Transfer Pricing

Transfer Pricing

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  • Sebastian Pawlita
    Sebastian Pawlita    Premium Member
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    German Exit Taxation: When the Trap Snaps Shut
    The German Ministry of Finance is presently drafting administrative guidelines ("Draft Guidelines") clarifying some of the ambiguities of the infamous German transfer of function tax. I would like to take this as an occasion to summarize the essentials of this tax in this posting. The German participants of this forum have probably heard it all already, but it might be useful to the international members.

    I. YOU CAN MOVE IN ANYTIME YOU LIKE, BUT YOU CAN NEVER LEAVE

    In a move to make Germany more competitive as an investment location, the corporate tax rate was reduced from around 40 % to approx. 30 % with effect as of January 1, 2008. Little did the German government publicise at that time that it followed a modified "Hotel California" approach: "You can move in anytime you like, but you can never leave." Companies are welcomed with open arms to set up shop in Germany. Once here, however, they are liable to pay ransom in the shape of a hefty tax bill if they want to reallocate even small parts of their activities to non-German lands again.

    The reason is a uniquely German exit taxation applicable to the transfer of functions, introduced concurrently with the reduction of the corporate tax rate and empowering the German fisc to usurp not only tax revenue generated in Germany, but also abroad. Unless companies structure their investment carefully before setting up business here, they risk being caught in this trap. Some ideas how to avoid being caught, or at least mitigate tax exposure, can be found at the end of this posting.

    II. THE IDEA BEHIND IT

    Many jurisdictions impose an exit tax when companies move activities across the border. Usually, however, they restrict themselves to taxing the hidden reserves of the assets leaving the country. They might classify so-called “chances of profit” as intangible assets that are, if transferred, liable to exit taxation, but only if these chances are specific and likely to materialize, such as in the case where a domestic company had secured a supply contract, but allowed its foreign subsidiary to fulfil it and receive the remuneration for it.

    Hidden reserves taxed in the jurisdiction of the transferor can usually be written down in the jurisdiction of the transferee. There is no double taxation.

    This was also the understanding of the German fisc until 2007. The transfer of function rules introduced as of 2008, however, changed it all. Now, the German fisc not only takes a shot at the hidden reserves of the assets leaving Germany, but additionally taxes part of the profits (50% in general) reaped by the transferee as a result of location factors abroad such as cheap labour, low taxation, or cheap energy. This “plus X” is an amount that is in fact taxed twice: Once in Germany when the function is transferred, and once again abroad when the transferee makes the corresponding profit.

    There is no mechanism available in national tax law that could help avoid this double taxation. It is hard to imagine that a foreign jurisdiction would relinquish its right to tax home-generated profits just because the German fisc pre-emptively usurped them. The only way out is a time- and cost-consuming mutual agreement procedure according to the relevant double taxation treaty. It is therefore important to find ways to keep the German exit taxation low.

    Needless to say that the German fisc wants to apply the new rules retroactively to years prior to 2008.

    III. HOW IT WORKS

    The reason why the German fisc has now access to profits generated abroad is a change in the method of valuating the transfer of the function. Instead of valuating each isolated asset transferred across the border - as it was done in Germany until 2007 and is still standard internationally -, the new legislation introduced the idea of a transfer package valuated as a whole.

    According to this new (and internationally unknown) concept, the price of this transfer package is, generally speaking, the mean value of the profit the transferor could have generated out of the function had it not been transferred, and the profit the transferee can expect to generate out of the function. The tax base for the German exit taxation is the thus calculated transfer price minus the book value of the transferred assets. This means that foreign-generated profits, including advantages out of location factors abroad, are part of the German tax base.

    Apart from the double-taxation risk, the taxpayer is saddled with an excessive amount of work to calculate - and document! - the transfer price. Needless to say, the transfer of a function gives rise to extensive documentation requirements which, if not met, lead to the German fisc being able to estimate the tax base (usually to the detriment of the taxpayer) and assess penalties.

    IV. WHEN YOU RISK FALLING INTO THE TRAP

    The unique German exit taxation (i.e., taxation of a transfer package as a whole including expected foreign-generated profits) only applies to the transfer of a function by a German entity to a related party abroad. A company is related to another company if (i) it directly or indirectly holds at least 25 % of the other company, (ii) at least 25% of its shares are directly or indirectly held by the other company, or (iii) it exercises a dominant influence on, or is subject to a dominant influence of, the other company.

    The law contains no definition of “function”. The Draft Guidelines list as examples "business activities that form part of management, research and development, procurement, stock-keeping, production, packaging, distribution, processing or refinement of products, quality control, financing, transport, organisation, administration, marketing, customer service, etc." Any transfer of an activity that so far has featured separately in cost or profit centre accounting should give rise to concern, but it is doubtful if this covers everything. It is clear that the tax authorities will try to qualify as many activities as possible as a "function" in order to profit from the enlargement of the tax base. This means that the tax authorities will probably show quite some ingenuity breaking down units into different functions (e.g., they could try to argue that the production of red screws of the type X-1 for the Lithuanian market and the production of the same screws for the Estonian market are, in fact, two different functions).

    A function is transferred if the German entity stops or reduces the activities associated with the function (e.g., shift of production or distribution activities to a foreign entity, conversion of a full-fledged manufacturer or distributor into a contract-manufacturer or commissionnair and vice-versa, outsourcing of the production to a contract-manufacturer). Staff cuts and/or the reduction of customers could prompt the tax authorities to investigate whether a function was transferred. There is a monitoring period of 5 years to allow the tax authorities to also capture functions that are transferred piecemeal over several years.

    V. WHAT YOU CAN DO ABOUT IT

    1. IF YOU HAVE NO BUSINESS IN GERMANY YET, BUT WISH TO SET UP ONE

    - Create as little profit potential in Germany as possible. The less profit potential there is in Germany, the less can be taxed by the German fisc if the function is shifted out of Germany again. This can be achieved by making the German entity a contract-manufacturer or commissionnair instead of a full-fledged manufacturer or distributor right from the beginning;

    - consider setting up a permanent establishment in Germany instead of a subsidiary. Permanent establishments do have their share of drawbacks, but they are not subject to the transfer of function rules (i.e., taxation of a transfer package as a whole including expected foreign-generated profits);

    - document everything. This might help when trying to prove that what you will eventually shifted out of Germany again is not a function.

    2. IF YOU HAVE A BUSINESS IN GERMANY AND WISH TO SHIFT FUNCTIONS TO RELATED PARTIES ABROAD

    - Shift as little profit potential out of Germany as possible. The less profit potential is shifted out of Germany, the less can be taxed by the German fisc. This can be achieved by making the foreign entity a contract-manufacturer or commissionnair instead of a full-fledged manufacturer or distributor;

    - consider setting up a permanent establishment abroad instead of a subsidiary. Permanent establishments do have their share of drawbacks, but they are not subject to the transfer of function rules;

    - within the EU/EEA, one can try shifting functions within the framework of corporate transformations (in particular, a spin-off - "Ausgliederung");

    - instead of creating functions in Germany and then shifting them, create them abroad right from the beginning;

    - try to make use of the exemptions provided by the law itself (e.g., in case of the transfer of routine functions, there is no need to valuate a transfer package as a whole if certain strict requirements are met);

    - try to rent / license assets to the foreign entity instead of selling them. This will not avoid exit taxation as such, but allow you to spread it over several years;

    - don’t forget to document the transfer in line with the transfer pricing documentation requirements;

    - have VAT consequences checked as a transfer of functions will typically give rise to new intra-group transactions.
    • 17 Sep 2009, 7:59 pm