Freedom of establishment and transfer pricing rules

For transfer pricing rules to be compatible with the fundamental freedoms, a taxpayer must be given the opportunity to provide justifications for non-arm’s length terms, which may be based on the interests of the taxpayer as a shareholder in the foreign subsidiary concerned.
  • Submitted 5 June 2018
  • Applicable Law Germany , European Union
  • Topic Tax > Corporate
The European Court of Justice (ECJ) has held that, in determining whether a parent company may be justified in agreeing non-arm’s length terms with a foreign subsidiary, the commercial interests of that parent as shareholder must be taken into account: Hornbach-Baumarkt AG v Finanzamt Landau (Case C-382/16) (ECJ, 31 May 2018). As such, a parent company must be given an opportunity to present commercial justifications for non-arm’s length terms applying to loan guarantees, even if these commercial justifications relate solely to its position as shareholder.

The decision confirms that Member States are able, in principle, to justify the existence of transfer pricing rules which apply solely to cross-border situations. However, in order for such rules to be proportionate, they must provide to taxpayers the opportunity to justify the application of non-arm’s length terms based on the individual circumstances of the case. This decision shows that the reasons which may be put forward may be reasons based solely on the financial interests of the taxpayer as shareholder in the entity which benefits from the non-arm’s length terms.


Hornback-Baumarkt AG (HB) was the German parent of Dutch subsidiaries which operated DIY stores. In 2003, two Dutch subsidiaries of HB had negative equity and required additional bank financing to continue their business and finance planned construction of a DIY store. The bank providing the finance to the Dutch subsidiaries required HB to guarantee those loans, which HB did, without charging any fee to the Dutch subsidiaries.

The German tax authorities took the view that the failure to receive remuneration in respect of the giving of the guarantees was contrary to the German transfer pricing rules and the income of HB was according increased in accordance with paragraph 1(1) and (4) of the German AStG by an amount corresponding to an arm’s length fee for the guarantees.

HB appealed, arguing that the German tax provisions were contrary to the freedom of establishment. In particular, HB pointed out that the provisions only applied in relation to arrangements with foreign subsidiaries and did not apply where the arrangements were in place with a local German subsidiary. The German courts referred the matter to the ECJ.

ECJ decision

The ECJ recognised, in line with its earlier case law (such as SGI) that the German transfer pricing rules were, in principle, contrary to the freedom of establishment. Applying the rules only to arrangements with foreign subsidiaries made it less attractive for a German company to set up a foreign subsidiary compared to a local German subsidiary. Howerver, equally, the court recognised that the German tax rules may potentially be justified by the need to maintain a balanced allocation of the power to tax between Member States. In this case, it was clear that the rules in question were designed to prevent conduct liable to jeopardise that right by preventing connected companies transferring profits outside the local Member State in the form of unusual or gratuitous advantages ie through the application of non-arm’s length terms. The case law of the court made it clear that such rules pursue legitimate objectives which are compatible with the Treaty and constitute an overriding reason in the public interest to justify a restriction on a fundamental freedom. Furthermore, such legislation is appropriate for attaining those objectives.

However, HB argued that the rules in this case were disproportionate in failing to allow it to provide a commercial justification for the non-arm’s length terms in the individual case. The German tax authorities contended that, whilst the legislation did not provide any statutory right to justify non-arm’s length terms, nevertheless, administratively, it was open to HB to justify those terms. However, the German tax authorities argued that any such commercial justification must be based on arm’s length justifications. In particular, for the purposes of assessing proportionality, economic and commercial reasons for non-arm’s length terms resulting from the position of HB as shareholder would not be taken into account.

HB argued that this failure to take into account its commercial position breached the principle of proportionality. It pointed out that the Dutch subsidiaries had negative equity and it was a condition of the bank loans that it gave the guarantees. These guarantees were necessary for the continuation of those businesses. The ECJ agreed with HB that these were relevant factors that should be taken into account. “In a situation where the expansion of the business operations of a subsidiary requires additional capital due to the fact that it lacks sufficient equity capital, there may be commercial reasons for a parent company to agree to provide capital on non-arm’s-length terms.”

In addition, the court noted that there was no argument of tax avoidance in the present case. Accordingly, there may be a commercial justification by virtue of the fact that HB the shareholder in the group which would justify the conclusion of the transaction on non-arm’s length terms, based on the economic interest of HB itself in the financial success of the foreign group and its responsibility as shareholder.

It was, of course, for the referring court to determine whether HB was in a position, without being subject to undue administrative constraints, to put forward elements explaining a possible commercial justification for the transaction in this case, without being precluded from putting forward economic reasons based on its position as shareholder.


It has been clear from earlier case law of the ECJ that Member States are able, in principle, to justify the existence of transfer pricing rules which operate cross-border only. However, in testing whether such rules comply with the principle of proportionality, the opportunity to justify the application of non-arm’s length terms based on the individual circumstances of each case is important. The HB decision shows that the taxpayer must be given the opportunity to put forward reasons based solely on the financial interests of the taxpayer as shareholder in the entity which benefits from the non-arm’s length terms.

What remains unclear, however, is in what circumstances a Member State should be prepared to accept those arguments as a justification for accepting non-arm’s length terms. There was no reason in principle why HB should not have required a fee for the guarantees in this case, of course, albeit the fee may have increased the indebtedness of the subsidiaries. Would it be necessary to show that the increased indebtedness of the subsidiaries would have jeopardised the bank funding? Or is it simply enough to show that the subsidiaries had “negative equity” at the time?

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