Germany publishes draft decree on attribution of profits to a PE

The Ministry of Finance has published a draft decree that details its views on the functionally separate entity approach to the attribution of profits to a permanent establishment. Comments on the draft decree must be submitted by 11 October 2013.

German’s Ministry of Finance published a draft decree on 5 August 2013 that details its views on the functionally separate entity approach to the attribution of profits to a permanent establishment (PE). Germany implemented the Authorized OECD Approach (AOA, as set out in article 7 of the 2010 OECD model treaty and commentary) into its domestic law in the Tax Act on the Implementation of the Administrative Assistance Directive and the Amendment of Other Tax Regulations that was passed on 30 June 2013. Under the AOA, the arm’s length principle must be applied to the cross-border profit allocation between a PE and the enterprise of which it is a part; for this purpose, the PE must be treated as a separate and independent entity. The draft decree is aimed at ensuring that the principles of the AOA are applied properly. Both domestic enterprises that maintain a foreign PE and foreign businesses with a German PE will be subject to the decree. Once adopted by the Bundesrat (upper house of parliament) and published in the Federal Gazette, the decree will apply retroactively as from 1 January 2013.

The draft decree covers the following topics:

Allocation of assets, chances and risks to a PE;
Attribution of capital and the funding of the operations of a PE;
Recognition of dealings between a PE and other parts of the enterprise (with a focus on financing activities); and
Special rules for PEs of banks and insurance companies and for construction/assembly and exploration site PEs.

The draft decree also describes situations in which rebuttable presumptions would apply when a clear allocation of assets, chances and risks within one enterprise based on legal reasons is not feasible, to avoid creating difficulties for the taxpayer in proving such allocations.

The most important features of the draft decree are as follows:

General approach to attribution of profits

Based on the AOA, profits to be attributed to a PE are the “profits that the PE would have earned at arm‘s length, in particular in its dealings with other parts of the enterprise, if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the PE and through the other parts of the enterprise.” The draft decree describes a two-step approach to apply the AOA: first, the activities of the PE must be analyzed based on the functions and risks assumed by the PE; and then the intercompany transactions (including dealings between the different parts of the enterprise) must be determined and an arm’s length remuneration applied.

Step 1: Analysis of the functions and risks and asset allocation â€’ The analysis of the functions and risks assumed by the PE must start with the determination of the (significant) people functions at the level of the enterprise as a whole and the level of the PE. Based on the result of the (significant) people functions analysis, the assets of the company must be allocated to the PE as follows:

Tangible assets are to be allocated based on the place where they are used;
Intangible assets are to be allocated based on the people function that created or purchased the assets;
Shareholdings are to be allocated based on the functional relationship with the PE; and
Any other assets are to be allocated based on the people function that created or purchased the assets.

Risks and chances that are directly connected to an asset follow the allocation of the asset; otherwise, risks/chances follow the people function that created the risk/chance. In cases where other people functions, such as administration or the controlling of risks/chances are unambiguously more important than the people function that created the risk/chance, these other people functions determine the allocation of the risk/chance.

Transactions with third parties and dealings between the PE and the other parts of the enterprise also are allocated based on the people function that is responsible for the relevant transaction, i.e. the people function that has concluded the transaction and assumed the related risks.

The draft decree includes an “escape clause” that allows a taxpayer to apply different allocation criteria for the above-mentioned assets if it can demonstrate that a different approach is justified.

The draft decree provides for different approaches for allocating capital to German PEs of foreign enterprises and to foreign PEs of domestic enterprises:

For a German PE of a foreign enterprise, the “capital-allocation methodology” must be applied, according to which the capital of the entire foreign enterprise must first be determined based on German tax principles. (This step may be omitted if the taxpayer makes a reasonable case that the equity shown in the foreign balance sheet does not substantially deviate from the equity based on German tax principles, or if appropriate adjustments easily can be made.) The equity determined then must be split between the PE and the foreign enterprise based on the significant people functions, assets and chances and risks.
For a foreign PE of a German enterprise, the “minimum equity method” or “thin capitalization method” must be applied, i.e. equity can be allocated to a foreign PE only to the extent the enterprise can provide adequate reasons that such an amount of capital must be allocated to the foreign PE (e.g. based on regulatory or other legal reasons). A higher equity amount can be attributed to the foreign PE only if this is in accordance with the arm’s length principle.

The allocation of interest expense generally follows the allocation of the relevant liabilities that gave rise to the expense. Different rules exist for German PEs of foreign enterprises and for foreign PEs of German enterprises. For German PEs of enterprises that are not required to prepare a balance sheet, interest expense can be allocated only to the extent an arm’s length profit remains in the PE. For foreign PEs of domestic enterprises that are not required to prepare a balance sheet, a minimum amount of interest expense must be allocated to the PE based on the PE’s relevant share in the outside sales of the group.

Step 2: Arm’s length remuneration for dealings between the PE and other parts of the enterprise â€’ One of the main purposes of the draft decree is to ensure that a PE is treated in the same way as a separate and independent legal entity. To achieve this goal, the decree treats business relationships between a PE and the enterprise as “deemed contractual relationships” to which the arm’s length principle applies. The decree provides some examples in which deemed contractual relationships exist (e.g. if the asset allocation changes or if third parties that are involved in a business transaction would have concluded a contract in such a situation).

The draft decree confirms that the deemed contractual relationship approach does not apply to financing transactions; loan transactions are regarded as a service for which arm’s length remuneration must apply.

Special rules

As noted above, the draft decree provides special rules for PEs of bank and insurance companies and for construction/assembly site and exploration site PEs.

For financial institutions, the asset allocation must be based on the “key entrepreneurial risk-taking functions” (KERT functions) rather than the significant people functions. This approach is in line with the description in the 2010 OECD report, and any other approach would be permitted only in very limited circumstances.

For construction/assembly sites and exploration sites, the draft decree provides for a rebuttable presumption that the activities of such a PE must be treated as a service rendered by the PE to the other parts of the enterprise. Routine functions carried out by the PE must be remunerated based on a cost-plus basis. In all other cases, a profit-split method must be used to determine the profit to be allocated to the PE.

Documentation requirements

The draft decree introduces an obligation to prepare an annual “auxiliary calculation” for a PE for tax years that start after 31 December 2012. This calculation must show the allocated assets, chances and risks, capital and dealings between the PE and the other parts of the enterprise and will be used for calculating the taxable income of the PE. If the taxpayer is using one of the exemption clauses and applies a method that is different from the method described in the draft decree, additional information must be provided as part of the auxiliary calculation. The auxiliary calculation must be made no later than the date the tax return for the PE is filed because it is the basis for the determination of the taxable income as shown in the tax return that may be subject to a future tax audit.

Comments

The draft decree provides valuable guidance on how the German tax authorities will apply the AOA in practice. The goal of the authorities is to achieve a clear asset allocation, but it remains to be seen whether such an allocation is possible in all instances. The different approaches for the allocation of capital to German PEs of foreign companies and foreign PEs of German enterprises have been subject to intense criticism, although it is unlikely that the Ministry of Finance will modify this approach. Further, the use of rebuttable presumptions (e.g. that construction/assembly sites only provide services) is not found in the 2010 OECD report on the attribution of profits to a PE. Specific guidance on the profit allocation to agency PEs would be useful, but is not included in the draft decree.

If this version of the decree becomes final, affected taxpayers will be subject to significant additional documentation requirements. Auxiliary calculations will need to be provided for each PE based on the above principles and finalized at the time the tax return is filed.

Further, the retroactive application of the principles described in the draft decree without any grandfathering rule could create additional difficulties for taxpayers.

Affected taxpayers should start taking action now, even though the decree still is in draft form. The main principles outlined in the draft likely will remain intact and the final decree probably will enter into force at the end of 2013 or early 2014 (with retroactive effect). Taxpayers will need to prepare the required documentation as soon as possible and analyze whether allocation methods used in the past are in line with the principles in the decree, or whether sufficient reasons exist for adopting a different approach under one of the exemption clauses. Documentation will need to be prepared in such cases.

Comments on the draft decree must be submitted by 11 October 2013.

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