A German company acquired shares in a company, which was financed as follows: unsecured subordinated shareholder loan (interest rate 8%); secured bank loan (interest rate 4.8%); and an unsecured loan from the shares' seller (interest rate 10%). After comparing it with the unrelated bank loan, the Tax Authority granted a tax deduction of the interest payable of 5.
After the Tax Authority assesment and an adverse decision by the Lower Court, the assessee company brought the case to the BFH, whereby the BFH disagreed with the lower findings.
The BFH held that the comparison with a bank loan was flawed as it is secured as an unrelated party would not grant an unsecured loan at the same "price" as a secured loan. In fact, the usual statutory subordination of shareholder loans cannot be relevant for arm's length determination for the BFH. In the context of the instant case, it was held that the association between the shareholder and the subsidiary was to be disregarded, meaning that the lender was not acting as a shareholder, and thus statutory subordination did not apply.
The Court further held that it is for the authorities to establish that the transfer price (interest rate in this case) is not set at arm’s length. The Court remanded the matter to the lower authority with the direction that for arm's length comparison, actual agreements with unrelated parties (in this case, the bank loan) would first have to be adjusted mathematically, to compensate for any special circumstances at affiliated companies, before they can be used and cannot be applied in a blanket way.