The question of how long initial losses of a German subsidiary are tolerated is repeatedly a hot topic discussed in tax audits. While under the OECD transfer pricing guidelines (TPG) initial losses are recognized for tax purposes as long as they are economically plausible and in line with arm’s length principles, the German tax authorities accept those losses under certain conditions only for a maximum period of 3-5 years. If this period is exceeded, they state that notional profits must be taxed, normally based a certain percentage of the costs of the German subsidiary (cost plus). Although there is no fixed time limit mentioned in the OECD TPG, however, after five years without any foreseeableprofits, the requirements for proving that an outside third party would continue to invest increase.
The basis for tax treatment in German law can be found in Sec. 1 ASTG (Foreign Tax Act) which is based on the arm’s-length principle: intercompany transactions must be priced as they would be between independent third parties. This principle allows for flexibility but requires that economic realities over time be considered. Therefore, it needs to be interpreted, but it is not clear which rule to interpret is prevailing.
First of all, a functions and risks analysis must be made. If it is clear that the German entity is a routine company with little functions and risks, and the strategy bearer is the foreign parent company the German tax authorities take the view that a third-party service provider would not accept losses and would not even accept a mark-up of 0% as they want to generate profits. Therefore, they state, the cost-plus transfer pricing method, taking into account all necessary direct and indirect costs, must be applied. Exceptions are only possible for initial losses, but those are limited to max. 3-5 years following court decisions of the German superior fiscal court BFH.
Foreign parent companies often only look at the OECD TPG and take a different view. In situations where an entity within a multinational group may incur losses over a reasonable period – for example, during the startup phase or while entering a new market, the TPG emphasize that independent parties would only tolerate such losses if there were a reasonable expectation of future profitability. Temporary losses can therefore be justified if they are part of a sound business strategy. If a company belongs to a multinational group, it can tolerate such losses if its commercial activities generate benefits for the multinational group as a whole.
As this contradiction always provokes disputes, German fiscal courts repeatedly had to deal with the question of how long initial losses can be accepted. It looks like there is some common understanding that the principle that the start-up phase until the company breaks even does not normally exceed a period of three years does not apply in the case of a newly founded company. However, court judgements leave open the exact time initial losses can be accepted and the start-up time for a newly established business must be determined on a case-by-case basis depending on the specific nature of the business. So far, there is no German court decision that accepted a longer period than 5 years.
Please also pay attention to the thin capitalisation rules/equity ratio of the German subsidiary. If the equity ratio is far below the equity ratio of the group of companies or if interest expenses are higher than 30% of the EBITDA in the tax balance-sheet, interest may not be tax deductible. Even if the rules of the so-called interest-barrier are only applicable for net interest expenses of 3 million Euros or more p.a., German tax authorities often check if third parties would have closed a such a contract. If there is thin capitalization, third parties like banks would probably stop providing loans, ask for securities or charge very high interest. In such cases German tax authorities often reduce the interest that is tax deductible because the loan is considered to not be according to arm’s length. Indications for constructive dividends are:
- Thin capitalization
- No genuine intention/ability to repay, de facto “permanent deferral”
- No maturity/repayment agreements, no enforcement, no collateral despite risk
- Subordination, profit dependency, etc., which justify economic proximity to equity capital
- Interest rates/terms deviate significantly from the market without justification (too high or too low).
Recommendations:
A German subsidiary that is still making losses after some years should be able to present a risk and functions analysis. If the German subsidiary if qualified as a routine or low-risk company they should be able to:
- present a sound business strategy that shows when break-even is reached and that the German subsidiary will profit from those future profits. Moreover, those profits should be sufficient to cover all additional losses, admin costs and a reasonable profit.
- demonstrate that such losses are part of a commercially rational long-term strategy, including detailed business plans, R&D milestones, and market potential. Recurring losses for a reasonable period may be justified in some cases by a business strategy to set especially low prices to achieve market penetration. An independent enterprise would not continue loss-generating activities unless it had reasonable expectations of future profits.
- describe both the causes of losses and the measures taken to mitigate them in a detailed TP-documentation. A German subsidiary that continues to incur losses for five years, must substantiate that such losses are economically justified, foreseeable, and consistent with market behaviour.
- document industry‑specific development cycles and comparable independent investors that accepted more than 5 years
- present additional circumstances that make it possible to determine that the taxpayer is not only engaging in the loss-making activity for personal reasons and inclinations related to his lifestyle or for saving taxes
- present extraordinary circumstances that delayed the process of becoming profitable (the OECD TPG refer to heavy start-up costs, unfavourable economic conditions, inefficiencies, or other legitimate business reasons), but not if they continue indefinitely
- plan that in a worst-case-scenario you may have to pay taxes on notional profits for loss-generating subsidiaries
- make plausible why third parties would have provided a loan in the way the shareholder did. Expect that interest paid on shareholder loans may not be tax deductible if the equity ratio is too low.