As noted in the German section of our Tax investigations and disputes across borders guide, tackling tax avoidance has been a major focus of the German tax authorities (GTAs) for some time now and we are expecting that to continue to be the case for the foreseeable future. There is a particular trend towards challenging in German tax audits cross-border structures of multinational enterprises (MNE) with presence in Germany.
Over the past few years, we have seen increasingly sophisticated tax audits of the transfer pricing (TP) models of MNEs. Moreover, we are seeing GTAs adopting increasingly robust positions in these audits and therefore we are expecting an increase in large-scale TP disputes over the coming month and years.
To help businesses better navigate this complex area of TP and prepare for upcoming challenges of the GTAs, both in tax audits and tax court proceedings, we have summarised three “hot topics” of TP tax audits below.
Financial transactions
It is very unlikely that any tax audit in Germany will be finalised without any GTA challenging intercompany cross-border financial transactions. Throughout the audit, the GTAs focus on understanding the legal background / contractual set-up, as well as the economic circumstances of financial transactions within MNEs. The GTAs not only focus on assessing the arm’s length nature of short and long term loans, but also closely evaluate TP approaches towards cross-border cash pools and complex financial transactions involving for example hedging or derivatives trading. Most of these GTA challenges require taxpayers to provide lots of additional information and detailed financial data analysis. For example, discussions commonly ensue around the potential reclassification of ex-post observed base amounts (Sockelbeträge) in cash pools to long-term loans requiring different arm’s length interest rates than short term obligations. In order to refute these GTA challenges, taxpayers are often required to provide detailed overviews of the flow of financial funds through different accounts involving multiple companies across various jurisdictions. Regarding other GTA challenges, taxpayers are often required to provide additional dept capacity analysis and argue intensively over the economic background of financial transactions, although the principle of financial freedom (i.e the choice between debt and equity funding) exists in Germany.
Furthermore, discussions around the appropriate TP methodology can occur at different stages of the tax audits: whereas the GTAs may follow the guidance as outlined within the German Administrative Principles Transfer Pricing to classify financial activities involving FinCos with a limited functional and risk profile as routine services requiring a cost-plus remuneration, usually taxpayers assess the arm’s length nature of interest rates via the comparable uncontrolled price (CUP) method. In 2021, this CUP approach was also confirmed by the German Federal Financial Court (BFH). In addition, challenging rating approaches of MNEs is also common practise in German tax audits. Again, the BFH ruled in 2021 that the creditworthiness assessment – as an important basis for the interest rate determination - should be based on the standalone perspective of the company taking out the loan. According to the BFH, a credit assessment that is based on the average creditworthiness of the MNE group would not meet the arm’s length principle. However, there often seems to be diverging views within and between GTAs regarding the overall credit rating determination, making it very difficult for taxpayers to implement tax compliant structures. This has become more pronounced following the current discussions in Germany around the potential introduction of a new interest rate cap rule (see our latest summary here).
Finally, as the GTAs themselves are currently evaluating certain databases for financial transaction data and credit rating determination, in-depth discussions in the area of intercompany financial transactions will likely further increase in upcoming years.
Relocation of functions
In June 2023, the German Ministry of Finance (BMF) published the new German Administrative Principles Transfer Pricing 2023. Besides amending rules for intercompany financial transactions, the main changes as compared to the 2021 version of this document concerned guidance on assessing the arm’s length nature of relocation of functions. Not surprisingly, GTAs often challenge in tax audits the TP approaches of MNEs regarding remuneration connected to such relocations. The GTAs are increasingly focused on understanding the value creation process within an MNE. When functions are relocated, the GTAs assess whether the remuneration aligns with the economic substance of the activities performed in Germany. They scrutinise the functions, assets and risks relocated to determine whether the compensation appropriately reflects the value added by the German entity. Documentation that effectively demonstrates the economic substance of the relocated functions, along with their contribution to overall value creation, is crucial to effectively counter any adverse views of the GTAs in this regard.
Moreover, as relocations often involve the transfer of intangibles and intellectual property (such as patents, trademarks, and proprietary technologies) the GTAs closely examine the valuation and pricing of these intangibles to ensure that the compensation paid to the German entity reflects the value contributed to the overall MNE. MNEs must conduct comprehensive valuations, considering market conditions, economic forecasts and the specific contributions of the German entity to be able to defend the economic rationale behind the chosen TP approach. It is likely that we will see additional German court rulings regarding relocation of functions issues in the near future, hopefully providing some more guidance for taxpayers about how to appropriately prepare for challenges, as currently there is rather limited case law available.
Matrix structures
Within MNEs, departments for certain functional areas are increasingly made up of employees who are scattered across a large number of different companies within the MNE group - often in different countries. Due to the increasing centralisation of functions, employees often have cross-border responsibilities within an organisation. This may imply that the activities of these employees are treated as undertaken by several legal entities within their functional area and may also be directly responsible or authorised to issue instructions to staff in different countries. Under such matrix structures, global workforces and virtual teams are not only undertaking traditional support functions, but are also involved in core business activities and management, and the GTAs closely evaluate questions regarding the appropriate allocation of costs and profits. This often requires taxpayers to explain complex new digital business models in an understandable way, defending the selected TP approach.
These are just three examples of common TP challenges that we are seeing arising in the context of German tax audits. If you would like to discuss any of the points raised in this blog post (or other TP topics) in further detail, please contact the authors, our tax investigations and disputes team or your usual Freshfields contact.
