Update on germany’s “relocation of functions” rules, sept2012

Invitation
Seminar on transfer pricing and
international tax

Seminar on Wednesday, 12 september 2012

Update on German
Developments
Arm„s Length License Rates

Stephan Rasch, Deloitte Munich

Arm‟s Length License
Rates

3 Update on German Developments © 2012 Deloitte & Touche GmbH Wirtschaftsprüfungsgesellschaft

Arm’s Length License Rates

Related Parties

Licensee License Fee Licensor

Discussion TP Methods
• CUP/ CUT
• C+
• Rules of Thumb
• TNMM
• Profit Split

• Planning Data
• Hypothetical Arm‟s Length Test


Approach 1: Cost Plus Approach
Concept: License rate should allow the licensor to earn a fair return on its investment

Year 1 Year 2 Year 3

Mark-up Mark-up Mark-up

R&D R&D R&D = Royalty Rate

Numerical Example:

Cost Plus Approach Year 1 Year 2 Year 3
R&D Costs 10.00 10.00 10.00
C+ Margin 10% 1.00 1.00 1.00
Total 11.00 11.00 11.00
License Base 200.0 200.0 200.0
Royalty Rate 5.5% 5.5% 5.5%

Critical Assumptions/ Comments
• Value of IP does not have to relate to historic costs
• May be more appropriate for an IP portfolio
• Critical assumption of steady-state situation
• How to deal if more than one licensee?

Approach 2: CUP Approach
Concept: Internal or external comparable royalty rates are known.


3rd party 3rd party 3rd party 3rd party
rate rate rate rate = Royalty Rate

Numerical Example:

CUT Approach Year 1 Year 2 Year 3
3rd Party Royalty Rate 6.0% 6.0% 6.0%

• To find comparable licensing contracts could be regarded as difficult
• Does not take into account the specific situation of the licensee and/ or licensor


Approach 3: Acquisition Price/ Market Cap. Method
Concept: Market value of the IP licensed is available or can be deducted from an acquisition/ market.
capitalization

Market
Value of
IP License
Fee
License
Fee
License
Fee
= Royalty Rate

Numerical Example:
Acquisition Price Method Year 0 Year 1 Year 2 Year 3
Acquisition Value of IP 30.00
Useful Life of IP 3 Years
License Base 200.00 200.00 200.00
License Fee 12.21 12.21 12.21
Present Value Factor (discount rate=10%) 0.91 0.80 0.75
PV License Fee 11.10 9.73 9.17
NPV License Fees 30.00

• How does future R&D costs enhance the IP value
• Useful life of IP critical assumption


Approach 4: TNMM Based Approach
Concept: Licensee should earn arm‟s length profits based on benchmarking after license fees.


IP IP IP
= Royalty Rate
Routine Routine Routine

Numerical Example:

TNMM Based Approach Year 1 Year 2 Year 3
EBIT Licensee before Royalty 10.00 10.00 10.00
Routine Remuneration 4.00 4.00 4.00
Residual Profit = License Fee 6.00 6.00 6.00
License Base 100.00 100.00 100.00

Critical Assumptions/ Comments:
• Arm‟s length profits of the licensee can be reasonable determined through benchmarking
• IP is the only non-routine value driver


Approach 5: Residual Profit Split Based Approach
Concept: Profits are explained through routine functions performed, IP No. 1, and IP No. 2.


IP No. 1 IP No. 1 IP No. 1 IP
IP No. 2 IP No. 2 IP No. 2
No.2 = Royalty Rate
Routine Routine Routine

Numerical Example:
Profit Split Approach Year 1 Year 2 Year 3
EBIT Licensee before Royalty 10.00 10.00 10.00
Routine Remuneration 4.00 4.00 4.00
Residual Profit 6.00 6.00 6.00
Allocabel to IP No. 1 25% 25% 25%
Allocabel to IP No. 2 75% 75% 75%
License Fee 4.50 4.50 4.50
License Base 100.00 100.00 100.00

Critical Assumptions/ Comments:
• Routine profits of the licensee can be reasonable determined through benchmarking
• IP considered is the only value driver
• Gross profit split vs. net profit split (steady-state assumption)
• Reliable determination of the allocation key


Use of Databases and Intangibles
Limitation to be expected in Germany? (1)
Problem:
• German tax authorities challenge that the determination of an arm„s length
remuneration for high-value and unique intangibles can be based on a CUT-
related analysis from a database
• German tax authorites argue that remuneration for intangibles needs to be
determined based on the so-called hypothetical arm„s length test

• Administrative Guidance on Relocation of functions, dated 13 October 2010 –
IV B 5 S 1341/98/10003, German Federal Ministry of Finance:
Section 69: Even if the prerequisities of an escape clause are fulfilled, „in
case of high-value and unique intangible assets and benefits, the
hypothetical arm‘s length test will have to be applied“.

Section 65: […] „However, this does not suggest that under the
hypothetical arm‘s length test license rates may be derived from data
bases.“


Use of Databases and Intangibles
Limitation to be expected in Germany? (2)

• Administrative Guidance is binding for tax authorities only
• It is currently under discussion whether this limitation will be transferred into
law
• It needs to be distinguished between the ultimate transfer of intangible assets
(application of the hypothetical arm‟s length test) and the “pure” right of use that
is granted to the transferee or licensee

• Federal Ministry of Finance is currently drafting a decree law: transfer of
intangibles and the appropriate method shall be determined – legally binding –
for both taxpayers and tax authorities – expected to come in effect as of 1
January 2013 (timing not final)


Update on Germany‟s
“Relocation of Functions”-
Rules


Relocation of Business Functions
Overview – Definition

Tangibles:
• Machinery
• Stock, etc

Intangibles: Function: Other advantages:
• Product • Chances to be determined based
• Process • Risks on profit potential
• Marketing • Other advantages calculation  Residual

Services:
performed associated
with function


Business Restructuring
Overview – Transfer Package Approach (1)

Sum of individual Residual
transfer prices

Profit potential of “Goodwill”
function as a associated with
whole function

= Transfer Services
Package

Intangibles

Tangibles


Overview – Transfer Package Approach (2)

Relocating Company Profit Potential Receiving Company

Forecasted profit after tax (including dispensed Forecasted profit after tax (including received function)
function)
./. Forecasted profit after tax (without dispensed ./. Forecasted profit after tax (without received function)
function)
= Difference = Difference

x Capitalization rate x Capitalization rate

= Purchase price claim = Willingness to pay
(Minimum price of the provider) (Maximum price of the receiving company)

Minimum price Mid price Maximum price
10 15 20

Range of possible agreement Sec.1 para. 3 sentence 7 FTC


German Regulations on Business Restructurings
Calculation of Exit Charges – Single Asset Approach versus
Transfer Package Approach


Do we have a relocation of
Application of single asset
functions under the legal
valuation approach, § 1 Abs. 3 S.
definitions, taking into account
1-8 AStG
exemptions?

 

Does third party data for the
„Escape-Clauses“ of § 1 Abs. 3 S.
business transaction as a whole
10 AStG, related to transfer of
exist which is unlimited/ limited
significant intangibles, applicable?
comparable?


Application of § 1 Abs. 3 S. 1-4

AStG as business transaction as a Valuation of Transfer Package with
whole Hypothetical Arm‟s Length Test

Result: Agreement on this price

Can a price be found within the

Result: Agreement on Midpoint  price range which complies with
the arm‟s length standard?


Allocation of risk - Trend in German tax audits
• Determining whether the allocation of risks in a controlled transaction is arm‟s
length – OECD perspective taken up in German tax audits

The risk allocation in the
controlled transaction is
arm`s length
Relevant, although not
determinative factors:
Is there reliable evidence Yes • Which party has
of a similar allocation of
Is the allocation of risk greater control over risk?
risks in comparable
uncontrolled No one that might be • Is the risk allocated to a
transactions? expected to have been party which has the
agreed between financial capacity to
independent parties in assume it?
comparable
circumstances?

Lacking such evidence, determine whether the risk
Search evidence of the actual allocation is one that would have been agreed between
conduct of independent parties independent parties in comparable circumstances


Ny juridisk
dokumentations-
vejledning

18 © 2012 Deloitte

Ny juridisk dokumentationsvejledning

• Offentliggjort d. 16. juli 2012

• Vejledningen fra 2006 (Transfer pricing; Kontrollerede transaktioner;
Dokumentationspligt) er omskrevet og flyttet til Den juridiske vejledning
(afsnit C.D.11)

• Formålet med Den juridiske vejledning er at give en beskrivelse af og
vejledning i de krav, som er fastsat i dokumentations-
bekendtgørelsen

• Den juridiske vejledning 2012-2 er en
netbaseret udgave, som kan findes på
www.skat.dk (Juridisk Information >
Juridiske vejledninger)

19 © 2012 Deloitte


• Indholdet i Den juridiske vejledning er i høj grad det samme som i
vejledningen fra 2006

• Baseret på SKATs erfaringer og de senere års udvikling på transfer
pricing-området i Danmark, er visse formuleringer blevet præciseret,
uddybet eller afkortet

• Nye væsentlige bidrag til fortolkning og anvendelse af
armslængdeprincippet i den nye 2010 udgave af OECD‟s Transfer
Pricing Guidelines har også gjort det nødvendigt at opdatere og omskrive
vejledningen fra 2006:
− Nyt kapitel om ”business restructurings” (OECD Transfer Pricing Guidelines, Chapter 9)
− ”Mest egnede” transfer pricing-metode fremfor hierarkisk model
− 9-trins proces ved bedømmelse af transaktioners sammenlignelighed

Impact for taxpayer

20 Ikke mere konkret afklaring for skatteyder! © 2012 Deloitte


Eksempler på omskrevne afsnit i dokumentationsvejledningen:

C.D.11.4.2.5 Forklaring på
eventuelle underskud
C.D.11.4.10 Frist for at indsende
”…Beskrivelsen skal også indeholde
dokumentation:
en præcis og specificeret angivelse af
”Dokumentationen skal kunne
underskuddets/tabets størrelse samt
indsendes inden 60 dage. På
en oversigt over resultater eller
selvangivelsestidspunktet skal der
avancer/tab i øvrige relevante
således altid være udarbejdet en
koncernenheder. Det skal fremgå af
dokumentation, der gør dette muligt.
oversigten eller en tilhørende
I dokumentationsreglerne er det
redegørelse, om virksomheden bærer
forudsat, at dokumentationen
underskud eller tab på aktiviteter eller
udarbejdes løbende. På
transaktioner, som andre
selvangivelsestidspunktet skal
virksomheder i samme koncern har
dokumentationen således under alle
overskud eller gevinst på”.
omstændigheder være opdateret for
det pågældende indkomstår”.

21 © 2012 Deloitte


Nyt APA afsnit i C.D. 11.7.3

• Hvad er en APA og hvorfor anmode om det?
• APA processen
• Hvilke transaktioner kan dækkes af en APA?
• Kan en APA fortrydes?
• Hvor længe gælder en APA og kan den have bagudrettet virkning?

22 © 2012 Deloitte & Touche GmbH Wirtschaftsprüfungsgesellschaft

OECD releases discussion draft on intangibles

• The discussion draft contains proposed revisions to Chapter VI of Transfer
Pricing Guidelines, “Transfer Pricing Considerations for Intangibles”

• Effective retroactively from 1 January 2009

• The discussion draft is organized into four sections:
- Definition of intangibles;

- Identification of parties entitled to intangible-related returns;

- Defining transactions involving the use or transfer of intangibles;
- Determining arm‟s length conditions or prices in cases involving intangibles.

Impact for Transfer Pricing

Due to its broad scope, the discussion draft could increase compliance costs,
controversy and uncertainty regarding the allocation of intangible returns between
multinational enterprises.

24 © 2012 Deloitte

Malaysia issues revised transfer pricing rules and new
APA guidelines
• Transfer pricing rules:
− The rules are effective retroactively from 1 January 2009

− Apply equally to the transfer of tangible and intangible property, intragroup services,
and financial assistance arrangements, such as loans and guarantees

− Traditional transaction methods (CUP, Cost Plus and RPM) preferred to transactional
profit methods (Profit split and TNMM)

• Advance Pricing Arrangement (APA):

− The APA rules are effective retroactively from 1 January 2009
− The minimum term of an APA will be three years, and the maximum term is five years


The new rule sets reaffirm the IRB‟s increasing focus on intragroup transactions and
25
its pricing policies and is moreover broadening its area of assessment. © 2012 Deloitte

Australia - Hearing on proposed retrospective transfer
pricing law
Australia‟s Parliament recently introduced a bill proposing reform of the
country‟s transfer pricing rules:

• Australia‟s government announced reforms to the country‟s
transfer pricing rules last November, and has now introduced
legislation to enact those reforms

• The bill seeks to ensure retroactively that Australia‟s tax
treaties can be applied (from 1 July 2004) to make transfer
pricing adjustments independently of Australia‟s domestic
transfer pricing laws

• Also under consideration is a proposal to bring Australia's
transfer pricing rules fully into line with the current OECD-
endorsed approach.


In a future transfer pricing context, a practical impact for Australian multinationals will
be requiring OECD transfer pricing guidance to be used in framing intragroup pricing
policies and documentation.
26 © 2012 Deloitte

Advance Pricing Agreements in India:
• Effective at 1 July 2012 in the Finance Act 2012

• Transfer pricing audits in India are becoming increasingly aggressive, and
it is estimated that in the latest (seventh) year of audits transfer pricing
adjustments were made in more than 50 percent of the cases audited, with
adjustments totaling approximately USD 9 billion

• APA‟s to counteract the uncertainty caused by transfer pricing litigation

• For multinationals in India, APAs can be an effective mechanism for
obtaining certainty of tax positions in advance and avoiding protracted
litigation resulting from transfer pricing audits


Considering the uncertainty caused by transfer pricing litigation, the introduction of
APAs is a step in the right direction.
27 © 2012 Deloitte

Norway – Annual Transfer pricing report
Transfer Pricing Adjustments in 2011:

• In 2011 there were fewer but more detailed and comprehensive transfer pricing audits in Norway

• Although the number of audits decreased, the proceeds from adjustments in 2011 were double
compared to 2010

• It is expected that this trend will continue and that multinationals will face far more aggressive tax
authorities

Key Focus Areas for 2012:

• Focus on consistent loss-making enterprises;

• Focus on PE‟s of banks;

• Focus on cash-pooling arrangements; and

• Focus on intragroup sales of „dry gas‟.


Continuing the trend of 2011, adjustments for transfer pricing audits are likely to further increase. This trend will
confront multinationals with far more aggressive tax authorities.
28 © 2012 Deloitte

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© 2012 Deloitte & Touche GmbH Wirtschaftsprüfungsgesellschaft

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