MOF issues updated transfer pricing principles, replacing previous guidance

Tax authorities have amended controversial guidance regarding intercompany financing relationships.

The German Ministry of Finance (MOF) published an updated decree providing “Administrative Principles regarding Transfer Pricing” on 6 June 2023. The updated decree replaces two-year-old guidance that was published in a decree dated 14 July 2021 (see GTLN dated 07/29/21) and incorporates new jurisprudence, fundamental guidance regarding the application of the “price-adjustment” mechanism, and guidance with respect to a transfer-of-a-function doctrine. The 2022 OECD transfer pricing guidelines are also incorporated in the updated decree. The decree (including annexes) is 805 pages long and the MOF issued the decree without giving interested parties a chance to provide input or comments beforehand. The updated decree must be applied in all open cases, except for the guidance regarding a transfer of a function, which must be applied for any such transfers that take place after 12 December 2021.

The updated decree does not include controversial 2021 guidance regarding intercompany financing structures. The 2021 guidance provided that the interest rate on a loan provided by a foreign financing company had to be determined based on a risk-free market return, unless the foreign financing company has the ability and authority to control the investment of the funds and bear the financial risk. This approach by the tax authorities was rejected by the federal tax court in two decisions that were published shortly after the 2021 guidance. The updated decree provides that in a case where a group company other than the lender exercises control over the investment, it would need to be considered whether the exercise of the control constitutes an additional transaction and, if so, whether and how the transaction would have to be remunerated. However, in such a situation where the lender does not exercise control over the financing, an income adjustment (i.e., to reflect an interest rate based on a risk-free return) is no longer required to be made at the level of the borrower. This view is in line with the OECD approach, as provided in chapter X of the OECD transfer pricing guidelines, and should be a welcome clarification by the tax authorities. The updated decree also indicates that the German tax authorities will soon publish one of the federal tax court decisions mentioned above in the federal tax gazette, and therefore recognize the importance of the decision beyond the specific case for which it was decided by the court.

Another welcome clarification that is included in the updated decree is the statement that not only secured, but also unsecured loans can be regarded as being at arm's length. It is specifically stated that the arm’s length character of an unsecured loan between related parties must be determined based on a variety of factors, and that the arm’s length interest rate in such a situation might reflect additional compensation for risk. The updated decree states that in situations where a proper price adjustment clause has been contractually agreed upon, the application of the German Foreign Tax Act and an adjustment based on the rules therein are suspended. Although this is another welcome clarification, it is still unclear what the conditions for a price adjustment clause should look like to qualify as an “appropriate” price adjustment clause in the view of the German tax authorities.

The updated decree includes the view of the tax authorities on the concept of a transfer of a function, including the definition of a function and the definition of a transfer of such a function. Regarding the definition of a function, it is clarified that pure control over risk or the DEMPE (development, enhancement, maintenance, protection, and exploitation) functions represents a function and, accordingly, a relocation of such an activity must be evaluated based on the guidance provided in the updated decree. With respect to the definition of a transfer of a function, certain ambiguities remain, but any reduction of activities in Germany may be considered as a relocation of a function from the tax authorities’ perspective. This also includes certain reductions of activities with respect to, e.g., a product (“product A”), even if it is replaced by another product (“product B”) and no overall revenue reduction takes place in Germany.

In addition, the updated decree includes commentary on how to determine the size and the content of a function (“transfer package”) and how to determine the value of a function. The guidance on the estimation of the cost of capital to be assumed in the valuation is generally in line with international valuation standards and supports the application of the capital asset pricing model (CAPM). Although the decree does not specifically state this, additional premiums, e.g., size and country premiums, are typically not applied in Germany, as these are deemed to be inconsistent with the perfect diversification assumption of the CAPM. Another important aspect of the updated decree is the guidance on the lifetime of a routine company. Based on the degree, in a case where a routine function is valued, it has to be evaluated whether the activities of a routine company are based on a single contract with a group entrepreneur and, if so, what the annual probability is that the agreement will be canceled by the entrepreneur. The cancellation probability should be included in the valuation and may have a significant impact on the assumed lifetime of a routine company when valued.

The updated decree includes welcome clarification regarding several points and confirms the views of the tax authorities. However, it should be noted that particularly in the area of a transfer of a function, the updates that were included in the guidance also indicate a more restrictive approach by the German tax authorities. Further developments in this regard should be closely monitored.

Your Contacts