Clarifications with an impact on the deduction of interest expenses

The current version of the 2023 Administrative Principles on Transfer Pricing dated 6 June 2023 is 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. With the Growth Opportunities Act, this view was reversed to limit intercompany interest deductions to an interest rate based on the group credit rating, whereby a taxpayer may provide counter evidence to substantiate that another credit rating derived from the group credit rating that complies with the arm’s length principle (and hence possibly justifies a higher interest deduction) may be used. However, in such cases, the burden of proof lies with the taxpayer.

The new law includes the additional burden of determining serviceability of the debt (interest and principal) from the outset and the requirement to credibly demonstrate that the financing is economically necessary and is used for business purposes.

According to the VWG TP, for recognition as debt capital, the essential criteria are the credible expected ability to service the capital (interest and principal payments) and the genuine agreement for the lender to provide capital over time. It is particularly important to determine whether sufficient assets or cash flows are expected from the outset to satisfy the lender. The inclusion of the borrower's assets in the consideration is very welcome, since loan to value (LTV) considerations or the possibility of asset disposal are commonly used in the real estate sector. In the same context, the VWG TP also clarify that there may be phases with limited cash flow (and therefore limited interest/principal repayments) especially in early phases of a company, which may fit well with development phases in the real estate sector.

For the financing to be recognised as deductible, it must also be economically needed. The tax administration requires that in case of the financing of an investment, there should be a justified prospect of a return that covers the financing costs. In line with the previous administrative practice, this is not the case if the funds received are invested in an at-call bank account or in an intra-group cash pool. However, planning with a capital buffer and short-term investment in an intra-group cash pool is considered at arm's length. Furthermore, borrowing for the purpose of distributing profits can potentially be supported as being for business purposes.

To avoid reclassification as equity, the taxpayer must credibly demonstrate that the above criteria are cumulatively met. If not credibly demonstrated, the reduction in income caused by the financing relationship should be reversed to the extent of the non-arm’s length part.

Regarding interest rate determination, the new law now limits the interest deduction to an interest rate based on the group rating as the standard case. The VWG TP state that existing public ratings should be used as the primary benchmark for assessing the creditworthiness of the entire corporate group. Private ratings (ie, ratings that have not been published) should only be used secondarily. It is pointed out that a rating can also be created using standard rating software, provided that qualitative factors are appropriately taken into account. If a corporate group does not have a rating, an existing rating of the top group company can be used. If the top parent company does not have a rating, a group rating can be derived from the corporate group's financing costs to independent third parties for simplification purposes.

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. For this purpose, rating classifications based on concepts of well-known rating agencies can be used. This means that stand-alone ratings may also be used for specific circumstances. This clarification is welcome, since in the real estate sector, group ratings are often not available and the use of stand-alone ratings often makes more sense economically, eg, due to the limited strategic relevance of a single PropCo.

Given the current draft status of the VWG TP, the final version may still contain changes. However, we do not expect fundamental changes at this point. Since the law will apply for interest deductions starting 1 January 2024, real estate groups should promptly consider the new law and the VWG TP.

Regarding specific items, our current view is:

The law now requires starting with the group rating as a standard case instead of the stand-alone rating, which is currently standard for many real estate clients. In case real estate groups would like to follow the standard case according to the law, they should first determine which entities constitute a “multinational enterprise group” for the purposes of the German transfer pricing rules as the basis for the group rating and how to determine the group rating on this basis.

Since group ratings often do not exist or do not make sense from an economic perspective in a typical real estate environment, application of the escape clause should be considered. The new rules will however require significant additional documentation efforts to justify, eg, the application of a stand-alone rating.

Given that the new law applies to both existing and new loans, the appropriateness of the interest rates on existing cross-border intercompany loans should be reviewed considering the new provisions. Changes to existing arrangements or additional documentation should be considered.