Introductory Remarks
Germany’s most important law on transfer pricing and the arm’s length principle is Paragraph 1 of the German Foreign Tax Code (FTC). Starting in 2019, German government has initiated a major overhaul of the law, aiming at a closer alignment with the results of the OECD-Inclusive Framework BEPS initiative and the OECD Transfer Pricing Guidelines 2017[1].
Based on several preliminary drafts provided by the Ministry of Finance, the German government approved the new draft law on January 20th, 2021. German Upper House of Parliament (Bundesrat) provided comments to the draft on March 5th, 2021 and the last preliminary step, a hearing in the Finance Committee of the German Bundestag, was completed on April 14th. Final approval by the Bundestag in scheduled for May 5th and by the Bundesrat on May 28th, 2021. While it can therefore reasonably be expected that the FTC overhaul will be completed by June 2021, the changes will likely have effect as of January 2022.
While, generally, a closer alignment with the OECD framework is welcome, some of the nuances of the law unfortunately may, in sum, translate into a more strenuous burden of proof for taxpayers and thus create additional leeway for tax auditors to challenge transfer pricing arrangements. Due to the significant impact of the planned changes on the viability of transfer pricing systems adopted by multinational companies operating in Germany, we will summarize the main aspects in following.
Please note that we summarize the planned changes as of before the Bundestag’s approval. We will provide further updates after the Bundestag’s decision and after final approval by the Bundesrat.
Interpretation and Application of Arm’s Length Standard (§1 sec. 3 FTC)
The bulk of the changes embodied in the new draft law relate to the core part of the FTC, specifically section 3, which defines the arm’s length standard and its application within Germany. In this context, it is planned to include sections 3a, 3b, 3c (and potentially also 3d and 3e) as well as a new paragraph 1a FTC.
a) Functions, Methods and Ranges
A core element of the planned changes is that it gives much more importance to the business reality in terms of functions, risks, and assets (functional analysis) compared to contractual arrangements between the parties. Contracts shall still be a starting point of the analysis, however, ultimately the functions performed, risks borne, and assets employed by the parties in reality shall always prevail. In this regard, there seems indeed to be a close alignment with the updated OECD framework. It must, however, be considered that the transfer pricing regulations (so-called “Administrative Principles” issued by the German Federal Ministry) pertaining to the scope of documentation required to ascertain the relevant economic facts and circumstances were also recently altered (December 2020). Based on the updated Administrative Principles, tax auditors will have rather generous discretion to establish the “business reality”, potentially extending the scope of required information significantly beyond providing contracts and transfer pricing documentation.
Based on the identification of the business reality the most suitable transfer pricing method shall be identified. In other words, the existing catalogue of applicable transfer pricing methods will be replaced by the so-called „Best-Method-Rule“.
In case the result of an arm’s length analysis is a range of results (e.g., prices or profit margins), the so-called interquartile range must be calculated to ascertain an appropriate narrowing of the range. Other than before, the interquartile range will thus factually become the legally binding range concept. In case the taxpayer considers that a different approach to narrowing the arm’s length range (e.g., applying different, less strict, percentiles) is more appropriate in a specific case, he bears the burden of proof.
If the taxpayer’s results are outside of the interquartile range, then an adjustment to the median of the range shall be made. Taxpayers shall have the opportunity to justify other values (with burden of proof again being with the taxpayer), but the details of this are still under discussion.
While, legally, it shall still be possible to deviate from the default provision regarding the applicability of the interquartile range and the median, where appropriate, it is difficult to imagine taxpayers successfully shouldering the burden of proof during even a mildly confrontational audit. By introducing these default assumptions, the FTC thus severely limits the flexibility for target margin-based transfer pricing systems (allowing only the interquartile range) and simultaneously increases potential transfer pricing adjustments (adjusting to the median rather than to the lower end of an appropriate range).
b) Intangibles and DEMPE Concept
In the context of intangible assets the term „immaterielle Werte“ („intangible values“) will be introduced in the form of a legal definition. According to this definition “intangible values” are assets, which 1) are not tangible assets, shareholding investment or financial assets, 2) which however can be subject of a business transaction (without necessarily being transferrable on a stand-alone basis), and 3) which can provide a legal or factual position to dispose over the asset.
If such assets are an element of a business relationship and have financial implications for the parties to the transaction, then there must be an arm’s length remuneration.
Moreover, the application of the OECD DEMPE-concept will be legally implemented. As a starting point, ownership of the relevant intangible assets is to be identified, which shall be the basis for the allocation of returns earned from the asset. In the following, the owner shall provide arm’s length remuneration for each party performing DEMPE functions. If, however, only financing functions are performed, only an arm’s length remuneration for this specific (routine) contribution (e.g. proper interest) shall be due – thus, similar to the OECD framework, ownership without being embedded in other DEMPE functions will not entitle the legal owner to a share of the residual profits derived from the intangible.
c) Retroactive Price Adjustments
Up to now, retroactive price adjustments have been applicable only in the context of the hypothetical arm’s length test for business restructurings (“Funktionsverlagerungen”), if the price for a transfer package determined ex-ante significantly deviates from the price that results from a recalculation based on hindsight information. Over a 10-year period, German tax authorities can adjust such prices provided the taxpayer has not implemented a proper price adjustment mechanism by himself – which, if justified appropriately, could have a (much) shorter duration.
The essence of these rules will now be applied also to any other transactions involving significant intangible assets. At the same time, the relevant default period will be shortened from 10 to 7 years.
Exemptions shall apply in case of 1) unforeseeable developments, 2) inherent uncertainty has been considered already in a proper manner, and 3) sales or profit based license arrangements.
d) Business Restructurings
The specific rules for business restructurings (transfer of business functions) will largely be unchanged. However, the rules on the valuation technique will be changed. Up to now, specific valuation procedures shall be applied, which have been subject to – we believe, justified – criticism as long as this exists. Apparently, German government acknowledges this criticism and now plans to abandon these rules by simply stipulating that „economically well-recognized valuation methods” shall be applied.
e) Financial Transactions
The very first draft of the law included some rather aggressive new rules concerning inter-company financing transactions, which in later drafts were given up. However, German Bundesrat has suggested in his comments that such (or rather similar) rules shall become part of the new § 1 FTC. Insofar, it is yet not fully clear whether this will be finally approved. However, we believe that it is most likely that specific rules for financing transactions will ultimately be included. Thus, we summarize the main aspects of the current status of discussion. Originally, these rules were designed to apply independently from any double tax treaties (“Explicit Treaty Override”) and asymmetrically, i.e., only for interest expenses of German taxpayers. Bundesrat obviously believes that its suggestions are insofar weaker as they are intended to avoid a treaty override, which we believe is doubtful.
According to the draft law, interest expenses shall only be deductible expenses if taxpayers can substantiate that the debtor can bear the cost of the loan over the lifetime of the loan and that the loan was necessary from a business perspective. As such, it is evident that the issue of establishing the “business reality” discussed above will feature prominently in the context of financial transactions. Naturally, any re-classification of a loan would immediately translate to tax adjustments that systematically go far beyond discussions only on arm’s length interest rates. Irrespective of the further legal developments, we already experience German auditors increasingly scrutinizing financial transactions and challenging existing loan benchmarks by referring to the respective guidance included in the new Chapter X of the OECD Guidelines.
Concerning the arm’s length interest rate for inter-company loans the new rules stipulate that the relevant rating of the debtor shall be equal to the group rating, except for cases where the German entities stand-alone rating is better than the group rating, which is clearly inconsistent with the OECD guidelines. Taxpayers shall be free to substantiate higher interest rates as being arm’s length, however then they effectively bear the burden of proof. Considering that German auditors are frequently unwilling to accept the technical merits of an internal rating (even if conducted in line with international best practices, i.e., up/down-notching approaches as reflected in the OECD guidelines), that burden of proof will likely proof insurmountable in many cases and additional controversy seems likely.
Finally, group-internal financial services shall generally qualify as “routine services”. This includes e.g., financial brokerage, back-to-back financing, liquidity management, FX-risk management, etc. and obviously targets cash pool leaders and similar group entities. It is obvious that such general assumption is incompatible with business reality. In this regard, it becomes much more critical to demonstrate (quantitatively) to tax auditors, that a German subsidiary participating in a cash pool administrated by a cash pool leader located in “low tax” jurisdictions appropriately participates in the synergies realized on group-level.
As already mentioned, this was originally (in the first draft) planned to form a new § 1a FTC. However, it was dropped in later drafts and reappeared in the Bundesrat’s comments as suggested § 1 sec. 3d and 3e. Although the “Finanzausschuss des Bundestages” has not suggested to re-include this into the law, we believe that the Bundesrat’s draft will most likely be very close to the finally approved law.
Other Planned Changes and Amendments
a) Definition of Related Party (§ 1 sec. 2 FTC)
Although the Governments draft has not included this, the Bundesrat has in its comments to the Government draft suggested that network companies (i.e., parties without any shareholding relationship but cooperating in network structures) should usually be considered to be related parties in the sense of the law, based on a rebuttable assumption that in such cases there is no natural conflict of interest between the parties that would insure arm’s length behaviour. This appears to be in line with other attempts to generally widen the concept of “relatedness” beyond shareholder relationships in case of “concerted action” also for other parts of German tax law (e.g. CFC rules). Taxpayers engaged in networks or Joint Venture structure should carefully observe this development.
b) Legal Basis for Advance Pricing Agreements (§ 89a General Tax Code)
Aside from the changes to §1 FTC, in the context of the overhaul it is also planned to amend German General Tax Code in a way that a specific legal basis for Advance Pricing Agreements (APAs) is established. For this, a new §89a GTC shall be introduced. At the same time, the fee for APAs shall be lifted up from 20,000 Euro to 30,000 Euro, while however providing for discounts if the APA is linked to a joint audit.
Final Remarks and Conclusion
The changes to the law as summarized above are expected to be enacted the day after their publication and will be applicable as of beginning 2022. As already now, § 1 sec. 6 will provide the legal basis for a future decree law to provide more details on the application of the law.
In general, it is certainly appreciated if German laws are updated and streamlined with international developments and guidelines because this usually increases legal certainty for international taxpayers. However, aside technical issues, it is rather worrisome from a transfer pricing practitioners’ perspective that the German authorities utilized the FTC update to shift the burden of proof further towards the taxpayer.
In respect to financial transactions, it is hard to understand that the new law does not at all reflect European Supreme Court’s decision on the Hornbach case where the ESC made clear that income adjustment rules like § 1 FTC must provide the taxpayer with the possibility to substantiate business reasons for non-arm’s length behaviour. We cannot find anything in this sense in the draft law. Moreover, long lasting uncertainties and discussions about the relationship of § 1 FTC to other German income adjustment rules appear to remain unresolved. Insofar, the chance to repair some major flaws of the existing law have been unused.
Considering the planned changes, the following key recommendations can be given:
a) Review the TP system in general on whether it is consistent with business reality (functions & risk). Special emphasis should be put on identifying information that can be used, if required, to substantiate that existing contracts and the transfer pricing documentation indeed reflect “business reality”. Despite the enhanced focus on business realities, taxpayers need to remain aware that formalities in respect to documentations and contracts are still vital to ensure acceptance by local auditors.
b) Review choice of TP methods under the Best Method Rule rather than priority of traditional methods. In case a target-margin system (TNMM or Cost Plus) is implemented, it should also be ascertained that the system is not in conflict with the default provisions contained in the FTC regarding the applicability of interquartile range and median.
c) Implement DEMPE concept for intangible transactions (if not yet done) and consider retroactive adjustment mechanisms for intangible transactions.
d) Review I/C financing system with respect to the planned changes.
We hope that this is useful for you. In case you have any questions please feel free to contact the experts of the Quantera Global network.
Dr. Klaus Dorner (Klaus Dorner Consulting, Hamburg/Germany)
Dr. Oliver Treidler (TP&C, Berlin/Germany)
Quantera Global Network Partners
[1] For those interested in the nuances of the legislative process, it shall be noted that the draft law discussed in the following is the so-called “Abzugssteuerentlastungsmodernisierungsgesetz” (AbzStEntModG).