Appropriate level of interest as the subject of contention
In the case that reached the Federal Fiscal Court (Bundesfinanzhof, BFH), the legal action was brought by a German GmbH [a limited liability company] that had had taken out three loans in order to finance a corporate acquisition; the arrangements in terms of maturity, loan interest rate and collateral were different for each loan (cf. graphic).
The GmbH deducted the interest expense for the shareholder loan as business costs. The tax auditor was of the opinion that the interest rate of 8% that had been agreed in the loan contract concluded with the parent company was not appropriate. The arm’s length interest rate was 5% and - despite the different maturity and collateral - the bank loan had to be used as a basis and the rate had to be adjusted accordingly. The difference between the interest expense that had been posted and the appropriate one had to be regarded as a constructive dividend.
The Cologne tax court accepted the constructive dividend assessment
The legal action taken by the GmbH against the amended tax assessment was unsuccessful at first. The tax court, in its ruling of 29.6.2017, endorsed the view of the local tax office (case reference: 10 K 771/16). A portion of the interest payments constituted a constructive dividend because the interest rate agreement for the shareholder loan did not stand up to an arm’s length comparison.
The benchmark was the interest rate of 4.78% for the bank loan. According to the Cologne tax court, neither the subordination for insolvency purposes of the shareholder loan nor the absence of collateral would lead to the elimination of this benchmark. Consequently, adding a risk premium when determining the interest rate was not justified. The vendor loan, which was likewise unsecured, - and had been granted by an unrelated third party - was also not relevant for the level of the arm’s length interest rate, even though it had a higher rate of interest despite the shorter maturity. In the opinion of the Cologne-based judges who rule on fiscal matters, it was possible that the different sets of interests here (e.g. reduction in the purchase price) had had an impact on the rate that was charged.
The BFH called for a differentiated approach
The BFH, in its ruling of 18.5.2021 (case reference: I R 62/17) did not endorse the view of the Cologne tax court. A secured senior bank loan is not a benchmark for a shareholder loan. An unrelated third party would only accept a comparable degree of agreed subordination for insolvency purposes if, in return, it was compensated for accepting this disadvantage and the greater risk.
Furthermore, the notion that an unrelated third party would agree the same interest rate for an unsecured subordinated loan as for a secured senior bank loan is, in fact, contrary to the principles derived from experience. With its decision the BFH clarified that the lack of loan collateral is generally associated with a higher rate of interest being charged on the loan; in effect, the court has thus acknowledged that there is a connection between the risks associated with a loan and the interest that is received for this.
Please note: According to the BFH ruling, the comparable uncontrolled price method should initially be used as the basis for determining if an agreed interest rate for a shareholder loan satisfies the arm’s length principle. Essentially, this requires identical supply relationships and that is why individual adjustments might be necessary.