Back to square one? Latest news regarding the proposed German interest cap rules

In August 2023, the German legislator proposed the introduction of a new German interest cap rule (Zinshöhenschranke) that would impact the deductibility of interest expenses beyond the existing German interest barrier and transfer pricing rules (see our previous blog post). Over the last few weeks, this proposal has been deliberated by the committees of the German Federal Council (Bundesrat) and resulted in the publication of the position paper of the German Federal Council on 20 October 2023. 

By way of reminder, the interest cap rule itself was proposed as part of the larger “Growth Opportunities Act” (Wachstumschancengesetz). Various aspects of this draft bill have been subject to lively public debates. Due to its classification as a “Consent Act” (Zustimmungsgesetz), the draft bill needs both the consent of the German Federal Parliament (Bundestag) as well as the German Federal Council in order to be enacted. 

“Recycling” of unsuccessful ATAD rules from 2019

Focusing only on the interest cap provisions in the draft bill, the current proposals of the two German regulatory bodies could not be further apart. The German Federal Council’s recent position paper completely rejects the introduction of an interest cap rule as proposed by the German legislator. However, the position paper goes on to suggest implementing additional new regulations regarding the tax treatment of intercompany financing transactions. When reviewing this recent position paper, informed readers might have noticed the striking similarities of these proposed changes with the draft bill published in 2019 to implement certain provisions of the EU Anti-Tax Avoidance Directive (ATAD). 

Four years ago, the German legislator wanted to implement a new Section 1a German Foreign Tax Act (AStG) that included proposed provisions to limit the tax deductibility of financing transactions in certain circumstances, but this was ultimately never implemented. It appears that in its latest commentary responding to the proposed interest cap rule, the German Federal Council has essentially recycled this proposal with “only” one major modification: in this latest version no treaty override is incorporated. As such, the latest proposed changes (as new Sections 1 para. 3d and e AStG) would “only” act to further develop the application of arm’s length principle as codified in Section 1 AStG (i.e. the transfer pricing rules) for financial transactions.  

If enacted, both proposals (i.e. the interest cap rule proposed by the German Federal Parliament and extended transfer pricing rules proposed by the German Federal Council) will impact intercompany financing transactions. While no definitive implementation timetable has been announced, the planned date for enactment of the law remains 1 January 2024. To help prepare for this, key points regarding each proposal are summarised below: 

Proposal 1: Interest cap rule

• Source: Proposed by German legislator as part of the draft “Growth Opportunities Act” (Wachstumschancengesetz), subsequently discussed in the German Federal Parliament and subject to relatively minor adjustments since the first publication in August 2023.
• Legislative reference: Located within the “general” German tax regulations on the determination of profits (i.e. new Section 4l German Income Tax Act (EStG)) after the existing interest barrier rules.
• Scope: Intended to apply to domestic as well as cross-border financing arrangements between related parties.
• Proposed rule: Interest expenses are not deductible if they are based on an interest rate above the maximum rate. This maximum rate is determined by the base interest rate according to § 247 BGB, which is updated semi-annually and currently set at 3.12%, plus 2%. A higher interest rate, i.e. an interest rate higher than the current maximum rate of 5.12% (3.12% + 2%), is only deductible if one of the following two “escapes” is satisfied:
  1. Escape 1 (refinancing rates):

a. The ultimate parent company (within the prescribed in the Pillar 2 rules) could, all other things equal (ceteris paribus), only refinance at higher rates; and 

b. The relevant group financing company (FinCo) could, ceteris paribus, only refinance at higher rates. 

Noting that evidence for items (a) and (b) above needs to be provided, which could, for example, be in the form of database studies, but it is expressly provided that bank offers are not regard as sufficient for these purposes.

  2. Escape 2 (substance):

a. FinCo engages in significant economic activity in the context of the financing transaction; and

b. FinCo is not resident in a non-cooperative state (within the meaning of Tax Heaven Defence Act).

For these purposes, detailed functional and risk (F&R) analysis must be completed that demonstrates that actual risk control as well as decision-makers with the necessary experience, competence and information base are located within FinCo.

• Comments: This proposed interest cap rule has been heavily criticised in commentary on the proposed rules as regards the following main points:

1. The proposed interest cap rule does not represent a “safe harbour rule”, implying that further adjustments via transfer pricing regulations remain possible, even if the maximum interest rate is adopted by companies.
2. Linking the interest rate cap to the base rate according to § 247 BGB rather than the EURIBOR rate, which is often considered as the reference rate in intercompany financing transactions, restricts this rule even further: in recent years, the proposed base rate in § 247 BGB has always been significantly lower than the EURIBOR rate, implying that the “plus 2%” has to be significantly lower, where EURIBOR is used as the reference rate to determine the intercompany interest rate in line with the proposed interest cap rules.  
3. Controversial para 3.92 of the “old” German Transfer Pricing Administrative Principles 2021 has only recently been adapted to reflect the current German case law (by way of reminder: para. 3.92 proposed a C+ remuneration for a FinCo with a limited F&R profile). According to this recent German case law, the price comparison (CUP) method is to be applied, irrespective of the F&R profile of the FinCo. Therefore, no longer following the C+ logic was seen as a step towards the OECD understanding. In contrast, the proposed interest cap rule now aims to undermine the CUP method, by simply limiting interest deductibility in scenarios with FinCos operating limited F&R profiles. This is viewed as an unhelpful approach, particularly as recent German case law and OECD Transfer Pricing Guidelines already envisage a “solution” on how to deal with these cases, that is, firstly, the application of a “normal” CUP method followed by a “new transaction” between FinCo and the actual risk taker, to allocate appropriately the remuneration in line with the actual F&P profiles of the involved companies. 
4. No grandfathering for existing contracts is proposed. Further it is unclear what evidence and/or documentation is required in order to apply the escape rules. 

Proposal 2: Extended arm’s length principle rules for financing transactions

• Source: Response of the German Federal Council to the draft bill of 20 October 2023. This is viewed as a “revival” of the proposed Section 1a AStG from ATAD initiative in 2019 (which was rejected at the time) with some minor additions (as discussed below), and importantly is no longer structured as a treaty override.    
• Legislative reference: Located within the “general” German transfer pricing rules. As such, the proposed changes as new Sections 1 para. 3d and e AStG would act to further develop the application of arm’s length principle as codified in Section 1 AStG for financial transactions.  
• Scope: Intended to “only” apply to cross-border financing arrangements between related parties.
• Proposed rule (new Section 1 para. 3d AStG): Interest rates on intercompany financing transactions will not be in accordance with the arm’s length principle according to Section 1 AStG if:
  1. no proof of debt service capacity can be provided (for example in the form of debt-capacity analysis); and
  2. the taxpayer cannot credibly demonstrate that financing is economically needed and used for the purpose of the enterprise; or
  3. using a group rating, ceteris paribus, would not lead to a lower interest rate.
• Proposed rule (new Section 1 para. 3e AStG): Financing activities regularly represent “routine” services if:
  1. FinCo only arranges the financing transaction; or
  2. FinCo is only responsible for “passing-on” the financing. This would be assumed in cases where FinCo is only engaged in liquidity management, financial risk management or currency risk management.

This classification as “routine” services (i.e. requiring a C+ remuneration, for which the draft proposal foresees 5–10% on directly attributable costs plus the refinancing rates with a risk-free return, instead of the application of a CUP method) should not apply where detailed F&R analysis is provided.

• Comment: The proposed new Section 1 para. 3d AStG regarding the economic reasoning as well as the debt-capacity analysis broadly aligns with the OECD view regarding the analysis of intercompany financing transactions. Whereas the introduction of a “presumption” of financing activities as “routine” services under the proposed new Section 1 para. 3e AStG may been seen as a step backwards and not aligned with the OECD’s view. In addition, focusing on the group rating rather on the stand-alone rating of the FinCo does not align with the OECD’s approach. However, it is welcomed that these proposed new rules are no longer structured as a general treaty override.

What’s next?

In terms of next steps, the German legislator/German Federal Parliament are expected to present their position on the proposals made by the German Federal Council on 17 November 2023. Where the requests put forward by the German Federal Council are not addressed, it is likely that the Mediation Committee will become involved with the aim of negotiating a solution between both parties. 

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