Changes with an impact on the deduction of interest expenses

History

An earlier version of the Growth Opportunities Act included a fixed maximum interest rate that would have been tax deductible in Germany. This approach was completely abolished and replaced by the final version, which moved to a specific German interpretation of the arm’s length principle, and now closely mirrors the draft legislation published in 2019 as part of the ATAD initiative2. Prior to the current change, the practice in Germany to determine arm’s length interest rates was strongly influenced by German Federal Fiscal Court (BFH) decisions3 being widely aligned with the international practice based on OECD Transfer Pricing Guidelines which essentially start with the stand-alone credit rating, eg, of a real estate PropCo, to determine arm’s length interest rates for inbound loans.

Types of arrangements

Although the new provisions will predominantly apply to loans, other financing relationships (such as debt-like instruments) are also covered.

Group rating as the standard case

The law includes significant changes in German transfer pricing regulations to the AStG. In principle, the new law now limits the interest deduction to an interest rate based on the group rating. Higher interest rates are generally not considered to be at arm’s length (new Section 1 (3d) AStG) and are prima-facie not tax-deductible (beyond that calculated with reference to the group rating).

Notably, while the approach of using the group rating is mentioned by the OECD Transfer Pricing Guidelines4, this applies only to specific cases, eg, where the relevant entity is of special importance to the group. As a result, this creates an inconsistency with the international interpretation of the arm’s length principle outside these specific cases and most relevant for the real estate sector.

It should also be noted that the term “multinational group” is not specifically defined in the new Section 1 (3d) AStG, although defined in the existing law to broadly mean at least two companies based in different countries, where such companies are related parties under German transfer pricing rules, whereby a 25% (direct or indirect) voting / participation right / capital right threshold is used5.

Given the uniqueness of real estate structures (eg, the use of various funds and asset / investor managers rather than the typical parent-subsidiary relationship), it needs to be examined closely which entities fall under the German transfer pricing definition of a related party for the purpose of ascertaining the composition of the group.

Escape clause

The law provides an escape clause, whereby a taxpayer may provide counter evidence to substantiate that another credit rating derived from the group rating complies with the arm’s length principle (and hence possibly justify a higher interest deduction), although the burden of proof here lies with the taxpayer.

What is remarkable is that the term “derived from the group rating” is neither defined in the new law nor in the OECD Transfer Pricing Guidelines. Whilst there are accepted practices in the financial industry for deriving a credit rating for a specific group entity from the group rating, eg, through downward credit rating notching when classifying an entity as “highly strategic” to the group6, how this applies in other cases – relevant inter alia for most cases in the real estate sector – is not clear.

In the explanatory memorandum to the then draft law7, reference is made to the OECD Transfer Pricing Guidelines, which notes factors that can be considered when calculating an interest rate, such as maturity, currency risks and principal. In the explanatory memorandum, it is also acknowledged that the impact of implicit support can also be considered, which by definition would include the possibility of using or starting with the stand-alone rating. However, the explanatory memorandum explicitly notes that the credit rating of the group of companies is generally decisive, unless the stand-alone credit rating is better. Hence, taxpayers will have to be convincing when using a stand-alone rating.

Application to domestic financing arrangements

The new Section 1 (3d) AStG specifically references cross-border financial transactions, meaning that domestic loans arguably do not fall within the new section (just as the German transfer pricing provisions in general only apply to cross-border transactions). As such, there could potentially be a mismatch if interest deductions are limited under the new Section 1 (3d) AStG with respect to a cross-border loan but not in relation to a similar domestic loan.

In the past, the Court of Justice of the European Union (CJEU) has dealt with various issues concerning whether transfer pricing provisions are consistent with the „freedom of establishment“ concept under EU law8 (ie, whether cross-border loans can be treated differently to domestic loans, given that these new rules only apply to cross-border intercompany financing).

It can be argued that different treatment may be justified, eg, on the basis of the Hornbach case9 (in which it was decided that the German transfer pricing provisions, which solely apply to cross-border transactions, were appropriate to ensure an appropriate allocation of taxing powers between Member States). However, time will tell whether there are challenges to the new rules, given a number of recent cases on this matter10.

Application to outbound loans

The new law arguably only applies to inbound loans (ie, where a German taxpayer is deducting interest expenses), given that the new law refers to deductions (and not income). In cases where a German taxpayer lends money to a related party abroad, the new law would arguably not apply to adjust the interest income of the German lender by basing the interest rate on one derived from the group rating. On the other hand, the new law does not specifically preclude any income adjustments concerning interest income. As such, where German tax authorities argue that the stand-alone rating is more appropriate, which would likely serve to increase the interest rate on the intercompany loan and thereby increase the income attributable to the German lender, reference may need to be made to recent German Fiscal court decisions11, rather than the new law, in order to substantiate an income adjustment. However, the German Transfer Pricing Administrative Principles of 202312, which state (paragraph 3.3) that the arm’s length principle is to be applied consistently in inbound and outbound cases should practically limit such inconsistent approaches.

Existing loans

The new law deals with interest deductions made in or after assessment periods 2024. As such, existing loans (with respect to interest deductions claimed from the 2024 assessment period) also fall under the scope of the new provisions, in addition to any new loans issued.

Additional requirements

The new law includes the additional burden of documenting serviceability of the debt (interest and principal) from the outset.

Given the wording of the new law (ie, to demonstrate serviceability of the loan from the beginning), a serviceability analysis in the form of estimating free cash flows of the borrower and comparing these to the borrower’s cash flow requirements under the loan (at a minimum covering interest) could be undertaken. As real estate projects often take many years to generate positive cash flow, it would be important to review the terms of the loan (ie, whether interest can be capitalised) and ensure that these conditions reflect behaviour amongst third parties.

Further, there is the requirement to credibly demonstrate that the financing is economically necessary and is used for business purposes. This requirement arguably applies not only to newly issued loans, but also previously issued ones. In particular, the German Transfer Pricing Administrative Principles of 202313 that also cover this point (paragraph 3.124) apply retrospectively to all open cases.

Arranging / on-lending of funds

In addition, the law now also contains a provision (new Section 1 (3e) AStG), according to which the arranging or on-lending of funds is in principle to be regarded as a service with a low functional and risk profile (unless demonstrated otherwise). This means that in such cases, only a remuneration based on a cost-plus basis is appropriate (in line with OECD pronouncements).