Executive summary

On 12 December 2024, the German Ministry of Finance (MoF) published the eagerly awaited update of the administrative principles on transfer pricing with regard to the new regulations on intra-group financing relationships and financing services introduced with the Growth Opportunities Act. The Growth Opportunities Act started as the biggest corporate tax reform since 2008 but shrank to a minor stimulus package during the legislative process.¹ The enacted bill includes new limitations on deductible interest expenses on intercompany financing, which are now addressed in the final guidance published by the MoF.

The guidance also comments on the application of the so-called Amount B. Accordingly, the guidance clarifies that for in-scope transactions of Amount B the transfer price can be determined according to the simplified and streamlined approach. However, this only applies if the transaction is with a "covered jurisdiction" with which a double taxation agreement exists and this jurisdiction is not a noncooperative jurisdiction for tax purposes within the meaning of the German Anti-Tax Haven Act. The Amount B guidance is applicable for tax assessment periods 2025 and onward.

Detailed discussion

The newly introduced provisions on intercompany financing generally provide (in Sec. 1 para. 3d Foreign Tax Act (AStG)) that interest expenses for an intercompany cross-border financing relationship (loans, in particular, as well as the use or provision of debt or debt-like instruments) can only be deducted if the taxpayer can demonstrate that:

1. Principal and interest payments can be serviced throughout the entire term of the financing period (debt-serviceability test).
2. The borrowed funds are needed economically and are used for the purpose of the business (business-purpose test).

Additionally, the interest rate for the cross-border intercompany financing relationship transaction must not exceed the interest rate based on the better of either the stand-alone rating of the borrower or the overall group rating unless it is demonstrated, in a particular case, that a credit rating deviating from, but nonetheless derived from, the group credit rating is in line with the arm's-length principle.

Furthermore, a new provision in Sec. 1 para. 3e AStG includes a rebuttable presumption that the mediation, arrangement or forwarding of intercompany cross-border financing arrangements is considered per se a low-risk, routine service. This is also applicable to captive treasury centers and captive financing companies performing, for example, liquidity management or financial risk management for other group companies. How such low-risk, routine service should be remunerated is described only briefly in the explanatory notes to the bill. According to these notes, the remuneration for such transactions is typically to be determined based on the cost-plus method, considering directly attributable operating costs but not including refinancing costs in the cost base. A 5% to 10% markup is not considered unreasonable. In addition, refinancing costs can be taken into account with a risk-free return.

The wording of the rules is rather general and, hence, requires substantial interpretation to be applied in practice. By nature, this provides for uncertainty. It is therefore a welcome development that the issued guidance illustrates the tax authorities' interpretation of some of the key questions surrounding the rules.

In general, the guidance emphasizes at the outset that the provisions of Section 1 para. 3d and 3e AStG are to be applied in accordance with the Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines (Chapter X) and that a function and risk analysis is also required for intercompany financing transactions.

The guidance clarifies that the debt serviceability test is not per se failed only because the repayment of the principal and accumulated interest requires a refinancing. Moreover, the tax authorities clarify that the analysis of serviceability is not limited to cash and liquid assets but may include all assets. Furthermore, the guidance confirms that high-risk financing relationships can be arm's-length. On the flipside, the guidance states that the financing needs to be with "serious intent." This requirement exceeds the wording of the law. Although the requirement is grounded in caselaw, in principle, the MoF seems to interpret the requirement stricter than German caselaw, but in line with the OECD Guidelines (in particular, para. 10.12ff.). The MoF also requires a number of additional criteria be fulfilled to accept a financing transaction, such as a defined term of the loan, interest being charged based on agreed payment terms and the general ability of the borrower to borrow funds from third parties at comparable conditions.

Concerning the business-purpose test, the "economically needed" criterion is met according to the guidance if the financing is required for the operation or maintenance of business activities. This may involve, for example, the financing of operating resources or investments in plants and equipment. However, the guidance emphasizes that a managing director will not take on external debt in the market unless there is at least a reasonable expectation of a return that covers the financing costs. In principle, an after-tax approach is to be assumed, unless the analysis is carried out uniformly within the group on the basis of pre-tax figures. Thus, the MoF's interpretation also requires a quantitative analysis to satisfy the business-purpose test.

Further, the guidance confirms that financing of a dividend distribution to shareholders is a valid business purpose if it is done within the framework of the typical distribution policies. The guidance further provides that the taxpayer must consider its options realistically available. Presumably, this means that available excess cash (i.e., cash not required for the business and not generating a return higher than the financing costs) should be used before any additional funds are borrowed. However, this does not preclude the holding of arm's-length liquidity reserves or capital buffers. The guidance confirms that, in an acquisition context, it is generally considered arm's-length to plan with a capital buffer and use these funds for a short-term investment (e.g., in a cash pool).

Because the taxpayer must demonstrate compliance with the requirements of the rules, the guidance also includes comments on how the tax authorities would expect taxpayers to do so. According to the guidance, this means that the taxpayer must demonstrate the following on a more-likely-than-not basis:

1. Whether and how the debt can be serviced
2. What purpose the financing had and how the funds are actually used

Forecast or investment calculations, which can also include a refinancing, may be used to demonstrate compliance. The guidance clarifies that the debt serviceability test is met if an investment grade rating is used to determine the interest rate at the time the contract is concluded. Further, for short-term financing arrangements, in particular cash pools, it can regularly be assumed that the debt service will be provided.

Lastly, the guidance clarifies both the debt-serviceability and business-purpose tests are understood as "to the extent" type rules, meaning that the interest deduction would only be denied to the extent the requirements are not met, and the interest is, therefore, considered not to be at arm's-length. This means that, in general, only part of the interest expense is at risk; however, according to the guidance, this also includes additional costs, such as commitment fees, prepayment penalties and other ancillary loan costs.

With regard to the credit rating to be used to determine the maximum interest rate, the guidance provides that an existing rating of the ultimate parent entity can be used if a rating for the overall group does not exist. If a rating for the ultimate parent is not available, the determination of a rating based on the group's existing financing costs vis-à-vis third parties can be accepted for reasons of simplification. Furthermore, rating analyses prepared by the Deutsche Bundesbank are accepted, according to the guidance. Also, a rating can be prepared using standard market-rating software. However, in such cases the taxpayer must document how the qualitative factors of the rating were appropriately considered.

The guidance further states that the group rating should be synonymous with the rating of the corporate group. If the scope of the companies to be included in a group of companies differs from that of a corporate group, it is important to consider how rating agencies deal with such a situation. This exception is especially relevant for investment funds.

The guidance further clarifies that a rating differing from the group rating can also be used to determine the interest rate if the taxpayer can prove that a rating derived from the group rating complies with the arm's-length principle. Unfortunately, the administrative principles do not include detailed guidance on the criteria that such a proof would need to satisfy, but only list the following requirements:

1. Qualitative and quantitative factors are appropriately included in the rating for the specific borrower.
2. Distortions of the key financial figures relevant for the rating analysis due to transactions with related parties have been eliminated and, as a result, only key figures that are in line with the arm's-length principle are used.
3. The rating is comprehensible and reproducible.
4. The rating methodology applied is in line with market standards at the time the loan is granted.

In this context, the administrative principles also include detailed explanations of how group support would have to be considered in this case, in particular depending on the borrower's strategic importance for the group.

The guidance refers to the recently implemented statutory transition rule for existing financing arrangements, according to which Sec. 1 para. 3d does not apply to expenses incurred up to 31 December 2024 that are based on financing relationships agreed to under civil law before 1 January 2024 and for which actual implementation began before 1 January 2024. If affected financing relationships are significantly changed after 31 December 2023 and before 1 January 2025, Sec. 1 para. 3d does not apply to expenses incurred before the significant change. If the financing relationship continues in the form of a continuing obligation beyond 31 December 2024, the MoF will allow the debt serviceability to be demonstrated as per 31 December 2024, rather than at the loan issuance date.

Concerning the application of Sec. 1 para. 3e AStG (i.e., the default definition of treasury functions as low-risk routine services), the MoF is essentially maintaining its previous interpretation that the determination of an arm's-length price for the lending of capital between related parties is generally to be based on the comparable uncontrolled price method (in line with corresponding caselaw). However, low-risk, routine financing companies are nevertheless only entitled to a risk-free return. If the granting of a loan on the one hand, and the actual control over the associated functions or risks on the other hand are split between different entities, a further transaction between the financing company and the company that exercises the actual control over the functions or risks associated with the loan may exist in accordance with OECD principles. If the company exercising the actual control over the associated functions or risks is a German entity, the guidance therefore requires a review of the remuneration to be allocated to this entity for the service provided to the financing entity. Although not explicitly stated in the guidance, this suggests that the MoF does not interpret Sec. 1 para. 3e AStG as providing for an adjustment of an arm's-length interest expense at the level of the borrower. The MoF's interpretation would therefore be in accordance with corresponding caselaw and OECD principles. A transition rule concerning Sec. 1 para. 3e AStG is not included in the guidance.

In addition to the explanations regarding financing relationships, the Administrative Principles 2024 on transfer pricing now also contain statements on the implementation of the so-called Amount B (margin no. 3.63a). Accordingly, the MoF generally does not object to transactions that fall under the scope of Amount B if the transfer price for these transactions is determined according to the simplified and coordinated approach. However, this only applies if the business relationship is with a so-called "covered jurisdiction" within the meaning of Annex 5, a double taxation agreement exists with this jurisdiction and this jurisdiction is not a noncooperative tax jurisdiction within the meaning of the German Anti-Tax Haven Act. Both the final report of Amount B and the list of the so-called "covered jurisdictions" are attached as annexes (Annex 4 and Annex 5) to the Administrative Principles 2024 on transfer pricing.

Implications

Taxpayers should review the MoF's interpretation of the arm's-length principle with respect to intercompany financing and determine any implications for their transfer pricing policy and documentation strategy, particularly for existing and new financial transactions.