Detailed transfer pricing (TP) regulations explicitly addressing the cross-border transfer of functions were originally incorporated into the German Foreign Tax Act (FTA) in 2008. With the Withholding Tax Relief Modernization Act, Germany adopted legal changes to the TP framework that came into force with effect as of 1 January 2022 including, among other modifications, to the cross-border transfer of function rules (in section 1 paragraph (3b) FTA). These recent law changes now require an update of the existing Order Decree Law on Transfer of Business Functions (Funktionsverlagerungsverordnung – FVerlV). An order decree law has the character of law in Germany and thus is legally binding for taxpayers and courts.
On 31 August 2022, the German Government published a draft order decree law (Government draft) to update the existing FVerlV. The objective of the Government draft is to amend the existing FVerlV to align with recent legal changes in order to enhance legal certainty, but also to provide clarification with respect to certain details of the existing FVerlV. However, the Government draft includes some aspects where the rules get further tightened beyond the recent legal changes of section 1 paragraph (3b) FTA and the existing FVerlV. Among others, the Government draft extends the definition of a “transfer of function” and includes changes to the calculation of the transfer package, e.g., consideration of tax effects and determination of comparable third party discount rates. In addition, certain provisions of the existing FVerlV with high relevance in practice were deleted without replacement. Additionally, while the existing FVerlV only required a taxpayer to provide prima facie evidence, the Government draft now shifts the burden of proof to taxpayers by requiring a taxpayer to provide evidence under certain provisions. If the Government draft is passed into law without modifications, an increasing application of the transfer of function rules and a rise in controversial discussions in German tax audits are expected.
The updated FVerlV is intended to apply with retroactive effect for all completed transfers of functions for tax assessment periods beginning after 31 December 2021.
This Alert summarizes the key aspects of the Government draft as well as the recent key legal changes to provide the relevant background of the developments with respect to German exit taxation rules in business restructurings.
Background information on the legal changes to the TP framework
Section 1 of the German FTA includes the German interpretation of the arm’s-length standard and has been completely rewritten by recent legal changes, including modifications to the cross-border transfer of function rules in section 1 paragraph (3b) FTA and the introduction of the DEMPE1 concept into German law. In particular, the following key aspectsoutlined below were changed.
Legal definition of the transfer package
If a business function is transferred, including the corresponding opportunities and risks as well as any assets or (previously and) other benefits transferred or licensed along with it, and if the hypothetical arm’s-length method is applicable to the relocated business function because no comparable data can be determined for the transfer of the business function as a whole (transfer package), then the arm’s-length range must be determined on the basis of the transfer package.
Elimination of certain escape clauses that allowed for single asset valuation
The formerly three existing escape clauses that allowed for single asset valuation instead of calculation a transfer package for a cross-border transfer of functions have been narrowed down to one escape clause. Single asset valuation is now only possible if a taxpayer plausibly demonstrates (i.e., provides prima facie evidence) that neither significant intangible assets nor other benefits were part of the business function transfer. This applies if the transferee enterprise performs the transferred business function exclusively for the transferring enterprise and if the remuneration payable for performing the business function and for rendering the corresponding services is determined by means of the cost-plus method.
Introduction of the DEMPE concept
The DEMPE concept was newly introduced into German law including a definition of what constitutes an intangible. An intangible constitutes an asset that is not a tangible asset or shares, that could be subject to an intercompany transaction without being necessarily separately transferrable and provides a person a factual or legal right regarding the specific asset. Further, it is specified that essentially the entity performing the DEMPE functions, assuming risks and providing these assets should be entitled to the intangible-related return. Notably this definition focuses on the value contributed by an intangible and not the accounting definition of an intangible asset.
Price adjustment clause
An arm’s-length individual price adjustment clause agreed in a written contract may avoid that German tax authorities can correct the transfer price once within 7 years (previously 10 years) after the transfer took place. This right is otherwise with the German tax authorities should there be a significant difference between the forecast data used to determine the exit charge compared to the actual result (i.e., if the transfer price determined using the actual outcomes deviates by more than 20% compared to the outcome based on the financial projections). Notably, this rule only applies to the disadvantage of the German taxpayer but not to its advantage.
Government draft regarding order decree law on cross-border transfer of function rules
The recent law changes to section 1 paragraph (3b) FTA tightened the already rather strict transfer of function rules. In addition, the Government draft includes aspects where the rules get further tightened beyond the legal changes and the existing order decree law on the transfer of functions. Particularly the aspects outlined below are noteworthy.
Definition of a “transfer of function”
The Government draft intends to change the definition of a transfer of function in certain cases. In particular, a transfer of function shall also exist in the case of a partial transfer of a function. In addition, the restriction of the function at the level of the transferring company is no longer a required criterion to constitute a transfer of function. Instead, according to the Government draft, it is sufficient that the receiving company can exercise the function or expand an existing function. Further, the provision that a transfer of function can also exist if the acquiring company only takes over the function temporarily will be deleted.
Determination of the transfer package
Consideration of tax effects
Tax effects (i.e., tax gross up from the transferor perspective and tax amortization benefit from the transferee perspective) are to be considered in the determination of the transfer package (this is a controversially debated pro-fiscal aspect in practice and currently only included in German administrative guidance, which is not binding for taxpayers and courts, but serves as guidance for the interpretation and illustration of the tax law and order decree law).
Determination of discount rates
The risk premium for determining the discount rate must not be based on usual company-specific comparability criteria, as was previously the case, but it must be measured for both the acquiring and the transferring company on the basis of comparable transfers between third parties. This means that in the future, taxpayers will have to determine standard market discount rates and can no longer refer to internal company practice as such.
Licensing option in cases of doubt
The existing order decree law stated that in the event of any doubts as to whether a transfer or grant of use is to be assumed regarding the transfer package or individual parts thereof, a grant of use shall be assumed upon request by the taxpayer. Such licensing option has the objective to avoid an immediate capital gain taxation and is commonly used in practice. Notably, this provision is not included in the Government draft. According to the explanatory notes, these cases of doubt are already reliably regulated by the correct application of the other applicable tax law and this provision could therefore be deleted.
(Negative) Definition of exceptions that do not constitute cross-border transfer of functions
While the existing order decree law listed certain exceptions that do not constitute a cross-border transfer of functions (e.g., if only assets are sold or allowed to be used or if only services are rendered – unless these transactions are part of a business function relocation), this section was deleted in the Government draft. According to the explanatory notes, such deletion is justified by referencing that the remaining provisions ensure that these exceptions continue to apply.
Application to permanent establishments
The Government draft further clarifies that the regulations on the transfer of functions also apply to transactions between a company and its permanent establishment in line with section 1 paragraph (5) Sentence 1 FTA.
Shift of burden of proof to taxpayer
Whereas prima facie evidence was sufficient in the existing FVerlV, the Government draft now requires a taxpayer to prove that (1) a shorter than an infinite capitalization period applies when determining the transfer package as well as (2) that no significant intangible assets or other benefits are subject to the transfer in the case of statutory or contractual claims for damages, indemnification and compensation as well as claims to which third parties independent of one another would be entitled if their scope of action was contractually or de facto precluded are used as basis for taxation of cross-border transfer of functions.
The DEMPE concept was legally implemented in section 1 paragraph (3c) FTA and has been applied retroactively to all open cases by the German Ministry of Finance through the Administrative Principles on Transfer Pricing since 30 September 2021 (publication in the Federal Tax Gazette).2 However, the Government draft does not include any references to the DEMPE concept and the potential implications on cross-border transfer of functions.
Against the objective to enhance legal certainty and to clarify certain aspects of the existing FVerlV, it is expected that the envisaged changes lead to an increasing application of the transfer of function rules as well as a rise in controversial discussions in German tax audits. The Federal Council Resolution as the last legislative step is expected on 7 October 2022 and it remains to be seen if the Government draft will be subject to any modifications. Nevertheless, taxpayers should be aware of the upcoming changes, identify and assess relevant fact patterns at early stages accordingly and prepare the required documentation, since the changes will become retroactively effective for tax assessment periods beginning after 31 December 2022. It should be noted that a transfer of function is considered an “extraordinary transaction” from a German TP perspective for which a contemporaneous TP documentation requirement applies.
For additional information with respect to this Alert, please contact the following:
Ernst & Young GmbH Wirtschaftsprüfungsgesellschaft
Ernst & Young LLP (United States), EMEIA Transfer Pricing Desk, New York
Development, Enhancement, Maintenance, Protection and Exploitation.
See EY Global Tax Alert, German Ministry of Finance issues new Administrative Principles regarding transfer pricing, dated 23 July 2021.