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The hypothetical arm’s-length test: Germany’s way of calculating the ALP for IP

The German approach to determining the arm’s-length price for intangibles/intellectual property (IP) is based on the relevant German tax code and related administrative guidance, explain Richard Schmidtke, Bjorn Heidecke and Oskar Glaser of Deloitte. If other methods are used to determine the arm’s-length price for IP, this may result in non-compliance in Germany.

Method selection

In Germany, the determination of an arm's-length price for IP follows a transfer pricing (TP) method hierarchy (see first sentence onwards of Section 1 Paragraph 3, Foreign Tax Code). The comparable uncontrolled price (CUP) method, the cost plus method, and the resale price minus method are the highest ranked methods in the hierarchy. If those methods are not applicable, other methods, such as the transactional net margin method and the profit split method, must be applied (see first sentence of Section 1 Paragraph 3, Foreign Tax Code), always based on unlimited or limited comparable third-party data.

If none of the aforementioned methods is applicable, for example due to the lack of third-party data, the so-called hypothetical arm's-length test must be performed (see the fifth sentence of Section 1 Paragraph 3 Foreign Tax Code). The hypothetical arm's-length test was introduced as part of Germany's 'company tax reform', and is applicable for financial years starting after December 31 2007.

Generally, the hypothetical arm's-length test is used in cases of 'relocation of functions' in the course of business restructurings to evaluate the 'transfer package' made available by the transferor to the transferee. A relocation of functions is assumed if an entire function, including risks and opportunities as well as assets, is transferred (see the ninth sentence onwards of Section 1 Paragraph 3, Foreign Tax Code). Given the unique features of a transfer package, limited or unlimited comparable third-party data is often unavailable, making the hypothetical arm's-length test the standard method in practice. Therefore, a plethora of additional guidance on the relocation of functions and its application of the hypothetical arm's-length test has been published by the German tax administration. In particular, the Decree on Relocation of Functions issued on August 12 2008 needs to be considered. The 80-page administrative principles issued by the German Ministry of Finance on October 13 2010 are binding on the tax administration but not on the taxpayer.

Despite the availability of general guidance, specific guidance regarding the application of the hypothetical arm's-length test in cases other than a relocation of functions is limited. Below, the authors propose an analogous interpretation of the available guidance when dealing with IP transfers.

An economic way of thinking: The hypothetical arm's-length test

The idea behind the hypothetical arm's-length test is to simulate negotiations between seller and buyer in consideration of potential alternative options. Thus, the hypothetical arm's-length test employs functional analysis and internal company planning calculations to determine a minimum selling price for the seller and a maximum buying price for the buyer, under the assumption that two conscientious business managers will negotiate. In addition, the legislation assumes that the two conscientious business managers have complete transparency of information within the framework of the simulated price negotiations. Hence, the pricing is based on the assumption that the business managers are aware of all material circumstances of the business relationship (third sentence of Section 1 Paragraph 1, Foreign Tax Code) in this two-sided approach.

Two values are then derived – a minimum value from the seller's perspective and a maximum value from the buyer's perspective, constituting the range of agreement that results from the differing profit expectations (profit potential). German tax legislation assumes the midpoint of this price range to be the actual transfer price if no other price can be substantiated as the arm's-length price with the highest likelihood.

The minimum value claimed by the selling entity is influenced by the expected loss of profit potential from the exercise of the IP, that is, the minimum price is determined by compensation for the potential profits forgone. Realistic alternatives must be considered.

The maximum value representing the buyer's willingness to pay is affected by expected additional profit potential considering own contributions such as the receiving company's IP or workforce, as well as synergies expected to arise from the transferred IP. As with the minimum value, realistic alternatives must be considered.

Figure 1: The hypothetical arm’s-length principle

Figure 1 illustrates the hypothetical arm's-length principle as described above.

Because both the loss and additional profit potential must be calculated, a four-sided valuation is common: both the minimum and maximum value can be established by comparing the profit potential before and after the intended transfer of IP, requiring two valuations for each party.

The next section outlines a numerical example based on the administrative guidelines for relocation of functions to illustrate the application of the arm's-length test. Because the administrative guidelines are not binding on the taxpayer, the taxpayer can also apply other valuations to calculate the minimum and maximum prices.

Application of the hypothetical arm's-length test

The following simplified example illustrates the hypothetical arm's-length test in the case of an IP transfer when applying the available guidance for relocation of functions by analogy (see Administrative Principles Relocation of Function 2010, Appendix, Case C). More details on the application can be found in Schmidtke et al (2017), Transferpaketbewertung, in Heidecke et al (editors) Funktionsverlagerung und Verrechnungspreise, Springer. The latter have presented a hypothetical arm's-length test application considering the common valuation practice.


A parent company (Company S) transfers IP to a foreign subsidiary (Subsidiary B). The IP has been fully developed and no additional development costs are necessary during the use of the IP over a five-year period. Company S's profit potential with the IP would be €0.6 million ($700,000) per annum higher than without the IP for five years. Correspondingly, Subsidiary B's profit potential would increase by €0.9 million per annum for five years if the IP was transferred. For both companies, it is assumed that the risk-free interest rate is 4% and the appropriate risk premium is 5%. In the case of post-transfer development costs, the pre- and post-transfer discount rate will often need to be adjusted to reflect the difference in systemic risk between the realistic alternatives. Company S's tax rate is assumed to be 30%, and Subsidiary B's 20%. The example assumes that Compamy S's book value of the IP amounts to €1,372,818.


Company S's minimum price before tax impact amounts to the net value of the profit potential tansferred, that is, discounting €0.6 million with a discount rate of 9% for five years results in a net present value of €2,333,791. Given that it is assumed that the IP transfer is a taxable event and the capital gains are taxed at 30%, the minimum price amounts to (€2,333,791 – 30% × €1,372,818)/0.70% = €2,745,636.

Subsidiary B's maximum price before tax amounts to the net value of the profit potential received, that is, discounting €0.9 million with a discount rate of 9% for five years results in a net present value of €3,500,686. Under the assumption that the transfer price paid for the IP can be capitalised and the resulting amortisations would be tax deductible by Subsidiary B, the net present value of the tax amortisation benefit would amount to 1/(1-0.1556) = 18.43% (see Figure 2).

This results in a maximum price to Subsidiary B of €3,500,686 × 1,1843 = €4,145,699.

The resulting midpoint between €2,745,636 and €4,145,699 is €3,445,688, which the taxpayers would have to apply.

Figure 2

Year 1Year 2Year 3Year 4Year 5
Amortisation in %20%20%20%20%20%
Discount factor9%9%9%9%9%
NPV factor0.9170.8420.7720.7080.65
Tax rate0.
Amortisation benefit0.0370.0340.0310.0280.026
NPV amortisation benefit0.1556


As result of the amendment of the Foreign Tax Code in 2007, Germany introduced the hypothetical arm's-length test into the Code. The hypothetical arm's-length test must be applied if no limited or unlimited comparable third-party data is available. It is a two-sided approach that considers both the minimum ask price from the seller's perspective and the maximum willingness to pay from the buyer's side. The most likely value within that range must be chosen. In its practical application, the following parameters should be carefully analysed and documented:

  • Profit potential expectations associated with the IP pre- and post-transaction;
  • Realistic alternatives;
  • Capitalisation rate for a risk-free investment, increased by a premium that adequately reflects functions and risks;
  • Capitalisation period associated with the useful life; and
  • Tax gross-up approach.

German legislation goes beyond what is stipulated by Article 9 of the OECD's Model Tax Convention on Income and on Capital. Thus, it is debatable whether the hypothetical arm's-length test is covered by typical double tax treaties. This issue should be further investigated, especially because the analysis must hold for both jurisdictions involved in the transaction. Practical experience in that regard is limited. Court cases on the application of the hypothetical arm's-length test and its compliance with double tax treaties are not available yet.

Dr Richard Schmidtke

PartnerMunich, Germany

Tel: +49 (89) 29036 8690
Fax: +49 (89) 29036 8482

Dr Richard Schmidtke is a partner with Deloitte's German transfer pricing service line and leads the local transfer pricing team in Munich. Richard has advised clients mainly in the areas of business model optimisation, IP transfer pricing planning, documentation work for various companies including support in tax audits, mutual competent authority procedures and advanced pricing agreements. As part of his work, Richard also assisted multinationals defining and implementing transfer pricing policies and related corporate governance processes. Richard's clients include European, Japanese and US multinational corporations in a wide range of industries, including manufacturing, pharmaceuticals, chemicals, wholesale/retail, consumer goods and logistics.

Richard studied economics and business informatics in Munich and Toulouse and holds a PhD in economics from the University of Munich. He further holds a master's degree in accounting and taxation from the Business School Mannheim and is a chartered financial analyst charterholder of the CFA Institute. Richard is a certified German tax adviser and member of the German Chamber of Tax Advisors. He is also a member of the German Chartered Financial Analyst Society.

He is a leader of the intellectual property group, an international group of Deloitte transfer pricing experts focusing on transfer pricing and intellectual property. Further, Richard teaches transfer pricing at the Business School of Mannheim and transfer pricing valuation of intangibles for tax auditors at the internal university of the Federal Tax Office (Bundesfinanzakademie).

Richard has published various articles in national and international tax and transfer pricing journals. Most of his publications deal with business restructurings, compensation payments and IP migration topics. He is a regular speaker at national and international conferences.

Richard is recognised as one of the world's leading transfer pricing advisers by Euromoney/Legal Media Group.

Bjorn Heidecke

Senior manager, transfer pricingHamburg, Germany

Tel: +49 40 320804953

Bjoern Heidecke is a senior manager in the transfer pricing practice of Deloitte's German member firm and is based in Hamburg.

He focuses on issues relating to valuations, business restructurings, and intangibles.

Bjoern serves clients from all industries, including fast-moving consumer goods, pharmaceuticals, and the digital sector. He is a frequent speaker at the German Training Center for Tax Auditors (Bundesfinanzakademie) as well as at universities. Bjoern is a regular contributor to international tax publications on transfer pricing topics, and is the editor of a compendium on transfer pricing and restructurings.

Bjoern holds a PhD in economics.

Oskar Gläser

ManagerTax and legal, transfer pricing

Leipzig, Germany
Tel: +49 341 992 7092
Mobile: +49 151 5807 4750

Oskar Gläser is a transfer pricing manager in the Leipzig office. He joined Deloitte in January 2018 after gaining nine years of professional experience as a transfer pricing adviser with another Big 4 firm.

Oskar has general experience in all areas of transfer pricing. He advised large DAX companies as well as mid-sized companies in a wide range of industries. Oskar has mainly been engaged in projects focusing on tax audit defence and implementation projects in Germany.

Recent relevant experience

  • Tax audits, administrative appeals and criminal tax proceedings.
  • Support regarding the design of franchise fees, trademark licenses and service charges.
  • Transfer pricing advisory with focus on inter-company financial transactions as well as BEPS Action 13 (MF/LF/CbCR).

Academic background

  • External PhD student at TU Dresden.
  • Diplom-Wirtschaftsjurist (FH) at Trier.

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