Draft German tax law has big implications for transfer pricing

By Oliver Treidler & Tom-Eric Kunz, TP&C GmbH, Berlin

Germany’s Ministry of Finance has introduced a draft law that would have a substantial impact on day-to-day transfer pricing in Germany.

The draft law, released 10 December 2019, amounts to over 100 pages and has already received detailed and uncharacteristically critical responses from key stakeholders, reflecting its potential impact.

The draft proposes a wide range of changes to German tax legislation, including implementation of the EU anti-tax avoidance directive (ATAD). The most significant changes for transfer pricing relate to the so-called Außensteuergesetz, which applies the arm’s length principle in Germany (the other, non-transfer pricing, aspects of the draft are not in scope of this article).

To be sure, some of the proposed changes to the German transfer pricing law are sensible (and overdue) as they promise a closer alignment of German transfer pricing law with the OECD transfer pricing guidelines. Other changes, however, seem bound to increase uncertainty and administrative burdens for MNEs. The devil is in the details.

OECD alignment

As a general theme, the draft mirrors the stronger focus on economic facts and circumstances, featured in the post-BEPS OECD guidelines.

As a general theme, the draft mirrors the stronger focus on economic facts and circumstances, featured in the post-BEPS OECD guidelines.

As such, the draft German law confirms the key importance of a functional and risk analysis for an arm’s length analysis.

Unfortunately, though, the proposal does not provide further details or references to the updated and extended guidance on evaluating risk, prominently featured in the 2017 OECD guidelines.

Specifically, the OECD’s definitions of “risk mitigation,” “risk management,” “financial capacity,” and the condition to control risks are not accounted for.

Hierarchy of transfer pricing methods

German transfer pricing practitioners know that the German Finance Ministry and German tax auditors traditionally exhibit a preference for the comparable uncontrolled profits method and that the existing German transfer pricing regulations imply a mild “hierarchy” of transfer pricing methods, with profit-based methods being a bit circumspect (i.e., the scope for applying the transactional net margin method (TNMM) is explicitly limited to tested parties classified as “routine”).

The draft legislation proposes to abolish the hierarchy of methods and clarifies that the most appropriate method for each specific case is to be adopted.

Eliminating the hierarchy is generally helpful and economically sensible. It would, however, have been desirable for the draft legislation to clarify to what extent evidence should be provided for selecting the most appropriate method.

Also, the draft guidance introduces a stipulation for adjustment calculations which closely match the OECD guidance; namely, adjustment calculations only need to be performed if they are feasible and reliably enhance comparability.

If no reliable method can be identified, the draft German law stipulates that the taxpayer shall apply a hypothetic arm’s length test (i.e., valuation methods or bargaining theory).

In sum, these proposed changes aim to facilitate an application of the arm’s length principle based on economic facts and considerations rather than on formalistic requirements and would not greatly change transfer pricing practice.

The positive aspect of this closer alignment with the OECD transfer pricing guidelines is, however, not to be underestimated, as it holds the promise that taxpayers may in the future steer clear of having to discuss idiosyncratic German positions regarding the selection of transfer pricing methods.

Arm’s length ranges

These positive aspects of the Finance Ministry proposal are counterbalanced by highly idiosyncratic proposals with respect to the application and interpretation of arm’s length ranges.

The draft law introduces an explicit default presumption that taxpayers shall apply the interquartile concept when narrowing a range and further stipulates that the median shall be used as the default anchor for adjustments when the prices (margins) actually realized by the taxpayer fall outside of the interquartile range. Note that this would also apply when a hypothetical arm’s length test is applied, as in such a case, the mid-point of a bargaining range would be applied.

The draft law introduces an explicit default presumption that taxpayers shall apply the interquartile concept when narrowing a range and further stipulates that the median shall be used as the default anchor for adjustments when the prices (margins) actually realized by the taxpayer fall outside of the interquartile range. Note that this would also apply when a hypothetical arm’s length test is applied, as in such a case, the mid-point of a bargaining range would be applied.

Taxpayers must justify any deviation from the default presumption or anchor by proving that the approach (or value) is commensurate with the arm’s length principle.

This provision would severely curtail the existing flexibility to apply different approaches (percentiles) for narrowing the arm’s length range and reverse the burden of proof in case of adjustments.

The proposed law seems to render the implementation of a flexible target margin system (outcome testing) impractical or, at the very least, fraught with additional uncertainty.

Likewise, the proposal is contrary to the fundamental principle that all results (prices) of an outcome testing that fall within an appropriate range are commensurate with the arm’s length principle.

In a nutshell, German transfer pricing law would become much more restrictive when it comes to identifying arm’s length prices.

If these components of the draft are sustained, taxpayers will be forced to carefully assess the implications on their transfer pricing systems.

The proposed changes to the application of arm’s length ranges seem unfortunate as well as unnecessary. It is not at all evident how the German Finance Ministry expects these changes to curb any, however insignificant, BEPS effects related to the narrowing of arm’s length ranges.

A simple reference to the OECD transfer pricing guidelines would have been a much more sensible regulatory improvement.

DEMPE functions

The draft law also implements the concept of analyzing the development, enhancement, maintenance, protection, and exploitation (DEMPE) of intangible assets into the German transfer pricing realm.

This component of the draft must be seen as a welcome alignment with the OECD transfer pricing guidelines. While this guidance does not necessarily imply an immediate change to day-to-day transfer pricing, the explicit reference to DEMPE should, ideally, constitute an important building block of a more economic-based application of the arm’s length principle.

To be sure, existing German transfer pricing law lacks the level of detail reflected in Chapter VI of the OECD transfer pricing guidelines and some uncertainties regarding the details persist.

Considering that the DEMPE concept is rather untested on the OECD level as well, however, there seems to be no reason for undue concern that Germany is about to introduce idiosyncratic regulations (or administrative procedures) when it comes to intangibles.

Transfer of functions

The positive aspect of the integration of the DEMPE concept is unfortunately counterbalanced by proposed transfer pricing changes relating to the transfer of functions (business restructurings, or in German: “Funktionsverlagerungen”).

The changes proposed by the draft law translate to a drastic reduction in the threshold conditions for triggering a cross border transfer of functions.

Under current law, a transfer of functions is only triggered if material or intangible goods and the economic chances connected to a function are transferred.

Under the draft, a transfer of a function would be triggered if goods or economic chances are transferred.

Also, just as important, the existing escape clauses for calculating the value of a “transfer package” for a transfer of function would be scrapped. These escape clauses may apply when a revenue threshold from the perspective of the transferor is not met, when the transfer is only of mere routine functions, or when no unique and valuable intangibles are transferred.

Again, it is not clear why the German Finance Ministry decided to propose such restrictive changes.

We are unaware of persistent BEPS effects from the transfer of functions and such effects are not referenced by the German Finance Ministry.

Also, the track record of the existing regime is, arguably, not bad; the system is not the subject of any prominent debate that would indicate the need for a radical amendment.

Hard-to-value intangibles

The draft also aligns with OECD guidelines on the determination of transfer prices for hard-to-value-intangibles, which are often part of a transfer of functions.

Specifically, the draft would modify the regulations for price adjustment clauses if the actual value (profit) generated by the relevant intangibles deviates substantially (>20%) from the valuation underlying the determination of the transfer prices.

The relevant period for performing the adjustment calculation is seven business years (the status quo in Germany is ten years).

Exceptions for price-adjustments for hard-to-value-intangibles proposed by the draft are akin to those stipulated by the OECD. As such, taxpayers must either prove that deviations are attributable to unforeseen developments or were appropriately considered in the original valuation, or that the implementation of a license arrangement which is based on the revenues or profits of the licensee adequately accounts for uncertainties in the valuation.

Intercompany financing

Perhaps one of the draft’s most idiosyncratic proposals relates to regulations for intercompany financing. This proposal also appears to be a treaty override.

Perhaps one of the draft’s most idiosyncratic proposals relates to regulations for intercompany financing. This proposal also appears to be a treaty override.

Here, the German Finance Ministry proposes a two-step test for determining whether an intercompany loan will be accepted as such or should be subject to recharacterization.

In the first step, the taxpayer must demonstrate that an independent third-party (borrower) would be in an economic position to make interest payments for the entire duration of the loan (starting from the effective date of the loan) and that an independent third-party (borrower) would actually require the funding for its business purposes.

To determine arm’s length interest rates, the draft proposes that the group-rating (refinancing costs) is stipulated as a default value.

To deviate from this default value (applying a stand-alone rating or a down-notching approach), taxpayers must demonstrate that the interest rate is commensurate with the arm’s length principle.

Again, this proposal translates to a regulatory framework that is more inflexible and that reverses the burden of proof.

Considering that there is no consensus on the relevant issues on the OECD level, it might, from a regulatory perspective, be more prudent to omit this element of the draft and to wait for and assess developments at the OECD level.

From the perspective of a transfer pricing practitioner, the proposed changes present a substantial challenge, as they would require a comprehensive review and possible adjustment to existing intercompany financing while at the same time navigating regulations that lack clarity and detail.

The proposed law for remuneration to the financing function appears, at first glance, somewhat less controversial. Similar to the OECD position, the German Finance Ministry proposes that the financing function (cash pool leader, pass-through loans) are to be viewed as a (routine) service.

It is unfortunate, however, that the draft, again, proposes a highly restrictive and inflexible implementation; i.e., unlike the OECD guidelines, the draft applies this default position to all financial transactions without allowing any consideration of the individual transaction (based on a functional and risk analysis.

Also, the draft makes an explicit reference to the risk-free interest rate (German federal bonds) as a default remuneration for the service provider, which seems to make little economic sense. Negative interest rates on German federal bonds would actually make the service provider pay the service recipient. This, again, reflects an unnecessarily restrictive stance of the German Finance Ministry.

Related Party Definition

Other proposed changes to the German transfer pricing law refer to the definition of a “related party” for transfer pricing purposes. This change extends the scope of the definition to capture cases where a party is entitled to at least a share of 25% in the profits or from the proceeds from the liquidation of another party.

Master file threshold

The draft also proposes changes to the so-called “Abgabenordnung” (German Fiscal Code). Namely, the threshold of revenue that triggers the obligation to compile a master file is proposed to be reduced from EUR 100 million to EUR 50 million (on the level of the German taxpayer not consolidate revenues) and the reporting and filing requirements are more restrictive.

Again, it is not at all clear why the German Finance Ministry deems these changes to be necessary. Obviously, this will increase administrative burdens but is more of a nuisance than a challenge.

Lastly, the draft proposes various amendments to regulations to advance pricing agreement (APA) proceedings that could potentially translate into a more pragmatic and less cumbersome access to APAs in Germany.

Final thoughts

To be sure, it is early days and we will have to wait and see which of the proposed changes are eventually adopted.

It seems evident at this stage, however, that 2020 will feature changes to German transfer pricing regulations that are too important to ignore and which should be monitored closely.

— Oliver Treidler is the managing director of TP&C GmbH, Berlin.

— Tom-Eric Kunz is a transfer pricing consultant at TP&C GmbH, Berlin.

 

Editors note: This article was modified on February 5 to clarify details about the proposed master file threshold.

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