In the Hornbach-Baumarkt case, a German parent company guaranteed loans of two related companies for no remuneration. The German tax authorities made an assessment of the amount of income allocated to the parent company as a result of the guarantee, based on the fact that unrelated third parties, under the same or similar circumstances, would have agreed on a remuneration for the guarantees. Hornbach-Baumarkt argued that German legislation was in conflict with the EU freedom of establishment and lead to an unequal treatment of domestic and foreign transactions since, in a case involving german domestic transactions, no corrections to the income would have been made for guarantees granted to subsidiaries. The company further argued that the legislation is disproportionate to achieving the objectives as it provides no opportunity for the company to present commercial justification for the non-arm’s-length transaction.
The German Court requested a preliminary ruling from the European Court of Justice on these arguments.
In May 2018 The European Court of Justice concluded that German transfer pricing legislation is consistent with EU freedom of establishment. Moreover, the Court ruled, that a parent company’s position as a shareholder of a non-resident company may be taken into account in determining whether there is sufficient commercial justification for a non-arm’s length related-party transaction.
The Court further stated that transfer pricing legislation inherently constitutes a restriction to the freedom of establishment. However, this restriction can be justified by the need to preserve a balanced allocation of taxing rights between the Member States. The goal of the transfer pricing legislation is to prevent profit shifting via transactions that are not in accordance with market conditions.
German legislation does not go beyond what is necessary to attain the objectives relating to the need to maintain the balanced allocation of the power to tax between the Member States and to prevent tax avoidance, without being subject to undue administrative constraints, to provide evidence of any commercial justification that there may have been for that transaction.
The Court concluded that the income adjustment made by the German tax authorities was limited to the portion of the income which exceeded what would have been agreed between unrelated companies.
The concept of Commercial justification may include economic reasons resulting from the very existence of a relationship of interdependence between the parent company resident in the Member State concerned and its subsidiaries which are resident in another Member State. A parent company has sufficient commercial reason to provide capital on non-arm’s-length terms to a subsidiary when a subsidiary lacks sufficient equity capital to expand. Therefore, the Court stated that comfort letters containing a guarantee free of any remuneration might be commercially justified because the parent company is a shareholder of the foreign group companies, which would justify the transaction at issue under non-arm’s-length terms.
(In three later German cases dated 27 February 2019 (I R /73/16, I R 51/17 and I R 81/17) ) the Bundesfinanzhof took a new position on the application of the arm’s length principle in relation to tax deductions for write-off of intercompany receivables. In past decisions the BFH had ruled that, under article 9(1), the application of the transfer pricing rules was limited to the determination of the interest rate on intercompany loans. However, in these later cases the BFH held that the scope of transfer pricing now also comprises losses from the impairment or waiver of receivables.)
European Court of Justice Judgment in Hornbach-Baumarkt case, Case No C-382/16Germany vs HornbachBaumarkt AG 31 May 2018 JUDGMENT OF THE COURT Case No C-382-16