Germany introduces new administrative principles for transfer pricing

By Oliver Treidler, TP&C GmbH

The German tax administration released new administrative principles for transfer pricing on 14 July that are effective immediately and will constitute a focal point of the German transfer pricing regulations. Practitioners operating in Germany should not wait too long before taking a closer look.

The new administrative principles replace, amongst others, the administrative principles of 1983, as well as parts of the administrative principles procedures of 2005 that were outside of a December 2020 update. They also follow May 2021 transfer pricing updates to the German foreign tax code.

In a nutshell, the new administrative principles for transfer pricing ensure that the interpretation and application of the arm’s length principle within Germany is aligned with the post-BEPS transfer pricing guidelines.

In the past, the alignment of German transfer pricing regulations with the OECD transfer pricing guidelines was of a rather indirect nature and cross-references were scarce. Now the OECD transfer pricing guidelines are integrated as an annex to the administrative principles for transfer pricing and there are ample cross-references. This generally should provide some degree of comfort to practitioners, as Germany will likely remain among the rather “orthodox” transfer pricing jurisdictions – at least when taking a casual glance at the formal framework.

The challenges, however, promise to surface during future tax audits. German idiosyncrasies and increasingly heavy compliance burdens were already identified in the previous updates to the foreign tax code and administrative principles procedures.

While the earlier updates were preceded by the release of public discussion drafts, the introduction of the new administrative principles for transfer pricing blindsided many practitioners. The unwillingness to engage in meaningful dialogue displayed by the tax administrations as such is mildly concerning.

Some of the most notable idiosyncrasies might well be interpreted as a further manifestation of the German tax administration’s willingness to adopt an even tougher stance when auditing transfer prices.

The following presents a selective list of noteworthy regulations contained in the German administrative principles for transfer pricing (unless otherwise indicated, the referenced/cited paragraphs relate to these).

Looking beyond the transfer price when assessing the arm’s length nature of a transaction

Paragraph 1.5. could be seen as a sort of Leitmotiv for the administrative principles. Here it is stipulated that the application of the arm’s length principle is not solely focused on correcting transfer prices but will rather encompass the underlying rationale of the transaction (i.e., the general conduct of the parties) as well as the terms and conditions.

While the OECD is also addressing the need to conduct an analysis of the broad-based circumstances of the taxpayer and to appropriately delineate the controlled transactions, the German administrative principles, arguably, overemphasize this aspect. Amongst others, this is reflected in paragraph 1.22, which stipulates that in addition to the price, terms, and conditions (such as duration of a contract, payment terms, rebates and bonus provisions), adjustment clauses, collateral, as well as clauses relating to the amendment and termination are subject – on a stand-alone basis – to an application of the arm’s length principle and could trigger a transfer price adjustment.

While paragraph 1.22 stipulates that in cases when individual terms and conditions are found to not be commensurate with the arm’s length principle, this would not necessarily render the entire transaction to be qualified as being not at arm’s length, there is no reference to comparability adjustments featuring prominently in the OECD Guidelines.

This Leitmotiv, especially when considering it in combination with the December 2020 amended administrative principles procedures, is the harbinger of more controversial and fragmented discussion in tax audits. German auditors could demand extensive explanations on the arm’s length nature of individual terms and conditions, which not only increases the compliance burden (and burden of proof) but also renders a holistic approach to the application of the arm’s length principle, including outcome-testing approaches focused on aggregate results, susceptible to challenges.

Economic substance, control of risk and the hypothetical arm’s length test

The alignment with the OECD framework naturally implies that transfer pricing regulations reflect an economics-driven view of the arm’s length principle, with the functional and risk analysis being the single most important manifestation. The German administrative principles for transfer pricing can generally be seen as facilitating a close alignment with the OECD in this respect and, notably in paragraph 3.5. and 3.6, which contain specific cross-references to the control of risk concept contained in OECD guidelines.

Paragraph 3.7 contains the stipulation that a value-chain analysis is to be seen as the basis for assessing whether the profit allocation within a multinational enterprise is adequately aligned with the functional and risk profile of the individual entities. The provision is, however, somewhat vague in respect to identifying the cases in which a taxpayer is generally expected to conduct a value-chain analysis (i.e., going beyond the mere functional and risk analysis in the sense of quantifying individual value-added contributions).

With respect to the transfer pricing methods, the German administrative principles for transfer pricing are idiosyncratic insofar as they put a strong emphasis on the so-called hypothetical arm’s length test, i.e., the application of economic valuation techniques, such as discounted cash flow approaches. Pursuant to paragraph 3.12, the hypothetical arm’s length test is to be applied in lieu of traditional transfer pricing methods in case these do not yield sufficiently reliable results (e.g., due to lack sufficient comparability). Paragraph 3.12 further stipulates that the hypothetical arm’s length test shall “in principle” be applied to transactions: involving (any, not just hard-to-value) intangibles, business restructurings, and transactions for which the profit split method is applied but for which no comparable data can be identified.

From a practitioner’s perspective, the tricky issue in this context is that, combined with the wide-ranging obligations to disclose and provide internal information (planning data, etc.) to the tax authorities, the tax authorities can factually apply the hypothetical arm’s length test as a tool to second guess any analysis prepared by the taxpayer based on the OECD transfer pricing methods. This is true not only, but especially for, the type of transactions explicitly identified above. An interesting side note in this context is that, pursuant to paragraph 3.14, the taxpayer will be expected to explain all deviations that may be detected between valuations that have been conducted for non-tax purposes and those valuations performed for transfer pricing purposes.

Other transfer pricing issue to be aware of

The German administrative principles for transfer pricing feature provisions on some practical issues that reflect certain, unnecessary idiosyncrasies. First and foremost, they do not differentiate between intangibles and hard-to-value-intangibles when it comes to price-adjustment clauses (paragraph 3.52) – and it seems that the German tax authorities are generally unwilling to draw this distinction (see above remarks on paragraph 3.12). As a result, any intangible will likely be subject to a heightened scrutiny during audit. Moreover, paragraph 3.60 explicitly rejects the admissibility of arm’s length prices (license fees) determined based on references to (copyright or patent) infringement cases. Instead, the hypothetical arm’s length test is to be applied (see above).

With respect to intercompany services, the German administrative principles for transfer pricing mimic and cross-reference chapter VII of the OECD guidelines. What is conspicuously absent in this context, however, is any reference or inclusion of the documentation related to a “simplified benefit test” (or the notion of such a simplified benefit test). Instead of cross-referencing paragraph 7.64 of the OECD guidelines, paragraph 3.78 of the German administrative principles for transfer pricing emphasizes the wide-ranging obligations of the taxpayer to provide complementary documentation. In other words, cost allocations promise to remain an area of potential conflict and high administrative burden for taxpayers.

With respect to financing transactions, the German administrative principles for transfer pricing refer to chapter X of the OECD guidelines. Flanking that reference, however, there are various provisions outlining the view of the German tax authorities on the “implicit support” derived from being a part of a multinational enterprise. In this context, paragraph 3.94 emphasizes that the importance of an assessment of the stand-alone creditworthiness (rating) of a borrower will be deemed diminished in proportion to the importance of the implicit support. Given the wording of this provision, coupled with the known skepticism displayed by German tax auditors towards internal ratings (also implied in the draft law to the foreign tax code – see above reference), it can reasonably be anticipated that for practical purposes we are also looking at a rebuttable presumption.

Perhaps one of the most intriguing developments – at least from a German perspective – is that the construct of a so-called “hybrid entity” seems to have been expunged from the German transfer pricing regulations (this at least appears to be implied in paragraph 3.33). In the past this classification for entities exhibiting characteristics of routine entities as well as entrepreneurs sometimes made it difficult to align German transfer pricing regulations with international regulations, especially when it came to the identification of a tested party and the application of the transactional net margin method. It will remain to be seen how such a change would impact discussions with German tax auditors, but it is to be assumed that some additional discussions on this issue may surface in the near future.

Lost in translation?

One of the most puzzling aspects about the German administrative principles for transfer pricing is the translation of provisions that in the context of the OECD guidelines are implemented utilizing the wording “generally.” In many cases, the Germany tax authorities opted for a translation utilizing “grundsäztlich,” which, however, seems a much closer approximation of the wording (and intent) of the “in principle” (see above). There is little to be gained to engage in linguistics at this point, but it seems to be the case that the more restrictive wording is not entirely unintentional and may have implications with respect to the burden of proof, i.e., the taxpayer will likely be forced to fight an uphill battle when it comes to the respective rebuttable presumptions.

A case in point may be seen in the provisions on the classification of a cash pool leader (paragraph 3.98). While the substance of the provision is certainly similar to the cross-referenced OECD-guidelines (10.130), including the acknowledgement that a functional and risk analysis will ultimately be decisive for the classification, it will likely prove difficult to argue against the default routine classification in the course of a tax audit – largely due to the “in principle” wording enshrined in the administrative principles – there are 35 uses of grundsäztlich in the administrative principles but zero uses of “im allgemeinen,” which perhaps would be the more accurate (friendly) translation of “generally.”

While these linguistic aspects should admittedly not be overinterpreted, they provide a general flavor of the intent and future interpretation of the tax authorities. In this context, one additional, funny, or perhaps scary, wording was contained the paragraph 1.22, referenced above (arm’s length nature of terms and conditions). Specifically, the paragraph refers to the “Berichtigungsbefehl” (perhaps translated as an “order to adjust”) implied in the § 1 of the foreign tax code. While it is understandable that the foreign tax code and – perhaps – the administrative principles for transfer pricing are to be seen primarily as an anti-avoidance tool, the chosen (militaristic-sounding) wording, as well as the context in which it is embedded, seem a bit over the top.

Other tax issues to keep in mind

Naturally, there are also many aspects contained in the new German administrative principles for transfer pricing that first and foremost will be dealt with by the tax lawyers rather than the economists. It will be worthwhile to watch out for future discussions on the German definition of what constitutes a “related party” and a “covered transaction”. Both issues are regulated in chapter 1 of the new administrative principles, featuring a detailed explanation of how these concepts are to be applied in practice.

Considering that the definition of a related entity seems now to include the participation in “networks” (paragraph 1.14) or “pyramidical organization” (1.15), i.e., members subjecting themselves to a common framework of rules to (for example) conduct a competition, it seems evident that the scope of applying the foreign tax code and the arm’s length principle has been increased. How substantial this increase is for practical purposes remains to be seen.