BMF publishes draft revision of the Administrative Principles on Transfer Pricing 2023

The amendments to Administrative Principles TP 2023 proposed in the BMF draft letter deal with the new regulations for cross-border financing relationships and services that were introduced in Section 1 (3d) and (3e) of the German Foreign Tax Act (AStG), as part of the Growth Opportunities Act passed by the Bundestag on 22 March 2024.

Legal basis – Growth Opportunities Act

The following graphic provides an overview of the legal changes underlying the draft and possible recommended actions:

Interpretation of the tax authorities – BMF draft letter

In its administrative instructions, the BMF defines the administrative interpretation of the applicable law in order to ensure a uniform and predictable application of the law for taxpayers by the tax authorities in each individual case.

With regard to Section 1 para. 3d of the Foreign Tax Act, the BMF draft letter now specifies the criteria for financing with debt capital and thus the tax deductibility of interest and other financing expenses with reference to the relevant case law and the OECD Transfer Pricing Guidelines (in particular chapter X). The basis for this is the actual business transaction and the functional and risk profiles of the affiliated companies involved. This definition of the initial situation and the assessment framework is initially to be welcomed.

In line with the law, the requirements for the debtor's ability to service the debt (interest and repayment) at the time the loan is granted are taken into account. The inclusion of the use of the loan in the consideration is carefully designed as an "optional rule", which is also to be welcomed. After all, third parties also agree on working capital loans or credit lines without a fixed purpose. The statement that the need for follow-up financing does not have to be unusual for third parties also appears appropriate. However, the other criteria, which according to the administrative opinion must be examined in the necessary overall view, do not necessarily follow the arm's length principle. For example, contractual provisions on interest, maturity and the enforcement of capital and interest payments are not required to enforce capital and interest payments, at least according to German civil law principles, as the general rules of civil law apply in their absence. In addition, third parties also negotiate loans that are repayment-free, or bullet loans, or loans where the interest is capitalized.

Furthermore, the draft contains explanations on the need for and use of the borrowed funds. On a positive note, the guidance clarifies that debt capital is often taken on with a certain buffer for unforeseen costs of an acquisition or can also be used to finance a profit distribution.

Factors such as the purpose of the loan, term, loan volume, collateralization and various risks as well as the borrower's credit worthiness must also be taken into account when reviewing the arm's length nature of an interest rate. In principle, the group rating should be used as a basis. Alternatively, it is possible to derive a rating from the group rating, in which case the credit assessment, including the usual external qualitative and quantitative factors and the consideration of possible group backing, must be presented.

In practice, this rule leads to a reversal of the burden of proof in those cases in which an individual rating is used to determine an arm's length interest rate, to the benefit of the taxpayer. The assumption reiterated in the BMF draft letter, that the group rating is preferable to an individual rating, does not appear to be compelling either. Rather, it is also a question of the individual case as to whether group and individual ratings differ or are congruent. The more appropriate rating is then given the preference.

Overall, the new Section 1 para. 3d of Foreign Tax Act continues to impose more difficult conditions that must be met in order for a loan to qualify – in principle – as debt capital. However, it was not to be expected that the BMF draft letter would contain any concessions on this point.

In Section 1 para. 3e of the Foreign Tax Act, the performance of intra-group financing functions is classified as low-function and low-risk services. The BMF draft letter defines the financing functions as support functions for the core business, for which the arm's length method is generally to be used to determine the arm's length price, irrespective of the role of the lending company. Exceptions to this principle are cases in which financing functions are a central component of value creation, e.g., at banks or insurance companies. The management of financial resources within the corporate group should be treated similarly, e.g., liquidity management, financial risk management, currency risk management or activities as a financing company. Any deviating classification of financing activities as a value-adding function must be demonstrated by the taxpayer on the basis of a detailed functional and risk analysis.

Here, as well, the principle stated at the beginning – that the individual case must be analyzed on the basis of the functional and risk profile – and the further explanations in the BMF draft letter on the new legal situation contradict each other. The assumption that affiliated companies have a standardized functional and risk profile is neither substantiated nor is it in any other way obvious.

Summarized assessment

From the perspective of taxpayers, the BMF draft letter is to be welcomed, insofar as it clarifies the new regulations introduced with section 1 para. 3d and 3e of the Foreign Tax Act, e.g., with regard to the requirements for the arm's length nature of a loan or the determination of the rating. The BMF draft letter reaches its limits in cases where the legal situation to be interpreted already regulates individual aspects (such as presumed ratings or presumed functional and risk profiles) in an unbalanced manner. The fact that the new regulations introduced are not applied equally to outbound and inbound cases should be viewed critically. Unilateral regulations on the deduction of domestic business expenses for transactions between affiliated companies inevitably lead to distortions in all cases. It remains to be seen which of the explanations outlined in the draft letter will find their way into the administrative principles on transfer pricing.