NOVEMBER/DECEMBER 2005 GERMANY Global Trading Axel Nientimp' and Achim Roeder 1 INTRODUCTION a very high level of operational integration of the var ous participants in one and the same transaction Germany's transfer pricing environment has changed dra- an inability to allocate costs or revenues to individual matically during the last three to four years. Although with transactions in an appropriate (i.e. arms length)man its original 1983 transfer pricing regulationsGermany ner, ol is one of the first OECD countries to deal with transfer an existence of more than one non-routine intangible was not before 2003 that the tax employed in such a transaction by more than one authorities were able to introduce transfer pricing docu ownet mentation requirements in tax law. This legislation is gen- Perhaps it took a sufficiently complex and apparently dif- mark Federal Tax Court ruling in October 2001+ which trading of financial institutions to justify a deviation from made it clear that, in essence, at time of the ruling German the extreme preference for standard methods at that time tax law did not provide for transfer pricing documentation In some cases, high-level representatives of the tax author requirements. 5 ities even seemed to be automatically endorsing the appli The new rules introduced in 2003 provide transfer pricing cability of the profit split method for any investment bank documentation requirements for fiscal years commencing ing activity, implicitly identifying global trading to the on or after I January 2003. For fiscal years beginning on latter. or after I January 2004, non-compliance with the docu These sanctions include penalties of up to 10% of the 2. EXPERIENCE WITH APPLICATION OF adjusted amount and a reversal of the burden of proof to the taxpayer. Documentation rules and sanctions are not limited to German taxpayers, but also apply to German Currently, no explicit regulation of global trading of finan permanent establishments(PEs) of foreign taxpayers. On cial instruments is found in German tax law, but the tax 12 April 2005. the Federal Ministry of Finance(BMF) authorities are supposed to work on industry-specific issued extensive administrative principles on transfer pi transfer pricing regulations (including the financial ser- cing documentation, describing the interpretation of the vices Before the enforcement of the new transfer tax authorities with regard to the documentation require- pricing mentation requirements, the tax author ments. 8 preference for the traditional transacti Against such a historical background, it should not be sur- prising that the legislative change is also reflected by a L. Manager, Deloitte Transfer Pricing Group, Dusseldorf change in the taxpayers'behaviour as well as in that of the 2. Partner, Deloitte Transfer Pricing Group,Dusseldorf tax authorities. German-based international financial insti- 3. Administrative Principles for the Examination of Income Allocation in the tutions, as large multinational enterprises, increasingly 4. See federal Tax Court decision of 17 October 2001, IR 103/00, Bundes. recognize the need to address transfer pricing and transfer steuerblatt 1 2004. at 171 pricing documentation in a coordinated and globally con- 5. Kroppen, Rasch and Roeder, " German Federal Tax Court Issues Landmark sistent fashion, while tax auditors increasingly focus on Transfer Pricing Decision", Tat Notes International (10 December 2001). transfer pricing in almost all tax audits. At the same time at lIll Cf Sec. 90. Para. 3 of the General Tax Code(AO) and the documentation the level of technical and economic sophistication of tax- Decree-Law Gewinnabgrenzungsanfeichnungsverordnung(GAufZ) payers and auditors alike is moving rapidly towards com Sec 162. Para. 3 and 4 General Tax Code(AO)and Art. 97, Sec. 22 of the mon international standare ds. A greater emphasis on profit- introductory act of General Tax Code(EGAO) related transfer pricing methods and the use of financial 8, Administrative Principles for the Examination of Income Allocatio between Related Parties with Cross-Border Business Relations in Respect of the benchmarking for net margins is the most prominent Duty of Determination, the Duty of Cooperation. Adjustments,Mutual Agree example of this development ment Procedures and EU Arbitration Procedures (12 April 2005)(Administr On the other hand, banks may be considered to have been tive Principles- Procedures). For a discussion, see Kroppen and Rasch. "New a vanguard of profit-oriented methods in Germany in the national (10 January 2005), at 197; Eigelshoven and Nientimp, "German Versus past. Typically, global trading served as one of the very OECD Transfer Pricing Principles -a Recipe for Double Taxation?, ax Notes few standard examples for the application of profit splits International (22 August 2005), at 725 or residual profit splits in German transfer pricing litera- derbereichen". Intemationaies Steuerrecht (1995). at 549: Selling. "Global ture. Traditionally the prerequisites for the application of Trading", Internationales Steuerrecht(1998). at 417; Wassermneyer and a profit split method used to b Baumhoff, Verrechnungspreise verbundener Unternehmen( Cologne: 2001) @2005BFD
OVEMBER/DECEMBER 2005 ITPJ 307 based methods in transfer pricing; other, profit-based, financial institutions in Germany involved in global trad transfer pricing regulations was note 2.4.6. of the Admin- trading functions, as well as for example structuring and circumstances the profit could be split between related thermore, all middle- and back-office functions can be parties if a third party had also agreed to such an alloca- found in German entities or branches as well tion. In practice, with reasonable economic justification The financial products for which the three pure or standard profit splits have been implemented within the transfer models are used are much the same in Germany as in other pricing system of multinationals in Germany and have also been accepted by the tax authorities major international banking locations. The integrated trad model is often used for foreign exchange(F/X) busi- The new Administrative Principles -Procedure of 2005 ness in the major currencies and certain derivatives, while are somewhat clearer on profit splits, as they now expli- the centralized product management and separate-enter- city allow the profit split method in cases where more prise trading model are often used for more localized prod than one entrepreneur is involved in a transaction. The ucts (e.g. European equities). However, the business tax authorities even mention global trading as an example model also strongly depends on the overall strategy of the o apply a profit split, and also refer to Secs. 3. I and 3. 5 of relevant bank, and particularly specialized institutions raster lines). From a German transfer pricing perspective, the application of a profit split is not limited to the global trad ing of financial instruments. A profit split could in princi- 3. FUNCTIONAL ANALYSIS AND ple apply to all other business models with more than one BENCHMARKING entrepreneur involved in initiating, conducting and com- pleting a transaction, but where the individual contribu- One of the basic transfer pricing documentation requir tions of a party could not be identified ments in Germany is a functional and risk analysis with a description of the value chain of the taxpayer's business As published rulings in German tax law, administrative Such an analysis would be the basis for any transfer pri- principles or tax court rulings on global trading are not ng analysis of a banks global trading business. There pricing regulations or PE profit allocation rules apply. exist only general rules for the functional analysis, which With the absence of specific German rules, the OECD should contain a description of the type, content and scope ipers are often used as guidance in day-to-day tax work. of related cross-border transactions, as well as indicating In competent authority or arbitration procedures and aPa the economic and legal conditions of such transactions negotiations, the tax authorities regularly take the oeCD articular, the functional analysis should enable the papers into consideration as well. As the tax authorities reader to understand the determination of the transfer put aside their former reluctance with regard to profit- prices employed by the taxpayer based methods, the acceptance of profit splits in global Despite the absence of more precise guidance in the Ger trading situations is expected to increase further in the man regulations. it is generally advisable for a taxpayer to future. The mentioning of global trading(without further take into account the model description used by the OECD guidance)as an example of a business model justifying a in the text of the draft. Practical experience suggests that profit split in the 2005 Administrative Principles- Proce- the majority of cases can in fact be described by using a dures should be regarded as very helpful in this context combination of the different activities and risks referred to o lished in Ger man tax ite apure ach and the opinions pub- an thys es will be addres ed ta sat least two iferent riax For tax purposes, the OECD Discussion Draft Part IIl3 authorities, a high degree of recognition of OECD guid distinguishes bety ween three types of global trading, ance will generally be helpful in discussions with local tax namely separate-enterprise trading, centralized product ditors. This will serve to minimize any appearance of all of these types of trading can be found within financial Institutions in Germany. In practice, often models other 10. Sce press release of the Federal Ministry of Finance. Internationales than these three pure or standard models are used: business Steuerrecht(1995). at 38 models, as well as the function and risk allocation between 12. Set ortner. w sceinsistrativhe Principles e Procedure. derbereichen, /nternationales Steuerrech(1995). at 549-551: Selling. "Global types and may even be more complex. The German bank- Trading", Internationales Steuerrecht(1998). at 417-423: Menzel, "Global ing environment is comprehensive, with various global Banking/Global Trading. Das Verrechnungspreissystem der Dresdner Bank national and international institutions operating in Ger dited by many. The variety of banking business ranges from small, aupach. (Herne- Berlin: NWB-Verlag. 1999) at 175-191: Hauselmann highly specialized banks acting in specialized markets, to sniederlassungen und Tochtergesellschatten". Internationales Steuerrechn the globally active banks doing business in virtually all (2003). at 139-1-44 markets. Banks present in Germany are active in the full 13. OECD Discussion Draft on the Atribution of Profits to Permanent Estab range of banking business and, in view of global trading, lishments (PEs: Part Ill( Enterprises Carrying on Global Trading of Financial perform all functions discussed in the OECD draft. Within nstruments) 14. 3.4.1 1. Administrative Principles- Procedures ②2005BFD
NOVEMBER/DECEMBER 2005 arbitrariness in the taxpayer's documentation and transfer The use of the general capital adequacy rule for PEs also leads to a stronger emphasis of risk for tax purposes. As the standard regulatory rules take into account different However, it will likely be useful to also take into account risk classes for assets that lead to different capital require oles-Procedure in light of the selection of transfer t' of a risk weightings based on a wider use of individual credit taxpayer. The regulations identify three types of com panies for the application of the transfer pricing method Is els. In the wake of this development, the standards that are applied to the allocation of banking assets for global trad The first group of companies performs only routine func- ing, but also including other banking business, are increas- low-risk routine functions. The tax authorities assume that mine an arm's length allocation of such assef? ' cs to dete. manufacturers. Pure service providers (e.g. in the back tigating or implementing internal transfer prio office)are also likely to be classified as performing such guidelines using balanced scorecard approache this type of company will derive a rather steady profit from its activities. For this group of companies, the trans actional net margin method (TNMM) is fully applicable if 4. APPLICATION OF TRANSFER PRICING o CUP, cost-plus or resale price method can be used. A METHODS proper benchmarking for those functions is essential to determine the arms length remuneration Historically, standard transactional transfer pricing The second group of companies consists of so-called methods have been favoured by the tax authorities. As dis- entrepreneurs or strategy leaders. These companies own cussed above, developments in recent years have to a cer substantial non-routine intangibles and their profits are tain extent reversed this tendency in favour of profit-based determined by these specific intangibles. Therefore, no methods. The new transfer pricing regulations on proce- reliably comparable companies are available for the appli dures refer to net margin approaches in a number of cation of the TNMM or the traditional, transaction-based prominent instances. For example methods. The entrepreneur typically receives the residual the use of the TNMM is explicitly allowed to Income from the transaction. If more than routine functions under certain conditions 17 and nice one entrepreneur is involved and no CUPs are available, the example on the putation of inter-quartile profit split could apply ranges uses database search results for a net operating The third group of companies is the so-called middle com panies, It seems that in other industries, a fully fledged The strong preference for standard methods in the past in distributor or a manufacturer licensing its intellectual some cases let to situations in which, for example, a CUP property will fall into this category. The TNMM is not method was applied and accepted by the tax authorities applicable to such companies, according to the tax author- even though under a strict application of OECD Standards ities, because allegedly no comparable data are available. the CUP data may not have been regarded as comparable If no other method could be used. the arm's length price a bank seeks to revise its approach and changes to another must be determined based on the companys budget da Otherwise, the taxpayer might be exposed to transter transfer pricing method, discussions with the German authorities in tax audits are to be anticipated cing sanctions Another aspect that must be taken into account is the allo- Compared to other industries, the financial services indus- cation of equity to the banking PE involved in the global try perhaps offers the widest range of comparable data for trading business. Here at least the basic principles of the the application of the CUP method. This is not only OECD Working Hypothesis (WH) seem to appear most because of the widespread existence of quantitative mar- clearly in German transfer pricing regulations for PEs. In ket data and the existence of a body of detailed, relevant September 2004, the tax authorities released regulations economic theory, but also because in recent years the on the allocation of equity to banking PEs, 16 From a regu- Tinancial sector has also experienced an increasing trend latory perspective, German branches of international of cooperation among unrelated parties(thereby leading to the existence of third-party service fees or commission equity depending on the location of the bank's head office. rates). Hc r, the current trend appears to be directed However, as there are rules regarding the minimum capital towards a more regular use of profit-based methods(also requirement for operations in Germany, the Septembe including the TNMM). Thus, Germany is continuously 2004 regulations basically stipulate that to determine an moving towards international standards in the application adequate (i.e. arm's length) equity capital dotation of a of transfer pricing methods, and this should also be banking PE, the non-tax regulatory rules that apply to legal entities conducting banking business should be applied to the branch for tax purposes, as well. Hence, the (iSn Seecaisle s ige Recipe for double taxation am Tar Notes international (22 tax authorities are primarily treating a PE like a separate August 2005), at 725. for a detailed discussion and distinct enterprise, claiming that for tax purposes the 16. Principles on the Allocation of Dotation Capital of Internationally Active capital adequacy requirements should be applied in the Banks (29 same manner to PEs as to separate legal entities 17. TZ. 3.4.10.3 b) Administrative Principles -Procedure 18. Tz. 3.4. 12.5 d) Administrative Principles-Procedure G 2005 IBFD
NOVEMBER/DECEMBER 2005 ITPJ reflected in easier procedures during competent authority instances, very often transactional market data from the proceedings, arbitration proceedings and bilateral or mul- non-tax regulatory monitoring systems of the bank may be bilateral APA the appropriate transfer pricing method will ultimately OECD's WH is the current status of 1999 German regula depend on the results of the economic analysis of a given tions on the treatment of PEs. These regulations stipulate banks business model and business strategy that is to be that not all transactions between head offices and PEs may documented. Nevertheless, the three basic types of global be at arms length prices. Instead, the application of the trading(i.e. separate-enterprise trading, centralized prod- arm's length principle and thus the WH is limited to core uct management and integrated trading) in their pure form economic activities of a taxpayer. The most relevant limi will typically encourage the use of different transfer pri- tation stemming from this is the treatment of routine st cing methods in view of the key entrepreneurial activities port activities. To the extent that they were considered non-core or auxiliary activities, it could be argued under Assuming a simplified but not uncommon set-up (i.e. with the German PE regulations that only a cost allocation trading and risk management being the dominant should apply without any profit mark-up. Similarly, the se of tangible (e.g. centralized, physical information entrepreneurial functions, and the remaining functions technology infrastructure)and intangible property (e.g tice the transfer pricing methods applied to the trading and proprietary software systems for the pricing of financial pending e bal tra herated t. In this ●=mm sible for either all its books or for one exclusive book. a In line with Secs. 123 ff. of the oecd draft, routine activ multi-entrepreneurial set-up in principle occurs only under ities and functions should normally fall under the scope of the integrated trading model. Thus, under both the sepa- standard methods like the CUP method or the cost-plus rate-enterprise model and the centralized product manage- method if the necessary third-party data are available ment model, the low-risk, routine service providers should However, as indicated above, the new German regulations receive their remuneration based on either standard trans- also allow the use of the trmm in the case of low-risk fer pricing methods (e.g. CUP or cost-plus) or the TNMM routine activities. As a first precondition for the applica in the event that the standard methods not be applicable tion of the tNMM. it must be verified that standard Such a transfer pricing system design should basically methods will not be applicable because of a lack of usable allocate the residual profit to one location. It is only under third-party data. Second, the regulations indicate that the such residual profit to more than one location responsible transactions that can also be consolidated to one uniform for trading and risk management Under such a scenario, activity or transaction. Finally, it must be documented that the profit split method should be an acceptable transfer ficiently comparable to the tested party. In the financial pricing method to apply. In fact, the new German regula- tions refer to global trading as an exemplary business services industry these three conditions will be met in a draft. Even though the regulations do not make a distinc- wItness an increasing number of global-trading transfer tion between the three types of global trading defined in pricing systems that will rely on net margins or the the OeCd draft, the application of the profit split method TNMM as the method of choice for routine support activ to the separate-entity model and to the centralized produc tion model will normally not be acceptable if the applica- Another not uncommon approach to allocate the cost of tion of standard methods were possible routine support activities is to use a cost contribution ch is applied, the documentation of arrangement in line with Chap. VIll of the OECD Guide he arms length nature of the pricing mechanism will refer to the arm's length nature of the allocation key used for the for the pooling of costs and their subsequent allocation profit split. Both German literature and practical experi without a profit mark-up for auxiliary activities under ence suggest that the most common allocation keys are n for the mutual benefit of all pool om a still based, in principle, on the adjusted compensation of German perspective, a major benefit of such an approach key global trading personnel. Such a key would also be for a mixed banking organization consisting of branches as line with the suggestions of the OECD draft. It is only recently that individual German authors have suggested 19. Tz. 3. 4. 10.3 c) Administrative Prin Procedures alternative keys such as value at risk. As far as the other 20. Sec. 240 OECD Discussion Draft Part Ill. types of global trading are concerned. in some cases a 21. Id Sec.170. CUP method is applied to transactions between 22. Reinhardt. Erfolgsabgrenzung im Global Trading(Hamburg: DrKovac entrepreneurially active parts of an enterprise. In these 23. Sec 1. I Administrative Principles on Auditing Cost-Sharing Arrange ments between Internationally Related Enterprises (30 Decemher 1999)
NOVEMBER/DECEMBER 2005 vell as of separate legal entities, is the fact that a cost con- Germany has moved closer to OECD standards than had tribution arrangement can interface between the partially been the case in the past. Indications of this include a different standards applied to pricing for these activities greater openness towards non-standard profit-based between the PE on the one hand, and the strict application methods (e.g. the TNMM) and increased reference to of the arms length test(including a profit element) for OECD Guidelines in the German regulations. However, it separate legal entities on the other This category includes is unlikely that Germany will follow other OECD member ot only general head-office functions or functions of a countries that literally transformed OECD regulations into bank which could be considered as support or auxiliary national law activities compared to the core banking activities (e.g. Nevertheless, in view of the OECD Discussion Draft Part human resources, audit, legal and tax departments),but also certain general or group-wide risk management or s I on global trading of financial instruments, taxpayers re well advised to follow closely the discussion at the treasury functions as well as several information technol- OECD level and also basically rely on this discussion for ogy and infrastructure functions their planning in cases of doubt where they do not explicit From a practical point of view it should also be noted that ly oppose domestic legislation. This should be advanta the use of a cost contribution arrangement will as well geous not only in the case that intenational negotiations require to make documentation available to taxpayers that between national tax authorities become necessary (e.g are charged costs under those arrangements, which is pro- arbitration procedures, competent authority procedures viding sufficient detail regarding the costs that are allo- and APAs), but there is also a certain expectation that ger- cated. The same is true for any transfer pricing method that many may increasingly adopt the essentials of the OeCd is cost based working hypothesis in the future 5. CONCLUSION German transfer pricing rules have been significantly overhauled in recent years. In this process, it appears that continued from page 3051 DOCUMENTATION United states eran Gregory G. Palmer, Michael A DiFronzo and Dr ulf andresen David s lee The Usability Test in the Administration Principles Federal Income Tax Benefit for Domestic Production Procedure Activitie 122 Administration Principles- Procedures(Principles on the audit of the profit allocation between related persons Carlos m. d' Arrigo g. and Juan Carlos Gomez stolk with cross-border transactions in relation to the duties Transfer Pricing Audit Examinations- What Is Yet f determination and cooperation, adjustments of income To Come 154 and mutual agreement and arbitration procedures) 20051BFD
NOVEMBER/DECEMBER 2005 ITPJ A CONTENTS !BFD VOL 12 NO. 6 NOVEMBER/DECEMBER 2005 COMPARATIVE SURVEY: GLOBAL TRADING NTErnatiOnal GLOBAL TRADING: AN ADVENTURE IN FINANCIAL MARKETS AND INSTRUMENTS 282 Louan Verdoner Louan Verdoner has written the introduction to this special issue of the International Transfer Pricing tion of Profits to Permanent Establishments. This article first explains briefly the context in which Dis cussion Draft Part Ill has been developed, and next it summarizes the contents of Part lll in a consice and comprehensible manner. Louan Verdoner has also drawn up the questionnaire sent to the authors of the country chapters as the starting point for their studies BELGIUM GLOBAL TRADING 288 David Ledure and Alessandra Howard CANADA GLOBAL TRADING: SOME COMMENTS ON THE CANADIAN TRANSFER PRICING PRACTICE AND ON J. Scott Wilkie FRANCE TRANSFER PRICING AND GLOBAL TRADING Pierre-Jean Douvier GLOBAL TRADING 306 Axel Nientimp and Achim Roeder SPAIN RADING Carreno, Rebeca Rodriguez and Ana Mayo RECENT DEVELOPMENTS INTRA-GROUP MANAGEMENT SERVICES: LEARNING FROM TRANSFER PRICING AUDITS Shyamal Mukherjee UMULATIVE INDEX 02005BFD
