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

Invitation

Seminar on Wednesday, 12 september 2012

Seminar on transfer pricing and international tax

Update on German DevelopmentsArm‘s Length License Rates

Stephan Rasch, Deloitte Munich

© 2012 Deloitte & Touche GmbH WirtschaftsprüfungsgesellschaftUpdate on German Developments3

Arm’s Length License Rates

© 2012 Deloitte & Touche GmbH Wirtschaftsprüfungsgesellschaft

Arm’s Length License Rates

Update on German Developments4

Licensee Licensor

Related Parties

License Fee

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

• Planning Data• Hypothetical Arm’s Length Test

4


Approach 1: Cost Plus Approach


Year 1

R&D

Year 2 Year 3

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

Numerical Example:

Mark-up

= Royalty Rate

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?

R&D

Mark-up

R&D

Mark-up

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

Royalty Rate 5.5% 5.5% 5.5%


Approach 2: CUP Approach


Year 1

3rd party rate

Year 2 Year 3

Concept: Internal or external comparable royalty rates are known.

Numerical Example:

= Royalty Rate


• To find comparable licensing contracts could be regarded as difficult

• Does not take into account the specific situation of the licensee and/ or licensor

3rd party rate

3rd party rate

3rd party rate

CUT Approach Year 1 Year 2 Year 33rd Party Royalty Rate 6.0% 6.0% 6.0%



Approach 3: Acquisition Price/ Market Cap. Method


Year 1

License Fee

Year 2 Year 3

Concept: Market value of the IP licensed is available or can be deducted from an acquisition/ market. capitalization

Numerical Example:

= Royalty Rate


• How does future R&D costs enhance the IP value

• Useful life of IP critical assumption

License Fee

License Fee

Market Value of

IP

Acquisition Price Method Year 0 Year 1 Year 2 Year 3Acquisition Value of IP 30.00Useful Life of IP 3 YearsLicense Base 200.00 200.00 200.00Royalty Rate 6.1% 6.1% 6.1%

License Fee 12.21 12.21 12.21Present Value Factor (discount rate=10%) 0.91 0.80 0.75

PV License Fee 11.10 9.73 9.17NPV License Fees 30.00


Approach 4: TNMM Based Approach


Routine

IP

Year 1 Year 2 Year 3

= Royalty Rate

Concept: Licensee should earn arm’s length profits based on benchmarking after license fees.

Numerical Example:

Critical Assumptions/ Comments:

• Arm’s length profits of the licensee can be reasonable determined through benchmarking

• IP is the only non-routine value driver

Routine

IP

Routine

IP

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



Approach 5: Residual Profit Split Based Approach


Concept: Profits are explained through routine functions performed, IP No. 1, and IP No. 2.

Numerical Example:

= Royalty RateIP No.2

Year 1 Year 2 Year 3

IP No. 1

IP No. 2

Routine

IP No. 1

IP No. 2

Routine

IP No. 1

IP No. 2

Routine

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


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 IntangiblesLimitation to be expected in Germany? (1)



• 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)

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


© 2012 Deloitte & Touche GmbH WirtschaftsprüfungsgesellschaftUpdate on German Developments12

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


Function:• Chances• Risks• Other advantages

Other advantages:to be determined based on profit potential calculation Residual

Services: performed associated with function

Intangibles:• Product • Process• Marketing

Tangibles:• Machinery• Stock, etc

Relocation of Business FunctionsOverview – Definition

13 Update on German Developments


Profit potential of function as a whole

= Transfer Package

Services

Intangibles

Tangibles

“Goodwill” associated with

function

Sum of individual transfer prices

Residual

Business RestructuringOverview – Transfer Package Approach (1)


© 2012 Deloitte & Touche GmbH WirtschaftsprüfungsgesellschaftUpdate on German Developments

Business Restructuring Overview – Transfer Package Approach (2)

Receiving CompanyProfit PotentialRelocating Company

Mid price

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

Maximum price Minimum price

10 15 20

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

= Difference

x Capitalization rate

= Purchase price claim (Minimum price of the provider)

Forecasted profit after tax (including received function)

./. Forecasted profit after tax (without received function)

= Difference

x Capitalization rate

= Willingness to pay (Maximum price of the receiving company)

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© 2012 Deloitte & Touche GmbH WirtschaftsprüfungsgesellschaftUpdate on German Developments

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

Do we have a relocation of functions under the legal

definitions, taking into account exemptions?

Application of single asset valuation approach, § 1 Abs. 3 S.

1-8 AStG

„Escape-Clauses“ of § 1 Abs. 3 S. 10 AStG, related to transfer of

significant intangibles, applicable?

Does third party data for the business transaction as a whole exist which is unlimited/ limited

comparable?

Application of § 1 Abs. 3 S. 1-4 AStG as business transaction as a

whole Valuation of Transfer Package with

Hypothetical Arm’s Length Test

Can a price be found within the price range which complies with

the arm’s length standard?

Result: Agreement on this price

Result: Agreement on Midpoint

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• Determining whether the allocation of risks in a controlled transaction is arm’s length – OECD perspective taken up in German tax audits

Business Restructuring Allocation of risk - Trend in German tax audits

17 Update on German Developments

Search evidence of the actual conduct of independent parties

Is there reliable evidence of a similar allocation of risks in

comparable uncontrolled transactions?

Relevant, although not determinative factors:

• Which party has greater control over risk?

• Is the risk allocated to a party which has the financial capacity to

assume it?

The risk allocation in the controlled transaction is

arm`s length

Is the allocation of risk one that might be

expected to have been agreed between

independent parties in comparable

circumstances?

Yes

No

Lacking such evidence, determine whether the risk allocation is one that would have been agreed between

independent parties in comparable circumstances

© 2012 Deloitte

Ny juridisk dokumentations-vejledning

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© 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 påwww.skat.dk (Juridisk Information > Juridiske vejledninger)

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http://www.skat.dk/

© 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

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Impact for taxpayer

Ikke mere konkret afklaring for skatteyder!

© 2012 Deloitte

Eksempler på omskrevne afsnit i dokumentationsvejledningen:

C.D.11.4.2.5 Forklaring på eventuelle underskud”…Beskrivelsen skal også indeholde en præcis og specificeret angivelse af underskuddets/tabets størrelse samt en oversigt over resultater eller avancer/tab i øvrige relevante koncernenheder. Det skal fremgå af oversigten eller en tilhørende redegørelse, om virksomheden bærer underskud eller tab på aktiviteter eller transaktioner, som andre virksomheder i samme koncern har overskud eller gevinst på”.

C.D.11.4.10 Frist for at indsende dokumentation:”Dokumentationen skal kunne indsendes inden 60 dage. På selvangivelsestidspunktet skal der således altid være udarbejdet en dokumentation, der gør dette muligt. I dokumentationsreglerne er det forudsat, at dokumentationen udarbejdes løbende. På selvangivelsestidspunktet skal dokumentationen således under alle omstændigheder være opdateret for det pågældende indkomstår”.


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© 2012 Deloitte & Touche GmbH Wirtschaftsprüfungsgesellschaft22


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?

© 2012 Deloitte

• 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.

OECD releases discussion draft on 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.

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© 2012 Deloitte

• 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

Malaysia issues revised transfer pricing rules and new APA guidelines


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

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© 2012 Deloitte

• 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.

Australia - Hearing on proposed retrospective transfer pricing law


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

Australia’s Parliament recently introduced a bill proposing reform of the country’s transfer pricing rules:

© 2012 Deloitte

• 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

Advance Pricing Agreements in India:


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

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© 2012 Deloitte

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.

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Norway – Annual Transfer pricing report

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

Documents

investment year

profit split approach

benchmarking ip

acquisition value of

ip licensed

acquisition price method

license fee6

license fee4