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Expected changes in German transfer pricing regulations

Changes and further regulation in relevant areas of transfer pricing expected in 2013 require taxpayers to revisit their transfer pricing model.

Most notably, this refers to the implementation of the so called Authorised OECD Approach for permanent establishments and an ordinance providing more specifics on the arm’s-length principle and discussing matters such as comparability, benchmarking studies and year-end adjustments.

Implementation of the Authorised OECD Approach for permanent establishments

To implement the Authorised OECD Approach for permanent establishments (PEs) in Germany, the application of section 1 Federal Tax Act (FTA) shall be extended to PEs by a new section 1 (5) FTA. Insofar, 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, the income adjustment provisions set out in section 1 FTA will then apply.

The proposed change would result in, among other 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 statutory wording now. And conflicts with existing double tax treaties might occur which can only be mitigated if specific conditions are met. Various questions about the transition to the new rules are yet open.

The tax authorities plan to enact the amended version of section 1 FTA by the end of 2012 to become effective from 2013 onwards. An ordinance (decree-law) to provide further details on the new section on PEs is expected to follow by early 2013. In addition, the tax authorities will publish administrative guidelines on the new section 1 (5) FTA outlining their interpretation of the new regulation and revise existing guidelines on PE income allocations accordingly.

Specification of the arm’s-length principle

The Ministry of Finance plans to provide more specifics on the arm’s-length principle in an ordinance on section 1 (3) 1 - 8 FTA in 2013. So far, no draft version has been published. However, the content of the ordinance as discussed would have a significant impact on German taxpayers. The most striking of the discussed provisions are as follows:

· Due to a clarification or tightening of acceptance criteria, arm’s-length analyses based on databases (so-called benchmarking studies) would in many cases be rejected. An exception is expected to be 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) shall be clearly defined in the ordinance. It is intended not to consider distributors as routine entities.

· The terms “limited comparability” and “incomparability” (in the context of comparables resulting from benchmarking studies) are expected to be specified with regard to the different legal consequences. In this context, procedures on how to narrow a range of comparables shall be further defined.

· Arm’s-length benchmarking analyses based on databases for “unique” intangible assets would generally be rejected. Instead, a hypothetical arm’s-length analysis based on a twofold valuation considering both the seller’s and the buyer’s perspectives would be required. Nevertheless, the potential existence of arm’s-length ranges from comparables of limited comparability might be taken into account as a reference under certain conditions.

· Year-end income adjustments would be generally rejected as these would result in a profit guarantee which is considered not to be arm’s length. An exception shall be made for certain routine entities.

If implemented as discussed now, the regulations would certainly raise a lot of discussion as they are likely to be in conflict with foreign rules and common practice. And many taxpayers would need to revisit their transfer pricing model. As an example, distributors and manufacturers may no longer qualify as routine entities under the new and stricter definition, so the German tax administration might longer accept the practice of year-end adjustments based on benchmarking analyses.

Further topics on the agenda

In 2013 the Ministry of Finance intends to revise existing administrative guidelines (particularly, the guidelines dated February 23 1983 and April 12 2005, both outlining principal procedures and issues in relation to the arm's-length principle) to specify their view on topics such as group financing, permanent losses and valuation of intangible assets. Though not binding for taxpayers, such guidelines express the tax administration’s view and tax auditors have to follow them.

Michael Jakob (, senior manager in PwC’s transfer pricing group in Germany.

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