The following provides an overview of the key substantive aspects of the draft VWG TP:

General

• OECD principles: The draft generally refers to the OECD Transfer Pricing Guidelines for orientation when it comes to income delineation for intra-group financing relationships. Accordingly, this suggests that the German tax authorities aim for a uniform application of the arm's length principle in both inbound and outbound cases and to avoid double taxation.
• Applicability: Fortunately, the new law shall not be applied to expenses based on financing relationships that were legally agreed upon before 1 January, 2024, and for which actual implementation began before 1 January, 2024. However, this principle does not apply if a financing relationship is significantly changed after 31 December, 2023, or continued beyond 31 December, 2024. This restriction may have a severe impact as this ultimately means that long-term financing relationships that were concluded and implemented before 1 January, 2024, would fall back within the scope of the new law while independent third parties typically set the terms at the time of granting and do not adjust them during the term of the loan as a general rule.

Financing Relationships in principle

• Debt Capacity Analysis: For recognition as debt capital, the essential criteria are the credible expected ability to provide or service the capital (interest and principal payments) and the genuine agreement to provide capital over time, where it is particularly important to determine whether sufficient assets or cash flows are expected to satisfy the lender. The arm's length nature of follow-up financing should be recognized and the draft states that risky financing relationships should not be considered non-arm’s length per se, mentioning start-up businesses as an example.
• Economic reasons: For the financing to be accepted in principle, it must be economically required. The tax administration requires a justified prospect of a return that covers the financing costs (post-tax consideration), and realistic alternative actions for the borrower should be included.
• Company purpose: The use of the borrowed capital must be in line with the company's purpose. This is not the case if, e.g., the funds are invested in an at-call bank account or in an intra-group cash pool, i.e., if no higher return can be expected. An exception should exist for acquisition financing arrangements. In addition, borrowing for the purpose of distributing profits should generally not be in contrast with the company's purpose.
• Required proof: To avoid reclassification as equity, the taxpayer must credibly demonstrate (1) whether and how the capital provided can be serviced, (2) that the capital service is provided as agreed, and (3) what purpose is pursued with the provided capital and how the capital is used.
• Non-fulfillment: If it is not credibly demonstrated, the reduction in income caused by the financing relationship should be reversed to the extent of the non-arm’s length part (not to be denied entirely – which is in line with OECD principles).

Arm's Length Interest Rate

• Credit rating approach: Referring to and in line with the OECD Transfer Pricing Guidelines, the creditworthiness of the borrower should be considered when determining interest rates. However, the draft VWG TP clarifies that the interest rate to be determined is generally based on the creditworthiness of the entire corporate group (contradiction between the OECD's position which refers to a stand-alone credit rating of the borrower). Existing public ratings should be used as the primary benchmark for assessing the creditworthiness of the entire group. Private ratings (i.e., ratings that have not been published) should only be used secondarily. Ratings can also be created by using standard rating software, provided that qualitative factors are appropriately considered. If no rating at corporate group level is available an existing rating of the top group company can be used. If the top parent company does not have a rating, a group rating can be derived from the corporate group's financing costs to independent third parties for simplification purposes.
• Deviation from group rating: Deviations from using the group rating for determining arm's length interest rates are allowed, if it can be demonstrated that the rating used instead is at arm’s length. The latter requires that, e.g., credit assessments are based on arm's length quantitative and qualitative factors, consider group support and a standard rating methodology at the time of the loan grant was applied.

Classification of financing relationships

• According to the wording of the law, not only the mediation and forwarding of financing relationships, but also typical treasury functions up to the activity of a financing company classify as low-function and low-risk services which should be remunerated using a cost-plus method. The draft now explicitly clarifies that the comparable uncontrolled price method is generally used to determine an arm’s length price for the provision of debt capital between related parties. However, it can be assumed that financing functions generally only represent support functions for the value-creating core business (besides the banking or insurance sector).