New era for dependent agent PEs in Germany?

A new era of discussions on dependent agent PEs is expected

On October 10 2014, the Upper House of the German Parliament (Bundesrat) consented to the Federal Ministry of Finance's final version of its ordinance on the application of the arm's-length principle (ALP) to profit allocations between head office and permanent establishments (PEs).

By modification of Section 1 of the Foreign Tax Act (FTA) in June 2013 with retroactive effect to January 1 2013, the legislator already implemented the Authorised OECD Approach (AOA). This approach aims at defining international rules on the allocation of profits between head office and PE under the assumption that the latter would act as a functionally separate entity. In the adjusted section 1 FTA, paragraph 4 treats deemed contractual relationships between head office and PE (dealings) as business relations for the purposes of income allocation, whereas paragraph 5 contains regulations substantially corresponding to the AOA. Furthermore, paragraph 6 allows the Federal Ministry of Finance to submit an ordinance to ensure the consistent application of the ALP in cases of profit allocations between head office and PEs. Such ordinance requires the consent of the Bundesrat before it can come into force. More than four years after the OECD provided its 2010 update on the Model Convention, presenting a modified version of article 7, the German legislator has now finalised regulations for implementing the AOA in national tax law. The ordinance is binding on taxpayers, the tax administration and tax courts and will be applied to financial years starting after December 31 2014. Despite this, it should be noted that the revised version of section 1 (5) FTA is already applicable with effect from January 1 2013. To avoid possible discussions with the German tax authorities, taxpayers are well-advised to interpret the new section 1(5) FTA in light of the provisions of the ordinance and to apply the regulations stipulated therein already for profit determinations with effect from January 1 2013.

The final version of the ordinance consists of seven chapters, of which Chapter 1 is the most comprehensive, containing general provisions to be considered for each type of PE.

The German regulations basically follow OECD standards stipulating a two-step approach. The ordinance puts its emphasis on the first step, hypothesising the PE as a functionally separate entity including performing a functional analysis and identifying dealings between the head office and the PE. In this regard, the ordinance contains detailed attribution provisions. On the basis of the significant people functions (SPFs) identified, the allocation of assets, opportunities and risks, capital and business transactions to the PE is further determined. Although the ordinance is generally in line with the AOA, in certain areas it deviates from OECD standards (for example, no partial allocation of tangible assets, deduction of finance expenses, attribution of opportunities and risks, and so on).

"The ordinance aims to ensure a consistent application of the arm’s-length principle in cases of profit allocations between head office and PEs and, in so doing, aims to provide guidance for determining how much profit can be attributed to a PE"

In the second step, the ordinance requires a comparability analysis to be made for the business activities of the PE in order to determine an arm's-length profit. In this regard, the general German transfer pricing regulations for transactions between associated enterprises (for example, OECD Transfer Pricing Guidelines 2010, section 1 FTA, German Administrative Principles as of February 23 1983, among others) need to be followed.

In addition, the ordinance obliges the German taxpayer to prepare an auxiliary and supporting calculation ('PE Income Calculation'), alongside the statutory and tax accounts of the PE typically required under commercial and/or tax law, to ensure a consistent profit determination for the PE in line with the assumption of a functionally separate entity. All assets, capital and liabilities attributed to the PE based on its significant people functions as well as income and expenses associated therewith are to be included in such PE Income Calculation. In addition, the PE Income Calculation contains the deemed income and expenses attributable to the PE as a result of dealings between the head office and the PE. The PE Income Calculation must be prepared at the beginning of each financial year, continued during and closed at the end of the financial year.

Chapters 2 to 5 of the ordinance include special regulations which are only relevant for PEs operating in a certain industry (banking, insurance, construction or the exploration industry). It should be noted that these special provisions partially deviate or go beyond OECD standards (which only include special considerations for bank, global trading and insurance PEs), in particular in the construction industry. Chapter 6 stipulates the treatment of representatives.

Chapter 6 of the ordinance merely consists of one section, section 39, containing special regulations on the treatment of permanent representatives within the meaning of section 13 of the German General Tax Code. Paragraph 1 of section 39 states that the ordinance is to be applied analogously to these permanent representatives. A permanent representative often creates a PE of the non-resident enterprise it acts for (under article 5 (5) OECD Model Convention). Since such dependent agent PE also falls within the scope of article 7 of the OECD Model Convention, it is perceived to be appropriate to apply the same set of regulations to this type of PE.

Therefore, according to the abovementioned two-step approach, the significant people functions identified form the starting point for further determining the allocation of assets, opportunities and risks, capital and business transactions to the dependent agent PE. In case the permanent representative is a separate legal entity, people functions in the state where the dependent agent PE exists are generally performed by said permanent representative on behalf of the non-resident enterprise it acts for. For such situation, paragraph 2 of section 39 of the ordinance creates a fiction by stating that people functions performed by the permanent representative are deemed to be people functions of the non-resident enterprise it acts for and, consequently, should be considered to be people functions of the dependent agent PE. Subsequently, it is to be investigated whether (and, if so, which) assets can be (economically) allocated to the permanent representative and whether the representative assumes certain risks. The expertise and skills of the permanent representative's personnel can be indicators in this regard. Decisive, though, is which functions are performed by the permanent representative on behalf of the non-resident enterprise and which risks are assumed by the permanent representative, for which it is to be investigated whether these can be attributed to the dependent agent PE.

"Recent developments suggest that the threshold for the existence of a dependent agent PE may be substantially lowered in the (near) future"

In its commentary to section 39 of the ordinance, the German legislator acknowledges the fact that in many situations attributing the people functions of the permanent representative to the non-resident enterprise it acts for, should not result in a compensation for the dependent agent PE that exceeds the (arm's-length) remuneration of the permanent representative. In this regard, the income of the dependent agent PE is generally to be passed on to the permanent representative (the single taxpayer approach). Should, however, the permanent representative manage certain risks that can legally only be borne by the non-resident enterprise it acts for (that is. the relevant people functions are performed by the permanent representative, whereas the risks are borne by the non-resident enterprise it acts for), the conclusion would be different. In such scenario, the risk premium is to be attributed to the dependent agent PE. Under the arm's-length principle, the permanent representative is merely remunerated with a service provision fee (for managing the risk), since, according to civil law, the permanent representative does not effectively bear the risk. With reference to the examples mentioned in the OECD's Report on the Attribution of Profits to Permanent Establishment dated July 22 2010, it is stated that in these type of situations the result of the dependent agent PE can deviate from the remuneration for the permanent representative.

In German transfer pricing practice, discussions with tax authorities on dependent agent PEs have been rather exceptional in the past. This can be explained by the fact that the 'Null-Summen-Theorie' (the German equivalent of the single taxpayer-approach) has been the common approach for determining the profit to be attributed to such dependent agent PE. Consequently, the profits attributable to the dependent agent PE in Germany would typically not exceed the arm's-length payment to the permanent representative. Upon implementing the AOA, the German legislator moved away from Null-Summen-Theorie and, by means of section 39 of the ordinance on the application of the arm's-length principle to permanent establishments, has provided German tax authorities with a legal basis for claiming a profit at the level of a German dependent agent PE in excess of the arm's-length remuneration for the permanent representative.

The ordinance aims to ensure a consistent application of the arm's-length principle in cases of profit allocations between head office and PEs and, in so doing, aims to provide guidance for determining how much profit can be attributed to a PE. Prerequisite for being able to attribute profit to a dependent agent PE is the conclusion that the requirements for a dependent agent PE are fulfilled (section 13 FTA, article 5 (5) OECD Model Convention). Recent developments in this area give rise to an assumption that the threshold for the existence of a dependent agent PE may be substantially lowered in the (near) future.

In this regard, reference is made to the OECD's recent release of its discussion draft on BEPS Action Step 7 (Preventing the artificial avoidance of PE status). In this discussion draft, the OECD proposes changes in five separate areas, one of which is commissionaire arrangements and similar strategies. In relation to these type of arrangements, four alternative options for amending the dependent agent PE (article 5 (5) of the OECD Model Convention) are proposed. The envisaged lowering of the dependent agent PE threshold is likely to widen the scope of the dependent agent PE rule, thereby increasing the number of dependent agent PEs to be identified. In this regard, one may argue that the suggested changes seem to go beyond the commissionaire arrangements, also bringing limited risk distribution and other principal sales structures within the scope of the dependent agent PE rules.

Based on the implementation of the AOA in German tax law, which is further specified by the recently-published ordinance on the application of the arm's-length principle to PEs, taxpayers should be well advised to reexamine their existing structures potentially leading to further documentation work. By stating in Chapter 6 of the ordinance that the regulations should be applied analogously to dependent agent PEs, the German legislator has paved the way for an increase in the number of discussions on dependent agent PEs in Germany. Especially in light of the recently released discussion draft on BEPS Action 7, which envisages a significantly lower threshold for the existence of a dependent agent PE, section 39 of the ordinance on the attribution of profits to dependent agent PEs may gain in practical importance in the (near) future.

Susann van der Ham
		PwC Tel: +49 211-9817451 Email: susann.van.der.ham@de.pwc.com Susann van der Ham is a transfer pricing partner at PwC Düsseldorf. Susann has more than 10 years of experience in consulting multinationals in the field of transfer pricing. Her expertise encompasses transfer pricing structuring, value chain transformation, system implementation, documentation and tax audit defence. She advises large international clients (both German and foreign headquartered) and has led a variety of projects in the retail and consumer, automation and automotive industry, among others. Susann frequently publishes articles in international and domestic tax and transfer pricing journals and she is a regular speaker on transfer pricing events. Susann holds a degree in economics and she is a German certified tax adviser (Steuerberaterin).

Guido Schepers
		PwC Tel: +49 211-9811650 Email: guido.schepers@de.pwc.com Guido Schepers is a transfer pricing senior manager at PwC Düsseldorf. After his studies in business economics and tax law at the University of Maastricht, Guido started his career in corporate tax and transfer pricing in 2005 with PwC in the Netherlands. In 2011, Guido joined the transfer pricing team of PwC Düsseldorf. Guido has extensive experience in international tax structuring, in particular in planning and implementing transfer pricing systems. He advises both inbound and outbound multinational corporations, which are active in a wide range of industries. In addition to tax efficient structuring of cross-border business processes and documentation of transfer pricing systems, Guido is experienced in defending transfer pricing systems in tax audits and obtaining advance pricing agreements (APAs).