Multinational companies regularly operate centralized financing entities, for example in the Benelux countries. More recently, this structure has come under increasing pressure from national (German) and supranational (OECD) government bodies. The viability of whether the financing center can survive this pressure is increasingly debated. In addition, if so, there are new considerations for what needs to be changed in their arrangements and documentation.
In February 2020, the OECD issued a “Guide on Financial Transactions”. This guideline especially enhances the documentation requirements for financial transactions: taxpayers must explain (and justify) the nature and state of the transaction and be more detailed about the functional analysis and risk of the entity. This is a big change because it means the taxpayer has to justify the structure of the loan instead of considering it as a gift. Most importantly, however, the OECD does not question that the benchmarks for interest ’(that is, bond market interest rate reviews) are still a valid transfer pricing method.
In contrast, in Germany this method of fixing transfer prices was attacked by financial courts and proposed laws. The latest ruling by the German financial court states that the standard length applies not only to the interest rate but also to the general nature of the agreement. Has an independent third party provided or received similar loans? For unsecured loans, the court questions the arrangement and reclassification of transactions as additional financial services that must be paid on a plus-fee basis.
This reclassification can have extreme consequences: A loan of, say, € 300 million with an interest spread of 1 percentage point will generate a profit of € 3 million at the finance center. On the other hand, the financing center itself may only have costs for example € 100,000, so even a 10% increase will only result in a profit of € 10,000.
The German financial court approach is basically supported by the German Ministry of Finance, which has issued a draft law as part of the implementation of the European Tax Avoidance Directive (ATAD). This draft law was issued in December 2019 with a public consultation period of only two and a half days, and most of the regulations came into force in January 2020. In addition to various other rules, it basically confirms the view of the financing center as a service provider that must get cost-plus margins .
The widespread attack on financing centers is bad news for many taxpayers who have relied on such structures for their internal financing needs. First, there is a risk that tax authorities in countries where interest is paid will reject deductibility, and second, differences in transfer pricing methods applied mean that international arbitration mechanisms will become more complicated and less effective. The result can be multiple taxes and increased controversy, so what can taxpayers do to alleviate the situation?
First and foremost, taxpayers must show that the nature of the transaction itself is a long arm and makes sense from a business perspective, that is, the focus is not only on comparing interest rates but also on providing evidence that the transaction is common in the market. Tax companies have succeeded in helping clients maintain financing centers in tax audits where auditors question the nature of the transaction. For some real estate companies, tax companies can show that unsecured loans can be found on the market between independent companies and that, depending on the borrower’s profile, these loans are common with arm-length standards with more than 25% of unsecured loans. Based on this evidence, the German tax authority in these cases has accepted the nature of the transaction and the overall arrangement.
Going forward, financial centers and benchmarking of interest will be under increasing pressure, and while taxpayers are likely to do well to improve their documentation, we also believe that many of these structures are commercially valid and valuable and will continue to exist if well documented.
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Philip de Homont
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