Germany has been an early indicator of how the OECD's rules
on so-called 'hard-to-value intangibles' may look when
implemented at the national level. Already in 2010 Germany
enacted rules on 'relocations of functions'
(Funktionsverlagerung). These rules have given rise to
many disputes in the field of tax audits throughout Germany,
and many lessons have been learned which are pertinent in light
of the new OECD rules.
Similarities between the OECD rules and existing German
In essence, German tax law prescribes that whenever a
– loosely defined – 'function' is relocated
within a multinational company from Germany to another country,
the net present value of the income of the functional income
transferred needs to be taxed in Germany. Importantly, the
rules stipulate that independent enterprises would agree on a
'adjustment clause'. If the taxpayer does not present an
arm's-length adjustment clause, the rules stipulate that
effectively there would need to be a revaluation of the overall
transfer within 10 years, and potentially an adjustment if a
significant deviation is found.
Both the very loose definition of 'functions' as any
commercial activity (not necessarily tied to an organisational
unit of the company) and the stipulation of the adjustment
clause are also cornerstones to the OECD rules on hard-to-value
intangibles. By the OECD's definition, an intangible is
anything that is neither a financial nor tangible asset, but
which would be remunerated between independent parties. This is
quite a loose definition. Furthermore, the OECD stipulates that
when an intangible is transferred that was "hard to value"
(and, almost by definition, many intangibles fall in this
category), there should be an automatic price adjustment after
The trouble with loose definitions
Germany's example shows the problem that the OECD's loose
definition of intangibles can entail: If almost anything could
be an intangible, it becomes very hard for taxpayers to decide
whether or not one has been transferred in even very small and
simple changes to inter-company transactions.
For example, while the German regulations were originally
aimed at whole factories being transferred with their
underlying intellectual property (IP), the loose definition
meant that today even the production of individual goods might
be considered to fall under these rules. We have seen cases
where the taxpayer had manufacturing activities in Germany and
France, and initiated a programme where both plants would share
the production of some goods to better capacity utilisation.
The German tax authorities claimed that the production of these
goods constituted a function that was now partially transferred
and calculated a significant adjustment.
In another case, a German company expanded their business by
opening a distribution entity in Austria. The company
previously had no dedicated sales activity for that market, but
some deliveries were made to customers from Austria who had
approached the company themselves. To the company's
astonishment, the German tax authorities thus stipulated the
existence of an export.
As these examples show, a loose definition unsurprisingly
increases the scope for disputes. In either case, the taxpayer
is well advised to very clearly present arguments about what
does or does not constitute a transferred function or
intangible in advance. It was possible to clarify these things
in the audit, but only with considerable effort.
The problem with adjustment clauses
What will the OECD's stipulation of adjustment clauses for
hard-to-value intangibles mean for taxpayers? Germany offers
some rather bleak lessons regarding actual adjustment clauses.
On the other hand, appropriate use of valuation techniques can
help to reduce the issues somewhat.
In practice, adjustment clauses are hugely impractical: The
valuation of an intangible (or a function) is generally based
on expectations of future income, which is inherently
uncertain. When a valuation is based on a single projection of
income, and a check is made after 10 years against the actuals,
this often results in a very significant deviation, and
therefore adjustment. However, additional payments 10 years
after the fact often prove to be very difficult in practice.
What happens if an internal reorganisation meant one of the
parties was sold to a different holding in the group in the
meantime? Would the purchase price need to be adjusted? What if
there had been a profit participating loan? What if there had
been a profit participation by employees? In practice,
adjustments for the income of up to 10 years ago leads to many
However, there is silver lining in the lessons from the
German relation of functions as well: The need for adjustment
payments can be significantly curtailed when using appropriate
economic tools for the valuation of the function – or
intangibles. Most importantly, the valuation should not just
take a single projection into accounts, but also reflect known
risks and variations. Specifically, valuation techniques that
are based on a variety of different future profit projects are
much more robust, as better or worse cases are already
reflected in the determined value.
We have used a number of different economic valuation
methods, most importantly 'Monte Carlo' simulations that are
based on appropriately reflected business scenarios. While
these methods require more economic input than a plain vanilla
discounted cash flow analysis, it does significantly reduce the
uncertainty that is introduced by the adjustment clauses of the
OECD and the German legislation alike.
NERA Economic Consulting
T: +49 69 710 447 502 and +49 69 710 447 508