Germany’s Growth Opportunities Act, applicable as of Jan. 1, highlighted a disparity between the German legislature’s application of the arm’s-length principle for intra-group financing versus OECD transfer pricing guidelines for multinational companies and tax administrations. This has created substantial uncertainty for multinationals, leaving many unresolved questions about application of the new tax legislation.

Germany’s finance ministry in August released draft updates to existing German transfer pricing guidelines. These include practical clarifications for taxpayers on applying the arm’s-length principle to intra-group financing and largely overturn the previous unilateral approach of the German legislature.

As a result, application of the German arm’s-length principle to intra-group financing should be more closely aligned with Organization for Economic Cooperation and Development guidelines, reducing the risk of non-deductibility of interest expenses in Germany. But the group rating is one notable exception.

Pursuant to the Growth Opportunities Act, companies must be able to show they can service the loan for the entire duration of the intra-group financing arrangement from the outset—and that the financing is economically necessary and used for business purposes. In this regard, the draft updates clarify that:

• Refinancings are deemed arm’s length, meaning full debt capacity doesn’t need to be demonstrated at the outset of intra-group financing
• Borrowing for profit distribution generally doesn’t conflict with the company’s objectives and business purposes
• Short-term investments of a “capital buffer” in intra-group cash pools may be considered arm’s length under certain conditions, such as capital buffers required for acquisition financing
• High-risk financing, such as in the startup sector, isn’t inherently contrary to the arm’s-length principle

The draft further clarifies that the German rules apply to cross-border intra-group financing agreements made after Jan. 1, 2024, and those significantly modified or extended beyond Dec. 31, 2023. For arrangements established before Jan. 1, 2024, the rules will only apply from 2025 if the financing agreement extend beyond Dec. 31, 2024.

In cases of non-compliance, the draft says interest expenses are non-deductible only to the extent they exceed the arm’s-length portion, rather than being entirely non-deductible. This is consistent with OECD guidelines but hasn’t yet been explicitly clarified in the respective German legislation.

CUP Method Preferred

The draft confirms the comparable uncontrolled price, or CUP, method is Germany’s preferred approach for determining arm’s-length interest rates for cross-border intra-group financing transactions. It also emphasizes that the ability and authority to control or bear the risk of the financing transaction are key factors in deciding which entity should ultimately receive the interest income.

This clarification was crucial, because the German legislature broadly classifies intra-group financing activities as routine functions with low associated risks to be compensated using a cost-plus method.

But it was unclear whether the German legislature intended to use the cost-plus method to determine the overall arm’s-length interest rate, which would contradict the OECD’s view, or whether the cost-plus method was meant “only” for compensating what the German legislature considers routine financing activities.

Group Rating

The OECD transfer pricing guidelines generally rely on the borrower’s standalone creditworthiness to determine an arm’s-length interest rate, an approach confirmed by the German federal fiscal court in 2021. In contrast, the German legislature generally uses the entire group rating to determine an arm’s-length interest rate. As these two approaches could support different appropriate arm’s-length interest rates, following the group rating approach could lead to disputes with countries following the OECD recommended stand-alone approach.

Unfortunately, the draft updates maintain this group rating approach, continuing the discrepancy with the OECD. However, the updates provide additional guidance on determining group ratings by outlining a review hierarchy: ratings intended for publication; non-published ratings; group ratings determined via rating software; and for simplification, ratings based on the group’s financing costs relative to third parties.

What’s Next

Overall, the proposed clarifications in the draft updates to German transfer pricing guidelines are welcome, as they align the application of the arm’s-length principle for intra-group financing in Germany more closely with OECD transfer pricing guidelines.

Continuing to use a group rating approach will lead to future disputes, however, as it isn’t aligned with the OECD’s view. The draft updates’ comment period closed Sept. 6. It isn’t yet clear which amendments included in the draft updates will ultimately be adopted.

Philipp Redeker is an attorney, tax adviser, and partner at Freshfields Bruckhaus Deringer.

Viktoria von Abel is an economist, tax adviser, and principal associate at Freshfields Bruckhaus Deringer.

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