Germany vs Capital GmbH, June 2015, Bundesfinanzhof, Case No I R 29/14

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The German subsidiary of a Canadian group lent significant sums to its under-capitalised UK subsidiary. The debt proved irrecoverable and was written off in 2002 when the UK company ceased trading. At the time, such write-offs were permitted subject to adherence to the principle of dealing at arm’s length.

In its determination of profits on October 31, 2002, the German GmbH made a partial write-off of the repayment claim against J Ltd. in the amount of 717.700 €.

The tax authorities objected that the unsecured loans were not at arm’s length.

The tax authorities subjected the write-down of the claims from the loan, which the authorities considered to be equity-replacing, to the deduction prohibition of the Corporation Tax Act. The authorities further argued that if this was not the case, then, due to the lack of loan collateral, there would be a profit adjustment pursuant to § 1 of the Foreign Taxation Act. Irrespective of this, the unsecured loans had not been seriously intended from the outset and should therefore be considered as deposits. In general, the so-called partial depreciation is not justified because of the so-called back-up within the group.

The Supreme Tax Court has held that a write-off of an irrecoverable related-party loan is not subject to income adjustment under the arm’s length rules, although the interest rate should reflect the bad debt risk.

The Supreme Tax Court has now held that the lack of security does not invalidate the write-off. The lender was entitled to rely on the solidarity of the group, rather than demanding specific security from its subsidiary as debtor. In any case the arm’s length income adjustment provision of the Foreign Tax Act applied to trading transactions and relationships, but not to those entered into as a shareholder. The loans in question substituted share capital and their write-off was not subject to income adjustment on the grounds that a third party would not have suffered the loss. However, the interest rate charged should reflect the credit risk actually borne.

In the meantime, there have been several changes to the relevant statutes. In particular, related-party loan losses can only be deducted if a third party creditor would have granted the finance (or allowed it to remain outstanding) under otherwise similar conditions. Also the Foreign Tax Act definition of “trading” has changed somewhat to bring certain aspects of intercompany finance into the scope of arm’s length adjustments. However, the general conclusion of the court that an arm’s length interest rate must reflect the degree of risk borne by the creditor remains valid

In its judgment of 24 June 2015, the Supreme Tax Court made reference to this case-law in relation to Article IV of the DTT United Kingdom 1964, which corresponds in substance to Article 9 (1) of the OECD MA. Accordingly, the reversal of a write-down of an unsecured loan by a domestic parent company to its foreign subsidiary in accordance with Section 1 (1) of the AStG is not lawful. For the fact that § 1 exp. 1 AStG would be overriding agreement, nothing is evident.

The wording of the law and also the will of the contracting parties of the DTTA do not permit the interpretation on which the BFH bases its judgments. Thus, according to Article 9 (1) of the DBA-USA 1989 and Article IV of the DTT-UK 1964, which correspond in substance to Article 9 (1) of the OECD-MA, according to their wording as a prerequisite for the correction of “profits” of affiliated companies, that “Are bound in their commercial or financial relations to agreed or imposed conditions other than those which would be mutually agreed by independent companies”. In this case, “the profits which one of the undertakings without these conditions has made, but has not achieved because of these conditions, must be attributed to the profits of that undertaking and taxed accordingly.”

On 30 March 2016, the Federal Ministry of Finance issued a non-application decree stating that Article 9 of the OECD Model Tax Convention does not refer to a transfer price adjustment but to a profit adjustment. According to the decree the principles of these two decisions are not to be applied beyond the decided individual cases insofar as the BFH has a blocking effect of DTT standards, which correspond in substance to Art. 9 (1) OECD-MA.

The exclusive limitation of the correction on prices or transfer prices postulated by the BFH can not be inferred either from the wording of Article 9 DTT-USA 1989, Article IV DTT-UK 1964 or Article 9 (1) OECD-MA. The OECD Commentary on the OECD MA explicitly refers to the arm’s length terms and states that Article 9 (1) of the OECD-MA is concerned with adjustments to profits and not a price adjustment.

If in the audit practice a situation is to be examined which corresponds to the facts of the cases of judgment, it must first be ascertained whether the loan relationship is to be recognized for tax purposes (eg no hidden distribution of profits) and whether the conditions are met pursuant to Section 6 (1) 2 sentence 2 EStG for recognizing a write-down on the loan receivable. If there is a loan relationship to be recognized and a partial depreciation should be carried out on the loan receivable pursuant to § 6 (1) (2) sentence 2 EStG , it must be examined whether the application of § 1 AStG in accordance with the BMF letter of 29 March 2011 (BStBl I S 277) means that the taxable person’s income is to be increased by the amount of the depreciation.

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Bundesfinanzhof I R 29-14

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