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Freshfields Risk & Compliance

| 9 minutes read

Fifteen years after introducing the “trend setting” interest barrier rule, German Finance Ministry proposes further interest cap rule

The German Federal Ministry of Finance (BMF) recently released the draft “Growth Opportunities Act” (Wachstumschancengesetz). If enacted, it would provide for numerous changes to the German corporate tax landscape. Most of the changes lower the tax (compliance) burden of companies. However, the proposed change that has attracted the most attention in the German tax community is the introduction of the so-called “interest cap rule” that would limit the deductibility of interest expenses beyond the existing interest barrier rule and transfer pricing rules. 

Introduction of interest rate cap 

Back in December 2021, the German governing parties negotiated – very abstractly – the introduction of an interest rate cap (Zinshöhenschranke) as part of the coalition agreement. Within the draft bill, a new Section 4l German Income Tax Act (EStG) provides the first indications of how the German legislator envisages the design of such an interest rate cap. However, what remains open is which supposedly “aggressive tax structures” the German legislator wants to prevent with this new rule and whether the exceptions to the rules embedded in the draft law are appropriately targeted for achieving this presumed goal.

In a nutshell, the interest rate cap is aimed at limiting the deduction of interest expenses resulting from business relationships between related parties (within the meaning of Section 1 para. 2 German Foreign Tax Act (AStG)) to 2% above the applicable base rate (meaning the current limit would be 5.12%). In order to prevent – according to the German legislator – aggressive arrangements involving foreign FinCos without substance, the proposed new interest rate cap would limit the deduction of interest expenses in these (cross-border) cases to an “appropriate amount”. According to the draft bill, this “appropriate amount” reflects the maximum deductible interest expense and is calculated by adding 2% to the base rate according to Section 247 German Civil Code.

The draft bill foresees two exceptions to the application of the proposed new interest rate cap:

1) Higher FinCo and group re-financing rates: Higher interest rates than the above outlined maximum rate are deductible, if both the FinCo (acting as lender) and the ultimate parent company (within the meaning of the draft German Pillar 2 bill) can only refinance at higher interest rates. As a result, the most favourable financing alternative under comparable circumstances should be decisive.

2) Substance: If the FinCo (acting as lender) is engaged in substantial economic activities within the meaning of German Foreign Tax Act (which requires material and personnel resources, sufficiently qualified staff, independent and autonomous exercise of activities and no outsourcing) and the FinCo is not resident in a non-cooperative state, higher interest rates above the outlined maximum rate are deductible.

Setting the scene: German tax authority vs. German Federal Fiscal Court

According to the German legislator, the introduction of an interest rate cap is particularly required because of recent case law of the German Federal Fiscal Court (BFH) considering application of the arm’s length regulations to determine an appropriate interest rate for cross-border intercompany loans. By way of background, in 2021 the BFH concluded that when determining arm’s length loan interest rates, it must be examined whether the comparative values can be determined using the price comparison method (or “CUP method), before applying the so-called cost-plus method. Moreover, when assessing creditworthiness, the BFH took the view that it is not the average creditworthiness of the group as a whole that is decisive, but rather the creditworthiness of the group company taking out the loan (that is, a "stand alone" rating). This approach aligns with the approach set out in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the OECD TP Guidelines).

According to the German legislator, the BFH’s approach of “only” considering the financial strength of the company paying the interest to determine an arm’s length interest rate opens up structuring possibilities that are used to shift profits to low-tax foreign countries, notwithstanding the BFH’s approach follows the widely agreed OECD TP Guidelines. By way of further background, in December 2019, the German tax authority had published a draft bill to implement certain EU Anti-Tax Avoidance Directive (ATAD) regulations. A new Section 1a AStG in this draft bill included a proposal to restrict the tax position regarding financing transactions. Some aspects of these highly controversial regulations included in the draft bill at the time – which were ultimately never implemented – still made their way into the updated German Transfer Pricing Administrative Principles 2021.

German tax authorities second attempt regarding “aggressive tax structurers” 

In particular, in para. 3.92 of the German Transfer Pricing Administrative Principles 2021, the German tax authority took the view that the deduction of interest expenses in the case of a domestic group company receiving intercompany loans from another foreign group FinCo with a limited functional and risk profile may in general not exceed a “risk-free” interest rate. In these cases, the FinCo should, according to the view of the German tax authority, only be entitled to receive remuneration based on the cost-plus method – noting, however, that the cost-plus method does not require refinancing costs to be included in the cost base.

Figures 1 and 2 below illustrate the “baseline scenario” of example in para 3.92 of the German Transfer Pricing Administrative Principles 2021 with and without the envisaged changes by the German tax authority to the transfer pricing approach as further detailed below:

  • Figure 1 illustrates the “baseline scenario” without envisaged changes by the German tax authority to the transfer pricing approach: FinCo with limited functional and risk profile provides an intercompany loan to T-AG and in return receives an arm’s length interest rate of 8% (determined via CUP-method) and interest expenses are fully deductible in Germany; and
  • Figure 2 illustrates the “baseline scenario” including envisaged changes by the German tax authority to the transfer pricing approach: Instead of receiving an arm’s length interest rate of 8%, FinCo should only receive a cost-based remuneration (100k EUR in this example) for providing the intercompany loan to T-AG, consequently limiting interest expense deductibility at level of German T-AG to this amount. This ultimately leads to double taxation.

Figure 1: Baseline scenario – FinCo no substance

Figure 2: Baseline scenario – FinCo no substance – proposed changes German tax authority and assumed consequences

Third act: New German Transfer Pricing Administrative Principles 2023

The German Transfer Pricing Administrative Principles were further updated in 2023, however, the relevant BFH 2021 case law outlined above was only partially adopted in this update. Notably, the BFH’s clear guidance identifying the CUP method as the preferred method for assessing the arm’s  length nature of financial transactions was not included. However, the controversial example in para. 3.92 outlined above was deleted. Nevertheless, the question remains whether this is still the “baseline scenario” (figures 1 and 2 above) the German legislator had in mind while drafting the new interest rate cap rules and trying to prevent “aggressive tax structures”.

Missed turning point? 

The German legislator’s thinking behind necessary adjustments to existing tax/transfer pricing rules to prevent aggressive tax structures may be well supported by the general view that remuneration should be aligned with the functional and risk profile of the respective companies, which is widely agreed amongst OECD member countries. Companies assuming and controlling the risk and performing the associated functions should be remunerated accordingly. However, how a correction in such cases is to be achieved according to the German legislator – namely by limiting the interest deduction of a domestic group company as borrower – as previously stated in para 3.92 German Transfer Pricing Administrative Principles 2021 and now envisaged by the interest rate cap, appears very problematic. This is particularly the case given there is already a solution to this problem: as per the OECD TP Guidelines as well as the guidance from the BFH, if all personnel and risk control functions are assumed by M-AG in this baseline scenario, no limitation of the interest deduction at level of T-AG is to be assumed. Rather, a separate transaction between M-AG and FinCo may be considered regarding the “services” rendered by FinCo, ultimately leading to an appropriate remuneration of M-AG (as well as FinCo) according to its functional and risk profile (and ultimately the taxable income will be allocated to Germany). This proposed solution according to the OECD TP Guidelines as well as BFH is illustrated in figure 3 below.

Figure 3: Proposed solution according to OECD TP Guidelines and BHF case law

Figure 4: Proposed solution according to new interest rate cap rules by German tax authority

In summary, both, the OCED TP Guidelines as well as recent BFH case law provide that the remuneration for control and risk-taking should ultimately be allocated to the entity actually performing these functions (e.g. via a new transaction between FinCo and M-AG). In contrast, it appears that the German legislator – still – intents to effectively “correct” remuneration of the FinCo that the German legislator perceives as not aligned with the function and risk profile of that FinCo, at level of the borrower (T-AG – see illustration in figure 4 above). The proposed intervention of the German legislator is even more questionable assuming that: (i) if one would otherwise simply follow BFH case law; and (ii) even if the intercompany loan would be provided from a FinCo with no substance being located in a low-tax country, ultimately the taxable base would still be allocated to Germany (as M-AG needs to be remunerated for actually controlling the risk and performing all associated functions from FinCo). Does this really represent an “aggressive tax structure” as envisaged by the German legislator?

Questionable design of exception rules

However, the exemptions of the application of the interest rate cap also seem – at a first glance – not suitable in order to achieve the goal of the German legislator of preventing “aggressive tax structures”. Aligning the permitted interest deductibility with the refinancing rates of both the FinCo and the ultimate parent company may lead to a situation whereby only one group-specific interest rate will be permitted. This will most likely be based on the credit rating of the group (i.e. the ultimate parent company), as the FinCo with (allegedly) no substance will most likely only be able to refinance at higher rates. This may in turn lead to a situation where the functional and risk profiles of all involved companies become irrelevant for determining an appropriate interest rate and therefore no improvement to align the remuneration, value creation and risk control approach occurs. Moreover, a FinCo with substance, which is not resident in a non-cooperative state might still have preferable tax regimes for interest rate income.

If the German legislator wants prevent “aggressive tax structures” – whereby “aggressive” is characterised by no or limited taxation of interest income – it seems more “straightforward” to design the interest rate cap as a “subject to taxation” rule without “hiding” behind transfer pricing principles.

What's next?

The proposed introduction of an interest rate cap reflects a far-reaching intervention of the German legislator in the application of the arm’s length principle as agreed amongst the OECD member countries regarding financial transactions. Multinational companies with presence in Germany should watch out for further developments on this proposal, as it could have a major impact on interest rate deducibility in Germany. A definitive timetable for the legislative process to introduce the interest rate cap is not yet available, but with the planned enactment of the law on 1 January 2024, we are expecting further in-depth discussions on this topic very soon and will provide further updates in due course.

Please get in touch with the authors or your usual Freshfields contacts if you would like to discuss the issues discussed in this blog post in more detail.


transferpricing, europe, financing and capital markets, regulatory, tax