Two changes to the German Foreign Tax Act (Außensteuergesetz – AStG) will affect the treatment of intercompany cross-border financing transactions for tax periods from 2024. This post summarizes the new rules.

After several attempts, the Growth Opportunities Act (Wachstumschancengesetz) came into force on 28 March 2024. In comparison to the original draft bill, the scope of the final version was greatly reduced. In particular, the interest deduction ceiling was not adopted. Nevertheless, amendments were made to Section 1 of the Foreign Tax Act (AStG) that affect the treatment of intercompany financing transactions starting from the 2024 tax period. A new subsection 3d sets out criteria for the tax deductibility of interest expenses, which must now also be based on or derived from the group rating, while a new subsection 3e generally follows the 2022 OECD Transfer Pricing Guidelines concerning limited-risk financing activities within the group.

Effects on intercompany financing transactions

The new subsection 3d stipulates that, in the case of intercompany cross-border financing transactions with a domestic borrower, income-reducing interest expenses are only at arm’s length if the taxpayer provides evidence that:

  • The debt (both principal and interest) can be serviced over the entire term from the outset (debt sustainability test), and
  • The financing is economically necessary and is for the purpose of the enterprise (business purpose test).

Furthermore, the interest rate for intercompany cross-border financing may not be higher than the interest rate at which the group can finance itself from third parties, unless it can be proven in each case that a credit rating that differs from the group rating – but which is still derived from the group rating – would be at arm’s length. This shifts the burden of proof completely to the taxpayer. With this definition, the legislature appears to be implying that only the group’s external interest rate meets the arm’s length principle. It thereby assumes that unrelated third parties would only ever demand this interest rate as the maximum risk compensation, irrespective of the borrower’s individual credit risk. 

The new subsection 3e is mostly based on the recommendations of Chapter X of the OECD Transfer Pricing Guidelines 2022. This subsection lays down that intercompany financing activities only involving the forwarding and mediating of financing transactions within the group should be deemed limited-risk services. This primarily concerns pass-through loans and cash pool structures. An exemption clause allows taxpayers to demonstrate that the financing entity performs more complex functions and bears more risks.

Potential for conflict in tax audits

We see potential for conflict in upcoming tax audits, particularly with the rules of subsection 3d. To counter conflicts relating to the debt sustainability test, we recommend that credit ratings should in future no longer be determined purely on historical data but also on budget data or projections. Ideally, the budgets should cover the entire term of the loan. However, in practice, this will only be possible for short or medium-term loans. Furthermore, we recommend discussing the business purpose test in more detail in the transfer price documentation, i.e., demonstrating the arm’s length nature of the loan itself.

If the interest rate is not determined on the basis of the group rating, we recommend calculating the interest rate based on the group rating as well, in order to estimate the risk from significant differences between the two. When risk exposure cannot be reconciled between the group and stand-alone ratings, it is likely that a rating derived from the group rating (e.g. by way of a simplified notching approach) will not match the risk assessment made by third parties. This could be the case, for instance, for a diversified multinational group (group rating) and an intragroup single-project company that has high operational risks (stand-alone rating).

Documenting the facts and circumstances at hand and deriving the rating

Since the explanatory memorandum to the act does not contain any further information, it is currently unclear how these potentially wide-reaching rules and the exemption clause for individually-derived ratings are to be interpreted. This particularly applies to the question of how much an individual stand-alone rating may deviate from the group rating and still qualify as a “derived” rating as defined by the legislation. We recommend documenting both the circumstances of the individual case and the derivation of the rating in detail, otherwise there is a risk that a tax auditor will adjust the arm’s length interest rate to match the interest rate on the group’s external funding.