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German Transfer Pricing and Business Restructur-ing Regulations
Initial Comments
In this chapter the German transfer pricing regulations will be generally described, and the regulations on business restructurings in particular. The chapter will present some general German provisions on transfer pricing, as the reader is not assumed to have any particular understanding of German transfer pricing law. The arm’s length principle is foundational in this area; therefore a subchapter will be devoted to describe how the German legislator applies it. Further, risk allocation in a German perspective will be presented. This chapter aims to give the reader an understanding on the German ap-proach of risk allocation for associated enterprises.
German Transfer Pricing Law
General
Being one of the largest export countries in the world has made transfer pricing the most important issue for German tax authorities in the recent decade. Domestic transfer pric-ing documentation requirements with penalty provisions were implemented in 2003 (re-placing the 1983 documentation regulations) and in 2005 the Administration Principles-Procedures, binding to the tax authorities, were released, which maintain principles on the audit of the profit allocation between related persons with cross-border transac-tions.208 Administrative principles and circulars published by the German tax authorities are not binding to the public; however they provide information on how the law should be interpreted and what the approach of the tax authorities will be.209 Specific tax provisions governing the transfer pricing treatment of business restructur-ings came into effect in 2008. These provisions were a result of a concern in Germany that great deals of tax revenues were lost due to questionable tax planning.210 Germany was the first country to introduce specific tax regulations on transfer pricing issues re-garding business restructurings.211 By doing this, there has been concerns that German law is incompatible with international law and, possibly, in particular with Art. 9 of the OECD Model Convention.212
Transfer Pricing Provisions
According to the German Corporate Tax Act (Körperschaftsteuergesetz), all legal enti-ties operating in a registered office or place of management and control are subject to unlimited corporate tax liability.213 The Foreign Tax Code (Auβensteuergesetz) includes general rules regarding the application of the arm’s length principle and transfer pricing methods.214 Section 1 of the Foreign Tax Code is limited to cross-border business relations. Where there is a conflict between this rule and other domestic rules, the latter shall be given precedence.215 A draft circular has been published for public comment on the Federal Ministry’s website in July 2009 to further establish how the provisions should be ap-plied.216
Arm’s Length Principle and the Hypothetical Arm’s Length Test
In determining an appropriate transfer price for a transaction, taxpayers are according to the 2008 Business Tax Reform obliged to apply the arm’s length principle. If no compa-rable data is available the hypothetical arm’s length price concept will be applied.217 The hypothetical arm’s length test is done by establishing a functional analysis and in-ternal business projections and thereby determining a minimum price of a hypothetical seller and the maximum price of a hypothetical purchaser.218 Location savings and any synergies ought to be considered in this calculation, why the hypothetical arm’s length price is a kind of profit split among the parties.219 Tax auditors generally allocate loca-tion savings to the principal, i.e. usually the German parent, as German MNEs have had a tendency to set up contract manufacturing in countries with low labor costs.220 The hypothetical arm’s length test might lead to taxation in Germany that exceeds what the taxpayer would have been able to generate on its own, since the maximum bid of the re-cipient is taken into account and i.e. synergies of the recipient, location savings, tax benefits etc.221 The German legislator wants to tax the value of hidden reserves of the transferred function; both the current and the future value are included, and synergy ef-fects.222
Business Restructurings and Risk Allocation
The German regulations concerning business restructurings are applicable when a stan-dard transfer pricing method cannot be applied appropriately. The transfer of functions should then be valued as a package, unless the taxpayer can demonstrate the contrary. 223 A function is defined as “a business activity consisting of an aggregate of similar oper-ational tasks performed by certain offices or departments of an enterprise”224. There is also a requirement of a certain degree of economic independence; however the determi-nation of such is rather subjective.225 The arm’s length principle shall in general be ap-plied to transfer pricing adjustments.226 A reallocation is assumed when assets or other benefits with related opportunities and risks are transferred by a company to another related party, or the other related party is allowed to use such assets or benefits and thereby being able to perform a function that was previously performed by the transferring enterprise.227 A transfer of functions could include outsourcing functions, if the transfer means that the function as a whole (with associated profit and risks, as well as decision making power) is closed down complete-ly at the transferor, and set up at a new place of business in another jurisdiction. It also includes the reduction of functions, where a full-fledged manufacturer is converted into a contract or toll manufacturer.228 According to Sec. 1 Para 2. of the Foreign Transactions Tax Law (FVerlV) a transfer of functions needs to include assets. When a fully fledged distributor is converted to a li-mited-risk distributor, there is generally no transfer of tangible or intangible assets. Therefore it can be argued that the criteria of Sec. 1, Para. 2 of the Foreign Transactions Tax Law are not fulfilled.229 It is primarily the risk profile that changes and not the physical activities. If the foreign company receives no support from the principal, e.g. by staff transfers, it could be argued that there has not even been a transfer of function from Germany to the foreign company, hence no reduction in relevant business activi-ties at the German principal.230 The new principal has to be able to manage and control the risk transferred, and have the financial capacity to bear the risk should it materialize or the arm’s length profit level may be impacted.231 Sec. 42 of the General Tax Code (Abgabenordnung) stipulates that legal structures must not be abusive and must not be used to circumvent tax law.232 A structure which is made for pure tax saving purposes will be ignored for tax purposes. The transaction will in-stead be taxed as if an appropriate legal structure had been implemented.233 Other rea-sons than tax saving purposes may be of economic or personal nature, however, it is enough that the main purpose of the structure is to save tax. The burden of proof in this scenario seems according to Lieber and Roeder lie on the taxpayer.234. If an uncommon legal structure is used, this will constitute abuse, unless the taxpayer can provide justifi-cations for it, which are not tax related.235 Contracts are usually the main source in allocating risks and assets. A transaction is rec-ognized according to the German substance-over-form rules.236 This has an effect on risk allocation as a party who bears a risk should also control that risk. Legal agree-ments may therefore be limited by this provision.237 The substance of a transaction will be judged by determining how functions, risks and assets of a transaction are allocated between the parties. The function and asset allocation will typically, limit the potential scope of risk allocation, as the arm’s length principle is applied. There is some indica-tion that Germany tries to expand its possibilities to re-characterize a transaction. Sec. 1 para. 1 sent. 1 of the Foreign Tax Code seems to open up for the arm’s length principle to be applied not only to the transfer price of a transaction, but also to the other terms and conditions agreed by related parties. This is contrary to the OECD guidance.238 Cauwenbergh and Lucas Mas mean that the German transfer pricing provisions might not reflect economic reality. Under the fairly new legislation, a large part of restructur-ings may be considered to be tax motivated and to potentially impact the national tax base. It is obvious that the concern over losing tax income to other jurisdictions has made Germany produce tight rules, however perhaps too restrictive.239 It is part of reali-ty that taxes do present a large cost for MNEs, why they will often, if not always, play a role in determining how to conduct a restructuring. The German legislation seems to at-tack any type of business restructuring, not just the ones which are purely tax driven. This is not in line with the OECD approach. Another remark is that tax authorities should not at all intervene in the MNEs reasons for a restructuring; this is part of their commercial freedom. Tax authorities should refrain to apply correct existing tax and transfer pricing rules. Hence, the entrepreneurial freedom is interfered with.240 When a business function is transferred from a German enterprise to a foreign enterprise, it will be assumed that both parties have complete information about the transaction in calcu-lating a minimum price (of the transferor) and a maximum price (of the transferee). These provisions have been criticized as to violate the German tax treaties. There has not yet been any case law developed which deals with these provisions.241
Compliance Issues
The German transfer pricing regulations have been considered not to be in line with cur-rent OECD guidance. The way the arm’s length principle is applied presents an issue as it is applicable to contractual arrangements as well as prices. If a transaction of a loan was paid for in Yen, the transaction may be re-characterized merely because a prudent business manager would only have agreed to a loan in Euro. Under the OECD guidance, contractual terms may only be disregarded in exceptional cases. Another crucial differ-ence in the German application of the arm’s length principle is that participants are as-sumed to have complete and reliable information when determining transfer prices. This does not reflect the situation of independent parties.242 The German rules are applied to such an extent that its transfer pricing might actually be characterized as an exit tax, where an excess value over the arm’s length value shall be paid from the foreign company to the transferring company. This would also depart from the basic premises of the Guidelines.243 The Guidelines do not include opportuni-ties such as profit potential or business opportunities in their valuation approach of as-sets. In the transfer of a risk, where no assets are transferred, the risk on its own should not entitle the seller to a compensation for any in the future expected performance.244 The extensive German transfer pricing regulation will result in increasing double taxa-tion issues according to Cauwenbergh and Lucas Mas; taxpayers will be exposed re-gardless of whether or not they follow the German rules. This will most likely lead to German and foreign competent authority proceedings, “since the new rules contravene 95% of the tax treaties concluded by Germany”245.246 The German regulations are still new in the area and its applicability will still need to be clarified in some instances. It does however give rise to a growing concern in the busi-ness community and national tax administrations that double taxation issues will arise and is described as tough and far-reaching.247 Rasch and Schmidtke believe that the German law on business restructurings is not formulated in an unambiguous way and that this creates unacceptable uncertainty for taxpayers.248
1 Introduction
1.1 Background
1.2 Purpose
1.3 Method
1.4 Delimitations
1.5 Outline
2 Associated Enterprises
2.1 Initial Remarks
2.2 Art. 9 of the OECD Model Convention
2.3 The Guidelines
2.4 Transfer Pricing Aspects of Business Restructurings: Discussion Draft for Public Comment
2.5 Public Comments on the Transfer Pricing Aspects of Business Restructurings
2.6 Issues Notes 1 Incorporated in a New Chapter IX of the Guidelines
3 Permanent Establishments
3.1 Initial Comments
3.2 Art. 7 of the OECD Model Convention
3.3 The PE Report
4 Applying the Risk Allocation Approaches of Art. 9 and Art. 7
4.1 Initial Comments
4.2 Key Concepts of Art. 9 and Art. 7
4.3 The Approaches of Art. 9 and Art. 7 Compared
4.4 The Contradiction Between Art. 7 and Art. 9
5 German Transfer Pricing and Business Restructuring Regulations
5.1 Initial Comments
5.2 German Transfer Pricing Law
6 Analysis
6.1 Initial Comments
6.2 Does the Approach Given in Issues Notes 1 Contradict the Approach for PEs as Stated in the PE Report?
6.3 The German Attempt to Provide Domestic Provisions Governing the Transfer Pricing Treatment of Business Restructurings
7 Conclusion and Recommendations
7.1 Issues Notes 1 of the Discussion Draft Does Not Provide Satisfactory Guidance on Risk Allocation for Associated Enterprises
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Transfer Pricing Aspects of Business Restructurings
