Draft Administrative Principles for the profit attribution to permanent establishments 8 April 2016 German Tax Alert On 18 March 2016, the German Ministry of Finance (BMF) issued for public discussion the draft version of the Administrative Principles on the Profit Attribution to Permanent Establishments ( Draft Administrative Principles ). The Draft includes 152 pages of details and clarifications concerning the application of the Authorized OECD Approach ( AOA ) that is already implemented in Section 1, subsection 5 of the Foreign Tax Act ( FTA ) and the Regulation for the Profit Attribution to Permanent Establishments ( PE Regulation ). It represents in addition to the mere legal provision in FTA and the PE Regulation with direct binding impact on the taxpayer (law character) the typical third element in German tax legislative process in form of Administrative Principles with indirect and indicative impact on the taxpayer (application guide for the tax authorities). This Alert provides a summary of the draft version s essential content and points out areas for the taxpayer to take action. Prior to the introduction of the AOA, German tax law contained only minor provisions determining the profit allocation between a permanent establishment ( PE ) and its head office. Remaining legislative loopholes were closed by case law, which has mostly become obsolete with the implementation of the AOA. Taxpayers may expect the Administrative Principles to provide them with clear application guidelines which would be fully consistent with the AOA. However, the Draft Administrative Principles do not fully meet these expectations.
Permanent establishments treated as fully separate entities For all financial years starting after 31 December 2012 Germany treats a PE having its head office in another state as a (nearly) separate and independent enterprise for income tax purposes and follows therewith the basic principles of the AOA which is outlined in the OECD Reports on the Attribution of Profits to Permanent Establishments dated 17 July 2008 and 22 July 2010 and already introduced in Art. 7 of the OECD Model Tax Convention ( OECD MTC ) 2008 and 2010. Accordingly, the profit attributable to the PE is determined in a two-step approach. In a first step the PE has to be hypothesized as a separate and independent enterprise. For this purpose the functions performed, assets owned or used, risks assumed and external transactions are attributed to the head office or PE based on the identified significant people functions. Next, an appropriate share in the free capital has to be allocated to the PE. Finally, dealings between the different parts of the enterprise, such as the supply of goods, a service provision and even licensing arrangements, have to be recognized. In a second step these dealings have to be priced in accordance with the arm s length principle and the transfer pricing methods discussed in the OECD Transfer Pricing Guidelines can be applied in analogy. As a result, intra-company cross-border transactions can lead to a taxable profit at one part of the enterprise before the enterprise as a whole has realized a profit in an outside market transaction. Correction into both directions based on AOA principles The introduction of the AOA into Section 1 of the German FTA which represents a onesided correction norm just to the detriment of German taxpayers had been heavily criticized and discussed. Now, the Draft Administrative Principles explicitly outline that the application of the arm s length principle according to the AOA is also possible for the benefit of German taxpayers due to the barrier impact of the respective double tax treaty (referring to Art. 7 of the OECD MTC 2010). Therefore, the AOA application rules as outlined in the Draft Administration Principles take effect into both directions if the underlying treaty includes the 2010 Art. 7. This, however, is not the case for the vast majority of the German Treaties in place. issued for public discussion April 2016 2
Attribution of functions, assets, chances and risks People functions as starting point Since between the different parts of the same enterprise legally binding contracts are not possible, the function and risk profile just as the endowment of the assumed separate entity is determined by its people functions. Consequently the starting point for the profit attribution to PE is the personnel of the enterprise, its operative significance for the value chain and its place of activity. Based on German tax law and the Draft Administrative Principles, a people function is attributed to a PE if personnel performs the respective activity at the place of business of the PE (geographic concept). Deviation from this general principle is possible for activities that are not related to the business of the PE and that are just performed for a short period of time by the PE (max. 30 working days per fiscal year). As a consequence of the attribution of a people function to a PE the related personnel costs and the performed function are allocated to the PE. In case people functions are qualified as significant (operative decision takers) the respective assets, opportunities and risks etc. will follow the attribution to the PE as outlined below. Exemption from the geographic concept for travelling personnel For travelling personnel the Draft Administrative Principles allocate the personnel s functions to that PE with the closest functional relationship. This exemption corresponds with the former principle of economic attribution and manages the attribution issue from frequently travelers people functions. Scope for judgment evaluation Further, in case of doubt the enterprise is given a certain leeway in assessing the attribution of the people function. Such cases of undetermined attribution comprise also the challenges in complex organizational structures, e. g. to determine who is conducting the respective people function or for which part of the enterprise the decision is taken. Also in this case the attribution of the people function should comply with the above principles and the decision has to be taken for the preparation of the Auxiliary Calculation at latest and needs to be documented properly. A pro-rata attribution is not allowed. As a result, on the one side the documentation effort increases significantly, on the other side this regulation offers room for designing a certain structure of the business model. Assets The terminus assets incorporates tangible and intangible assets and values, advantages, investments and participations. The definition as an asset and its attribution to the respective part of the enterprise has to be considered for the related revenue and expenses, as a subject for dealings and for the function and risk analysis in order to determine an arm s length remuneration of cross-border dealings or intercompany transactions. German or international GAAP regulations as well as the capitalization in the PE Auxiliary Calculation have no impact on the definition of assets. Based on the identification of the significant people functions, the assets of an enterprise are attributed to the different parts of an enterprise based on a legal presumption as outlined in the table below. However, if people functions, which are conducted in another PE, are of more significance for the respective asset ( competition of people functions ), the asset will be allocated to the other PE. issued for public discussion April 2016 3
Attribution of functions, assets, chances and risks Attribution of assets based on people functions Legal presumption Competition of people functions Relevance of people functions in connection with: Tangible assets Place of use respectively location for immovable assets Purchase, production, management or sale of the respective asset Not applicable for immovable assets Intangible assets Performance of the significant people function that was responsible for their creation or purpose Use, management, further development, protection or sale of the respective intangible asset Participations, investments Other assets (working capital, trade accounts receivable) Functional relationship to the business of PE Significant people function related to their production or purchase Purchase, management, risk control or sale of the respective asset This explicitly includes the people function responsible for generating the funds for the acquisition Use, management, risk control or sale of the respective asset In general, the Draft Administrative Principles aim at a clear and unique asset attribution based on the above principles. A pro-rata attribution is just possible for intangible assets and for a certain period in order to avoid permanent dealings through permanent modifications of attribution. If personnel in different parts of the enterprise perform relevant people functions ( split functions ), just the people function with the highest importance to the asset can be regarded as the significant people function to which the asset is attributed. According to the Draft Administrative Principles such importance is generally measured on qualitative considerations, only exceptionally on quantitative aspects (e.g. amount of wages). As a consequence of deviating attributions from the legal presumption different types of sub-contractor-dealings such as toll manufacturing or contract R & D have to be assumed and the Draft Administrative Principles provide examples thereof. Nevertheless, it should be noted that based on the AOA risks follow the related asset or function and therefore the sole transfer of risks does not work. In cases where an asset previously attributed to a PE shall be reattributed to another PE in a different tax jurisdiction ( sister-pe ), German tax authorities suggest to assume an indirect fictitious transfer from the first PE to the head office with subsequent fictitious transfer from the head office to the second PE. A direct allocation of profits between PEs from issued for public discussion April 2016 4
Attribution of functions, assets, chances and risks different tax jurisdictions shall according to the Draft Administrative Principles not be possible for fictitious services as well. From the point of view of a German head office, there exists neither a legal basis nor a necessity for such a treatment in cases where the profits from both foreign PEs are tax exempt in Germany. In case, based on the above principles a definite attribution of an asset is not possible, the enterprise is given a certain leeway in assessing the attribution. Such a decision should comply with the foregoing principles and has to be made for the preparation of the Auxiliary Calculation at latest. Further a proper documentation of the reasoning behind is required. An important aspect of the introduction of the AOA with its new attribution principles is the possible reattribution and therefore assumed transfer of assets between head office and PEs. Based on the Draft Administrative Principles in such cases dealings are not assumed, but the regulations on exit taxation are applicable and a realization of capital gains is possible. In order to avoid the taxation of such realized reserves in only one year, the taxation can be spread over five years via deferred items (also in relation to PE in non-eu countries). It is also allowed to design a situation, e.g. via introduction of new people functions, that no transfer has to be assumed. In principle, such a design can be done in the first year of application of the PE Regulation. I.e. this should have been realized already in 2015 in case of financial year equal to calendar year and can still be done in financial year 2015 / 2016 in case of financial year deviating from calendar year. Overall, a review of the existing situation of PE is strongly recommended. Further attribution items Opportunities and risks that are directly related to an asset follow the attribution of the respective asset. The other opportunities and risks are allocated based on the respective significant people function. A pro-rata attribution is not possible. External transactions with third parties or related entities including all related revenues, costs and profits are fully attributed to that part of enterprise whose significant people function contributes most to the conclusion of the respective transaction respectively generated the transaction. Hedging instruments follow the attribution of the hedged asset or transaction. issued for public discussion April 2016 5
Determination of the capital attributable to permanent establishment Following the AOA, the endowment capital will be directly attributed to the PE and its amount affects indirectly the allocable liabilities and the respective interest deduction. Asymmetric approach The asymmetric approach clearly favouring the domestic part of a single enterprise would in many cases force the taxpayers to attribute more than 100 % of the capital to different tax jurisdictions and thus increase the likelihood of double taxation. An asymmetric approach in the determination of the capital attributable to domestic and foreign PEs, which was proposed in the PE Regulation and heavily criticized as contradicting to the AOA and solely aiming to maximize the domestic tax base, shall according to the German Ministry of Finance be maintained and expanded even further. In case of a domestic PE, the equity of the whole enterprise determined in accordance with the principles of the German tax law shall be allocated on the basis of the arm s length value of the assets of the domestic PE to the arm s length value of the whole assets of a single enterprise (so-called capital allocation method ). The Draft Administrative Principles render more precisely that all assets and risks irrespective of their recognition in the tax accounting or Auxiliary Calculation, including i.e. self-created intangibles, goodwill and warranty provisions, shall be considered by determination of the allocation ratio. In contrast to the above, capital shall be attributed to a foreign PE of a domestic enterprise if and only to the extent it is economically justifiable (so-called minimum capital method ). An amount of capital attributable to a domestic PE of a foreign enterprise in a similar case in accordance with the capital allocation method shall constitute the upper limit. A German enterprise shall primarily use tax book values of the assets instead of their arm s length values for the calculation of the upper limit of the capital attributable to a foreign PE. At least equity recognized in the German statutory accounts of a domestic PE shall be attributable to it. On the other side, the capital attributable to a foreign PE of a domestic enterprise may not exceed the equity recognized in the local statutory accounts of the foreign PE. Special rules for domestic PE of thin capitalized enterprises German tax authorities also continue to adhere to the determination of the capital attributable to the domestic PE based on the consolidated group s equity in cases where the foreign enterprise belonging to the group is thinly capitalized. Based on the Draft Administrative Principles, thin capitalization shall always be assumed in cases where a domestic PE after debt servicing will in the long run not be able to generate taxable profits. In the opposite scenario, i.e. where a domestic enterprise belonging to a group is thinly capitalized, the Draft Administrative Principles does not provide for determination of the capital attributable to the foreign PE based on the consolidated group s equity. Monitoring required during the financial year In case of significant reallocation of people functions, assets, chances or risks during the financial year, the capital attributable to a PE has also to be adjusted during the same financial year. The Draft Administrative Principles define a significant reallocation at the level of a domestic PE as an increase of the attributable capital by more than 50 % or at least by more than 2m compared to the beginning of the financial year; whereas a decrease of the attributable capital by more than 50 % or at least by more than 2m com- issued for public discussion April 2016 6
Determination of the capital attributable to permanent establishment pared to the beginning of the financial year should be considered significant at the level of a foreign PE of a domestic enterprise. Compliance with these rules would require a taxpayer to prepare and continuously update a kind of a shadow accounting which, depending on the intensity and frequency of the transformations, may become highly time intensive. As a consequence of the asymmetric approach and in contrast to an enterprise as a whole from a commercial GAAP point of view, the endowment capital of the PE under the German PE profit attribution rules is not a residual amount but determined in favor of the German tax authorities. Attribution of interest expenses Attribution of capital to foreign PEs has a significant impact on the attribution of interestbearing liabilities which in turn determine the allocation of interest expense to different parts of the single enterprise. Liabilities directly connected with assets, chances and risks of a PE shall be directly attributed to this PE. In case the sum of directly attributable liabilities, capital and risks exceeds the sum of assets and chances recognized in the Auxiliary Calculation, the differential amount may not be attributed to the PE. In case the sum of directly attributable liabilities, capital and risks is lower than the sum of assets and chances, the residual amount should be absorbed by (partial) attribution of other liabilities. Interest expenses arising from the liability directly connected with the PE shall be directly allocated to this PE. In case of a partial attribution of the interest-bearing liability to the PE, interest expenses shall also be partially allocated to the PE. Recognition of dealings From a legal perspective, contractual relationships between separate parts of the same enterprise are regularly not possible. Following the separate legal entity approach, section 1, subsection 4 and 5 FTA therefore provide that cross-border business transactions between a PE and the remaining parts of the enterprise constitute a so-called assumed contractual relationship (similar to the OECD wording dealing ) that has to be remunerated on an arm's length basis. Such an assumed contractual relationship takes place if the asset attribution changes or a business activity is performed for which third parties would have had concluded a contract or would claim a legal position. The Draft Administrative Principles connect the definition of an assumed contractual relationship to the performed people functions and assumed risks of the PE and the remaining parts of the enterprise which exceed a certain still not further defined - threshold. Furthermore, the Draft Administrative Principles clarify that an assumed contractual relationship is in particular given in the following cases and provides several examples: Change of people functions related to assets (fictitious sale / grant of use) Provision of supporting people function (fictitious service) Third parties would claim a legal position (e.g. fictitious claim for indemnity or warranty claim). issued for public discussion April 2016 7
Recognition of dealings However, a loan transaction between different parts of the same enterprise is explicitly excluded from the definition of an assumed contractual relationship. If a PE manages the funding or invests exceeding liquidity for one or more other PEs of the same enterprise, such activity is regarded in general as a service (and not as a financing transaction) for which a cost-based transfer pricing method has to be applied. In this case, the interest expenses are however not part of the allocable cost base. For the identified assumed contractual relationships transfer prices have to be determined in line with the arm s length principle based on the generally acceptable transfer pricing methods. The resulting fictitious business income and business expenses are subject to the Auxiliary Calculation and the related documentation requirements. The Draft Administrative Principles point out that due to the attribution rules the entrepreneurial freedom of choice is limited and the documentation has not the character of binding legal agreements between separate legal entities. Furthermore, the assumption of assumed contractual relationships has no impact on other tax areas, e.g. withholding tax or VAT. Specific rules for different industrial sectors In line with the PE Regulation the Draft Administrative Principles also provide additional guidance on the specific requirements for profit allocation to PEs of banks and insurance companies as well as construction and exploitation sites. These rules will be subject to separate EY Tax Alerts. Auxilairy Calculation and General Transfer Pricing Documentation Requirements Preparation of Auxiliary Calculation For all financial years beginning after 31 December 2014, the taxpayer the domestic PE of a foreign head office as limited German taxpayer or the foreign PE of a domestic head office as unlimited German taxpayer - has to prepare an Auxiliary Calculation on a financial year basis with respect to the assets, the capital, the remaining liabilities and the revenues and expenses attributable to the PE, including deemed revenues and expenses resulting from internal dealings (calculation of taxable income of the PE). However, the Draft Administrative Principles do not provide an explicit template for the Auxiliary Calculation. Preparation of transfer pricing documentation Part of the Auxiliary Calculation has to be documentation notes on the reasoning for the applied asset / capital / liabilities and revenues / expenses attribution. In particular, if the taxpayer deviates from the basic principles for the attribution laid down in the PE Regulation and the Draft Administrative Principles, the taxpayer has to properly document that such deviation leads to a result that better reflects the arm's length principle by providing the foreign tax return filed and the related tax assessment notes. issued for public discussion April 2016 8
Auxiliary Calculation and General Transfer Pricing Documentation Requirements Due to the lack of legally binding contracts between the head office and its PEs, contemporaneous transfer pricing documentation becomes even more crucial in order to defend the transfer prices applied for internal transactions (dealings). If, e.g., the head office develops a software solution that is used by the foreign PE, a license fee has to be charged under the AOA from the head office to the PE. Alternatively, the development of the software can be structured in the way of a (notional) cost contribution arrangement or as contract software development. However, such tax planning alternatives have to be documented contemporaneously in order to increase the power of proof towards the tax authorities. One approach can be to set-up an internal guideline similar to an intercompany agreement between head office and PE per identified dealing. Relevant deadlines and timing The Auxiliary Calculation has to be prepared at the latest, when the tax return for the respective financial year is filed (as stipulated by the PE Regulation it has to be set-up at the beginning of the financial year, further developed during the financial year and finalized at the end of the financial year). But the Draft Administrative Principles do not include any clarification on E-balance sheet filing purposes applicable for PEs for financial years 2015 onwards. In case of mandatory accounting, the local GAAP books can regularly be used as basis for the Auxiliary Calculation (granted simplification rule: Application of exchange rate per financial year end). However, the Auxiliary Calculation just leads to no balance sheet continuity. Although the general transfer pricing documentation can only be requested by the German tax authorities in the course of a tax audit, documentation requirements for the Auxiliary Calculation already apply at the point of time of filing the tax return (reduction of effective documentation deadline in practice). The taxpayer is well advised to update its documentation process and integrate the reasoning for the applied asset / capital / liabilities and revenues / expenses attribution in order to avoid income estimation and penalties in absence of timely and appropriate documentation. This is in particular true in the context of the increased documentation requirements according to BEPS 13 (Master File / Local File approach and Country-by-Country-Reporting) expected to be implemented in German tax law for financial years beginning after 31 December 2015. Impact on BEPS Action 7 Based on BEPS Action 7 ( Preventing the artificial avoidance of PE status ) the threshold to create a PE will be reduced and PEs without (significant) people functions will increase. This will require additional guidance on how the AOA rules would apply to such PEs. Comments or guidance on profit attribution and transfer pricing are still expected from OECD in connection with the BEPS project before the end of 2016. The Draft Administrative Principles do not comment on so far. issued for public discussion April 2016 9
Application of new law With regard to the implementation of the AOA into German tax law for financial years beginning after 31 December 2012, the Draft Administrative Principles differentiate the following scenarios depending on the type of double tax treaty (DTT) in place: For financial years beginning after 31 December 2014 the PE Regulation applies, i.e. the preparation of an Auxiliary Calculation is required and the attribution rules for capital etc. apply. In other words, the taxpayer has to prepare an Auxiliary Calculation for the first time for its PE for financial year 2015 onwards although the arm s length principle has to be considered already from financial year 2013 onwards for the PE profit allocation. In contrast to the law, the Draft Administrative Principles assume that the AOA will already apply for financial years starting before 1 January 2013 if a DDT according to Art. 7 OECD MTC 2008 or 2010 is applicable (as described in the table above). A possible double taxation should be resolved by means of the application of a mutual agreement procedure. Further proceedings of finalizing The German Ministry of Finance has invited the industrial and municipal associations as well as the groups of experts to comment on the Draft Administrative Principles by 13 May 2016. It is expected that the final Administrative Principles will be published by the German Ministry of Finance in the second half of the year 2016. issued for public discussion April 2016 10
Recommendations and required action points AOA-Review of existing PE income allocation As for all financial years starting after 31 December 2012 the basic principles of the AOA are already applicable and for all financial years starting after 31 December 2014 the consequences from reattributions have to be considered, it is advisable for foreign companies having PEs in Germany and for German entities having PEs abroad to screen whether the PE income allocation complies with the specific German AOA rules. This should include for instance the identification and attribution of (significant) people functions, assets and capital. Further, internal dealings have to be identified and priced based on the arm s length principle. Germany implemented the AOA with some deviating rules, in particular the asymmetric determination of endowment capital for the benefit of German tax authorities. This might result in double taxation and the Draft Administrative Principles suggest to resolve this via the application of a mutual agreement procedure (MAP). Effective compliance and risk management To meet the increased compliance requirements in form of the Auxiliary Calculation, the taxpayer is well advised to prepare at the point of time of filing the PE or head-office tax return for financial years beginning after 31 December 2014 not only the Auxiliary Calculation, but also the reasoning of the attributions made of (significant) people functions, assets, capital and effective as well as assumed business profits and expenses. Consequently the transfer pricing documentation shall ideally be prepared already at this point in time in order to avoid additional documentation efforts several years later in case of a tax audit and under potential time constraints and potential employee fluctuation. This is in particular true in light of the increasing documentation requirements under BEPS 13 which anyway shortens the documentation deadline to the tax return filing. In addition, it is also recommendable to analyze when filing the tax return which scenario in terms of application of a DTT applies in order to anticipate and mitigate a potential double taxation risk from deviating rules for profit attribution to PE. In this case it might make sense to pro-actively liaise upfront with the German and/or foreign tax authorities. In order to be prepared for a tax audit and to manage the increasing tax audit risk, the preparation of sound documentation is highly recommendable. issued for public discussion April 2016 11
EY contacts International Tax Services Munich Christian Ehlermann Telefon +49 89 14331 16653 christian.ehlermann@de.ey.com International Tax Services Transfer Pricing Düsseldorf Oliver Wehnert Telefon +49 211 9352 10627 oliver.wehnert@de.ey.com Frankfurt/Eschborn Dr. Sophie Margerie Telefon +49 6196 996 17648 sophie.margerie@de.ey.com Berlin Ina Sprenger Telefon +49 30 25471 21411 ina.sprenger@de.ey.com Publisher Ernst & Young GmbH Wirtschaftsprüfungsgesellschaft Flughafenstrasse 61 70629 Stuttgart EY Assurance Tax Transactions Advisory About the global EY organization The global EY organization is a leader in assurance, tax, transaction and advisory services. We leverage our experience, knowledge and services to help build trust and confidence in the capital markets and in economies the world over. We are ideally equipped for this task with well trained employees, strong teams, excellent services and outstanding client relations. Our global purpose is to drive progress and make a difference by building a better working world for our people, for our clients and for our communities. The global EY organization refers to all member firms of Ernst & Young Global Limited (EYG). Each EYG member firm is a separate legal entity and has no liability for another such entity s acts or omissions. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information, please visit www.ey.com. In Germany, EY has 22 locations. In this publication, EY and we refer to all German member firms of Ernst & Young Global Limited. 2016 Ernst & Young GmbH Wirtschaftsprüfungsgesellschaft All Rights Reserved. DLE 1604 ED None This publication contains information in summary form and is therefore intended for general guidance only. Although prepared with utmost care this publication is not intended to be a substitute for detailed research or the exercise of professional judgment. Therefore no liability for correctness, completeness and/or correctness will be assumed. It is solely the responsibility of the readers to decide whether and in what form the information made available is relevant for their purposes. Neither Ernst & Young GmbH Wirtschaftsprüfungsgesellschaft nor any other member of the global EY organization can accept any responsibility. On any specific matter, reference should be made to the appropriate advisor. www.de.ey.com