21.08.2024Lower tax court clarifies transfer of function rules for principal structures
The implementation of a principal structure and the resulting change in the profit potential of a German entity does not automatically result in the transfer of a function.
On 17 July 2024, the tax court of Lower Saxony published a ruling on the transfer of functions, which already had been decided on 3 August 2023. This is the court’s second judgment on this issue. The first ruling (further discussed below) was published in March 2023 and is currently under review by the Federal Fiscal Court, which is the highest German tax court.
Backround
The conditions under which a transfer of functions can be assumed is the subject of some dispute. If there is a transfer of functions within a group, any hidden reserves that are transferred abroad are disclosed and taxed. Cases in which functions, including opportunities and risks as well as tangible and intangible assets, are transferred abroad are relatively uncontroversial. The law also contains the undefined legal term “other benefits.” However, it is unclear whether a transfer of functions also can be assumed if neither tangible nor intangible assets are transferred. The answer then depends on whether “other benefits” are transferred. To date, the tax administration has understood “other benefits” to mean mere profit expectations. The Lower Saxony tax court did not agree with this broad interpretation of “other benefits” in its first ruling dated 3 March 2023. In that case, a production function had been transferred abroad without the transfer of tangible or intangible assets. The court found in favor of the taxpayer but the decision is currently under review by the Federal Fiscal Court. The latest decision dated 3 August 2023 was also in favor of the taxpayer and is described in more detail below.
Facts of the case
A business-to-business (B2B) US group engaged in manufacturing and distribution activities through entities in Germany. In return for a service fee and a licensing fee, respectively, the entities received strategic guidance from a related party in France and the necessary intangibles from the US. Beginning on 1 January 2011, the group decided to establish a principal company in Switzerland in order to achieve cost savings and advantages from a consistent sales strategy in Europe by centralizing planning, procurement, and sales processes and improving the management of production activities. The main decision-making processes and risks (i.e., production, sales, transport, and warehousing) were then borne by the Swiss entity, which performed the functions that the French entity had previously performed (medium- and long-term production program planning, product portfolio, production process guidelines, as well as quality and safety). The German entities were reduced to the roles of contract manufacturers and one low-risk distributor. Neither tangible nor intangibles assets were transferred. Accordingly, the German manufacturing companies received a cost-based remuneration for their manufacturing activities and the German distributor was entitled to a transactional net margin method- or TNMM-based sales return.
No exit payment was declared as the German taxpayers assumed that the facts did not constitute a relocation of functions. Only a fee for the premature termination of the licensing agreement, whose term expired two years later on 1 January 2013, was paid to compensate the German entities for their loss of profit potential.
View of the tax authorities
The tax audit of the German companies assumed a transfer of functions and used a package valuation. It assumed that the requirements for a transfer of functions had been met, as essential functions had been transferred from Germany to Switzerland. Especially, the entrepreneurial capacity of the German taxpayers had been shifted. The transferred functions were to be assessed as a whole because production and distribution contributed inseparably to value creation and thus to the transferred profit potential, taking into account an unlimited capitalization period. The amount calculated in this way was higher than the compensation paid to the German entities and thus was adjusted.
Taxpayer’s arguments
The German taxpayer appealed the amended assessment notice for 2011 regarding the amount of corporation tax and solidarity surcharge. The objection was rejected. The taxpayer then filed an action with the Lower Saxony tax court, arguing that neither functions nor assets had been transferred to Switzerland. The production and distribution function had continued to be performed in Germany. The Swiss principal had only taken over business activities that had previously been carried out by entities in other countries. There had only been a transfer of risks from Germany to Switzerland. However, a mere reduction of risks without an associated transfer of functions and assets did not meet the requirements for a transfer of functions.
Court decision
The case was decided in favor of the taxpayer as neither tangible nor intangible assets were transferred, there was no transfer of a concrete business opportunity in the form of an asset position (“other benefit”), and the operating German companies continued to carry out production and sales activities largely unchanged. Also, no function was shifted from Germany to Switzerland as the French entity had the entrepreneur function beforehand. The lower functional and risk profiles under the principal model were offset by remuneration with fixed profit margins. The German entities were appropriately compensated for the early termination of the licensing agreement. No customer base was transferred from the German companies as the customer data within the group was not exclusive data to which the German companies had exclusive access anyway. In addition, even before the restructuring, the German companies did not manage the relationships with major customers.
Practical consequences
- Change in risk profile: The conversion to a principal structure has been frequently implemented in recent years. Analogous to the previous Lower Saxony tax court ruling on the relocation of production, the court stated that if there is no transfer of tangible or intangible assets and only the remuneration structure and the risk profile are changed, it is often assumed in practice by the tax administration that “another benefit” has been transferred. The Lower Saxony tax court disagrees with this very broad interpretation of “other benefits.” It outlined that a shift of function is needed, which was not shown in this case.
- Customer base in the group: It is often disputed how a customer base already known within the group is viewed. The court emphasized that customer data known within the group was not exclusive. Hence, it could not be transferred. In addition, there was no transfer as the German entities were able to continue supplying the customers as routine entities.
- Conclusion: It is advisable to compare the “before and after” situation for every restructuring, to address tangible and intangible assets, and to name the specific functions and risks that are (or are not) being transferred. This should be well documented. Termination rights, such as those under the licensing agreement in this case, and economic access to customers should be analyzed in detail. The Lower Saxony tax court rejects the taxation of a “transfer” of functions simply because a company’s profits in Germany have changed.
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