Cross-border business restructurings play a central role in multinational enterprises. They often entail the relocation of functions from one tax jurisdiction to another and the shift of business profits between these countries, often to the detriment of the former tax jurisdiction. In 2008, the German legislature adopted “business restructuring” (i.e. OECD Guidelines Chapter IX) transfer pricing rules.
The “relocation of functions” regulations aim at safeguarding tax revenue on profit potential arising from functions that are relocated abroad and whose value contributions are thereby withdrawn from German taxation. These rules and their interpretation have since been continuously developed by the German tax legislature and are considered a hot topic in tax audits.
Major Changes to Transfer Pricing Legislation
The Abzugsteuerentlastungsmodernisierungsgesetz (Act to Modernise the Relief from Withholding Tax and the Certification of Capital Gains Tax,“AbzStEntModG”), which was formally promulgated on June 8, 2021, entails major changes to the German transfer pricing legislation and has a significant impact on the way business restructurings are approached in the present and future.
Besides broadening the meaning of the term “transfer of function” by addressing the relocation or transfer of “assets or other benefits”—in the former version it was “assets and other benefits”—the taxpayer’s opportunities to use escape clauses to avoid Germany’s well-known hypothetical arm’s-length approach for the determination of the transfer package are now strongly restricted.
This article aims first to introduce the German approach towards determining transfer prices for the relocation of functions, and second, to outline the impact of the limitation of escape clauses which were available in the old version of the Außensteuergesetz (German Foreign Tax Law,“AStG”).
The German Ministry of Finance already proposed a fundamental extension of the transfer pricing legislation in the winter of 2019, when a draft of the Gesetz zur Umsetzung der Anti-Steuervermeidungsrichtlinie (ATAD-Umsetzungsgesetz), i.e., the law for the implementation of the EU’s Anti-Tax Avoidance Directive (ATAD), was published. The ATAD is a legal act of the EU released in 2016 with the purpose of combating tax avoidance in EU member states and safeguarding the functioning of the internal market from a tax perspective. Unlike an EU regulation, a directive is required to be adopted by the national legislature.
The German draft bill implementing the ATAD was published by the German Ministry of Finance on December 10, 2019 and renewed on March 24, 2020. The ATAD draft bill contained a number of changes and extensions of the transfer pricing legislation as stipulated in Section 1 of the AStG. The wide range of new transfer pricing regulations would, inter alia, include the application of the arm’s-length principle, advance pricing agreements, financial transactions, intangibles, and transfer pricing documentation. A further area affected by the ATAD draft bill is German relocation of function rules.
In the wake of the Covid-19 pandemic in winter 2020, the German upper house (Bundesrat) downsized the draft bill considerably, because many transfer pricing related topics were not seen as an integral part of the ATAD. It took less than a few months for the proposed changes of transfer pricing legislation to appear (although in a slightly different form) in another bill, the AbzStEntModG, proposed by the German Ministry of Finance’s transfer pricing specialists. As with the ATAD approach special regard was given to the German transfer pricing approach towards business restructurings. The AbzStEntModG was promulgated on June 8, 2021 in the Federal Law Gazette, meaning the completion of the legislative procedure.
The transfer pricing related measures took effect on June 9, 2021, one day after the promulgation, and are applicable to income and corporate income tax returns for the tax assessment period 2022.
Legal Basis and Documentation Requirements
The legal basis in Germany for taxation on relocation of function is, since the coming into effect of the AbzStEntModG, Section 1 paragraph 3b of the AStG. Section 1 of the AStG embodies Germany’s core transfer pricing regulation, including the arm’s-length principle and the methods to test the arm’s-length nature of inter-company cross-border transactions. The legal regulation on relocation of function is complemented by:
- the ordinance Funktionsverlagerungsverordnung (Ordinance on Relocation of function, “FVerlV”); and
- the administrative principles Verwaltungsgrundsätze Funktionsverlagerung (Administrative Principles on Relocation of function, “VerwFVerl”).
The ordinance FVerlV can be considered an extension of the law binding taxpayers and tax authorities alike. The administrative principles VerwFVerl, issued by the German Ministry of Finance, include advice on the application of German relocation of function rules and reflect the tax authorities’ interpretation thereof. As such, they only bind the tax authorities but not the taxpayer.
A relocation of function within the meaning of Section 1 paragraph 3b of the AStG is a cross-border inter-company transaction. As such, German taxpayers are in general required to document the business transaction in the form of a transfer pricing report (Section 90 paragraph 3 of the Abgabenordnung (General Tax Code)). Relocations of function commonly constitute extraordinary business transactions, as they often affect the taxable income of the German taxpayer to a significant extent.
Transfer pricing documentations for extraordinary business transactions are required to be prepared contemporaneously, i.e., at the latest six months after the end of the fiscal year in which the relocation of function occurred, and they need to be submitted within 30 days upon request by the local tax authorities (the submission deadline for ordinary business transactions is 60 days). In case of non-compliance, taxpayers can face penalties based on German tax law and imposed by the local tax authorities. The adoption of the AbzStEntModG will bring no change to the documentation requirements stipulated in the Abgabenordnung.
A relocation of function involves a transferring party/seller, legal entity or permanent establishment, that transfers a function and a receiving party/buyer that receives said function. A function is a business activity consisting of business tasks of similar nature which are carried out by certain positions or departments of a company.
A relocation of function occurs (according to Section 1 paragraph 2, sentence 1, of the FVerlV) when:
- a company transfers assets and other benefits together with the opportunities and risks associated with them, or makes them available for use, to a related company;
- such that the receiving company can perform that function which has been previously performed by the transferring company; and
- thereby limiting the extent to which the transferring company can carry out said function.
Assets include tangible assets such as machines and equipment, as well as intangible assets such as technological know-how or a trademark. “Other benefits” refers to economic benefits such as synergy effects, an experienced sales team, or market know-how. Opportunities and risks in their materialized form generally refer to business profits and losses arising from the transferred function.
A relocation of function occurs for example when a German company discontinues its production function and transfers it to a foreign affiliated company. Such a cross-border transaction typically involves the transfer of assets such as machines and production know-how as well as the transfer of chances and risks associated with the production function.
The ordinance FVerlV provides exceptions to the above regulation. A relocation of function cannot be assumed in the following cases:
- A duplication of function, i.e., the affiliated company performs its new function upon transfer of assets and other benefits as well as opportunities and risks, but the activities of the transferring company associated with said function are not stripped down within a time frame of five years (Section 1 paragraph 6 sentence 1 of the FVerlV).
- Only assets are transferred or made available for use or where services are provided except when such transactions are part of a relocation of function (Section 1 paragraph 7 sentence 1 of the FVerlV).
- Similarly, employee secondments absent the involvement of a transfer of function do not constitute a relocation of function nor do transactions that are not considered by independent parties as a relocation of function (Section 1 paragraph 7 sentence 2 of the FVerlV).
The relocated function together with the opportunities and risks as well as assets and other benefits associated with the function constitute a so-called Transferpaket (transfer package). The value attributed to the transfer package is the transfer price or the compensation to be paid by the buyer to the seller for the purchase of the transfer package.
One of the major problems is to find a sufficiently reliable price which satisfies the arm’s-length principle for such a transfer package. Since transfer packages bundle different, often hard-to-value, intangible assets, German tax law prescribes the so-called transfer pricing approach for determining an arm’s-length price of the transfer package, which is reflected by the hypothetical arm’s-length principle.
Hypothetical Arm’s-Length Approach
The value of a transfer package is in general assessed by the hypothetical arm’s-length approach (HALA) principle. The HALA is Germany’s default transfer pricing “method” applicable if arm’s-length transfer prices cannot be determined on the basis of other appropriate methods (it should be noted, however, that the German Ministry of Finance does not consider HALA as a method but as a standalone approach, i.e., note 45 of the Verwaltungsgrundsätze 2020 refers to the application “methods respectively the hypothetical arm’s-length principle”).
Comparable market data for “transfer packages” are typically not available due to the unique nature of transfer packages and in particular the intangible assets included therein.
The HALA stipulates a present value method and requires the calculation of a minimum price from the perspective of the seller and a maximum price from the perspective of the buyer, resulting in a two-sided present value method. The valuation is carried out under the assumption of two prudent business managers (buyer and seller) under full transparency of information.
Minimum price and maximum price constitute the “settlement range.” A settlement or bargaining range can only be established if the minimum price is smaller than the maximum price.
The value of the transfer package is in general the midpoint of the settlement range (i.e., the arithmetic mean of both values) if the taxpayer cannot demonstrate that another value within the settlement range is more adequate from an arm’s-length perspective.
The new Section 1 paragraph 3 sentence 7 of the AStG still stipulates a two-sided valuation, but under the now additional requirement that it is carried out under “economically accepted valuation principles.”
Valuation Method and Parameters
Minimum and maximum price that constitute the settlement range are each calculated as a present value, i.e., the sum of discounted profits as at date of valuation. The minimum price (maximum price) reflects the net economic benefit associated with the transfer package from the perspective of the seller (buyer). Widely accepted valuation methods are the discounted earnings method and the discounted cash flow method.
The German tax authorities suggest the application of the valuation principles and methods IDW S1 and IDW S5 set out by the German Institute of Public Accountants (IDW).
The valuation exercise depends on several parameters; slight changes in certain parameters can have an enormous impact on the value of the transfer package. The key valuation parameters are summarized in the table below.
Simulation of Tax Effects from the Transfer Package Valuation
The administrative principles VerwFVerl, which reflect the view of the tax authorities, suggest the consideration of additional tax effects.
From the perspective of the seller, a tax gross up is applied on the minimum price as the compensation constitutes taxable income subject to the seller’s effective tax rate.
From the perspective of the buyer, a tax amortization benefit is applied on the maximum price as the transfer package is assumed to be amortized over its useful life, hence creating tax saving effects on a pro rata temporis basis. A multiplier for the tax amortization benefit is calculated and derived from the tax saving effects considering the applicable amortization period, discount rate, and effective tax rate at the level of the buyer.
Although the VerwFVerl are not binding on the taxpayer, it is in general recommended to take these tax effects into consideration for tax risk mitigation purposes. The minimum price including the tax gross up and the maximum price including the tax amortization benefit constitute the final settlement range. Tax gross up and tax amortization benefit usually yield higher transfer package values.
The consideration of these tax effects and the determination of the final settlement range are summarized in the illustration below.
Tax effects and final settlement range
Escape Clauses (Old Version of AStG)
The taxpayer can waive the application of the holistic transfer package method by way of escape clauses. In the old version of the AStG, the escape clauses were nested in Section 1 paragraph 3 sentence 10.
Escape clauses allow the determination of the transfer package value by individual transfer prices for the assets and services pertaining to the transfer package. The application of individual transfer prices often yields lower valuation results than those derived by way of the transfer package method. The former is therefore in general considered more favorable than the latter from a tax burden perspective.
The old escape clauses are described in more detail in the following paragraphs.
First Escape Clause
Based on the old version of the AStG, the first escape clause stated that individual transfer prices are applicable if the taxpayer can demonstrate that no essential intangible assets or other benefits were part of the relocation of function. The ordinance FVerlV exhibits one particular case for the first escape clause allowing the application of individual transfer prices. This is the case if the receiving company performs the relocated function exclusively for the benefit of the transferring company and if the compensation for the function performed/the services provided, i.e., the transfer price, are determined on a cost plus basis (Section 2 paragraph 2 sentence 1 of the FVerlV).
Second Escape Clause
Based on the second escape clause and in cases where assets contained in the transfer package can be identified, individual transfer prices for the assets can be applied. This however is only the case if the sum of all individual transfer prices is in line with the arm’s-length value evaluated by application of the HALA. This legal condition is further specified in Section 2 paragraph 3 sentence 2 of the FVerlV which states that the sum of individual arm’s-length transfer prices can be applied if the said sum lies within the settlement range determined by the application of the HALA.
As a result, the second escape clause requires (i) the calculation of all individual arm’s-length transfer prices, and (ii) the valuation based on the transfer package method (HALA). The second escape clause yields more favorable results from a tax burden perspective only if the sum of all prices is smaller than the settlement value derived from the transfer package method, which is in general the midpoint of the arm’s-length range.
Third Escape Clause
According to the old version of the AStG, the third escape clause allowed the determination of the transfer price for the function based on individual transfer prices if (i) at least one essential intangible asset is part of the relocation of function, and (ii) that intangible asset can be clearly delineated.
While the first escape clause requires the absence of essential intangible assets, the third escape clause requires the presence of at least one essential intangible asset. An intangible asset is “essential” if it is “necessary” for the relocated function (qualitative characteristic) and if its transfer price is larger than 25% of the sum of all transfer prices pertaining to the assets and other benefits of the transfer package (quantitative characteristic).
An intangible asset can be clearly delineated if it can be precisely identified such that the taxpayer can resort to sufficiently comparable market data or to the HALA for determining the value of the intangible asset.
Limitation of Escape Clauses (New Version of AStG)
In the new version of the AStG, the escape clauses available are now substantially reduced, considerably limiting German taxpayers’ legal possibility to circumvent the holistic transfer package valuation under the HALA.
According to the new regulation, a transfer package valuation may be waived if the taxpayer can credibly demonstrate that neither significant intangible assets or other benefits were the subject of the transfer of functions. More precisely, such a situation occurs if the acquiring company performs the transferred function exclusively for the transferring company and the remuneration to be recognized for the exercise of the function and the provision of the corresponding services is to be determined using the cost-plus method.
This new escape clause mirrors Section 2 paragraph 2 sentence 1 of the FVerlV with the prerequisite that the German company remains entitled to the taxable residual profit from the overall business. The compensation on a cost-plus basis typically implies the presence of a routine function and that the transferring entity remains the economic owner of intangible assets associated with the business being entitled to the taxable residual profit.
The case of routine functions being outsourced and compensated on a cost-plus basis was one of many possible cases that generally qualified for the first escape clause in the old version of the AStG. In other words, the new escape clause is a highly limited version of the former first escape clause.
The strong limitation with regard to the first escape clause and the definitive removal of the second and third escape clauses will result in a more prevalent application of the transfer package method in the future (HALA with two-sided valuation).
The limitation of escape clauses to the case of routine functions clearly shows that the German government intends to defend the tax base more fiercely. This is not limited to ongoing transactions but, as is the case with business restructuring, also takes into account future profits potentially derived from performing such functions.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Michel Braun is a Director with KPMG’s Global Transfer Pricing Services (GTPS) team in Düsseldorf (Germany); Sebastian Hoffmann is a Senior Manager with KPMG’s GTPS team in São Paulo (Brazil); and Paul Chao is a Manager with KPMG’s GTPS team in Düsseldorf (Germany).