On November 9 2001, the German Ministry of Finance issued new administrative principles for the tax treatment of secondments. The subject of these administrative principles is the oft-neglected issue of the allocation of expatriate expenses between international related companies for the purposes of corporate, trade, income and foreign taxes.
The transfer of personnel is acknowledged as a potential tool for moving profits into low-tax jurisdictions and it therefore counts as a transfer pricing issue. Accordingly, the new German principles on personnel transfers are the third result of the continuing process of updating and supplementing the general German transfer pricing guidelines of 1983, following the earlier changes to the principles covering cost sharing agreements and permanent establishments. In the near future, further changes can be expected ? eg the principles governing the movement of business opportunities (base shifting) are being worked on at present.
Contents of the guidelines
The new administrative principles define expatriation as arising when the transferred employee is working for the host company for a limited period of time ? not usually less than three months. The expatriate must be fully integrated into the business operations of the host company, which is assumed to be the case when a supplementary work contract exists between the host company and the transferred employee, or when other evidence suggests that the host company is the real economic employer, eg when the host company is authorized to determine job activities and bears the economic responsibility for the expatriate's salary. In general, the principles are assumed to be relevant for transfers lasting more than three months, but may also apply when the transferred employee is engaged by the host company for shorter time periods, if this is regularly repeated over a longer time period.
Activities carried out in the context of service or work contracts do not constitute cross-border personnel transfers, as in these situations, the employee is acting for another firm in which he or she is not integrated and is not under its management authority. Such services are remunerated at market prices under arm's-length conditions and thus typically include a profit component.
Critical for the matter of income allocation is the question of whether and to what extent the transferring and the host company have an economic interest in the cross-border transfer of staff. This is to be evaluated on the basis of the arm's-length principle. Under this, two implicit requirements arise:
all expenses of the transferred employee are to be examined on the basis of the economic interest of each party and allocated accordingly; and
the costs borne for a transferred employee by one party should not exceed the amount that a prudent and conscientious businessperson would be willing to bear for a comparable unrelated employee. This hypothetical arm's-length comparison can either be made with a comparable employee from the local labour market, or, if local comparables do not exist, with unrelated employees from the transferring state's labour market, including transfer costs.
Should the tax authority determine that the arm's-length requirements are not adhered to, all or part of the secondment-related business expense deductions are reclassified as constructive dividends or are disallowed by the Foreign Transactions Tax Act (Aussensteuergesetz ? AStG).
Compilation of expenses
The transfer of an employee between two related companies usually creates costs that are additional to the actual salary. Before an expatriate is able to start work abroad, legal matters such as work and residence permits for the expatriate and their accompanying family members may have to be settled, adequate housing has to be found and personal belongings may have to be moved. Furthermore, training may be offered beforehand so that the expatriate can learn about the host country's language, culture, customs and so on. Such activities give rise to costs that are usually compensated by the employer. Furthermore, the actual stay may create additional costs on account of the temporary status of the employment abroad. Such costs may include travel allowances for regular trips home, compensation for double rental payments and the second household, or schooling fees for accompanying children.
As each case is different, the extent to which these additional costs occur depends on a number of factors such as the status of the expatriate, the country they are moving to and coming from, the length of stay, and whether the expatriate moves alone or is accompanied by their family.
Therefore, in any case, before costs can be allocated adequately to the transferring and the host company, care has to be taken that all the relevant costs created by the transferred employee are accounted for. Not only must salary and social security contributions be paid, but the costs described above must also be considered. In practice this means that refunds for the employee's costs of moving, rents, allowances for a second household, regular travel back home, company car, etc, must be accounted for. In principal, even costs for office space, software and hardware or telecommunications have to be included in the cost accounting, although in some cases the insignificance of the relevant amounts will prohibit their consideration. However, what is clear through this analysis is that expatriate expenses go well beyond the amount of money received as salary or in the form of other pecuniary benefits.
Allocation of costs
To demonstrate the consequences of the new German principles on cost allocation, some examples may be helpful. These are described next.
Case 1 (standard expatriate)
Consider first that a French company is sending one of its marketing experts to the German sales subsidiary. The reason behind the move is to use the marketing expert's knowledge about the firm's successful French marketing strategy and combine it with German market expertise to successfully launch a new product in the German market. The development of the adjusted German marketing strategy is scheduled to take six months. The question revolves around who has to carry the costs caused by the transferred employee.
To find an acceptable allocation key, the interests of both the parties to the transfer have to be determined. The benefit to the German subsidiary is obvious: by making use of the expatriate's knowledge, the German entity can develop the necessary marketing strategy in less time, which reduces costs and brings expected returns in a shorter time frame. Due to this strong interest, the German entity will be willing to carry costs that exceed the costs of a local expert, as the expatriate brings additional value in the form of specific knowledge that may be of use to the German entity. This is acknowledged in section 3.4.1 of the new German guidelines.
This benefit alone, if documented comprehensively, is sufficient to allocate all the costs of the expatriate to the German entity. Nevertheless, the French interest should be examined as well. If the results show that benefits also accrue to the French entity, the French entity will have to assume responsibility for a part of the expatriate's costs too. This could be the case, for example, if the expatriate also performs market research while working in Germany that will be used to better adjust the company's products to meet the needs of German customers in the future ? something which may prove beneficial to the French entity.
The costs of the expatriate now have to be split between the two entities according to their respective benefits. This, of course, gives rise to a problem of evaluating and quantifying the benefits to both entities so as to compare them. Therefore, an alternative allocation key that is easier to measure might be used as a proxy for the real benefits, if it can be justified and documented well. In some cases, it might even be advisable to get the alternative allocation key approved by the tax authorities beforehand.
Case 2 (trainee)
A German company sends high-potential juniors to foreign subsidiaries for six months as part of their training programme. The aim is to give the trainees the opportunity to gather international experience, learn about foreign business practices, make useful contacts and understand the global corporate culture. The return for the company is higher motivation, better understanding and more knowledge of the returning trainee, which is beneficial for the company in the long run. Therefore, the expenses of the transferred employee can be regarded as an investment in high-potential juniors. Accordingly, it is only the transferring company that has an interest in the transfer, which means it has to bear all of the costs.
In cases of transfers solely for training purposes, it is hard to find good arguments in favour of the interests of the host companies. Only in situations where the trainee is productively adding value to the host company could a division of costs be acceptable. The new German guidelines acknowledge this by clearly stating that the costs of staff transfers for training purposes only are always attributable to the transferring company (section 3.4.3).
Case 3 (rotation)
The post of managing director at the German distribution subsidiary of a south-east Asian manufacturer of electronic equipment is regularly assigned by the Asian parent company, which usually sends one of its managers on a two-year basis. After two years, the manager returns home and is replaced by another manager from the parent company.
Such a set-up is referred to in the new German guidelines under the heading "rotational mode" (section 3.4.2). The rotational mode encompasses transfers that result from personnel concepts decided by the parent company, which means that the host company cannot autonomously fill a certain (leading) position with its own employee of choice. When deciding whether this is the case, certain characteristics should be checked:
Is the transfer unilaterally decided by the parent company?
Is the expatriation period of a typical length?
Are key positions regularly filled with employees of the parent company?
Does the hosting company actively try to fill the position with local people?
The guidelines assume that such a set-up is always connected with benefits for the transferring company, which means that the transferring company has to bear all the costs that exceed the costs of a local comparable. Therefore, it is not assumed that the expatriate is not beneficial for the host company; rather, it is only assumed that the expatriate does not bring any extra benefits compared to a local employee in a comparable position. Therefore, all the extra benefits that justify higher costs have to be attributed to the transferring company.
Case 4 (groups of expatriates)
A German company sends a number of engineers and experienced workers to its new production affiliate in China, where know-how and machinery provided by the German company are used to produce a specific product. The German expatriates are responsible for setting up the production process, training local staff and ensuring that certain quality standards are met. The benefit for the Chinese unit is obviously the implicit know-how transfer that occurs when experienced expatriates set up a new plant. But the German company also has an interest in the transfer as they can exercise the necessary control functions for selling products made in China on the German market. As a result, both parties involved in the transfer share an interest in it and, according to the German principles, each party has to take over an appropriate share of the costs.
As described above, the costs for each expatriate have to be accounted for and then related to the benefits of their work for each entity involved. The benefit analysis in particular is rather difficult, as it has to consider, among other factors, the job description of the expatriate, comparable salaries on the local market, the profit forecasts of the entities involved and so on. If this task is already challenging for one expatriate, it becomes nearly impossible if a number of employees are being transferred.
This is acknowledged by the German principles in section 3.5, which allows, in such cases, for expatriates to be grouped together according to their functions, and for a cost-benefit analysis to be performed for each group instead of each expatriate. On the basis of this analysis, for each group one allocation key has to be defined that allows for an adequate division of the costs of each member of one group. To gain legal certainty, this allocation key can be agreed with the German tax authorities during a tax audit for the years under audit and, in the form of an advance pricing agreement, even for the future. In the latter case, it is advisable to also include the other tax authority involved, to be on the safe side in both countries.
Case 4a (knowledge transfer)
As described above, the interest of the Chinese entity in the transfer of employees from Germany resides in the transfer of know-how. This raises the question of whether this know-how constitutes an intangible asset of the German entity, the use of which would have to be paid for by the Chinese entity. On the other hand, the purpose of such a staff transfer is the implicit transfer of the know-how embedded in the expatriate, otherwise local staff could fulfil the same tasks. The German guidelines explicitly state that the know-how embedded in an expatriate and used in his or her regular work does not have to be specially paid for. But if, in addition, rights to use further know-how are transferred as well, eg in the form of patents, blueprints, manuals or formulas that would normally not be available for free, this transfer has to be remunerated separately. This might even include information that is accessible to the expatriate, but not to the staff on site, eg intranet sites with restricted access, if the expatriate uses this information for the benefit of the hosting company. A benefit analysis will provide the necessary information to evaluate the knowledge transfer and there to adequately apportion the costs to the companies involved.
Case 5 (services)
To conclude, consider the following case: the IT service centre of a US bank sends an expert to the Frankfurt office to implement the new global trading software and train local staff in its use. The stay is scheduled to last 15 weeks, during which the expatriate's tasks only include supervising the implementation process and conducting workshops.
In such a case, the new German guidelines will not be applicable, as the work performed by the transferred employee will be regarded as a service to the Frankfurt office provided by the IT service centre. The reason for this is that the transferred employee is not integrated into the business operations in Germany and is not under the authority of the German entity. Instead, the expatriate performs a well-defined task without guidance from the Frankfurt office. Therefore, the German entity has to pay for the service at market prices, including a profit element, instead of bearing the costs of the transferred employee. The salary of the employee still has to be paid by the service centre from the revenues generated by its operations, eg the work being carried out in Germany. Therefore, the IT service centre remains the real economic employer throughout its employee's stay in Germany.
The best response
The purpose of the new German principles is to provide taxpayers with guidelines that should help them to avoid the transfer pricing problems related to staff transfers. Therefore, they contain propositions on what to do to actively counter any problems that might arise. Apart from adequate cost accounting for the expenses created by the expatriate, the taxpayer should ultimately be able to provide information about its own interest in the transfer, regardless of whether it is transferring or hosting the expatriate. This interest can be expressed in numerous aspects of the transfer, eg the functions performed and activities undertaken by the expatriate, their skills, knowledge and contacts, their contribution to the taxpayer's results in relation to the costs, the costs and availability of comparable employees in the local labour market, specific projects the expatriate works on, the question of which party took the initiative for the transfer, special conditions of the transfer arrangements, etc.
As the taxpayer is obliged to cooperate during the tax audit procedure under section 90 (2) AO, the taxpayer is expected to provide meaningful information about all relevant aspects of the transfer, preferably supported by evidence of the facts. According to the guidelines, such evidence may include the relevant contracts, descriptions of the host company's business activities and the expatriate's activities therein, correspondence with respect to the transfer, analyses of the local labour market, profit calculations and cost benefit analyses with respect to the transfer, data from time recording systems, travel expense reports and other recorded proof of activities.
As described above, the German guidelines allow for grouping expatriates if a substantial number of employees are transferred. The relevant procedure described in the guidelines may be used to categorize different employee transfers in advance by defining certain groups of expatriates and exemplarily performing a cost-benefit analysis for one member of each group. The results of these analyses should then be used to identify an adequate allocation key that attributes a share of the costs to each entity, which reflects the benefit the respective entity receives from the transfer. In the case of more complex circumstances or high amounts being at stake, it is advisable to apply for competent authority guidance. By getting the cost accounting practice and the allocation key approved ? preferably by both of the tax authorities concerned ? it is possible by means of an advance pricing agreement to obtain legal certainty well in advance.
Conclusion
With the publication of the new administrative principles for the tax treatment of cross-border personnel transfers, the German Ministry of Finance issued a set of rules that provide guidance for the allocation of costs arising from the use of expatriates. By using the benefits to the parties involved as the basis for testing the adherence of the cost allocation to the arm's-length principle, the new guidelines further develop German transfer pricing rules while being in line with the OECD guidelines.
For taxpayers that actively want to avoid problems in this area, the new guidelines contain a number of concrete propositions on what to do without dictating any particular behaviour. Thereby, orientation is given without limiting the taxpayer's scope regarding staff transfers, which means that transfer pricing problems can be avoided with a limited amount of cost and effort.
