Tax and legal implications of Europe’s emerging hybrid industrial defence players

Growing geopolitical tensions and a reconfiguration of global security priorities are driving a fundamental reassessment of defence preparedness and industrial resilience across Europe. Governments are increasingly prioritising the strengthening of domestic defence capabilities and the robustness of critical supply chains.

The European Defence Industrial Strategy, introduced in 2024, explicitly seeks to enhance the capacity, responsiveness, and strategic autonomy of Europe’s defence technological and industrial base, while embedding defence considerations across broader industrial and economic policies. Complementary initiatives, including the ReArm Europe framework and NATO’s Defence Production Action Plan, further underline the urgency of scaling up defence production and accelerating industrial capacity expansion across Europe.

In response to the evolving geopolitical landscape, many established multinational enterprises (MNEs) in the industrial products and construction (IP&C) sector are actively expanding their activities to capture new growth opportunities and align with changing policy priorities.

At the same time, parts of the sector are facing increasing cyclical volatility alongside structural adjustments. Certain machinery and equipment manufacturers have recorded significant demand volatility and declining output, reflecting subdued investment cycles, persistent supply chain disruptions, and weakening industrial demand. As a result, capacity utilisation across manufacturing networks leaves significant portions of industrial assets available for redeployment.

In response, companies are seeking to reallocate excess capacity and skilled labour towards alternative, more resilient, and policy-supported demand segments; in particular, defence-related production. This reallocation is operationalised by repurposing existing production assets and engineering capabilities, forming new joint ventures (JVs) with incumbents from the defence sector, and/or the exploitation of existing dual-use technologies that can be deployed across both civilian and defence applications.

Against this backdrop, a new generation of hybrid industrial defence players is beginning to take shape across Europe. This transformation, however, extends beyond a mere expansion of existing business activities. It constitutes a structural shift from predominantly civilian operating models towards hybrid configurations characterised by dual-use outputs and heightened regulatory scrutiny, as well as defence-grade technical and compliance requirements. In turn, the emergence of hybrid industrial defence players gives rise to a range of complex tax and legal considerations as traditional value chains, functional profiles, intellectual property (IP), and risk allocations evolve in line with the demands of defence-oriented activities.

Given the breadth of the topic, this article focuses on selected core tax and legal considerations rather than attempting an exhaustive treatment of all possible scenarios.

The transition into defence markets triggers a fundamental shift in business models. Whereas many IP&C companies have traditionally operated in B2B environments characterised by market-based pricing, competitive dynamics, and often relatively short product cycles, defence-related activities are typically embedded in long-term, contract-driven arrangements with governmental entities, or within contractor-based supply chains. These frameworks are often characterised by regulated pricing mechanisms, detailed contractual obligations, and the specificities of public procurement law.

This shift necessitates not only adjustments to operational processes and governance frameworks but also a reassessment of transfer pricing approaches to adequately reflect the evolving customer base, pricing constraints, contract structures, and the increasing importance of contract-specific, multi-layered sales processes. It may also require companies to navigate self-imposed restrictions or constraints arising from the investor environment, including ESG-based investment policies, family-governance rules, or internal group policies limiting exposure to defence-related activities.

From a functional perspective, sales activities evolve towards more complex and highly tailored engagements. Compared to civilian markets, defence‑related sales cycles are typically highly formalised and resource intensive, involving lengthy procurement procedures, detailed technical specifications, and multiple layers of internal and external approvals. Pricing is frequently subject to heightened scrutiny and constrained by budgetary frameworks or public procurement rules, thereby limiting commercial flexibility and increasing the importance of thorough ex ante preparation and negotiation. As a result, sales functions require significantly greater involvement in tender processes, contract negotiation, and ongoing contract management.

In parallel, the increasing integration of engineering and product adaptation into the commercial process further blurs traditional boundaries between sales, production, and development functions. Thus, traditional characterisations based on routine distribution or limited-risk service provision should be re-evaluated in light of the nature and economic significance of the activities performed.

From a risk perspective, the extended and formalised sales cycles can give rise to a distinct set of economically significant risks. While longer-term contractual arrangements may mitigate exposure to short-term market volatility, they simultaneously introduce longer-term risks that are linked to mid-term and long-term contract performance and regulatory compliance. In particular, constrained pricing frameworks and limited ability to adjust margins post-contractually can concentrate risk in those entities responsible for upfront pricing, cost estimation, contract negotiation, and key execution-related decision-making.

At the same time, highly specified procurement arrangements can increase exposure to performance-related obligations, including risks related to delays, penalties, or termination rights, as well as risks arising from public procurement law, regulatory, and certification requirements. Moreover, reliance on public sector counterparties introduces concentration and compliance risks that are closely tied to budgetary decisions, procurement cycles, and evolving political priorities.

From a tax transfer pricing perspective, these developments require careful reassessment of risk allocation across a multinational group to ensure that risks are aligned with the entities exercising control over key commercial and contractual decisions and possessing the financial capacity to bear them.

The entry of industrial players into the defence sector entails a transition into a highly regulated legal environment, characterised by complex and multi-layered compliance requirements. Central to this framework are export control and sanctions regimes, which govern the cross-border transfer of goods, technologies, and services with potential military applications. These regimes impose strict obligations on companies, including licensing requirements, end-use controls, and ongoing monitoring of transactions.

From a German perspective, this framework is shaped, in particular, by the Foreign Trade and Payments Act, the Foreign Trade and Payments Ordinance, and, where applicable, the War Weapons Control Act, alongside directly applicable EU export-control rules. Participation in defence projects may also trigger classified information and security requirements affecting personnel, facilities, IT systems, and internal processes.

A second layer of complexity arises in the procurement environment, which in Germany is often shaped by formal tender procedures, budgetary controls, and approval requirements. These features influence pricing mechanisms, signature timing, milestone design, and change control procedures. They may affect subcontracting structures where prime contractor obligations are flowed down through the supply chain.

Beyond export controls and sanctions, entry into the defence sector may also subject companies to foreign investment screening, technology transfer constraints, and stricter trade secret protection requirements. From a German and EU law perspective, these regimes can affect market access and transaction timing, as well as where sensitive functions may be performed, who may access technical information, and how contractual structures must be designed.

For hybrid industrial defence players, these legal constraints are not merely a compliance overlay; they can directly shape the feasible operating model and, in turn, the transfer pricing analysis. This is particularly true where access to technical information, program data, or sensitive know-how is legally restricted to specific entities, functions, or personnel.

The entry of industrial players into the defence sector entails structural reconfiguration that extends beyond asset conversion and often includes new JVs, cooperative platforms, and restructured supply chains. JVs have become a key mechanism for market entry, enabling access to defence technologies, certification frameworks, and regulatory expertise while mitigating entry risks in a fragmented and highly regulated European defence landscape. In certain jurisdictions, such structures may constitute a prerequisite for participation in public procurement processes; for example, where collaboration with a local partner is required to access government contracts (e.g., in India).

From a transfer pricing perspective, such reorganisations may entail business restructurings, involving reallocation of functions, assets, and risks together with corresponding shifts in profit potential and changes in the practical ability to control relevant decisions and information flows. Central questions include whether one-time intercompany compensation payments are required for such business restructuring and whether the post-restructuring profit allocations adequately reflect economic substance, decision-making authority, and the arm’s-length principle under defence-specific constraints, such as export controls and limitations on technology transfer.

Especially in JV situations, these topics have to be addressed by tax departments in MNEs at an even earlier stage, enabling management to feed tax considerations into the applicable JV agreements at the time of the negotiations with the JV partner. Later adaptations to transfer prices vis-à-vis a JV company often turn out to be very difficult to negotiate.

In Germany and the EU, foreign-investment screening may affect transaction timing, governance rights, information access, and closing certainty in defence-related transactions. At EU level, the Foreign Subsidies Regulation may add further complexity in M&A and, depending on the procurement setting, in tender contexts involving non-EU financial contributions or other forms of foreign state-linked support.

For affected groups, this may require early information gathering, internal mapping of relevant support measures, and closer alignment between transaction, procurement, tax, and legal teams. These constraints can be relevant not only for deal execution but also for the subsequent allocation of control rights and decision-making authority within the group or JV structure. From a legal perspective, this requires attention to sanctions compliance, supplier due diligence, contractual risk allocation, and security of supply requirements.

Structural adjustments are increasingly shaped by the need to establish resilient sourcing models for strategically sensitive inputs. The exposure of defence-related supply chains to sanctions, export controls, reshoring policies, and geopolitical volatility, along with dependencies on critical raw materials, can amplify supply risks. As a result, supply chain design has evolved into a core element of restructuring analysis.

Companies must reassess procurement functions, supplier selection processes, inventory strategies, and stockpiling arrangements, particularly where access to rare earths or other critical inputs is concentrated in politically sensitive regions or subject to emerging trade frameworks. Developments such as increased political attention on alternative natural resource locations and the EU’s efforts to diversify sourcing through international agreements illustrate the dynamic environment in which sourcing decisions are made and continuously reassessed.

From a tax perspective, supply chain realignments can trigger various consequences, including complex interactions between transfer pricing and customs rules. In addition, the establishment of new JV and sourcing structures requires careful consideration of where newly created functions, decision-making responsibilities, and associated IP are located, as these determine the allocation of value creation within the group and may otherwise give rise to subsequent business restructurings, including a potential relocation of functions. Early alignment of the target operating model is therefore key to avoiding later transfers of functions, assets, or risks that could trigger exit taxation.

Overall, structural reconfiguration through JVs and supply chain realignment in the defence context represents a multidimensional tax and legal transformation under heightened regulatory scrutiny.

The transition towards hybrid industrial defence structures is further accompanied by the emergence and reconfiguration of IP, raising complex questions regarding the delineation, ownership, and remuneration within MNE groups. The development of defence technologies gives rise to a broad spectrum of intangibles, including proprietary technologies, adapted product designs, embedded software, and process-related know-how. In addition, less conventional value drivers such as industrial participation arrangements and defence-specific ‘offset credits’ may become economically relevant, even though their characterisation as intangibles is not always clear from a transfer pricing perspective.

In line with the OECD principles, legal ownership alone is not determinative. Rather, the allocation of income must reflect the performance of economically significant DEMPE functions, control over associated risks, and the financial capacity to assume them.

In practice, the entry into defence markets frequently results in a reallocation or enhancement of DEMPE activities across jurisdictions. Local entities may assume expanded roles in product adaptation, customer-specific development, certification processes, and the protection of sensitive technologies, driven by localisation requirements, security constraints, and proximity to government customers.

Defence-related products might require different development capabilities, which are not necessarily present in the same legal entities (or same jurisdictions) within a multinational group when compared with the group’s traditional business model. This can give rise to new intangibles emerging in locations/jurisdictions where a multinational group might not have had intangibles in the past. Such new locations may have different taxation approaches, regulatory frameworks, IP exploitation regimes, and IP exit regimes. If the tax and legal departments are involved at an early stage, they can help ensure adequate consideration of tax and regulatory issues.

At the same time, regulatory limitations such as export control restrictions, national security and classified information rules, and constraints on cross-border technology transfers may restrict the mobility of IP and influence where DEMPE functions can be performed. This can create structural tensions between development capability locations, legal ownership strategies, operational reality, and regulatory feasibility, requiring carefully calibrated alignment of IP structures, intercompany arrangements, and legal access restrictions. This requires effective coordination of licensing scope, retransfer restrictions, confidentiality protections, and export control limitations.

These dynamics are further intensified by the increasing prevalence of technology transfer and industrial participation requirements in defence programmes. Companies are often required to provide local manufacturing capabilities, grant access to technical documentation, enable source code escrow arrangements, or transfer specific elements of know-how as part of offset or localisation commitments.

From a legal perspective, this necessitates robust contractual frameworks that balance compliance with regulatory and contractual obligations against the protection of trade secrets and proprietary technology. Key elements include clearly defined licensing terms, restrictions on use and sublicensing, safeguards for confidential information, and mechanisms to address change in law or export control developments. From a tax perspective, such arrangements must be reflected consistently in transfer pricing models, particularly where they affect the allocation of returns associated with valuable intangibles.

Under German and EU trade secret rules, effective protection also depends on appropriate confidentiality and access control measures in practice.

The delineation of DEMPE functions is therefore closely linked to the governance of technology transfer and IP protection, and access to sensitive technical information. Entities that actively manage and control development activities, oversee technology adaptation, bear the risks associated with regulatory compliance, and determine how and to what extent IP is shared or localised may be considered to perform economically significant functions that warrant more than routine remuneration. Conversely, entities that primarily implement centrally defined technologies under tightly controlled frameworks may, depending on the facts, remain appropriately characterised as limited-risk or routine service providers. The challenge lies in ensuring that the transfer pricing model accurately reflects these distinctions in a context where regulatory constraints may blur the line between control and mere execution.

The emergence of hybrid industrial defence structures necessitates a more integrated and forward-looking approach to tax and legal structuring. The intersection of transfer pricing, export controls, sanctions, foreign-investment screening, the EU Foreign Subsidies Regulation, and defence-specific regulatory requirements demands operating models that are not only technically compliant but also internally consistent across all relevant dimensions. This is particularly relevant for internationally active groups that may benefit from non-EU support measures and therefore need to assess potential Foreign Subsidies Regulation implications not only for transactions but also for larger procurement processes.

A central requirement is the establishment of coordinated governance across tax, legal, and compliance functions. Decisions relating to IP, technology transfer, and supply chain configuration must be taken within a unified tax, legal, and compliance framework to ensure that contractual arrangements, functional control, and risk allocation remain aligned. This assessment may also need to take into account internal governance constraints, investor expectations, or shareholder-imposed limitations on defence-related activities.

Equally important is the embedding of tax considerations within the broader compliance architecture. Transfer pricing models, customs valuation approaches, and intercompany agreements must be aligned with export control and sanctions frameworks to ensure consistent treatment of cross-border flows of goods, services, and technology. The design of hybrid structures further requires that tax and legal considerations be incorporated at an early stage of strategic decision-making. Structural choices such as JVs, DEMPE function allocation, and sourcing models for critical inputs must be developed in a manner that is defensible under both OECD principles and applicable regulatory constraints, and workable in practice from a governance and compliance perspective.

In Germany, restructuring timelines may also be affected by employment law, co-determination, and security-related implementation requirements.

Finally, hybrid industrial defence operating models require continuous reassessment. The expansion into defence activities may materially alter functional contributions, risk profiles, and value creation. Transfer pricing policies and entity characterisations must therefore be regularly reviewed and recalibrated to ensure continued alignment with economic substance.

In this environment, the sustainability of hybrid structures ultimately depends on the ability to consistently align operational reality, legal structuring, and transfer pricing outcomes within a coherent and adaptable framework.

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