There is only rudimentary guidance on the treatment of cross-border I/C financing relations on the level of the OECD and in German tax provisions. Despite limited guidance, I/C financing relations are not only increasingly scrutinised in German tax audits but have also reached the tax court level in Germany. The judgement of two recent cases at the Münster and Cologne Fiscal Court come to different conclusions amongst other with regards to the appropriate transfer pricing method and are reflective of the missing guidance in the I/C financing sphere. Both cases are pending at the Federal Fiscal Court.
1 Recent judgement of the Münster Fiscal Court
(13 K 4037 / 13 K,F)
The plaintiff (X) is a German subsidiary of a multinational group. The German subsidiary’s shareholder (Y) as well as the financial hub of the group (Z), a sister company to the German subsidiary, are located in the Netherlands. In its function as a financial hub, (Z) granted several loans, amongst others, to (X). As part of a tax audit, the German tax authority considered that the interest rate on the I/C loans paid by (X) to (Z) was too high. In order to verify the arm’s length nature of the interest rate, (X) applied the CUP method, whereas the tax authority used the cost plus method. (X) subsequently filed a suit in the Münster Fiscal Court.
The court ruling established that the cost plus method was justly chosen by the tax authority. Additionally, the external CUP could not be reliably applied because the conditions of the uncontrolled transactions were not comparable with the conditions of the tested transactions.
2 Recent judgement of the Cologne Fiscal Court
(10 K 771/16)
The plaintiff (A), a GmbH, acquired all shares of (B) in May 2012. For this acquisition, (A) took up a bank loan (interest rate 4.78%, with business assets as collateral), a vendor loan (interest rate 10%) and a shareholder loan (interest rate 8%) with its sole shareholder (C). The interest rate on the shareholder loan was verified by (A) applying the external CUP method. For the German tax authority, the interest rate of the shareholder loan did not comply with the arm’s length principle. The pertinent interest rate should be 5% based on the bank loan (internal CUP). (A) subsequently filed a suit at Cologne Fiscal Court.
The court ruled that the interest rate of the bank loan (4.78%) is to be used as the standard for the interest rate of the shareholder loan. Insofar, the hidden profit distribution consists of the difference between the arm’s length interest rate of 5% (internal CUP) and the effectively paid interest rate of 8% (external CUP).
3 Discussion and Outlook
Both court rulings decided in favour of the tax authorities. Nevertheless, the two courts came to different conclusions regarding the appropriate transfer pricing method to be applied for determining an arm’s length interest rate for I/C loans. The Münster ruling discusses the question if any hierarchy among the standard transfer pricing methods should be considered and concludes that the cost plus method was justly chosen in the underlying case. The Cologne ruling raises the question of preferences of the internal over the external CUP and comparability criteria to be considered. The rulings further touch upon other important topics such as group association benefit and transparency needs for database studies.
The tax community is awaiting with great interest the decision of the Federal Fiscal Court on the appealed court rulings. It is hoped that the Federal Fiscal Court will take a uniform position on the questions raised, as it may set a precedent for future reference in the area of I/C financing relations in Germany.