Germany: Revolution in PE rules

Dr. Alexander Voegele and Philip de Homont, NERA, Frankfurt

Taxpayers should be aware of new law when tax planning

On August 5, 2013, the German Ministry of Finance issued a new, 84-page draft Decree on the transfer pricing treatment of permanent establishments (Betriebsstãttengewinnaufteilungsverordnung1), following the issuing of a new implementation law on legal and administrative co-operation (Amtshilferichtlinie-Umsetzungsgesetz) on June 26, 2013. Together, the law and the Decree imply profound changes and are in many aspects a complete reversal of current practices. Most importantly, the law and Decree are an attempt to put Germany in line with most of its important trading partners by following the “authorised OECD approach” for the taxation of permanent establishments (“PEs”).

l. A difficult background

It has taken quite some time for Germany to adapt to this new thinking, and some portions of the Decree still do not fully endorse these changes. The reluctance is partially due to the long heritage of transfer pricing regulations on permanent establishments in Germany, which were first introduced in the 1899 tax treaty between Prussia and Austria-Hungary. However, to some degree German tax authorities had already de-facto accepted aspects of the OECD standard in some circumstances, in particular in Mutual Agreement Procedures. Notably, several recent and important German tax treaties2 have already adopted the separate entity approach, and some have even fully adopted Article 7 of the OECD's 2010 model convention.3 Also, Germany has several mandatory arbitration conventions with EU-countries and the USA, which had previously necessitated some compromise.

The new law is somewhat overdue, as the changes originally had been planned as part of the tax law for 2013 (Jahressteuergesetz 2013), which failed to achieve support in both legislative chambers in late 2012 due to factors other than transfer pricing. Ultimately, the new law nearly fully adapts the wording of the proposed tax law for 2013, and thereby makes the same changes to the principal German foreign tax code (Auszensteuergesetz) and instructs the ministry of finance to draft the Decree, which is to be affirmed by the senate (Bundesrat).

ll. Extensive changes

Effectively, permanent establishments will in the future be treated as functionally separate entities, which can engage in 'dealings' with other permanent establishments. This is a marked difference from the previous assessment in Germany, which held that permanent establishments were an integral part of a business and could not effectively be discerned from other parts of the same legal entity. Transactions between the head office and a permanent establishment could not result in realised profits prior to external sales to other companies.4

Crucially, permanent establishments will in the future be largely defined by their 'people functions’, that is the functions carried out by the establishments' own personnel. This will strongly curtail the role of pure 'funding’ permanent establishments and will require an even higher standard of documentation.

Article 55 of the new law makes extensive changes to the principal German law on transfer pricing matters, which are largely mirrored in the Decree. Most importantly, the Foreign Tax Law now explicitly extends the arm's length principle to the attribution of profits to permanent establishments. Since PEs cannot enter into a formal contract with another part of the same entity, the concept of fictional contracts (“dealings”) is introduced into the law.

The main changes to the Foreign Tax Law are made to Section 1, which is amended by two new sections. The new section 56 explicitly states that a permanent establishment is to be treated as a separate entity in order to apply the arm's length principle, while section 6 authorises the Ministry of Finance to issue the Decree.

Furthermore, the law contains a comprehensive treaty override. Around 90 of Germany's tax treaties are still based on the older OECD model conventions, and do not follow the functionally separate entity approach. The draft law would supersede these treaties, unless the taxpayer can prove that the other state is actually exercising its right to taxation. The original government draft had stipulated that tax treaties would only remain valid if they led to a lower necessary adjustment; however this clause was struck out in parliamentary proceedings.7

As a consequence, taxpayers must now provide comprehensive documentation that the dealings of PEs are at arm's length. Goods and services rendered by or to PEs must now be remunerated at arm's length, and intellectual property rights should also be remunerated either through a lump-sum buy-out payment, or through licence fees. Interestingly, the new law explicitly retains the possibility to effectively defer the payments for such dealings until the profit is realised externally.

The treatment of PEs as quasi-separate entities also extends to other German transfer pricing legislation. In particular, a relocation of function (Funktionsverlagerung) can now also occur between a PE and a head office, resulting in potentially large transfer payments.

lll. New procedures to attribute assets, capital and business transactions

The arm's length character of permanent establishments will predominantly be based on the people functions of the respective permanent establishment. The people function is defined by the business function of the actual own personnel of the permanent establishment, that is, persons that are directly employed by the legal entity.

This people function is then used to identify which tangible, intangible, and financial assets are to be attributed to the permanent establishment. Interestingly, the assets will generally be fully attributed to the permanent establishment whose functions are determined to be the 'most important’ for this asset. A pro-rata attribution of an asset based on the relative importance is generally not allowed, or only allowed if other assessments cannot be used.

Which people function is the 'most important’ is not clearly defined, but it is clarified that 'supportive’ functions are not considered important, while functions relating to the procurement, administration, risk-management, or sale of an asset are generally held to be important.

Chances and risks that are directly related to an asset are attributed to the pertinent permanent establishment. Those chances and risks that are not directly related to an asset are assigned again based on the people's function. In both cases, the most important function gets all chances and risks, that is, there is generally no pro-rata assignment.

Business transactions with third parties - and all associated revenues, costs, and profits - are assigned to the permanent establishment that contributes most to the conclusion of the transaction. As is the case with assets, chances, and risks, the business transaction is fully attributed to the most important people function, and not shared between multiple functions.

Internal business transactions are not directly specified, but are generally understood to be subject to the normal transfer pricing rules, that is, they are to be evaluated based on the arm's length principle.

Equity in the form of endowment capital is attributed to the parties based on the previous rules for bank branches. In essence a 'capital apportioning’ is used, where the overall equity (in principle according to German tax law) of the legal entity is attributed between the head office and the permanent establishments according their respective assets, and the associated chances and risks. Notably, the rules differ for German permanent establishments and foreign permanent establishments. In general, foreign permanent establishments can only have the absolutely minimally required capital. German permanent establishments are always deemed to have at least their share of actual capital, while foreign permanent establishments can at most have their share of actual capital. Furthermore, German permanent establishments are subject to a sensibility check as to whether a prudent business person would accept the resulting endowment capital, while no such check is in place for foreign permanent establishments.

However, the new rules do not extend the functionally separate entity approach to treat PEs as entirely independent entities in all respects. In regards to the financing, PEs are not considered separate and there will be no possibility of financing contracts between the head office and its PE. Instead, the loans of the entire entity have to be split between the head office and the PE. Permanent establishments can potentially render financing services, but this is to be evaluated as a service not as a contribution of capital. Moreover, the Decree actually prescribes that in such a situation a cost-based transfer pricing method should be used.

Much more extensive special regulations are made for banks, insurance companies, building and construction companies, and exploration activities, due to the high importance of branches and permanent establishments in these industries. An extensive review of these areas would be beyond the scope of this article, however the situation is somewhat similar to what was in place before the new rules in that these exceptions serve to specify the general rules for these specific circumstances.

lV. Further regulations impacting PEs

Besides the changes that directly affect the treatment of permanent establishments, several other transfer pricing aspects have been changed or will be changed in the near future:

Importantly, another Decree is pending, which will address the application of the arm's length principle for all transactions (with or without a PE). Since permanent establishments will fall under the general transfer pricing rules, this second new Decree will very likely have further implications for permanent establishments.

Secondly, the new law makes extensive changes to the conduct of mutual administrative assistance on tax matters between EU member states (for which it is named).8 This will foster a more efficient exchange of information among EU members. Primarily, information may be exchanged on all taxes, except VAT and custom duties. New liaison offices have been established at the tax authorities of all EU member states, including offices of other states at the central German tax agency. This doubtlessly increases the level of European co-operation, including the potential for foreign states to conduct fact-checks and interviews in Germany (and vice versa), provided a German auditor is present. It is likely that simultaneous audits across countries will become increasingly common. So the transfer pricing of permanent establishments is not only changing rapidly, is also likely subject to increased scrutiny by German and foreign tax authorities.

V. Summary

Effectively, the new law moves Germany in line with the authorised OECD approach on PEs and introduces the separate entity approach into German law, including “people functions” as a concept to determine the characteristics of the PE.

Overall, these changes align Germany with recent OECD developments and should lead to an economically appropriate attribution of profits to PEs. However, taxpayers will face increased scrutiny and documentation requirements, in particular when operating in one of the more than 90 states for which older tax treaties are still applicable. The law has drawn considerable criticism, primarily from small- and medium-sized enterprises (Mittelstand) in the machine tool industries due to the increased documentation requirements. Furthermore, some judges at the financial courts have expressed their dissatisfaction with the new treatments of PEs.

Although the new law had originally been scheduled to become effective on January 1, 2013, it has yet to be approved by the Senate. The Senate had previously signalled dissatisfaction with various other Articles of the law that are not related to the Articles relevant to transfer pricing. Although there seems to be little disagreement in regard to the treatment of permanent establishments, the Senate effectively voted against the law on November 23, 2012, and the two legislative chambers failed to reach agreement during the last session of the arbitration committee on December 12.

The political arbitration process will delay ratification for some time, but it is relatively certain that the part of the law regarding transfer pricing issues will not be changed fundamentally. Taxpayers are strongly advised to keep the new law in mind for their tax planning, as it will also apply retroactively once it comes into force. Moreover, taxpayers will be very interested to see how the law will be implemented through the Decree that will be issued by the tax authorities in 2013.

Some existing tax-effective structures currently rely on the use of PEs and partnerships. A few of them will disappear. Certainly new structures will emerge and continue to provide tax-efficient solutions.


1 Short for Verordnung zur Anwendung des Fremdvergleichsgrundsatzes auf Betriebsstãtten nach §1 Absatz 5 des Auszensteuergesetzes.

2 In particular the relatively recent ones with the UK (2010), Turkey, Hungary, and Cyprus (all 2011) and the USA (2008).

3 Liechtenstein (2011).

4 Ditz, Internationales Steuerrecht 2005 pp. 37 (43)

5 Most other articles are not directly concerned with transfer pricing matters, but with several other tax issues.

6 The old section 4 is nullified, the old section 5 is changed and becomes the new section 4. Therefore the new section 5 is an entirely new addition.

7 Beschlussempfehlung des Finanzausschusses (7. Ausschuss) zu dem Gesetzentwurf der Bundesregierung - Entwurf eines Jahressteuergesetzes 2013 (October 24, 2012)

8 Gesetz über die Durchführung der gegenseitigen Amtshilfe in Steuersachen zwischen den Mitgliedstaaten der Europãischen Union (EU-Amtshilfegesetz - EUAHiG)