Landmark judgments: Market interest rates for group loans

Introduction

In May 2021, the Federal Fiscal Court (BFH) issued two landmark rulings on the determination of market interest rates for group loans and shareholder loans, which are still valid and are used as a guide by tax authorities, companies and tax consultants. These rulings have a relevant impact on the tax treatment of group loans and emphasize above all that the price comparison method is to be classified as the preferred method, while the cost-plus method was considered less suitable.

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First ruling: Arm's length interest rates for group loans (BFH case no. IR 4/17)

This case concerned a loan from a Dutch financing company to its German sister company. Although the German company had taken out secured loans from banks at a lower interest rate than the internal loan, the interest expense was reduced by the German tax office because it considered the interest rate to be unusual and too high. The tax office applied the cost-plus method instead of the price comparison method, as the financing company was considered an agent and not a bank. The Münster tax court confirmed this decision. However, on appeal, the BFH ruled that the price comparison method should be applied as a matter of priority in order to determine market interest rates for group loans. In addition, the creditworthiness of the borrower (taking into account the group structure) should be assessed independently instead of using a group rating.

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Second judgment: Interest on a shareholder loan (BFH case no. IR 62/17)

In this case, a German company had taken out a secured bank loan with an interest rate of 4.78% p.a., an unsecured loan from the seller with an interest rate of 10% p.a. and an unsecured shareholder loan with an interest rate of 8% p.a.. The tax office considered the interest rate on the shareholder loan to be too high and only granted an interest rate of 5% based on the bank loan. The difference between the two interest rates was regarded as a hidden profit distribution that increased the company's profit. However, the BFH ruled that an unrestricted comparison with the bank loan was incorrect, as a third party would not grant a subordinated and unsecured loan on the same terms as a senior and secured loan. According to the BFH, the statutory subordination of shareholder loans is irrelevant for the arm's length comparison. The intra-group affiliation of the companies must also be excluded. Actual agreements with third parties, such as the secured and senior bank loan, must be mathematically adjusted to take into account special circumstances at affiliated companies before they can be used for the arm's length comparison. The BFH thus followed the OECD transfer pricing guidelines.

Summary guidelines on group loans

1. Price comparison method: In order to determine arm's length loan interest rates, it should be checked whether the comparative values can be determined using the price comparison method before applying the cost-plus method. This also applies to unsecured group loans, regardless of whether they were granted by the parent company or by another group company acting as a financing company.
2. Credit rating: When assessing creditworthiness, it is not the average creditworthiness of the entire Group that is decisive, but the creditworthiness of the individual Group company, which is assessed on the basis of a "stand-alone" rating. Group backing that is not supported by legally binding purchase obligations of other Group companies should only be taken into account if an external lender would attribute a higher creditworthiness to the Group company that exceeds the "stand-alone" creditworthiness of the company.
3. Subordination of shareholder loans: When determining the arm's length interest rates for an unsecured shareholder loan, the statutory subordination of shareholder loans (section 39 (1) no. 5 InsO) does not prevent the interest rate from being adjusted to compensate for the lack of collateral.
4. External comparability: An external third party would hardly accept the same interest rate for a subordinated and unsecured loan as for a secured and senior loan; this is contrary to experience. An unrestricted comparison of group loans with bank loans can therefore be regarded as erroneous.

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Further requirements according to the judgment

As part of the ruling, the Federal Fiscal Court clarified that the interest rate charged for a group loan should correspond to the interest rate that would also be agreed for a comparable loan between independent third parties. Particular attention must be paid to the amount of the loan, the term, the type of loan (e.g. fixed-rate loan or variable-rate loan), the collateral and the creditworthiness of the borrower.

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Wrapping It Up

The BFH rulings from May 2021 have set out a clear line on how market interest rates for group loans and shareholder loans are to be determined. The price comparison method is in the foreground and should always be preferred, while the creditworthiness of the individual company and not that of the entire group should be assessed. These rulings provide important guidance on the tax treatment of group loans and contribute to clarity and legal certainty in this area.

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