On 27 March 2024, the “Growth Opportunities Act” (German: “Wachstumschancengesetz”) was promulgated in the Federal Law Gazette. In this context, Section 1 of the “German Foreign Transactions Tax Act” (German: "Außensteuergesetz") was expanded to include paras 3d and 3e and now provides special statutory rules for income corrections for financing transactions between related parties.
Practical implications at a glance
While the arm’s length principle for financial transactions enshrined in the Growth Opportunities Act is essentially identical in its application to the OECD Transfer Pricing Guidelines Chapter X published in February 2020, there is a “German way” that generally deviates from, and narrows the scope of, the guardrails stipulated in the OECD Guidelines. Thus, the following points should be considered in particular when it comes to intercompany financial transactions involving German companies:
Transfer pricing considerations and documentation should include an analysis of the business purpose for, and use of, intercompany financing as well as a demonstration of the borrower’s expectations as to its ability to service its interest and capital obligations (debt capacity analysis)
The interest rate should be derived based on the group credit rating – deviations must be well substantiated and entail a certain level of regulatory uncertainty
Pure brokerage service and/or forwarding of financing should generally (only) be remunerated based on the cost-plus method
The establishment of a cash pool leader featuring a more complex functional and risk profile that significantly participates in the profits earned through cash pool operation should be well substantiated, taking into account the requirements of the law
German taxpayers should, at a minimum, identify potential risks for existing intra-group financing (i.e. that which has not yet matured) and address these in light of the new regulations.
The new law is already applicable. The new legislation entered into effect on 1 January 2024, and we have already seen that the German tax authorities are also applying the new legislation to existing intercompany financial transactions (i.e. to those incepted prior to and still in force after 1 January 2024) and potentially even to loans that fully matured prior to 2024. The above-mentioned rules should therefore also be taken into account for transfer pricing documentation of previous years.
Previously, German tax audits have placed intense focus on intra-group financing – in particular on inbound loan transactions and cash pooling arrangements with high long-term balances held by German participants. Due to the new regulations, we anticipate that this will continue to be the case in subsequent years. To ensure that you are optimally prepared for future tax audits under these circumstances, we recommend that you review your existing transfer pricing policies and documentation now.
Section 1 para 3d of the Foreign Transactions Tax Act specifically stipulates that the following three criteria must be cumulatively fulfilled in order for interest expenses incurred by a domestic taxpayer in connection with a cross-border financial transaction to be tax deductible:
Financing required and used for the purpose of the business
The taxpayer must demonstrate that the financing is commercially required and used for the purpose of the business.
The legislator appears to take aim in particular at arrangements under which a German borrower receives a comparably low return on excess cash, for example through deposits in the intra-group cash pool or bank deposits, while not repaying other intra-group financial obligations that are subject to higher interest rates in the absence of any commercial justification for doing so.
We therefore recommend that your transfer pricing documentation include a description of how intra-group financing is used in keeping with the purpose and strategy of the borrower. Arrangements indicating that intra-group funds are not required and, for example, are deposited in an intra-group cash pool must be analyzed from a German transfer pricing perspective and potentially reconsidered in light of the new legislation. If German tax authorities consider this criterion to not be fulfilled, the full interest expenses in connection with the intra-group financing transaction under scrutiny may be considered non-deductible for tax purposes.
Sufficient debt capacity
The taxpayer must demonstrate that the borrower expects to have the ability to service its interest and capital obligations over the duration of the financing transaction (particularly loans) at the time of issuance (or renewal).
Most recent tax audits already indicate that German tax authorities will request such analysis even more regularly from now on. In view of this, we strongly recommend that a debt capacity analysis (DCA) be carried out for all material financing transactions to minimize the risk of future transfer pricing adjustments. Not preparing a DCA may be considered as failing to provide complete transfer pricing documentation and can lead to the full interest expenses being considered non-deductible for tax purposes. Particular attention should, for example, be given to loans where interest has been capitalized in the past and the borrower's debt sustainability could therefore be called into question.
Interest rate derived from group credit rating
In general, interest rates are only considered to be at arm's length if the interest rate does not exceed the financing conditions achieved with third parties when applying the rating for the corporate group ("group credit rating"). If it is proven in individual cases that the rating of a borrower derived from the group credit rating corresponds to the arm's length principle, this must be taken into account when calculating the interest rate.
At present, regulatory experts differ in their interpretation of the law. Some argue that it in effect requires application of the group credit rating, while others construe the law to mean that following the guidance of rating agencies for implicit group support1and applying (potentially upwards adjusted) stand-alone credit ratings is also in line with Section 1 para 3d of the Foreign Transactions Tax Act.
Taxpayers should bear in mind that determining interest rates based on credit ratings that are (significantly) below the group credit rating entails a certain degree of regulatory uncertainty. Any deviation from the group credit rating should therefore be assessed against the corresponding guidance for assessing implicit group support and well substantiated in the underlying transfer pricing documentation.
1 for example S&P Group Rating Methodology, dated 1 July 2019
Section 1 para 3e of the Foreign Transactions Tax Act regularly classifies a pure brokerage service or the forwarding of a financing transaction as well as typical treasury functions, such as liquidity management, financial risk management and the management of foreign exchange risks, as activities featuring a low-function and low-risk profile. Although the term “cash pooling” is not explicitly mentioned, the mentioned treasury functions will also include cash pools. Following transfer pricing principles as well as the officially published justification of the law, the respective functions would generally be remunerated using the cost-plus method on the basis of the directly attributable operating costs without including refinancing costs in the cost base. This does not apply if a functional and risk analysis substantiates more complex functions performed and risks assumed.
As the new statutory regulation basically corresponds to the requirements of the OECD Transfer Pricing Guidelines Chapter X published in February 2020, the actual impact on transfer pricing may generally be limited. However, particularly the functional and risk analysis with respect to cash pools involving German companies should consider the specifications made in Section 1 para 3e of the Foreign Transactions Tax Act beyond the regulatory guidance of the OECD. The establishment of a cash pool leader that features a functional and risk profile justifying participation in the profits earned through cash pool operation (regularly implemented through a significant spread between cash pool borrowing and deposit rates) should be well substantiated considering the specifications made in the law with respect to a bundle of treasury activities. A particular focus should be made on people functions and risk capacity when analyzing such arrangements.
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Marc Oliver Birmans
Partner, Tax, Global Transfer Pricing Services
KPMG AG Wirtschaftsprüfungsgesellschaft
Svetlana Kuzmina
Director, Tax, Global Transfer Pricing Services
KPMG AG Wirtschaftsprüfungsgesellschaft
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