Germany enacts significant changes to interest deduction limitations

In detail

Stricter rules for determining the arm’s length prices for financing relationships 

The Act limits the deduction of interest expenses for cross-border financing within multinational corporate groups to a group interest rate (i.e., any rate exceeding such rate is considered not to be in line with the arm's length principle). 

• Group rating approach: The group interest rate is the rate at which a corporate group can finance itself when considering the group's credit rating (not stand-alone rating) compared to third parties. There is a possibility of rebuttal if evidence can be provided that a rating derived from the group’s credit rating corresponds to the arm's length principle. 
• Debt capacity analyses: The Act introduces increased compliance requirements for loan relationships, requiring the taxpayer to prove from the outset that it could have provided the debt service (which includes interest and amortization payments) for the entire term and that the financing is economically necessary and used for company purposes. Failure to meet these requirements would result in the complete denial of interest deduction. 
• Requirement of cost-plus mark-ups: An assumption is made that on-lending within a multinational corporate group is a low-function and low-risk service which can only be remunerated with a cost-plus mark-up. The rule applies as well if a company within the corporate group assumes the activities of managing financial resources for one or more companies in the corporate group, such as liquidity management, financial risk management, currency risk management, or acting as a financing company. 

Observation: There is no escape from the limitation even if the lender is a company with sufficient substance. However, purely domestic constellations are not affected by the bill. The provisions introduced do not limit the application of double tax treaties so mutual agreement procedures are still possible.