Transfer pricing (TP) practitioners often face the migration of intellectual property (IP) assets in the course of business 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 the new German Foreign Tax Act in January 2022, Germany replaced earlier legislation dating from 2008. To the taxpayer’s benefit, the new law reduces the time frame in which tax authorities can impose retroactive price adjustments to seven years. There are also precisely defined threshold values for when tax authorities can conduct retroactive price adjustments.
In addition, the law specifies circumstances in which taxpayers can justifiably argue for no retroactive price adjustments at all.
However, Germany also followed the logic of the OECD 2017/18 TP guidelines and broadened the definition of intangibles to which valuation principles apply. The law now states that intangibles are intellectual values and benefits, rather than IP assets in the traditional narrow sense.
The reduction of the period for retroactive price adjustments
The rules state that, if material intangible values or benefits are the subject of a business restructuring transaction, and if ex-post the subsequent profit development of the transferring party deviates significantly from the ex-ante valuation assumptions, it is to be presumed that uncertainties existed with regard to the TP agreement at the time when the business transaction was concluded.
In this case, it is also to be presumed that independent third parties would have agreed on an appropriate price adjustment. This argument is in line with the OECD guidance on hard-to-value intangibles.
The time frame for such price adjustments has now been reduced from 10 to seven years. While this is beneficial to the taxpayer, as it reduces the post-transaction uncertainty period by 30%, it is not certain that this meets real arm’s-length standards.
We know that in M&A transactions between third parties, price adjustment clauses usually relate to a period between one and three years after deal closing – if a price adjustment clause is included at all.
The 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.
A significant point relates to when the actual profit development and the related transfer price deviates by more than 20% from ex-ante valuation. Below this threshold, tax authorities cannot impose a retroactive adjustment.
While this will not eliminate discussions about ex-ante valuation assumptions in future tax audits, it does at least provide taxpayers with more certainty regarding when restructuring-related transfer prices might be under critical review for an ex-post adjustment.
Conditions for avoiding any retroactive price adjustments
The new rules also provide some clarity and guidance on the conditions under which taxpayers can avoid retroactive price adjustments being applied. These conditions 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 they have adequately accounted for the uncertainties resulting from the future development when determining the transfer price; or
With regard to intangible assets and benefits, the licence agreements state that the licence is to be paid dependent on the licensee’s sales or profits. Alternatively, the licence agreements take sales and profits into account for the amount of the licence.
The first two conditions can be difficult to demonstrate and require in-depth analysis. To mitigate risks and avoid retroactive price adjustments, taxpayers and their TP experts should invest diligently (and, generally speaking, more than in the past) in a proper, comprehensive, and balanced analysis of the underlying assumptions related to future business and profit developments.
Extension of the definition of intangibles
The extension of the definition of intangibles considerably offsets the benefits of the three prior rule changes. Under the previous regime, in business restructurings, the so-called transfer package rules were applicable when at least one intangible in the traditional narrow sense was part of the package.
Under the transfer package rules, a package valuation involved the net present value of all expected future income foregone under the post-restructuring TP setup. In the absence of convincing arm’s-length justifications, the valuation period was infinite. This generally led to relatively high valuations and exit taxation.
In the new German regulatory environment, the extended definition of intangibles means that transfer package rules can apply even if the tax authorities find no traditional intangible asset in the narrow legal sense as part of the TP package.
In future tax audits, this could imply that any observed profit drop as an outcome of the revision of an existing TP system—for reasons that may be unrelated to a business restructuring—could trigger a finding that something of value must have been transferred. This in turn could trigger penalties because the transfer was not documented.
With a soft definition of intangibles, the burden of proof to successfully argue such a case is not particularly high for tax authorities. Multinational companies should expect related controversies to increase in number and size.
Key takeaways for TP practitioners
TP practictioners should regularly check whether observed drops in profit or profit margins may be brought into context with the transfer of a soft intangible (something of value). If not, they should explain in TP documentation the other business reasons for the drop in profit.
However, if this is the case, the TP team should retroactively address the situation (as if an intangible had been initially valued at zero, and now a price adjustment was necessary) and amend the tax returns if necessary.
If significant IP was transferred out of Germany at a specific valuation, and if no price adjustment clauses were agreed upon, TP experts should do a comparison. They should check whether the projections and valuation assumptions made in the past differ significantly from the actual developments over the previous seven years, causing an upward deviation of the transfer price of more than 20%. Again, an amendment to the tax return may have to be considered.
With regard to valuation and TP documentation, it is worthwhile to track the post-restructuring developments of the key valuation parameters; mainly sales volumes, revenues, and profits. In this regard, it is also helpful to collect and keep information about unforeseeable events (such as the COVID-19 crisis), whose financial impact in post-restructuring years should not be considered to challenge a pre-COVID-19 ex-ante valuation.
For ongoing business restructuring plans, it is worth considering price adjustment clauses in the transfer agreements. Based on our experience, we recommend formulating the price adjustment clause or mechanism as precisely as possible.
The critical item will be the definition of the so-called “trigger event” (the event that must be reached for the adjustment to be initiated), which might also deviate from the regulation if it is supported by the taxpayer’s business particularities.
Finally, to mitigate risk, taxpayers should be prepared to invest more in intangible valuation and in the documentation of underlying assumptions, as well as in post-restructuring segment profit and loss (P&L) tracking.
