interest and the ability of the borrower to obtain financing from third parties. The MOF also clarifies that the requirement to refinance the debt does not preclude the arm’s length principle in this regard.

In order to substantiate that the conditions of the debt capacity and business purpose test are fulfilled, the conditions need to be cumulatively met with a high degree of probability, i.e., the taxpayer needs to demonstrate that the debt can be serviced (and actually is being served) by, e.g., providing business forecast calculations, documentation for what purpose the funds are used, etc.

Additional noteworthy points include:

Under extraordinary circumstances, high-risk financing arrangements might qualify as being at arm’s length (e.g., startup financing);
Borrowing solely for the purpose of a leveraged dividend should not contradict the purpose of the company;
In case of acquisition financing, debt planning that includes capital buffers and the short-term contribution of excess capital into a cash-pool should generally be regarded as being at arm’s length;
If the taxpayer cannot credibly demonstrate that the conditions of the business purpose and debt capacity test are met, the tax deductible portion of the interest expense will be reduced only by the non-arm’s length portion of the interest expense, i.e., not necessarily a complete disallowance of the interest expense (and associated fees, etc.);
If a taxpayer has an investment grade rating, debt capacity can be assumed; and
For short-term loans, such as cash pool withdrawals, sufficient debt capacity can be assumed.

Arm’s length interest rate test

According to the new rules, the arm’s length character of the interest rate of a cross-border intercompany financing arrangement generally must be based on the group’s rating and external financing. However, the taxpayer has the ability to demonstrate that a different rating is more in line with the arm’s length principle.

With regard to the determination of the applicable group rating, the decree for the first time includes that a hierarchy based upon officially published ratings from a rating agency needs to be used first. Private (i.e., unpublished) ratings from rating agencies have lower priority. The group rating could also be determined by using standard market rating software, although the appropriate consideration of qualitative factors then needs to be documented. If the respective group does not have a rating, the group rating could also be derived for simplification purposes from the group’s external financing costs from third parties at the time when the loan is granted. Also, ratings prepared by the German Federal Bank (Bundesbank) are explicitly accepted.

In order to successfully prove the arm’s length character of a rating derived from the group rating, the credit assessment, including the (arm’s length) qualitative and quantitative factors, as well as the potential group support, need to be documented. To analyze the group support, the decree defines several aspects that need to be considered. In particular, the borrower’s economic and strategic importance, the financial size, and the interdependence within the group are mentioned in this regard. As a result, the strategic importance of the borrower for the group needs to be determined, on the basis of which a rating—based on S&P rating methodologies—could be determined using a top-down approach (i.e., notching down based on the group rating) or bottom-up approach (i.e., notching up based on the standalone rating). According to the decree, a successful proof of the arm’s length principle requires that qualitative and quantitative factors are both taken into account appropriately, distortions due to intragroup transactions are eliminated (“arm’s length ratios”), the rating is comprehensible and replicable, and standard market rating methodologies are used at the time the loan is granted.

The decree also includes further details related to the timing of the new rules based on section 1 (3d) FTA. For fiscal years prior to and including 2023, the 2023 decree (i.e., without specific guidance on section 1 (3d)) is applicable. For fiscal years as from 2024, the new decree is applicable. Hence, for loan arrangements newly incepted or old loans amended/extended in 2024, the amendment date would be relevant for purposes of debt capacity. For loan arrangements concluded and implemented before 1 January 2024, not amended in 2024, and in place beyond 31 December 2024, debt capacity can be demonstrated as of 31 December 2024.

Financing relationships as low-function and low-risk services/routine services

Section 1 (3e) FTA states that a low-function and low-risk service exists where a financing relationship is (i) arranged by one company with another company in a multinational group of companies or (ii) passed on from one company to another company within a multinational group of companies. In the decree, the MOF clarifies that an arm’s length remuneration for a financing relationship generally needs to be determined by primarily using the comparable uncontrolled price method, according to which the role of the financing company generally has no influence on the choice of method and price determination for the financing transaction (e.g., the loan).

Further highlights in connection with qualifying an intercompany financing relationship as a routine service as described in the decree are briefly summarized below:

Even if financing functions are generally regarded as support functions for the value-creating core business function, there might be exceptions where these functions are considered a central component of value creation (e.g., in the case of banks or insurance companies); and
If the financing function is located in Germany, there is no requirement for the tax authorities to qualify these services as routine services. However, the tax authorities need to provide evidence of a deviating assumption by means of a functional and risk analysis, whereby the same obligations to provide evidence apply for the taxpayer, i.e., the criteria must be met with substantial likelihood.

Guarantees, cash pools, and other financial transactions

The following provisions were already included in the 2023 decree and were not changed:

For guarantees, a remuneration is only appropriate if a real risk position is assumed by the guarantor. The determination of this remuneration is based on the difference in ratings/creditworthiness, using the group rating for the guarantee recipient. Similar considerations apply to loans in regard to acceptance of the guarantee first before the determination of the arm’s length fee.
Cash pool leadership is regarded as a routine service provision to be remunerated at the cash pool leader’s administrative cost (i.e., not including interest expenses) plus a 5% to 10% mark-up, while the cash pool’s residual profits need to be allocated to the members.
For the remuneration of other financing instruments, the actual risk allocation (considering the respective requirements) is relevant.

Comments

The decree is welcomed as it is generally follows chapter X of the OECD transfer pricing guidelines and explicitly refers to such guidelines several times. This should demonstrate the general commitment of the German tax authorities to recognize OECD standards when interpreting the newly introduced provisions in the FTA. The guidance, in addition, contains some helpful clarifications, in particular, in the area of debt capacity. The fact that a rating derived from the group rating could also be determined by using a bottom-up approach (i.e., based on a standalone rating) is also a highly welcomed approach, as this should ease the general focus on the group rating as provided by the law.

While, unfortunately, the wording of the law indicated a focus on inbound cases only, it is clear that the guidance provided by the decree is applicable equally for inbound and outbound cases.

Given the uncertainty in the law itself (as well as what was in the draft decree), it is helpful that the decree stipulates that for old loans incepted before 1 January 2024, that were not amended/extended in 2024, and that remain in place beyond 31 December 2024, debt capacity can be performed as of 31 December 2024. It is highly recommended that an evaluation of these transactions is carried out regarding the respective borrower’s debt capacity.

From a practical perspective, it also becomes clear that taxpayers are facing a significantly higher documentation burden. Taxpayers should analyze how the new transfer pricing rules affect their transfer pricing and documentation of intercompany financing transactions. Ultimately, the application of the new rules might result in an increased requirement to rely on mutual agreement procedures in order to eliminate double taxation.

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