Interest-free loan within the Group can be economically justified

Lending within the Group

In practice, parent companies regularly grant their (foreign) subsidiaries intra-group loans, for example to expand production. In order for these to be recognised for tax purposes and not lead to off-balance sheet income corrections, the loan relationships must generally be at arm's length.

In the present case (relating to the years 2005 to 2010), the German parent company initially provided its subsidiaries in Romania and Hungary with interest-free, non-repayable loans. The loans were granted for the purchase of land and the purchase of a factory building and to settle VAT debts. No collateral was provided in each case. Both subsidiaries operated as contract manufacturers and exclusively provided assembly services for the parent company.

Opinion of the tax audit and the taxpayer

As part of the external audit, the tax office took the view that the loan agreements were based on conditions that would not have been agreed between independent companies under the same or similar circumstances. A loan agreement would not have been agreed between unrelated parties without interest or without the agreement of collateral. The non-interest-bearing nature of the loan receivables constituted a violation of the arm's length principle of Section 1 (1) AStG, which would result in an income adjustment.

The parent company argued that Section 1 AStG was not applicable as there had been no reduction in the domestic tax base. Rather, the advantage of the subsidiaries' favourable production costs had already been transferred in full to Germany through the structure of the transfer prices for their work services. 

If the parent company had charged interest, this would have resulted in a mirror image increase in the transfer prices not only by the interest expense, but also by a surcharge in accordance with the cost-plus method. As a result, this would even have led to a reduction in the domestic tax base. The financial resources in the form of equity and shareholder loans were a necessary condition for the subsidiaries to be able to fulfil their intended function within the overall company. The granting of the loan was therefore primarily in the interests of the parent company due to plausible, objective economic reasons. 

Non-interest-bearing loan is contrary to arm's length principle

In addition to fundamental statements on the classification of a loan as a business relationship, the Saarland Fiscal Court ruled that the fact that the loans were interest-free - in particular also in conjunction with the lack of collateralisation - was contrary to arm's length principles, so that an off-balance sheet income adjustment pursuant to Section 1 AStG could be made on the basis of domestic law.

With regard to the security under the law of obligations, it also states that the waiver of this security is customary within the group, but not at arm's length. Furthermore, the tax court states that the existence of a profit shift abroad is neither an explicit nor an implicit requirement of Section 1 para. 1 AStG.

No income correction if there are economic reasons

With regard to the years from 2007 (Romania's accession to the EU), the court further examined the extent to which the standard must be interpreted in accordance with European law and the extent to which the correction violates the freedom of establishment. According to the case law of the ECJ in the "Hornbach Baumarkt" case, the economic self-interest of the group parent company in its associated companies and its responsibility as a shareholder in the financing of these companies justifies business transactions under non-arm's length conditions and precludes an adjustment in accordance with Section 1 AStG.

The tax court deduced from these principles that no correction is to be made in accordance with Section 1 (1) AStG if important economic reasons for the non-interest-bearing nature can be presented. All reasons that are not related to tax motives can be considered economic reasons. 

In the case in dispute, the plaintiff has comprehensibly demonstrated that the foreign subsidiaries were founded in order to reduce the production costs for assembly services and that the continuation or expansion of their business operations depended on an injection of capital. With the capital injections, the parent company pursued the goal of increasing the Group's sales and profits, securing liquidity and improving financial stability. The loans enabled the parent company to carry out production work abroad at favourable conditions and to achieve the highest possible profits in Germany. The motives were legitimate and economically sensible objectives within the group and were not aimed at a tax advantage. As a result, the circumstances described are to be seen as an economic reason justifying the arm's length nature, which precludes an off-balance sheet income adjustment in accordance with Section 1 AStG.

Conclusion, practical implications and outlook

The judgement of the Saarland tax court is to be viewed positively, as it allows a deviation from the arm's length principle in the case of significant economic reasons, analogous to the ECJ principles, and in this case no income correction has to be made.

Whether the judgement can be applied to similar cases or whether it results in a general overriding of the arm's length principle remains questionable, however, as the case is pending on appeal (case number BFH I R 23/24). In particular, it will be interesting to see how the BFH will assess the possibility of analysing the granting of loans together with the contract manufacturing services of the subsidiaries.

Until a supreme court decision is reached in the present case, proceedings in which the non-application of Section 1 AStG is at issue for economic reasons should be kept open.