Tax interest deduction is now more difficult (Section 1 (3d) of the Foreign Tax Act)

For taxpayers — including those with existing intragroup loans — the new transfer pricing rules create additional tax risks and further documentation requirements. At the same time, the legislative is going against the recent case law of the Federal Fiscal Court on intragroup financing. The new rules partly deviate from and partly conform with the Administrative Principles on Transfer Pricing 2023 and the OECD Transfer Pricing Guidelines 2022. We considerably doubt the constitutionality of the new rules and their conformity with EU law.

1. Content of the new rules

The tax deduction of interest expenses for cross-border intragroup loans and similar instruments is generally not recognized. The domestic debtor company can avoid this if and to the extent that it fulfills two conditions:

1. The debtor company must demonstrate that:
   1. It could have paid the debt service for the entire financing term from the beginning.
   2. It needs the financing economically.
   3. It uses the financing for the purpose of the company.

If the debtor company cannot credibly substantiate this, the interest deduction should be denied altogether.

2. The interest expense or the corresponding financing expense may not be higher than the interest rate at which the group could finance itself on the external market. The deduction of operating expenses is rejected in part. The deduction does not apply as far as the interest rate for the intragroup loan is higher than an interest rate in accordance with the group rating. In such a case, the domestic debtor company can maintain the deduction of operating expenses. It must prove that a rating for the company itself derived from the group rating is in line with the arm's length principle.

2. Time of application

The rules will apply from the 2024 assessment or tax period. There is unlikely to be grandfathering for loans that were agreed before 2024. Furthermore, according to the explanatory memorandum to the new rules, this is an interpretation of the arm's length principle within the meaning of Section 1 (1) of the Foreign Tax Act. We have already seen the approaches now written into the law in past tax audits. Tax court proceedings on the methods of determining the interest rate for intragroup loans are pending, some of which we have represented.

Financing companies, cash pool management and treasury as low-risk services (Section 1 (3e) of the Foreign Tax Act)

1. Content of the new rules

The new rules classify the raising and intragroup transfer of loans by a financing company, cash pool management as well as currency and liquidity management as low-risk services. The legislative only recognizes a cost-plus fee as remuneration. This is calculated based on the administrative and operating costs excluding financing and interest costs and a profit markup of generally 5% to 10%. Companies can only claim a higher fee for such activities if, based on a functional and risk analysis, they can prove that the activities performed are not low-risk services. The intention is to shift the burden of proof to the taxpayer. The actual financing costs of the financing company are only to be passed through in the amount of a "risk-free return" without a markup.

2. Time of application

This regulation will also apply from the 2024 assessment or tax period. There is no grandfathering for existing business relationships. Furthermore, according to the explanatory memorandum to the law, this is an interpretation of the arm's length principle within the meaning of Section 1 (1) of the Foreign Tax Act. Also for tax periods prior to 2024, taxpayers should expect tax authorities to attempt to reclassify financing activities as low-risk services. We have already encountered this legal view in tax audits in the past.

Comments and general recommendations for action

The topic of intragroup financing is likely to be addressed even more in tax audits. Both Section 1 (3d) and Section 1 (3e) of the Foreign Tax Act do not formally apply to assessment or tax periods prior to 2024. As an interpretation of the arm's length principle, the tax authorities will nevertheless attempt to apply and enforce the corresponding legal views to preceding periods as well.

Intragroup loans and similar financing relationships should be reviewed in the context of the new rules and restructured if necessary. Transfer pricing documentation should be revisited, either to be fully compliant or to provide the best possible defense in tax audits.

For assessment and tax periods from 2024 onward, the situation changes to the detriment of taxpayers. The new rules largely place the burden of proof on taxpayers. It is up to the taxpayers to validate deductions for interest or remunerations in excess of cost-plus fees. Precautionary documentation of the loan circumstances (e.g., creditworthiness, use of funds, business case) as well as the functions and risks of the parties involved will be crucial.

Companies should assume that the tax authorities will also increasingly scrutinize inbound financing relationships and attack interest deductions for assessment and tax periods prior to 2024.

Taxpayers may well have prospects of success in tax controversy. Section 1 (3d) of the Foreign Tax Act reverses the rule-exception-relationship for determining debtor rating. Both the Federal Fiscal Court (in particular, the ruling of 18 May 2021 — I R 4/17 (para. 43/44)) and the OECD Transfer Pricing Guidelines 2022 (Chapter 10) consider a standalone rating as the starting point or default approach. A group rating should only be used in individual cases. This view was essentially followed by the tax authorities in the Administrative Principles on Transfer Pricing 2023 (para. 3.126). Section 1 (3d) of the Foreign Tax Act now makes use of the group rating as the standard approach. A different rating can only be used after special substantiation, and then only a rating derived from the group rating. Therefore, strictly speaking, a standalone rating is no longer permitted.

Section 1 (3e) of the Foreign Tax Act provides that finance activities are generally to be classified as low-risk/low-value services. If the taxpayer wants a different classification, it must validate this on the basis of a functional and risk analysis. The generality of presuming low-value services goes beyond the OECD Transfer Pricing Guidelines 2022.

The new rules de facto reverse the burden of proof to the detriment of taxpayers in sections and intend to combat abusive structures in a standardized way. Both legislative intents are constitutionally only justified if high thresholds are met. We doubt that. There are also serious doubts whether the rules comply with EU law. Further, in a given case, nondiscrimination principles may also be relevant in relation to the US. In tax treaty cases, it should be checked whether the profit adjustment article (corresponding to Article 9 OECD Model Tax Convention) blocks profit adjustments based on Sections 1 (3d) and 1 (3e) of the Foreign Tax Act.

Taxpayers should also keep an eye on existing statutes bearing on intragroup finance. This includes, in particular, the interest barrier rules (Section 4h of the Income Tax Act, Section 8a of the Corporate Income Tax Act) and special regulations for the deduction of business expenses in the event of tax mismatches (Section 4k of the Income Tax Act). Current efforts at EU level can be expected to further complicate the legal situation.

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