CORPORATE What is the correct interest rate for loans from a corporation to its shareholders?

BFH (German Federal Fiscal Court) confirms its case law on the topic of “hidden profit distribution” for loans to controlling shareholders (BFH, the judgment of 22/02/2023 – I R 27/20 -)

What were the facts?

The managing director of GmbH (German limited liability company) held a 60% stake in the company’s share capital. For many years, the company kept a clearing account in its bookkeeping, to which payment transactions to the shareholder-managing director were posted and offset. The balance of this account had to be recognized separately in the company’s annual financial statements under Section 42 (3) GmbHG (German limited liability companies act). The financial statements shall recognize, among other things, unpaid salary deductions and payments to or payments made for the account of the shareholder managing director. However, management did not recognize interest in the receivables from the managing director in the years in dispute (2014 and 2015). For this reason, the tax office recognized a hidden profit distribution (vGA) of 4.5 % for failure to pay interest.

The GmbH ultimately filed an unsuccessful appeal against the tax office’s handling before the Schleswig-Holstein Tax Court dated 28 May 2020 1 K 67/16, EFG 2021, 223 and lost the appeal before the BFH.

How did the BFH rule?

1. According to established case law, if a corporation grants its shareholder a loan, this may be considered a VGA if the loan is granted without interest or at an unreasonably low-interest rate. This verdict is to be assumed if the company maintains an unreasonably interest-bearing clearing account for the managing partner (Section 42 (3) GmbHG), which shows a balance in favor of the company.
2. The method mainly recognized in science and case law to determine the appropriate (arm’s length) interest rate is the price comparison method . This method is the primary method for determining appropriate (offsetting) prices. The arm’s length price is the interest rate at which third parties would have granted the loan on the money or capital market under comparable conditions.
3. Whether an unreasonable price (interest) structure exists is a “factual” question, the answer to which is the responsibility of the lower tax court (Finanzgericht, FG) and not the BFH as the appellate court. The tax court determines the appropriate interest rate as part of an estimate (Section 162 I of the German Fiscal Code -AO-). For this estimate, the BFH recognizes the application of the principle of experience known as the “margin sharing principle” as appropriate.
4. In the case of credit transactions between a corporation, which itself does not conduct banking business and acts as a private lender, and its shareholder as a private borrower, the upper and lower limits of the estimation range required for the estimation are calculated using the credit interest rates customary in banking as the lower limit and the debit interest rates customary in banking as the upper limit. Suppose no other indications for a proper estimate are recognizable. In that case, it is not objectionable “in case of doubt” according to the margin sharing principle if the private lenders and borrowers share the customary bank margin between debit and credit interest. If the company does not conduct any banking transactions (and therefore has no associated expenses), recognizing the debit interest margin is generally unjustified.
5. You should note that, according to the case law on ranges, the “correct” arm’s length price is not a point value but consists of a range of “all” usual arm’s length prices. It is, therefore, perfectly permissible to deviate from the margin-sharing principle and set a different, economically justifiable interest rate within the range. However, this requires a comprehensible and reliable weighing of the interests involved. In any case, the result must be within the interest rates that third parties would have agreed with each other. The BFH attaches particular importance to the fact that the shareholder has not granted any collateral (unsecured loan)!
6. The above statements on the margi n-sharing principle do not apply to the case of loans granted within the group. Instead, they initially apply to instances of “private” occasional loans granted by a company with a personalized structure to its controlling shareholder. Therefore, The case law applies to financing companies with a customized structure.
7. In this specific case, the tax office, without objection from the BFH, used the standard bank borrowing rates for revolving loans and overdraft facilities to private households (based on the statistical data from the Bundesbank) to determine the standard bank borrowing rates. In individual cases, however, it would have to be checked whether other comparable reference interest rates exist concerning the relevant credit transactions.

What should shareholders and the company bear in mind?

It would help if you regulated legal relationships between a corporation and its controlling shareholder clearly in advance. These regulations must be set out in writing, comply with arm’s length principles, and actually be implemented. This is the proper method to avoid the financial consequences, which would be the assessment of VGA. It has been a long time since this has been new! It is also nothing new that this applies to assessing interest on shareholder loans. The BFH clarifies once again that the application of the margin sharing principle is not an obligation but must only be observed “in case of doubt” if no other interest rate calculation within the margin range has been made comprehensibly. To this end, it is essential to prepare evidence by documenting the decision parameters to decide in favor of the factual findings of the tax office and the tax court (see Section 118 (2) FGO). Otherwise, a convincing presentation will hardly succeed.