The economically relevant maturity of an intercompany loan is, alongside rating and currency, one of the central pricing factors when determining arm's length interest rates. Comparable bonds with shorter maturities regularly show lower interest rates in the market than long-term comparable instruments; a shortening of the maturity relevant for the interest analysis therefore directly leads to a narrower and lower comparable range. In current German tax audits, particularly in inbound constellations, we observe that the tax authorities are increasingly relying on this mechanism: through the interpretation of formal contractual elements, namely interest adjustment clauses and prepayment options, the economically relevant maturity is significantly shortened irrespective of the actual capital commitment. In the following, we discuss the two topics most frequently encountered in recent audit practice.

We observe the first topic in constellations of long-term intercompany financing in which the loan agreement provides for a periodic interest adjustment. An illustrative case from our practice concerns the project financing for German offshore wind farms: the intercompany loan was granted without a fixed maturity; contractually agreed was a review and adjustment of the interest rate after five years to the then prevailing market conditions. The original transfer pricing analysis was based on an economic maturity of 30 years, reflecting the economic capital commitment in the underlying projects.

In recent tax audits, the tax authorities in such constellations repeatedly take the view that the interest adjustment period agreed in the contract (in the specific case, five years) must necessarily be equated with the economically relevant maturity (rather than with the contractually agreed or economically justified maturity). The consequence of this view is the rejection of the transfer pricing analysis prepared by the taxpayer to the extent that it is based on the economic capital commitment, and the preparation of an alternative benchmark on the basis of comparable bonds with exclusively short residual maturities. 

In the case mentioned, the tax authorities, on the basis of a five-year comparable range, demanded an adjustment of the interest rate from 3.75 per cent to a value between 1.10 per cent and 1.80 per cent.

In our view, this position should be considered in a differentiated manner. The economic maturity of a loan derives from the economic capital commitment in the specific business model, not from the formal interest adjustment period. Project and infrastructure financing typically exhibit a technical and economic useful life of two to three decades, with repayment made exclusively from the operating income generated over that period. Accordingly, only long-term financing over the entire project term is economically meaningful; a short-term refinancing through five-year instruments would not be available to the borrower as a realistic alternative. Likewise from the lender's perspective, the capital is effectively bound over the entire project term; a short-term call would jeopardise the economic basis of the project entity and would not be economically enforceable. Periodic interest adjustment clauses, from our perspective, do not constitute a limitation of the economic maturity but merely a review mechanism for adjusting conditions to current market conditions; such a clause is also customary between unrelated parties in long-term financings and does not alter the underlying capital commitment. The primacy of economic substance over the formal contractual structure is, moreover, expressly anchored in para. 1.42 et seq. of the OECD Transfer Pricing Guidelines (accurate delineation of the actual transaction) and constitutes a recognised interpretation also in administrative practice.

A second, structurally related topic concerns clauses permitting prepayment at any time, as frequently agreed in intercompany arrangements, in particular for acquisition financing, but also more broadly for corporate financing. Where the loan agreement grants the borrower the unilateral right to repay the loan without prepayment penalty and on short notice, the tax authorities, in our observation, regularly conclude that, in the light of economically reasonable behaviour, the borrower would have repeatedly refinanced the loan on a short-term basis at falling market interest rates and on more favourable terms. As a consequence, the tax authorities assume an economically relevant maturity of only a few months in lieu of the contractually agreed maturity and derive hypothetical refinancing scenarios with substantially lower comparable interest rates. In one case from our practice concerning an acquisition financing with a contractual term of five years and an agreed interest rate of 7.50 per cent, the tax authorities assumed an economic maturity of six to twelve months and applied comparable interest rates in a range from approximately 4.4 per cent to 6.6 per cent after expiry of that maturity.

In our view, this position should likewise be considered in a differentiated manner. Of central importance is, first, the question of the economic purpose of the clause: prepayment options are typically agreed between intercompany parties to provide the borrower with flexibility, for instance in connection with the sale of individual assets or a restructuring of the financing portfolio. Economically, they do not aim at granting the borrower a unilateral possibility to optimise interest rates when market interest rates decline. Already within the scope of accurate delineation (para. 1.42 et seq. of the OECD Transfer Pricing Guidelines), it should also be examined whether such a far-reaching unilateral prepayment option would, in the case of a fixed interest rate, be arm's length in principle; among unrelated parties, such a clause would, if at all, typically only be available against a prepayment penalty.

Independently of the foregoing, the benchmark of the arm's length principle is the actual conduct of the parties and not the theoretical exercise of an option at any time. A contractually granted prepayment option is an option, not an obligation; its mere existence does not give rise to an arm's length expectation of repeated short-term refinancings. Unrelated parties, when considering a refinancing, typically take into account not only the isolated interest rate differential but also refinancing, transaction and opportunity costs as well as the availability of alternative funding sources. Marginal changes in interest rates, for example in the range of a few basis points, therefore generally do not constitute a sufficient trigger, under arm's length considerations, for a full repayment and re-borrowing of intercompany financing. Hypothetical multiple refinancing scenarios, as relied upon by the tax authorities in their adjustments, in our view do not reflect the economic reality of relationships between unrelated parties.

The economically relevant maturity of an intercompany loan is developing into a central area of dispute in current tax audit practice. Both observations, interest adjustment clauses as well as prepayment options, follow the same underlying logic: from the interpretation of a formal contractual mechanism, a shortened economically relevant maturity is derived for arm's length purposes, with the consequence of a significant income adjustment without the economic capital binding actually being altered. Inbound groups should therefore proactively review their intercompany loan agreements and address the following aspects:

• Clear agreement of a specific maturity in the loan agreement that corresponds to the economic capital binding in the underlying business model. Agreements without an express maturity provision are a frequent audit trigger for the tax authorities and should be avoided.

• Clear distinction between interest adjustment and maturity limitation: periodic interest adjustment clauses should be clearly identifiable in the contract as pure review mechanisms for the assessment of market conditions and should not be mixed with maturity limitations.

• Deliberate design of prepayment options with clear provisions, in particular making the prepayment subject to the consent of both parties, linking it to specific triggering events (e.g. asset sale, refinancing), agreeing an appropriate prepayment penalty or consciously refraining from such a clause.

• Documentation of actual conduct, for example the absence of short-term repayments despite market interest rate fluctuations, as an integral part of the transfer pricing documentation.

Our transfer pricing specialists at the German KPMG Center of Excellence for Financial Transactions will be pleased to assist you with any questions.