Recharacterisation in transfer pricing audits: focus on Poland and Germany

Taxpayers are facing the reality that tax administrations are increasingly using recharacterisation as a (broad) concept to challenge the transfer pricing of individual intercompany transactions or entire transaction set-ups in tax audits.

One may argue that if the taxpayer is in the position to demonstrate a plausible commercial rationale for a transaction, this should suffice as a defence, from an arm’s-length perspective. Nevertheless, tax administrations increasingly question the commercial rationality and substitute it with their understanding of what a prudent business manager would have done, complemented by a gradual shift of burden of proof in certain circumstances based on local transfer pricing regulations.

Based on the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the OECD Guidelines) as an internationally accepted framework, the purpose and potential categories for the instrument of recharacterisation are outlined in this article. Following that, the focus will turn to the legal implementation and tax audit experience in Germany and Poland.

The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, 2010 clearly stated that, as a general rule, tax administrations should not disregard the actual transactions or substitute other transactions for them unless the requirements of two exceptional cases are met:

• Substance over form; and

• Lack of commercial rationality.

In the case of the former, tax administrations may recharacterise in accordance with the substance of the transaction. The latter refers to the case that a transaction viewed in its entirety lacks the commercial rationality of arrangements between unrelated parties and should be adjusted in a commercially rational manner.

This explicit general rule exception system was significantly modified in 2017. As an outcome of the BEPS process, the substance-over-form test, which used to be applicable in exceptional cases, was now directly implemented within the framework of the accurate delineation of a transaction based on the actual conduct of the parties. The term ‘recharacterisation’ was not explicitly mentioned any more. By interpreting contractual terms (only) as a ‘starting point’ and implementing the substance-over-form test as part of the regular delineation process, the bar seems to be significantly lower for tax administrations to challenge business arrangements based on a (mere) different interpretation of the actual conduct.

The circumstances triggering a discussion on recharacterisation can be manifold and there is an increasing amount of transfer pricing controversy cases internationally. For tax administrations, this approach is less burdensome than invoking general anti-avoidance rules (GAARs), which usually have much stricter requirements. In this context, the following groups of cases can be observed:

• Disregarding a transaction, commonly in the area of financial transactions; e.g., debt recharacterised as equity;

• Reduction or enhancement of certain functions and/or risk; e.g., to adjust the characterisation from a non-routine to routine entity or vice versa; and

• Modification of allocation of functions and risks between transaction partners to change the transfer pricing method; e.g., from cost based to a sales-based remuneration or profit split.

Based on the outlined framework, the focus will now turn to the legal implementation and recent tax audit experience in Poland and Germany.

Polish provisions introducing a direct legal basis for transfer pricing recharacterisation were implemented in 2019. Nevertheless, numerous attempts to use transfer pricing provisions for recharacterisation purposes by tax authorities were undertaken long before this date. There were several reasons for this.

Firstly, the Polish Ministry of Finance was of the opinion that the introduction of recharacterisation provisions did not constitute any substantial change in domestic rules. According to the supporting explanation to the Corporate Income Tax Act, the role of the new provisions was the mere “clarification and confirmation of the applicability of already existing instruments”. Before this date, tax authorities were already applying the arm’s-length principle for recharacterisation cases and drawing their conclusions from this general rule. However, the approach has been rejected by the Polish Supreme Court (decision dated June 9 2022, II FSK 2508/19). The Supreme Court clearly stated that the change of rules was significant enough to allow the application of the recharacterisation mechanism only after 2019.

Another reason for the lack of clarity in the application of recharacterisation provisions was the lack of a clear list of actions that should be regarded as a recharacterisation. In the case where, for example, debt is recharacterised into capital, it seems to be clear that the transaction has changed its ‘character’. However, do we always need to apply the recharacterisation provisions to arrive at such a conclusion? When undertaking a proper functional analysis, in line with the OECD Guidelines, we may come to the same result when analysing the comprehensive behaviour of the parties to the transaction, the reasons to conclude the transaction, and accompanying market conditions.

This precise line between amendments following usual functional analysis and recharacterisation is especially difficult to establish in cases that are a part of typical transfer pricing work and discussions.

Consider the case of a manufacturing entity that acquires management services and royalties from its group. The relevant tax authorities, following a thorough functional analysis of its operations, conclude that the entity is a routine contracted manufacturing company. A simple transactional net margin method (TNMM) remuneration (e.g., a non-transactional operating fee) is introduced, replacing the existing management services and royalties. Would it be a clear case of recharacterisation, since two transactions have been replaced by a different one? If yes, would it mean that in Poland, such an adjustment for the years before 2019 is not permissible, since the Supreme Court rejected the possibility to apply new provisions for previous fiscal years?

In the majority of cases, this question would be difficult to answer unambiguously. From practice, it may be observed that tax authorities tend to directly apply recharacterisation provisions for cases considered (by authorities) as intentional tax planning leading to BEPS. At the same time, discussions about the functional profiles of entities and various adjustments of transactions – even significantly changing their scope and pricing – where conducted within ordinary discussions, are usually based on general transfer pricing rules.

An additional factor complicating the issue is the overlapping character of various anti-avoidance provisions, leading to similar conclusions in many cases; e.g., a GAAR, targeted anti-avoidance provisions, a principal purpose test, and other domestic rules.

In Polish practice, an evolutionary change in the selection by the tax authorities of legal bases for assessments has been observed for years, concerning old ‘tax planning’ schemes. In such cases, tax authorities also undertake a kind of feasibility analysis, trying to maximise the chances of a ‘positive’ outcome of the proceeding in court, depending on the latest court rulings in similar cases.

Also, since the application of a GAAR in Poland has been centralised at the Ministry of Finance level and safeguarded by additional requirements, it is often easier for local tax authorities (from an operational point of view) to apply transfer pricing provisions and to claim distortions in the pricing of intragroup transactions, instead of initiating complex GAAR discussions.

An increasing level of technical sophistication among Polish fiscal auditors within the past few years has led to numerous discussions in various areas where the legal basis for a substantial change of a transactional set-up were directly recharacterisation provisions, or the transactions have been more or less modified based on general transfer pricing provisions. Some of these practical cases seen in tax audits are as follows:

• Change of debt into equity;

• Recharacterisation of short-term loans into long term loans, or the opposite;

• Recharacterisation of a deposit into an intragroup loan;

• Replacing transactional set-ups connected to trademarks with other transactions (e.g., royalty payments replaced by very low remuneration for administrative support) – mainly in old tax planning cases;

• Write-off of receivables into a donation without remuneration;

• Mezzanine financing into capital;

• Third-party transactions impacted at the group level – switch into a controlled transaction;

• A loan guarantee into capital contribution; and

• A change of full transactional set-ups following a functional analysis rejecting the declared functional profile of an entity.

In Germany, the line between recharacterisation/non-recognition and adjustment of income attributable to the parties’ actual transactions can also be blurred.

Germany has a GAAR based on a principal purpose test that is typically not used in transfer pricing audits. There are no explicit recharacterisation rules for transfer pricing cases in place. However, Germany's Foreign Tax Code was changed by introducing the development, enhancement, maintenance, protection, and exploitation (DEMPE) concept, as well as substance over form, stipulating that the decisive factor is the circumstances of the respective business relationship, in terms of economic substance; i.e., the business relationship that is actually conducted. Both changes were only introduced in 2021 (effective from fiscal year 2022).

Following the above-mentioned changes, the German Ministry of Finance issued new Administrative Principles Governing Transfer Pricing in July 2021, with an extended version to include guidance on the relocation of functions in June 2023. Although not binding for taxpayers and courts, they lay down the interpretation of the tax law and regulations by the German tax authorities and are of practical importance for taxpayers.

The Administrative Principles Governing Transfer Pricing introduce the OECD Guidelines as guidance for the tax authorities (they are an annex to the Administrative Principles Governing Transfer Pricing, including the process of accurate delineation) but provide additional guidance and clarifications. They are effective for all open cases without any grandfathering provisions.

Since they also encompass the DEMPE and control over risk concepts, the view of the tax authorities is that these concepts can be applied immediately, although the changes to the Foreign Tax Code may not have been effective for earlier tax audit years. The German tax authorities do not consider, for example, the DEMPE concept a substantial change but the codification of an economic approach/economic ownership that always had to be applied in transfer pricing cases (different from the situation in Poland, there has not yet been a decision of the German Supreme Court on retroactive application).

The Administrative Principles Governing Transfer Pricing stipulate that the arm’s-length principle does not only refer to the transfer price but also the basis and the underlying conditions of a transaction, such as prices, agreement periods, (re-)payment terms, conditions of performance, discounts or bonuses, price adjustment clauses, and options for amending and terminating contracts. Thus, the arm’s-length character of the transaction itself is first analysed and subsequently the arm’s-length pricing. However, the fact that certain conditions are not arm’s length does not automatically lead to a recharacterisation of the transaction. Rather, the overall circumstances of the individual case have to be taken into account.

In most cases that could be considered a recharacterisation, it can be observed that the German tax authorities do not refer to a recharacterisation but focus on a function and risk analysis, or other conditions of transactions that they intend to adjust (even though these adjustments may ignore contractual conditions of the transactions and lead to significant changes).

The reasonings for adjustments range from detailed write-ups of function and risk analyses by the tax authorities to the mere claim that certain conditions or set-ups are not at arm’s length according to the (industry) experience of the tax authorities. Tax authorities may amend or substitute the taxpayer’s function and risk analysis with their own interpretation in the delineation process and challenge the conditions of intercompany agreements, such as termination periods or agreement terms, individually as well as in combination (e.g., an undefined term together with a fairly short termination period).

Cases seen in tax audits include the following:

• Similar to Poland, there are quite a few cases regarding financial transactions:

  • Change of debt into equity;

  • Non-recognition of interest payments due to available cash pool funds; or

  • Change of ratings, term, etc. in loan agreements.

• Change of the function and risk profile of a German entity from a routine entity to a co-entrepreneur (and based on this, application of a profit split model versus the TNMM).

• Change of the function and risk profile of a German entity from an entrepreneur to a routine entity (e.g., to limit losses in Germany).

• Change of the function and risk profile of a German entity from a licensed manufacturer that is selling per the TNMM mechanism to distribution entities to a routine manufacturer with a TNMM remuneration (argumentation based on the decision making of the German entity versus the headquarters; substance over form).

Global businesses should ensure they have appropriate intercompany agreements and thorough documentation that accurately reflect the legal and economic substance of their transactions. The activities of the parties should be critically evaluated and matched against the intercompany agreements.

This includes accurately delineating the transactions, a function and risk analysis (including identifying the economically significant risks and control over risks), the economic circumstances, and business strategies, ideally with evidence of the actual conduct of the parties to the respective transaction. Meeting minutes, emails, memos, and other internal communications can demonstrate and support decision-making processes (and the allocation of control over risk).

For dispute resolution, a mutual agreement procedure (MAP) application may be more difficult as a consequence of a recharacterisation of transactions; for example, in the case of the above-mentioned licensed manufacturer as the transaction partner (e.g., the headquarters as licensor), the tax authorities’ opinion may have changed. In addition, while a MAP will generally resolve the issue of double taxation, it might not fully resolve the question of recharacterisation, and leave uncertainty for subsequent years.

Notwithstanding countries where transactions are subject to potential recharacterisation in tax audits, the process of discussion is always difficult and requires broad experience. The potential success of a taxpayer in the process is mainly connected to a knowledge of local administrative practices and local court rulings in similar cases, a thorough understanding of the respective industry, and the availability of business reasons and arguments for the conclusion of the transaction. Also, strategic considerations are key, to avoid accepting solutions leading to significant problems for future transactions or to the extension of audit findings to other fiscal years.

A MAP initiation or court litigation process does not always efficiently lead to a positive outcome; the proper selection of available procedures is essential. Tax authorities seem to gather experience from previous cases and often feel more comfortable in applying instruments of recharacterisation.

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