Germany Introduces Stricter Rules on Intra-group Financing
Germany Introduces Stricter Rules on Intra-group Financing
Changes to the Foreign Tax Act
Germany recently introduced comprehensive changes to its intra-group financing rules, which have already come into force on 1 January 2024. The new principles earmark stricter regulation on the tax deductibility of interest expenses on intercompany financial transactions. These limitations are designed to prevent profit shifting through excessive interest deductions.
New Regulations
The new regulations are a part of the of the Growth Opportunities Act of 27 March 2024, and, with the new section 1, paragraph 3d of the Foreign Tax Act (“AStG”), reinterpret the arm’s length test for financial transactions. Additional rules for low-function foreign financing entities are introduced in section 1, paragraph 3e AStG. These new rules are aimed at inbound financing but are intended to also be applicable to outbound financing transactions.
The transition and non-objection periods for older contracts were originally not earmarked. However, with the Annual Tax Act 2024, they have been rectified.
Finally, on 12 December 2024, the Administrative Principles on Transfer Pricing 2024 (VWG) were published, which, as part of an addition to Chapter J on financing relationships, provide the German tax authorities' perspective on the application of the new regulations.
The planned regulations for an interest rate ceiling have not been implemented. The existing interest limitation rules (section 8a of the Corporate Tax Act, section 4h of the Income Tax Act) remain in force.
New Arm’s Length Test for Cross-Border Intra-group Financing
The new rules of section 1 paragraph 3d AStG require a much more detailed analysis for cross-border intra-group financial transactions to be considered arm’s length. The following conditions must be met:
- The interest rate has to be determined based on the group rating. It is also possible to demonstrate that a rating derived from the group rating complies with the arm’s length principle.
- It has to be proven that the financing is economically necessary and serves a business purpose.
- A debt capacity test has to be documented, covering both interest payments and repayment (ex-ante cash flow test).
The conditions listed above have to be met and documented, thereby further increasing taxpayers’ compliance obligations. Even though the rules describe the necessary steps, possible penalties for non-compliance are not explicitly mentioned in the law. A reclassification of debt as equity would be a possible sanction, but this would probably not be in line with the law’s intention. According to VWG, an income adjustment due to the (partial) non-recognition of interest expenses is the tax consequence.
Low-Function Foreign Financing Entities
The new regulations also target limiting the remuneration of foreign financing companies in certain cases. According to section 1, paragraph 3d AStG, a foreign financing company is considered to have a low-function and low-risk activity if one of the following conditions is met:
- The financing is arranged for another group company.
- The financing is forwarded on to another group company.
- Services such as cash pooling, financial risk management, currency risk management, or financing are provided.
It is, however, possible to provide evidence that the foreign entity’s function and risk profile indicates that the activity is not a low-function and low-risk service. Again, the new rules increase taxpayers’ compliance obligations.
It remains unclear what consequences these new provisions might have. A plausible approach would be to compensate such low-function and low-risk services using the cost-plus method (excluding financing costs from the cost base). However, this does not answer the question of where and how any remaining portion of the remuneration should be allocated.
When Does the Law Come into Force?
The new rules are to apply to all fiscal years beginning after 1 January 2024. For 2024, a transitional regulation applies, which was only introduced with the Annual Tax Act 2024. According to this, section 1, paragraph 3d AStG does not apply to expenses incurred by 31 December 2024, if they stem from financing relationships that had been agreed upon with legal effect before 1 January 2024, and whose actual implementation had begun before that date. If existing financing relationships were significantly modified between 31 December 2023, and 1 January 2025, section 1, paragraph 3d AStG does not apply to expenses incurred before such a significant modification.
This implies that new regulations are to be applied to both existing and newly concluded intra-group financing transactions.
Need for Action and Support from BDO
Multinational companies will need to reconsider their intra-group financing strategies and their documentation. It is important to verify whether all intra-group transactions can be justified under the new rules, and whether the interest rates for intra-group loans are arm's length and can be defended in a tax audit. Additionally, the transfer pricing documentation for financial transactions needs to be updated.
With the introduction of stricter regulations, German tax authorities are likely to audit cross-border financial transactions between affiliated companies more closely. Companies should be prepared for more frequent tax checks and inquiries regarding their intra-group financing activities.
The potential impact on your company should be assessed now. Your contact person at BDO is available to help identify any necessary actions. We would be happy to advise and support you here, with colleagues from our specialized departments and, if necessary, through our global network, which is currently active in 166 countries.