Globalisation of world economy requires tax authorities to move along the rapid change of the business environment. An increase in cross-border transactions has brought transfer pricing more and more into the focus. In Germany, recent developments such as the German corporate tax reform bill 2008 and the new German-US income tax treaty which came into force on 28 December 2007 have resulted in significant changes in the German transfer pricing rules.
New German legislation on business restructuring
The new Foreign Tax Act explicitly addresses business restructurings where business function(s), e.g. production, distribution or procurement, is transferred from Germany to a foreign country. In this case, an exit charge will be applied in determining the taxable income of the transferring German enterprise. The provision also covers the cases where business functions will be reduced in Germany and subsequently carried out elsewhere, e.g. transforming a fully fledged manufacturer to a contract manufacturer.
In determining the exit charge, the provision has established a new valuation concept for these transfers of functions whereby a ‘transfer package’, including all business opportunities and risks (profit potential of the function) as well as underlying tangible and intangible property and ‘other advantages’ associated with the operative function will be valued. Pursuant to this new concept, the profit expectations of the transferor (‘minimum selling price’) and those of the acquirer including foreign location benefits and achievable synergy effects (‘maximum purchase price’) form a range from which the exit charge will be determined.
In case the actual profit from the business transferred significantly differs from initially expected, the new Sec. 1 (3) Foreign Tax Act includes a reputable presumption that unrelated parties would have included a retroactive adjustment clause due to the uncertainty associated to the transaction. If the parties did not agree on such an adjustment clause and the actual profit development materially deviates from the presumption, the German tax authorities are in this case entitled to carry out a one time adjustment within the first 10 years from the transaction date. Therefore, to manage the risk, it is recommended that taxpayers include an adjustment clause in the contract of a business transfer transaction.
The new legislation is effective since January 1, 2008, including all business years starting prior to but ending during 2008. The compliance of this new concept with internationally accepted taxation standards seems nonetheless to be questionable. The German Ministry of Finance is currently working on an ordinance to further elaborate details of this new concept. The issue is currently being discussed on an international level. The OECD is expected to publish draft results of its Business Restructuring Group in 2008.
German-US income tax treaty
The signing of the protocol to the German-US income tax treaty on 1 June 2006 and its entry into force with the exchange of the instruments of ratification on 28 December 2007 have impacts on the German transfer pricing rules in several ways.
The new Article 7 - Business Profits - of the protocol where the OECD transfer pricing guidelines will be applied for the purpose of determining the profits attributable to a permanent establishment is of particular interest from a transfer pricing perspective. Pursuant to the new Article 7, any transfer pricing method described in the OECD transfer pricing guidelines is accepted in determining an at arm's length profits attributable to a permanent establishment as long as it is applied in accordance with the guidelines.
However, traditionally, transactional transfer pricing methods were given priorities in Germany. Profit-oriented methods were only allowed as a last resort for validation purposes. The German Administration Principles 1983 and the revised Sec. 1 (3) Foreign Tax Act indicate that the traditional transactional methods should be used; however, they do acknowledge that the application of other methods, such as Transactional Net Margin Method ("TNMM") or Profit Split, may be appropriate. According to the German Administrative Principles 2005, companies are categorised into three classifications, i.e. (i) routine; (ii) entrepreneur; and (iii) hybrid. Companies performing routine functions and not substantially contributing to the group's value chain fall into category one where the standard methods, and to a certain extent, the TNMM shall be used. Companies whose functions considerably determine the group's performance are classified as category two where standard methods and profit-oriented methods including the profit split method shall be used. Lastly, companies performing non-routine functions but not considered as an entrepreneur are regarded as hybrid companies where all methods are applicable. It should be noted that although the TNMM may be used, it can only be applied on a transactional basis; and that German legislation requires documentation explaining why profit-oriented methods were used as opposed to traditional transactional methods.
The new protocol to the German-US treaty treats a permanent establishment as if it is a separate distinct enterprise for the purpose of determining the profits attributable to the permanent establishment. This is in line with the OECD's functionally separate enterprise approach as outlined in the OECD ‘Report on the attribution of profits to permanent establishments’ and can be seen as an initial step towards an official acceptance of this approach in Germany. However, the German tax authorities have not yet officially recognised their acceptance.
The authorised OECD approach introduced the concept of ‘Significant People Functions’ (SPFs) and ‘Key Entrepreneurial Risk Taking Functions’ (KERT) for the financial services industry. The concept first hypothesises the permanent establishment as a distinct separate enterprise and allocates the economic ownership of the (financial) assets to the location where the strategic decisions are made and the risks are managed. The income and expenses associated to these assets will be attributed to permanent establishments accordingly by applying the OECD transfer pricing methods. This concept leads to a more sophisticated allocation of assets and profits taking the entire value chain into consideration.
Conclusion
The recent changes in the German transfer pricing legislation reflect the trend of tax authorities to focus more attention on crossborder activities of MNEs. The German tax authorities are taking the lead role among tax authorities worldwide by issuing explicit regulations concerning the transfer of business activities abroad. As a result the taxpayers should cautiously monitor the actual developments in this area and correspondingly pursue transfer pricing and tax planning activities in order to mitigate risks of one-sided adjustments and double taxation.
