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Changes in the area of transfer pricing rules – Part II: Approach for precisely defining the arm’s length principle

As already described in Part 1, important changes in the area of transfer pricing rules along with the EU’s Anti-Tax Avoidance Directive (ATAD) are going to be implemented. The German cabinet meeting to discuss this was originally planned for 8.4.2020; however, it has not yet taken place due to the COVID-19 crisis. Nevertheless, the timely conclusion of the legislative process (for application as of 2021) should still be possible. In the following section we discuss the key planned changes to the approach for precisely defining the arm’s length principle.

The arm’s length principle

As previously, the new draft Section 1(3) of the Foreign Transactions Tax Act (Außensteuergesetz, AStG) will specify how transfer pricing should be determined and reviewed. The new elements are:

  • Solely the circumstances at the time when the accounting transaction was agreed will be decisive for determining and reviewing transfer pricing.
  • In the future, the most appropriate method for determining transfer pricing will have to be selected. This constitutes a shift away from the hierarchy of methods previously specified in Section 1(3) AStG.

Cases where comparability is limited

Under the draft Section 1(3a) AStG, in the future, if there is a range of possible transfer prices then the use of the so-called interquartile method will be mandatory. If the previously selected transfer price lies outside of the range then it will have to be adjusted to the median. What is new here is that this adjustment will constitute a rebuttable presumption. There will thus still be an opportunity to provide proof that a different value does indeed comply with the arm’s length principles. However, the burden of proof will now lie with the taxpayer.

Transfer of a function

Up to now, in order to justify the transfer of a function there was a requirement that assets and other benefits would have to be transferred. This “and” conjunction will be omitted when the new draft Section 1(3b) AStG is adopted. Furthermore, the transfer package valuation approach will become mandatory if no precise comparative data are available.

Intangible assets

Draft Section 1(3c) AStG will include a legal definition of the term “intangible asset” for the first time. To this end, the definition in the OECD Transfer Pricing Guidelines from 2017 will be adopted. According to those guidelines, an intangible asset is defined as something which

  • is not a physical asset, equity interest or financial asset,
  • can be the object of an accounting transaction but without having to be separately transferable,
  • can be factually and legally attributed to a person.

If an intangible asset gives rise to financial effects between unrelated third parties, e.g. by transferring it or making it available for use, then these should be subject to intragroup remuneration.

However, ownership should be merely the starting point for the transfer pricing analysis for the calculation of earnings derived from intangible assets; an economic perspective should be adopted. In this connection, the so-called DEMPE concept will be legally codified. This will be the basis for an examination to determine which affiliated companies perform functions connected with the:

  • Development,
  • Enhancement,
  • Maintenance,
  • Protection and
  • Exploitation

of the intangible asset. This means that, in the future, separate and detailed functional and risk analyses will have to be carried out for the attribution of earnings derived from intangible assets.

Price adjustment clause

The time horizon of the current price adjustment clause was set to 10 years (Section 1(3) clause 11f AStG). In a new draft Section 1b AStG, this time period will be reduced to 7 years in the future. Moreover, three cases have been defined of how it would be possible to avoid a price adjustment:

  • the actual price development was unforeseeable at the time of the business transaction;
  • uncertainties surrounding the future price development were adequately taken into account when determining the transfer pricing;
  • agreement for a sales-related or profit-related royalty.
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