Expected developments in German transfer pricing

The Ministry of Finance has not shifted its focus away from transfer pricing. Source: www.bundesfinanzministerium.de

While many of the hot topics in transfer pricing may now have been addressed by the Ministry of Finance, and despite the wealth of existing transfer pricing regulations, the German tax administration still identifies white spots where the need for further specification is felt.

If one looks at the evolution of German transfer pricing regulations, it becomes obvious that these developments resemble a J-shape graph: From their subtle beginnings with the introduction of the Foreign Tax Act and its section 1, where the general notion of the arm’s-length principle was laid down, it took a decade until tax authorities published the 1983 administrative principles, in which they defined their views on fundamental questions including the choice of methods, typical inter-company transactions and procedural aspects. Not much more happened for almost two decades, until, in the late 1990s and the early years of the new millennium, several additional administrative principles were published (for example, on permanent establishments and on pool agreements in 1999 and on secondments of personnel in 2001).

A triggering event followed when, in 2001, the Federal Tax Court, the highest German court in taxation matters, decided that taxpayers are only under the obligation to present the facts underlying their cross-border inter-company transfer prices but taxpayers neither need to specifically prepare documentation or prove the arm’s-length character of the inter-company prices. This gave reasons for the legislator to introduce statutory documentation requirements and respective penalties in 2003. A triad of statutory law (sections 90 (3) and 162 (3) and (4) of the General Tax Code (Abgabenordnung)) was enacted, followed by an ordinance (2003) and extensive administrative principles (2005) specifying content and extent of documentation.

The next three layers followed in 2008: As of January 1 2008, a new Section 1 (3) of the FTA introduced the regulations on transfers of business functions (Funktionsverlagerungen). This included the introduction of a hypothetical arm’s-length analysis focusing on a two-fold valuation (on the basis of discounted cash flows) both from a buyer’s and a seller’s perspective of the transaction with the arithmetic mean of the two values as the relevant transfer price. An ordinance (2008) and again extensive administrative principles (2010) followed, which completed the legislative activities.

Looking at these developments of transfer pricing related regulations and administrative principles, it is clear that transfer pricing has increasingly attracted the attention of the German tax authorities. On the plus-side, it could be said that the established regulatory framework (despite all its arguable elements that certainly exist, and many of them do exist) provides taxpayers with considerable reliability and a planning perspective. Taxpayers are granted certainty on how to deal with a good number of transfer pricing aspects in order to mitigate tax audit risks. On the other hand, compliance with documentation rules and transfer pricing regulations represents a significant administrative burden for taxpayers. In addition, the regulations are rather detailed and complex so that adherence requires substantial effort and, no less important, resources. Though a mass of rules and clarifications may have been laid down in the regulations and administrative principles, many problems remain, including that the application of the transfer of function rules triggers so many questions that it is not hard to predict numerous disputes in future tax audits.

Nevertheless, with the regulatory track presented above, one wonders what could be next in terms of transfer pricing regulations. Indeed, the Ministry of Finance, which is intensely involved in directing and drafting new legislation, has its own agenda on further transfer pricing topics that it wishes to cover. Currently, changes to section 1 FTA and an ordinance on section 1 (3) FTA are in the focus. Under section 1 FTA, taxable income has to be adjusted if (i) a taxpayer’s income from (ii) a cross-border business transaction with (iii) a related entity is (iv) not at arm’s-length. The expected changes for 2012 concern the elements highlighted in the sentence before and cover the following topics:

• Application of section 1 FTA to permanent establishments;

• Application of section 1 FTA to business partnerships or co-entrepreneurships;

• Redefinition of the term business transaction; and

Issuance of an ordinance on section 1 (3) 1 – 5 FTA.

In February 2011, a draft version with planned amendments to Section 1 FTA became known under the title: Arm’s-length principle – allocation of permanent establishment profits. The title outlines one of the most relevant changes proposed in the draft.

The draft regulation states that the application of section 1 FTA shall be extended to permanent establishments (PEs). PEs will then be treated as separate entities, and will be deemed independent entities in the course of allocating income between a head office and its PE. In the case of a decrease of income in Germany or excessive income in a German entity’s foreign PE, because of conditions that are not in-line with the arm’s-length principle, section 1 (1), (3) and (4) FTA will then apply, regardless of regulations set out in double tax treaties. These rules shall also apply to permanent representatives (ständige Vertreter).

Section 1 FTA does not cover PEs because, at least from the German civil law perspective, no legally relevant business transactions can exist between a head office and its PE. The proposed change would result in, among others things, the application of the actual and hypothetical arm’s-length principle between head office and PE. Potentially even more relevant, the regulations on transfers of business functions would be applicable to PEs analogously thereby limiting respective tax planning opportunities, which exist under the current statutory wording. Of course, whether the hypothetical arm’s-length principle and the rules on transfer of business functions are in line with the OECD approach remains unclear.

In general, this adjustment could be seen as a tendency of approximation of German regulations towards the OECD separate entity approach. However, it is worth highlighting the phrase that section 1 FTA shall be “applicable regardless of the regulations of double tax treaties” as this phrase typically expresses a treaty override. Though widely criticised in the German tax literature, treaty overrides are, according to German case law, effective when explicitly set out in a law. It seems that the Ministry’s intention here is to avoid conflicts between the arm’s-length principle in its interpretation of article 9 of the OECD Model Convention as set out in section 1 FTA and the definition of article 7 in the OECD Model Convention on the one hand and the respective provisions in the already concluded German double tax treaties on the other hand. The treaty override limits the possibilities for taxpayers to benefit from existing double tax treaty regulations which might be more beneficial than any treatment under section 1 FTA. It still needs to be analysed whether this treaty override has further negative effects for taxpayers.

In the past, partnerships or co-entrepreneurships were not explicitly covered by the definition of taxpayer and related entity in section 1 FTA. According to the draft, a partnership (Personengesellschaft) or co-entrepreneurship (Mitunternehmerschaft) shall now be deemed to be a taxpayer or related entity in the sense of section 1 FTA. Thereby, the Ministry of Finance intends to clarify the personal scope of application of section 1 FTA.

According to the definition in section 1 (5) FTA, any relationship under the law of obligations (schuldrechtliche Beziehung) which does not represent an agreement in the context of the articles of association (gesellschaftsvertragliche Vereinbarung) is regarded as a business transaction.

In its draft, the Ministry of Finance includes two major changes: First, business transactions shall be individual or combined economic transactions (Geschäftsvorfälle). The reference to combined economic transactions points, for example, towards the transfer of business functions that typically comprise not only one transaction but a bundle of several diverse transactions. The Ministry of Finance seems to want to legitimise transfers of business functions as business transactions. Additionally, the draft refers to economic transactions instead of relationships under the law of obligations. The definition is therefore wider than before. Secondly, according to the draft, all economic transactions are deemed to be based on agreements under the law of obligations unless the taxpayer can show credibly, in any specific case, that this would be different in a third party situation.

In essence, the suggested redefinition of section 1 (5) FTA widens the definition of business transactions to cover all economic transactions (including transfers of business functions as a bundle of combined economic transactions) except for agreements in the context of the articles of association, and shifts the burden of proof for a missing agreement, for example, under the law of obligations to the taxpayer. The consequence is that almost all business transactions are subject to documentation requirements as well as to potential estimates and penalties under section 90 (3) and section 162 of the General Tax Code.

The Ministry of Finance has not yet published any draft version of a new ordinance on section 1 (3) 1 – 5 FTA. However, from what is known, the ordinance as planned would have a significant impact on German taxpayers. In the following, the most striking provisions are highlighted:

• Arm’s-length analyses based on databases (so-called benchmarking studies) would in many cases be rejected. An exception is made for certain (very) routine entities such as toll manufacturers, sales agents and commission agents. In this context, definition and differentiation between routine entities and intermediary entities (with a functional and risk profile between a routine entity and an entrepreneur) might be provided by the ordinance;

• The terms limited comparability (in the context of comparables resulting from benchmarking studies) and incomparability might be specified with regard to the different legal consequences;

• Arm’s-length analyses for unique intangible assets would be rejected. Instead, a hypothetical arm’s-length analysis, based on a two-fold valuation would be required if the income streams can clearly be attributed to the respective intangible asset. That means valuations (discounted cash flows of expected future income) both from the seller’s and from the buyer’s perspective have to be taken into account with the arithmetic mean of both DCF values as the relevant transfer price.

• Finally, year-end income adjustments would be generally rejected because they would result in a profit guarantee, which is considered not to be arm’s-length. Again, an exception might be made for certain routine entities.

This overview shows that the rules set out in the ordinance would certainly raise a lot of discussions, are likely to be in conflict with foreign rules and common practice, and require many taxpayers to revisit their transfer pricing model. For example, distributors and manufacturers may no longer qualify as routine entities under the new and stricter definition, so that the practice of year-end adjustments based on benchmarking analyses might no longer be accepted by the German tax administration.

Predicting the future is generally speculative. However, it is likely that the German transfer pricing rules will see further developments, many of which are likely to put an additional burden on taxpayers and might also be in conflict with international rules and/or widely used transfer pricing practices. This would certainly be true for restrictions with respect to the use of benchmarking studies and year-end adjustments.

Originally, the changes to section 1 FTA were scheduled to become effective on January 1 2012. However, this schedule does not seem realistic any longer so an introduction as of January 1 2013 is the likely scenario. Regarding the ordinance on section 1 (3) FTA, once the Ministry of Finance has published a draft version, industry and transfer pricing experts will usually have the opportunity to address their comments, concerns and recommendations. This procedure is expected to take place next year so that the ordinance could well be published and become effective in 2012.

Biography
		Lorenz Bernhardt PwC Lise-Meitner-Straße 1 10589 Berlin Tel: +49 (0)30 2636-52 04 Mobile: +49 175 584 23 59 Fax: +49 (0)30 2636-53 87 Email: lorenz.bernhardt@de.pwc.com Lorenz Bernhardt is a transfer pricing partner at PwC Berlin. He is also head of the German transfer pricing practice of PwC. Bernhardt has more than a decade of comprehensive experience in tax consulting, in particular in planning, implementation and defence of transfer pricing systems, as well as in international tax structuring. He advises large international clients (both German and foreign headquartered) and has led a variety of projects, among other things, in the automotive, chemical and pharmaceutical industry. Additionally, he lectures on transfer pricing and international tax at various seminars and at universities. Lorenz obtained a law degree from the University of Munich and an LL.M from New York University School of Law. Before joining the tax practice of an international accounting firm in Germany, he had been working as a foreign associate with Fried, Frank in New York. Bernhardt is a German certified tax adviser and has been admitted as attorney-at-law both to the German Bar as well as to the New York Bar.

Biography
		Michael Jakob PwC Moskauer Str. 19 40227 Düsseldorf Tel: +49 (0)211 981-7231 Fax: +49 (0)211 981-7362 Email: michael.jakob@de.pwc.com  Michael Jakob is a senior manager with the transfer pricing team at PwC Düsseldorf. Jakob joined PwC in 2003 and, since then, has gained broad experience in development, implementation, documentation and defense of transfer pricing models. He has been working on projects with many international clients in various industries such as retail, machinery and chemical. Jakob is a certified tax adviser. He graduated with a Masters in agricultural economics and wrote his PhD thesis on a cost accounting topic at Giessen University. His international background stems from internships and research visits in the US.