Transfer pricing (TP) practitioners are often confronted with the migration of intellectual property (IP) assets as part of corporate restructurings. The standard procedure is to specify the transaction in an asset purchase agreement, prepare a valuation of the assets to be transferred, and prepare TP documentation to show that the determined value is at arm’s length.
With the introduction of Germany’s new foreign tax law in January 2022, Germany replaced previous legislation dating back to 2008. For the benefit of the taxpayer, the new law reduces to seven years the period within which the tax authorities can impose retroactive price adjustments. There are also precisely defined threshold values for which the tax authorities can make retroactive price adjustments.
In addition, the law clarifies the circumstances in which ratepayers may properly argue for no retroactive price adjustment.
However, Germany has also followed the logic of the OECD Transfer Pricing Guidelines 2017/18 and broadened the definition of intangible assets to which the valuation principles apply. The law now states that intangible assets are intellectual values and benefits, rather than intellectual property assets in the traditional narrow sense.
Reduction of the retroactive price adjustment period
The rules state that, if material securities or intangible benefits are the subject of a corporate restructuring transaction, and if ex post the subsequent evolution of the transferor’s profits deviates significantly from ex ante valuation assumptions, it should be assumed that uncertainties regarding the TP arrangement existed at the time the business transaction was entered into.
In this case, it must also be assumed that independent third parties would have agreed on an appropriate price adjustment. This argument is consistent with the OECD guidance on hard-to-value intangibles.
The duration of these price adjustments has now been reduced from 10 to 7 years. While this is beneficial to the taxpayer, as it reduces the period of post-trade uncertainty by 30%, it is not certain that it meets true arm’s length standards.
We know that in M&A transactions between third parties, price adjustment clauses generally relate to a period between one and three years after the closing of the transaction – if a price adjustment clause is included.
Clear definition of adjustment thresholds
Precise definitions of threshold values, which identify when tax authorities can or cannot impose retroactive price adjustments, provide more certainty to taxpayers.
An important point is when the actual profit development and the corresponding transfer price deviate by more than 20% from ex ante Evaluation. Below this threshold, the tax authorities cannot impose a retroactive adjustment.
Although this does not eliminate discussions on ex ante valuation assumptions in future tax audits, this at least gives taxpayers more certainty as to when restructuring-related transfer pricing might be challenged for a ex post adjustment.
Conditions to avoid any retroactive price adjustment
The new rules also provide clarification and guidance on the conditions under which taxpayers can avoid the application of retroactive price adjustments. These terms include the following:
The taxpayer can credibly demonstrate that the actual development is based on circumstances that were not foreseeable at the time of the transaction;
The taxpayer proves that he has sufficiently taken into account the uncertainties resulting from future developments when determining the transfer price; Where
With regard to intangible assets and benefits, license agreements stipulate that the license must be paid according to the sales or profits of the licensee. Alternatively, license agreements consider sales and profit for the amount of the license.
The first two conditions can be difficult to demonstrate and require in-depth analysis. To mitigate risk and avoid retroactive pricing adjustments, taxpayers and their transfer pricing experts should invest diligently (and generally more than in the past) in a proper, comprehensive and balanced analysis of assumptions related to the future evolution of activities and profits.
Extension of the definition of intangible assets
The extension of the definition of intangible assets significantly negates the benefits of the previous three rule changes. Under the previous regime, in corporate restructurings, the so-called transfer package rules were applicable when at least one intangible item in the traditional narrow sense was part of the package.
Under the transfer package rules, an overall valuation involved the net present value of all expected future revenue lost as part of the post-restructuring TP setup. In the absence of convincing arm’s length justifications, the evaluation period was infinite. This has generally led to relatively high valuations and tax on exit.
In the new German regulatory environment, the expanded definition of intangibles means that the transfer package rules can apply even if the tax authorities find no traditional intangibles in the narrow legal sense under the TP package.
In future tax audits, this could imply that any decline in profits observed as a result of an overhaul of an existing TP system – for reasons which may be unrelated to corporate restructuring – could trigger the conclusion that something thing of value must have been transferred. This in turn could lead to penalties because the transfer was not documented.
With a flexible definition of intangible assets, the burden of proof to successfully argue such a case is not particularly high for the tax authorities. Multinational companies should expect related controversies to increase in number and scope.
Key takeaways for TP practitioners
PT practitioners should regularly check whether observed declines in profits or profit margins can be put into context with the transfer of an intangible (something of value). If not, they should explain in the TP documentation the other business reasons for the lower profits.
However, if this is the case, the TP team should treat the situation retroactively (as if an intangible had originally been valued at zero, and now a price adjustment was required) and modify the tax returns if necessary.
If significant intellectual property has been transferred out of Germany at a specific valuation, and if no price adjustment clause has been agreed, TP experts should make a comparison. They must verify whether the projections and valuation assumptions made in the past differ significantly from actual developments over the previous seven years, resulting in an upward deviation of the transfer price of more than 20%. Again, an amendment to the tax return may need to be considered.
With regard to the valuation and TP documentation, it is interesting to follow the post-restructuring evolution of the main valuation parameters; mainly sales volumes, revenues and profits. In this regard, it is also useful to collect and keep information on unforeseeable events (such as the COVID-19 crisis), the financial impact of which in the post-restructuring years should not be considered as calling into question a situation. pre-COVID-19. ex ante Evaluation.
For ongoing corporate restructuring plans, consideration should be given to price adjustment clauses in transfer agreements. Based on our experience, we recommend formulating the price adjustment clause or mechanism as precisely as possible.
The critical element will be the definition of the so-called “trigger event” (the event that must be reached for the adjustment to be triggered), which could also deviate from the regulation if it is supported by the business particularities of the taxpayer.
Finally, to mitigate risk, taxpayers should be prepared to invest more in valuing intangibles and documenting underlying assumptions, as well as tracking segment profit and loss (P&L) post-restructuring.