On 6 June 2023, the German Ministry of Finance released an updated version of its Administrative Principles on Transfer Pricing. The previous updates in 2020 and 2021 had already facilitated alignment with the post-BEPS OECD framework, and the 2023 update follows that alignment. Nevertheless, the updated 2023 guidance constitutes an important reference and will be the foundation for transfer pricing audits in Germany for the foreseeable future. For taxpayers operating in Germany which have previously adopted a “wait and see” approach to the BEPS reforms, the 2023 guidance in Germany signals a “last call” to address open issues for ensuring a compliant transfer pricing position. This article focuses on the role of intercompany agreements, and what approach taxpayers should consider in order to comply with the German and OECD guidance.
In February 2020, we contributed to the LCN Legal blog, emphasising that taxpayers should review their intercompany agreements ("ICAs”) for post-BEPS compliance. Among other things, we highlighted the importance of ensuring that ICAs accurately implement the intended allocation of risks of the underlying business model. We further emphasised that an (ex-ante) contractual allocation of risks needs to clearly stipulate who bears the potential costs which may occur if negative outcomes come to fruition (ex-post). As such, it is crucial that the ex-ante contractual allocation of risks provides clear evidence of a commitment to assume risk before the realisation of risk outcomes occurs. As a tax audit is often conducted by the respective authorities several years after outcomes have been established, an assumption of risks after the fact, when outcomes are known, is not an effective assumption of risk for transfer pricing purposes.
One of our key recommendations was that appropriate ICAs are implemented in such a way as to constitute a robust defence file that is available to respond to challenges to taxpayers’ transfer pricing positions. Most OECD countries have now integrated the post-BEPS OECD Transfer Pricing Guidelines into their respective national laws and regulations, and many have seized the opportunity for a holistic overhaul of their national transfer pricing regulations. Germany is a good case in point.
In short, the recommendations we made in 2020 based on the OECD BEPS project remain valid. However, the recommendations can now be further refined in reference to national TP regulations.
Updated German Administrative Principles on Transfer Pricing and the impact on ICAs
German TP practitioners have been confronted with a plethora of updates to the relevant regulations and Administrative Principles throughout 2020 and 2021. Specifically, the German legislator updated its foreign tax code in May 2021, and the German Federal Ministry of Finance released its Administrative Principles on 3 December 2020 (focusing on procedural provisions). On 14 July 2021, the Ministry updated the Administrative Principles on Transfer Pricing (focusing on the application of the arm’s length principle).
The new Administrative Principles are highly relevant for tax audits, as they constitute the rules of the game and ultimately shape the process and outcome of audits.
To put the importance of ICAs into a broader context, a look at the Administrative Principles is highly instructive. Specifically, Section 14 of the Administrative Principles stipulates the enhanced obligation for taxpayers to procure relevant information during an audit, specifically noting that the obligation extends to ensuring that data held by related parties (abroad) can be collected by the taxpayer and shared with the tax authorities.
In the case of cross-border transactions, the taxpayer is required to take precautions to ensure that he can fulfill its enhanced obligation to cooperate. He can, therefore, not rely on pleading to be unable to obtain the relevant facts of the case or not being able to provide evidence. The taxpayer must, therefore, e.g., when executing a contract by appropriate contractual provisions, ensure that he will have access to evidence to present it to the tax authorities. (Own translation – emphasis added.)
In other words, “appropriate” contracts are considered a default pre-condition. Taxpayers are thus expected to have ICAs readily available and to ensure that any contractual provisions (such as the definition of the cost base in cost plus arrangements) can be backed up and validated by accounting and financial information. Failure to provide the required information would trigger negative consequences in an audit situation. While, depending on the case at hand, a transfer pricing adjustment may not necessarily be imposed, the taxpayer would generally bear a higher burden of proof to defend the arm’s length nature of the applied transfer prices. Should the burden of proof not be met successfully, the tax auditor is entitled to apply estimates when adjusting the transfer price to arm’s length conditions. While the lack of evidence in this context is not linked to penalties, the consequences of transfer pricing adjustments based on estimates can be severe – and taxpayers should strive to avoid such a situation.
Looking at the Administrative Principles on transfer pricing released on 6 June 2023, which reflect the German interpretation of the OECD Transfer Pricing Guidelines (the “OECD TPG”), the following items relating to ICAs should be kept in mind for day-to-day transfer pricing.
Section 3.19 clarifies that the contractual provisions of a transaction constitute the first component of a comparability analysis – directly referencing 1.42 – 1.50 of the OECD TPG, which are adopted as an Annex to the German Administrative Principles on transfer pricing).
Section 3.24 is the German equivalent to 3.11 of the OECD TPG. While the economic rationale for applying an aggregated analysis for a “package deal” is identical, the German provision makes a much more explicit refence to the contractual provisions for such a package compared to the OECD TPG. The provision may be interpreted as a manifestation of a more formalistic (ex-ante or price-setting) approach to the arm’s length principle inherent in the German regulations.
Section 3.38 is a further distinct manifestation of this formalistic approach and explicitly stipulates that the decisive point in time (“maßgebender Zeitpunkt”) for applying the arm’s length principle is the “conclusion of the underlying contract” (i.e., not the time when goods or services are delivered).
Section 3.39 stipulates that, at arm’s length, a prudent and conscientious manager (“ordentlicher und gewissenhafter Geschäftsleiter”) would, when negotiating contracts, also evaluate whether the agreement of termination or modification clauses is legally permissible and economically advantageous for the entity on whose behalf the manager is acting – especially when negotiating long-term contracts. Consequently, to be commensurate with arm’s length conditions, an ICA should also reflect respective considerations or realistic alternatives. The role of termination clauses in the negotiation of new ICAs becomes also relevant in the context of restructurings where Section 3.107 assumes that a new ICA will be formalised taking into account the changed functional and risk profile, and depending on the previous ICA a party may be entitled to compensation (or an indemnity) due to the termination. This means that when entering into ICAs you should also keep in mind its termination and consequences.
The sections mentioned thus far constitute a framework that is highly relevant in the context of tax audits, and clarify that ICAs will inevitably constitute an important reference point for the auditor. In some cases, provided credible corroborative information is available, it might be feasible for taxpayers to defend missing or incomplete ICAs by emphasising that an informal (verbal) agreement existed between the parties and that actual conduct confirms the existence of such an agreement. In other words, ‘substance over form’ arguments may be feasible in some circumstances. Whether such arguments can be successful depends, as always, on the individual case. In any case, however, the effort required to draw up an appropriate agreement is dwarfed by the uncertainty and risk implied in not complying with the minimum standard regarding ICAs.
Lastly, the Administrative Principles on transfer pricing contain some provisions regarding ICAs that should be considered a “must”, in the sense that substance over form arguments will most likely remain futile.
Section 3.44 is of vital importance for taxpayers wanting to implement a viable target margin system. It stipulates that if ex-post transfer pricing adjustments based on budgeted vs. actual results continually result in one entity being put at either an advantage or a disadvantage (e.g., because the adjustment is consistently made to the upper or lower end of an arm’s length range), such adjustments would in principle indicate non-arm’s length (contractual) conditions.
Section 4.8 relate to customs duties and can be conceived as a logical extension of Section 3.44. Specifically, it stipulates that any transfer pricing adjustments will only be recognised if the contractual parties have clearly defined the rationale as well as the calculation mechanism for the adjustments (ex-ante) in an appropriate ICA. In other words, you cannot apply a viable target margin system in Germany without an appropriate ICA.
Section 3.52 reflects the fact that Germany does not differentiate between hard-to-value intangibles and other intangibles, and subjects all intangibles to price adjustment under § 1a of the German Foreign Tax Code (AStG - Gesetz über die Besteuerung bei Auslandsbeziehungen). Section 3.136 is also worth noting, as it allows taxpayers to utilise ICAs to proactively mitigate tax risks relating to hard-to-value intangibles. Specifically, this section provides that if the ICA contains an appropriate (“sachgerechte”) price adjustment clause, the application of hindsight by tax authorities in case of material deviation in the valuation is excluded until seven years after the transaction (§ 1a of the Foreign Tax Code or “AStG”). Meaning that if your intercompany transaction is based on a valuation of intangibles, which are mostly discounted cash flow calculations, you should think long and hard about what type of adjustment mechanisms (additional payments in case certain thresholds are exceeded) would be agreed to mitigate the prevailing uncertainty. Naturally, you would aim for a shorter timeframe (perhaps three years).
While most MNEs will strive for a realistic valuation, it is often not feasible to appropriately cope with uncertainty and volatility. As such, a vague or ambiguous ICA will be detrimental. The application of hindsight will always be utilised to the disadvantage of the taxpayer, and any explanations provided by the taxpayer to justify and explain the material deviations will naturally be scrutinised and (even if economically valid) will not always be accepted – or at least not accepted in full.
Section 3.104 recognises that in the context of restructurings, the relocation of functions may comprise a number of elements which may addressed in separate ICAs (e.g. regarding the sale of assets, licensing of assets, rendering of services, personnel) which specify how the pricing of the transactions is calculated. In order to avoid a transfer pricing adjustment, it is important to ensure that the sum of transfer prices for the individual transactions does not exceed the overall value of the “transfer package” (“Transferpaket”).
Some changes are to be observed within the framework of financial transactions due to recent case law by the German supreme court (BFH). It is required that an ICA exists and contains clauses for appropriately classifying the funds as debt as a first step (Section 3.123), and sets an arm’s length interest rate (transfer price) commensurate with the contractual rights and obligations resulting from the economic conditions, considering factors such as the amount, maturity, covenants and security (for which the update contains a more restrained provision – see Section 3.128). In addition to the existing commentary on implicit group support, Section 3.127 now addresses the enhanced position which related parties may have as regards to a so-called ‘knowledge edge’ (“Wissensvorsprung”) and ability to exercise control, which can have an influence on interest rates and should be considered in pricing and payment stipulations in the ICA. Where financing companies cannot independently control the contractually assumed risk, it may only demand a risk-free return for the provision of capital (Section 3.125). This may require further investigation into whether there are additional transactions between the lender and the company that actually controls and bears the risks. In such cases, those additional transactions may not be reflected in ICAs, due to the conflict between the point of view of the taxpayer and the tax administration.
Concluding thoughts from a risk management perspective
From a transfer pricing risk management perspective, ensuring that appropriate ICAs are in place should be considered as “low hanging fruit”. An ICA is your first line of defence during an audit, and tax auditors will habitually request and check your ICAs. Not being able to provide ICAs to the auditor will often lead the audit proceedings astray, as trust deteriorates and the auditor will inevitably raise several questions to ascertain the facts and circumstances that would normally be reflected in an ICA. Not being able to satisfactorily answer these questions would ultimately shift the burden of proof to the taxpayer.
By creating and updating your ICAs you will be able to spot misalignments between the applied transfer prices and economic substance, i.e., as reflected in the functional and risk profile of the contracting parties. Consequently, addressing the open issues relating to your ICAs is not a bad starting-point for your risk management efforts in Q3 and Q4 2023. As we said in the introduction, this is the “last call”.
 Strictly speaking the updates of the German TP regulations in 2020 / 2021 should already have triggered taxpayers to enact the required adjustments, but when allowing for a certain transition time (which auditors will not necessarily do), it seems appropriate to stipulate the “last call” for 2023 – as excuses are unlikely to be accepted going forward.
 If you need to familiarise yourself with basic transfer pricing concepts, we suggest the 2020 article provides a good starting point. https://lcnlegal.com/why-you-should-review-your-inter-company-agreements-for-post-beps-compliance/
 For details, see Treidler, O.; Kunz, T. (2022), Transfer pricing in Germany: issues to monitor and address in 2022, March 3rd 2022, MNE TAX: https://mnetax.com/transfer-pricing-in-germany-issues-to-monitor-and-address-in-2022-46896 as well as Dorner, K. and Treidler, O. (2021), German Bundestag approves significant changes to German Transfer Pricing Law, 5th May 2021, Quantera Global: https://www.quanteraglobal.com/blogs/german-bundestag-approves-significant-changes-to-german-transfer-pricing-law-on-friday/
 All of the Sections discussed below were already included in the 2021 administrative principles transfer pricing – except Section 3.136.
 In Germany the “material deviation” analogous to respective OECD provisions is +/- 20%.
 For a more comprehensive introduction to risk management for transfer pricing purposes, see Treidler, O. (2023), Transfer Pricing Survival Guide - A management guidance to identifying and mitigating transfer pricing risks https://www.amazon.de/Transfer-Pricing-Survival-Guide-identifying/dp/3750417148/ref=sr_1_1?crid=FUBIJ217Q5D6&keywords=transfer+pricing+risk&qid=1687267708&sprefix=transfer+pricing+risk%2Caps%2C140&sr=8-1
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