Bundesfinanzhof tests at arm’s-length principle
The decision of the Supreme Tax Court (Bundesfinanzhof) of 13 January 2022, published on 23 June (I R 15/21) confirms that the write-off of unsecured intragroup debt can be considered at arm’s length, but fails to clarify under which conditions this is the case.
The taxpayer is a German parent company of a German subsidiary that was part of a consolidated tax group (Organschaft). The German subsidiary had a 99.98% holding in a Belgian company, to which it had granted an unsecured offset account with an annual interest rate of 6%. In 2005 the taxpayer paid 3.14 percent interest on a loan of several million euros taken out from a bank. The German and the Belgian companies agreed on a debt waiver subject to a repayment of the waived loan with future profits in the amount of the worthless part of the claims against the Belgian company. As a result of the debt waiver, the German subsidiary took a bad debt deduction against its taxable profits.
The German tax authorities took the position that the loan was not at arm’s length because of the lack of security for the loan, they disallowed the write-off and added the amount back to the company’s taxable income in accordance with article 1 of the Außensteuergesetz (the Foreign Relations Tax Act).
The taxpayer claimed that article 9 of the double tax treaty only allows the correction of the income component of a loan (the interest rate), so that the tax deduction of the complete write-off as a worthless loan must be allowed under German domestic law.
In a decision of 10 November 2015, the Düsseldorf court (6 K 2095/13 K) had granted the write-off of the unsecured intragroup debt that had lost its value, on the basis that only the interest and not the missing security could affect the at-arm’s-length character of an intragroup loan. The Düsseldorf court was following the case law of the Bundesfinanzhof.
However, the Bundesfinanzhof overturned that decision in a surprise decision of 27 February 2019 (I R 73/16) that deviated from its long-standing case law. The Bundesfinanzhof took the position that the lack of a collateral was contrary to the arm’s-length principle in article 9 of the double tax treaty between Belgium and Germany.
That decision was overruled by the Supreme Constitutional Court (the Bundesverfassungsgericht) on 4 March 2021 arguing that the Bundesfinanzhof did not take into account a request for a preliminary ruling from the Court of Justice of the European Union to ascertain that the freedom of establishment applied and that the Bundesfinanzhof violated the taxpayer’s right to the correct lawful judge (2 BvR 1161/19).
In its 2022 decision, the Bundesfinanzhof has confirmed that the lack of a guarantee could indicate that a loan was not at arm’s length if a third party would not have given the loan. The court reiterated its position from 2019, that the double tax treaty does not prevent the tax administration from disallowing the loan write-off, but it did not elaborate on the reasons.
The court referred the case back to the lower court in Düsseldorf to ascertain the facts stating that the lower tax court would have to determine whether the unsecured loan could be recharacterized as equity. A capital contribution would have increased the acquisition cost of the participation. A write-off would then have no impact on the taxable income because dividends are tax-free under the participation exemption, the court added. The Bundesfinanzhof gave the lower tax court detailed guidance for assessing whether the payment from the German subsidiary to the lower-tier Belgian subsidiary is debt or equity. It would have to consider all circumstances surrounding the conclusion of the contract, such as the borrower’s legitimate earnings expectations, the lender’s influence on the borrower’s business activities, and the lender’s basic willingness to support the borrower in external business transactions. That assessment must be made regardless of whether an unusual waiver of a collateral for the agreement is possible.
Even if, after considering all the facts and circumstances, the lower tax court comes to the conclusion that the unsecured loan is debt rather than equity, it would have to determine whether there is a market for unsecured loans with third parties, such as an agreement at a higher interest rate. The Bundesfinanzhof added that if such a market existed, but the interest rate would be too low, only the interest rate could qualify for a readjustment.
Remarkably, the Bundesfinanzhof did not address the 2020 OECD transfer pricing guidance on financial transactions. Section 10.56 of the guidance says that "in the case of a loan from the parent entity of [a multinational enterprise] group to a subsidiary, the parent already has control and ownership of the subsidiary, which would make the granting of security less relevant to its risk analysis as a lender."
The taxpayer had requested a referral to the CJEU for a preliminary ruling to clarify whether section 1 of the Foreign Relations Tax Act is in compliance with the EU freedom of establishment. The Bundesfinanzhof refused this request because of the factual uncertainties.