Germany issues draft regulation for the profit attribution to permanent establishments
On August 5 2013, the German Ministry of Finance issued for public discussion the draft version of a new Regulation on the Profit Attribution to Permanent Establishments (PE regulation). The PE regulation aims to provide details on the application of the authorised OECD approach (AOA) that was recently implemented in the German tax law.
The main issues covered by the draft regulation are:
• Attribution of assets and risks to a permanent establishment.
• Allocation of the (free) capital/surplus to the different parts of the enterprise.
• Some clarification under which conditions a dealing (assumed contractual relationship) between different parts of the legal entity is recognised for tax purposes, in particular with respect to treasury dealings.
In addition, the PE regulation contains specific provisions with respect to permanent establishments of banks and insurance companies and construction and exploration sites. This article covers the main elements of the draft PE regulation and highlights areas for taxpayers to take action.
Two-step approach for the profit attribution
Germany treats a permanent establishment like a separate and independent entity for tax purposes for all financial years starting after December 31 2012. The draft
PE regulation now provides details on the two-step approach for the determination of the profit attributable to the permanent establishment that is required by the German tax law. Generally speaking, the draft PE regulation follows the guidance provided by the OECD Report on the Profit Attribution to Permanent Establishments dated July 22 2010. In a first step, the functions performed, assets used and risks assumed are attributed to the permanent establishment based on the identified significant people functions. Next, all intercompany transactions, including dealings between the different parts of the enterprise, have to be remunerated on an arm’s-length basis.
Based on the draft PE regulation, a people function is attributed to a permanent establishment if its own personnel perform the respective activity. Deviation from this fundamental principle is only possible for activities that are not related to the business and that are performed for a short period of time by the permanent establishment.
Based on the identification of the significant people functions, the assets of the company are attributed according to the following principles:
• Tangible assets are attributed based on the place of use.
• Intangible assets are attributed to the permanent establishment that performed the significant people function that was responsible for their creation or purchase.
• Participations are attributed to the permanent establishment to which they stand in a functional relationship.
• For any other assets, the people function related to their production or purchase determines the attribution.
• Hedging instruments follow the attribution of the hedged asset or transaction.
• Transactions with third or related parties are attributed to the permanent establishment that hosts the significant people function that has generated the transaction.
In general, the draft PE regulation aims at a clear and unique asset attribution. If different parts of the enterprise perform relevant people functions, only the people function with the highest importance to the asset can be regarded as the significant people function to which the asset is attributed. In all cases, an escape clause allows the taxpayer to apply other criteria for the asset attribution, for example to attribute the respective asset to the people function responsible for the administration, risk management or disposal of the asset, if it can be demonstrated that such approach better reflects the arm’s-length principle.
The attribution of chances and risks to a permanent establishment follows the attribution of the assets with which such chances and risks are associated. Risks that are not associated with any asset are attributed to the permanent establishment to which the people function that has caused the risk belongs.
Determination of the capital attributable to the permanent establishment
With respect to the determination of the capital attributable to a permanent establishment, the German Ministry of Finance proposes an asymmetric approach maximising the German tax base, which is subject to criticism as it is the potential source for double taxation. For a domestic permanent establishment of a foreign enterprise, in general the capital allocation methodology has to be applied that allocates the whole equity determined according to German tax regulations to the different parts of the enterprise, taking into account the significant people functions, assets and risks attributable to the permanent establishment. For the sake of simplicity, the equity of the foreign balance sheet can be used if the taxpayer can demonstrate that this equity amount does not significantly deviate from the equity determined based on German tax law or, if appropriate, adjustments can be made for deviations. If the whole entity is undercapitalised, the capital allocation has to be based on the equity-debt ratio of the consolidated group.
With respect to a foreign permanent establishment of a German enterprise, the draft PE regulation stipulates that the thin capitalisation methodology is applied, in that capital can only be attributed to the permanent establishment if the taxpayer makes plausible that the capital is required based on, for example, legal or regulatory requirements. A higher capital can only be attributed to the permanent establishment if this better reflects the arm’s-length principle - up to the amount resulting from the application of the capital allocation method. If the capital recorded in the accounts of the German permanent establishment is higher than the amount resulting from the application of a reasonable allocation method, the draft PE regulation stipulates that the capital of the German permanent establishment cannot be reduced retroactively. The opposite is true for a foreign permanent establishment of a domestic enterprise, which can only be attributed the capital recorded in the accounts. A retroactive increase is excluded. Therefore, it is important for taxpayers to analyse the applied methodology for the capital allocation and evaluate any compliance with the new ruling.
Attribution of interest expenses
After having determined the attributable capital, the directly allocable liabilities are attributed to the permanent establishment. If the sum of the attributable capital and the directly allocable liabilities exceeds the value of the assets, the amount of the directly allocable liabilities has to be proportionately reduced and, therewith, the directly allocable interest expenses, which are deductible for tax purposes. If the sum of the attributable capital and the directly allocable liabilities is lower than the value of the assets, the missing amount has to be filled with the remaining liabilities. The deductible interest expenses associated with these remaining liabilities have to be determined as the average interest expenses connected with these remaining liabilities. The draft PE regulation stipulates that domestic permanent establishments of companies that are not obliged to prepare a balance sheet must have a profit before tax that complies with the arm’s-length principle. A foreign permanent establishment of such companies must be allocated, at least, interest expense corresponding to its share in the outside sales of the enterprise.
Recognition of a deal
Based on the German tax law, business transactions between a permanent establishment and the remaining parts of the enterprise located in another jurisdiction constitute a so called “assumed contractual relationship” that has be remunerated on an arm’s-length basis.
The draft PE regulation defines that such an assumed contractual relationship takes place if the asset attribution changes or if a business activity is performed for which third parties would have had concluded a contract. In accordance with the OECD PE report, the draft PE regulation excludes in principle a loan transaction between different parts of the same enterprise.
If a permanent establishment manages the funding or invests exceeding liquidity for one or more other permanent establishments of the same enterprise, such activity is regarded in general as a service (and not as a financing transaction) for which a cost-based transfer pricing method has to be applied. The interest expenses are not part of the allocable cost base. If no direct allocation of the costs incurred by the financing permanent establishment can be performed, these costs can be recharged based on a reasonable location key. The invested assets and their return are usually not attributable to the financing permanent establishment but to the remaining parts of the enterprise. If no direct allocation is feasible, an indirect allocation of the investment yield has to be performed. Balances on internal clearing accounts do not bear any interest.
Specific rules for permanent establishments of financial services institutions
In accordance with the OECD PE report, the draft regulation for PEs uses the terminology “key entrepreneurial risk taking functions” (KERT functions) in relation to the asset attribution to permanent establishments of banks and insurance companies. With respect to assets resulting from the banking business (for example, a loan agreement), the draft PE regulation stipulates that the KERT function is the function that is most important for the asset creation. In case of a qualification conflict, the customer relationship is decisive. A re-attribution of the banking asset is only possible under very restrictive conditions. In line with the OECD PE report, the underwriting is defined as the KERT function with respect to insurance companies.
The draft PE regulation explicitly states that an internal reinsurance transaction between different parts of the same enterprise cannot be recognised as a dealing for tax purposes. With respect to global trading transactions, the Ministry of Finance acknowledges that a direct asset allocation might be infeasible or unreasonably burdensome due to the nature of the business. Therefore, a partial attribution based on a reasonable allocation key is allowed. Furthermore, the draft PE regulation stipulates there is a refutable presumption that the residual profit split method is the most appropriate transfer pricing method to be applied for global trading transactions.
The approach for the capital allocation to permanent establishments of financial services institutions follows the asymmetric general approach taking into account the regulatory environment of the industry.
For domestic permanent establishments, the (for insurance companies modified) capital allocation method is the preferred approach using risk weighted assets (banks) and technical reserves (insurance companies) as the allocation key. A lower capital can only be accepted for tax purposes if such deviation from the basic methodology better reflects the arm’s-length principle. The domestic permanent establishment has to be attributed at least the minimum capital required for regulatory purposes. For the capital allocation to foreign permanent establishments of a domestic company, the quasi thin capitalisation/regulatory minimum approach has to be applied, in that, the foreign permanent establishment is attributed the minimum amount of capital required for regulatory purposes. The taxpayer has to provide proof for such minimum capital requirement.
A higher amount of free capital/surplus – up to the amount resulting from the capital allocation method – can only be attributed to the permanent establishment if this better reflects the arm’s-length standard. If the foreign regulatory authority requires an even higher amount of capital, the foreign permanent establishment can be attributed the required capital endowment as long as the other parts of the enterprise do not become thinly capitalised by this.
Specific rules for construction and exploration permanent establishments
The draft PE regulation introduces a refutable presumption that the activities performed by a construction or exploration permanent establishment represent a service dealing with the rest of the enterprise. Such service dealing should be remunerated based on a gross or net cost plus approach if the activities performed by the permanent establishment can be regarded as routine activities.
According to the draft PE regulation, the main costs are the costs of the personnel employed because the machinery is assumed to be provided free of charge by the rest of the company if no significant people functions, with respect to these tangible assets (such as purchasing, maintenance) are performed by the permanent establishment. In the preamble to the regulations, it is noted that costs incurred due to wrong business decisions made by the permanent establishment should be eliminated from the cost base.
If the activities contributed by the construction permanent establishment are unique (due to unique intangible assets developed by the permanent establishment, for example), the profit split method has to be applied for the profit attribution using costs incurred as the allocation key. The costs used as the allocation key should include an appropriate share of the research and development costs and costs of failed acquisition activities.
Specific documentation requirements
For all financial years beginning after December 31 2012, the taxpayer has to prepare an auxiliary calculation on an annual basis with respect to the assets, the capital, the remaining liabilities and the revenues and expenses attributable to the permanent establishment, including deemed revenues and expenses resulting from internal dealings.
Part of the auxiliary calculation are documentation notes on the reasoning for the applied asset attribution. In particular, if the taxpayer deviates from the basic principles for the asset attribution laid down in the regulation, it should be properly documented that such deviation leads to a result that better reflects the arm’s-length principle. The auxiliary calculation has to be prepared at the latest, when the tax return for the respective financial year is filed.
The German Ministry of Finance has invited the public to comment on the draft PE regulation by October 11 2013. It is expected that the PE regulation will be adopted
by the Upper House of Parliament (Bundesrat) at the end of 2013 or beginning 2014 with retroactive effect as of January 1 2013.
Action points – AOA screen
It is advisable for taxpayers to screen the asset attribution, including the capital allocation, and the determination of the taxable income to determine whether they comply with the new and very specific rules of the draft PE regulation. In particular, the following areas require for a careful analysis of the company’s current procedures:
• Has the permanent establishment prepared an auxiliary calculation with respect to the balance sheet items and its revenues and expenses? Are the reasons for the asset attribution sufficiently documented?
• Is the taxable income of the permanent establishment located in Germany determined based on the principles of the AOA: Are all intercompany transactions (including dealings) remunerated in accordance with the arm’s-length principle? Is any deviation from the stipulated transfer pricing methods documented (if applicable)?
• Is the capital attributed to the permanent establishment in line with the applicable allocation method prescribed in the PE regulation? Has use of any escape clause been made and, if yes, is the reason for deviating from the general approach properly documented?
By Oliver Wehnert of EY Germany firstname.lastname@example.org