German amendment to withholding tax and transfer pricing

On June 9, 2021, the German legislature enacted the Withholding Tax Relief Modernization Act (German Tax Act) to amend and introduce new rules on the use of losses in legal restructurings, on tax certificates for capital gains tax, and on the exchange of information on tax arrangements using the capital markets. The new law also implements comprehensive revisions to the General Tax Code (AO) relevant to transfer pricing. Essential parts of the new tax rules are related to the following:

• New procedural rules to obtain relief from German withholding tax
  
• New anti-abuse provision section 50d (3)
• New transfer pricing rules

Anti-abuse provision section 50d (3) of the EStG

The comprehensive anti-abuse provision outlined in the recent German law is intended to take precedence over an applicable double tax treaty. The revised anti-abuse provision contains provisions on treaty shopping that apply to withholding taxes on dividend payments and royalty payments, including artist and supervisory board member remunerations.

Under the prior version of the law, an anti-abuse provision such as Article 28 of the double tax treaty between Germany and the United States took precedence over the application of the German domestic anti-treaty shopping provisions. According to the comprehensive revision of the new provision on anti-treaty shopping (sec. 50d (3) EStG), a foreign corporation is not entitled to withholding tax relief in Germany if the following applies:

• The persons involved in the (intermediary) company would not have been entitled to such relief if they had received the income themselves (personal relief entitlement)
  
• The source of income has no substantial connection with the economic activity of this foreign corporation (factual relief entitlement)

In essence, the mere generation of income and its transfer to shareholders or beneficiaries and activity without an appropriately established business are not considered sufficient to justify granting treaty benefits.

Withholding tax

In addition to the anti-abuse amendments, the German Tax Act would introduce several measures to update and modernize the current procedural rules to claim a reduced withholding tax rate under a tax treaty or an EU directive. The new rules regarding withholding tax came into effect on Jan. 1, 2022.

Under the new provision, exemption certificates for royalties will be issued even if it is unclear whether a tax liability exists. In addition, unlike under current provisions, the payer will still have to make quarterly declarations of zero withholding tax even where an exemption certificate has been granted. The new rules are particularly relevant for companies affected by guidance earlier this year on withholding tax arising from IP transactions. It is important to note the certificate of exemption must be issued when any dividends or royalties are paid; otherwise, the payer is still required to withhold and remit taxes, and the payee may claim a tax refund under the applicable double tax treaty or EU provision.

Dividends and royalties paid by a German company to a foreign payee are subject to a German withholding tax of up to 15%-25% plus solidarity surcharge. According to the new specific anti-treaty shopping rule, the payee of dividends/royalties is only entitled to relief from German withholding tax if certain conditions are met.

ASC 740 provision considerations

Under ASC 740, companies should reflect changes in tax law in the period in which they are enacted. Companies should evaluate the changes to withholding taxes and reflect any impact in the financial statement period that includes the enactment date. Companies should consult with an ASC 740 specialist for assistance in determining the impact of the German Tax Act on their financial statements.

Transfer pricing considerations

For transfer pricing purposes, the updated guidance for claiming a reduced withholding tax rate in Germany would apply to certain cross-border payments, which are subject to limited tax liability. These payments include royalties, trademarks, patents, franchises remunerations for supervisory board members of German companies or similar functions, and remunerations for film, television, and other performance industries carried out in Germany. The applicable maximum withholding tax rate on royalties under the amended withholding tax rules will depend on the type of royalty granted.

Group holding structures that rely on the tax-efficient repatriation of profits from Germany through dividend distributions or royalty payments should be reviewed and potentially reorganized to ensure a tax-efficient structure.

New transfer pricing rules

As mentioned, the German Tax Act as well as the new Circular “Administrative Principles Transfer Pricing” published by the German Federal Ministry of Finance on July 14, 2021, amend the German transfer pricing regulations significantly. The new transfer pricing regulations outlined generally the development of the OECD Transfer Pricing Guidelines 2017 (OECD Guidelines) and aim to address some of the OECD-BEPS Action items 8 to 10 project in a German context, but Germany has not adapted the OECD Guidelines as German tax law at all. The new transfer pricing rules in the German Foreign Tax Act will apply for the first time to the 2022 tax period.

The key transfer pricing changes in the German Foreign Tax Act include:

Best method rule

Section 1 (3) of the revised German Foreign Tax Act restructures the arm's length test and introduces the best method rule that requires applying the most appropriate transfer pricing method. The provision requires that arms lengths test solely be carried out based on economically recognized valuation methods from the perspective of both the provider and the recipient in a transaction.

The new version of the law now recommends applying the median value as a rule, except that the taxpayer needs to demonstrate that another price within the determined range complies with the arm's length principle.

Interquartile range (IQR)

Section 1 (3a) of the German Foreign Tax Act provides guidance on arm's length data and the correct approach to narrowing an arm's length price range. Moving forward and under specific circumstances, the German authorities will accept the interquartile range method in the case of limited comparability.

If the transfer price used by the taxpayer falls outside the (full or narrowed) range, an adjustment to the median is made unless the taxpayer can credibly demonstrate that a different result (within the range) is more in line with the arm's length principle.

The amendments to section 1 (3a) does require material changes in practice as the interquartile range has frequently been used in the past but in the event that comparables for the IQR potentially raise doubts by the tax authorities, the tax auditor will perform a sensitivity analysis and exclude the top and bottom comparable data from the benchmark analysis. In this case, it is therefore recommended that the IQRs are analyzed before and are not too close to the lower or upper interquartile of the IQR.

Function relocations

Section 1 (3b) of the German Foreign Tax Act implements the case of relocations of functions (business relocation) in the German Foreign Tax Act. Further, this section eliminates specific escape clauses and streamlines and modifies the transfer of functions.

Under the new section 1 (3b) of the German Foreign Tax Act, if no comparable data for the relocation of functions is in place, the total price for the function, assets, and risks to be transferred must be determined by recurring application of the prescribed transfer package approach based on the arm's length test.

Taxpayers do not have to apply a transfer package approach to credibly demonstrate that no significant intangible assets or other benefits are part of the transfer of functions. This applies to cases in which the function-receiving entity abroad solely performs the transferred function for the transferring entity and is remunerated based on the cost-plus method.

DEMPE analysis

Section 1 (3c) of the German Foreign Tax Act is a new tax regulation that provides guidance on functions connected to the Development, Enhancement, Maintenance, Protection, Exploitation (DEMPE) of intangible assets related to the transfer and assignment of intangible assets.

The new regulation defines intangible assets in alignment with the OECD Guidelines for German transfer pricing purposes. In addition, DEMPE analysis for transfer and assignment of intangible assets must be remunerated at arm's length.

Price adjustment clause

Section 1a of the German Foreign Tax Act modifies the price adjustment clause. The current price adjustment clause applies only for relocation of functions when the basis for determining a transfer price deviates significantly over time compared to when the transaction was realized.

Under the new section 1a, the price adjustment clause will apply to all transactions, including intangible assets.  The adjusted law also modifies the time frame for transfer pricing adjustments in case of prices agreed which are not at arm´s length from ten to seven years after the conclusion of the transaction.

Within the period of seven years, taxpayers will need to examine whether the actual profit generated with the intangible deviates significantly by more than 20% from the initial profit expectation. If this is the case, and no price adjustment clause has been agreed upon, the German tax authorities must adjust the taxpayer's income.

Advance pricing agreement (APA)

The German Fiscal Code introduced in its new section 89a comprehensive guidance on advanced pricing agreement (APA) procedures regarding the evaluation of exactly specified issues that are not realized at the time of the application for the APA.

Previous APA procedures were based on double tax treaty rules and a detailed circular by the German Federal Ministry of Finance. Under the new law, APA procedures will no longer be limited to transfer pricing but will encompass all other double tax treaty protection cases. The fees for the APA application have increased significantly to EUR 30,000 for an application.

Transfer pricing considerations

The adoption of the OCED-BEPS development-based transfer pricing rules significantly strengthens the position of the German tax authorities and signifies increasing focus value creation and contractual arrangements. Taxpayers may see an increase in the number of disputes is expected due to the new regulations.

Failure to comply with the transfer pricing requirements may result in penalties according to section 162 of the German Fiscal Code.

Further, the German Ministry of Finance already applies the German circular "Administrative Principles Transfer Pricing" which defines further transfer pricing regulations for the German tax auditors in current and future tax audits. This circular has to be regarded to all outstanding fiscal years which are not tax audited yet.