Germany introduces changes to Foreign Tax Code

The German Federal Council (Bundesrat) on 26 March adopted an amendment to section 1 of the Foreign Tax Code – the relocation of functions article – as part of the "Act for the implementation of tax related EU-guidelines and for the amendment of other tax provisions."

With the corporate tax reform act of 2008, the German legislature enacted a tax on cross-border business restructurings, or the so-called relocation of functions, in section 1 of the Foreign Tax Code (Außensteuergesetz, AStG). This was followed by a binding decree law, issued on August 12, 2008, to further explain section 1 and to ensure consistent application of the law and compliance with international principles concerning income allocation. Given the complexity of the issue, the German Federal Ministry felt it necessary to provide further guidance in terms of administrative principles; that guidance was published as a first official draft in an extensive 72-page document in July 2009 (cf. Kroppen/Rasch, BNA Tax Planning International – Transfer Pricing 10/09). As a result of the most recent amendment to section 1 Foreign Tax Code, the draft administrative principles of July 2009 were put on hold.

With the election of the new Federal Parliament in September 2009, however, a reevaluation of section 1 was undertaken: the new administration had decided that the "negative consequences" of the 2008 rules – particularly in respect of R&D activities – must be reversed. Thus, the governing coalition on 25 January 2010 issued a draft amendment to section 1 that was approved by the lower house of the German parliament on 5 March 2010 and that deals with the following issues.

One issue that has raised the most concern regarding Section 1 legislation is the so-called transfer package approach. According to the legislation, in case of a relocation a transfer package consists of a relocated function and its associated chances and risks, as well as the assets and advantages the transferring enterprise transfers in conjunction with the function and the services performed in this regard. The basic rationale of section 1 is that a third party would only be interested in taking over a function as a whole, and the profit potential as well as any potential goodwill associated with the relocated function, but not in acquiring separate tangible or intangible property.

The new administration has reviewed this aspect and basically suggesting introducing an additional exception to section 1 whereby taxpayers should be able to avoid the transfer package evaluation. If the taxpayer lists at least one significant intangible transferred in a business restructuring, the amendment of Section 1 Foreign Tax Code provides that the taxpayer may evaluate the transferred assets on a single asset basis excluding a residual value such as goodwill associated with the transferred assets, thus avoiding the transfer package approach. It seems that this amendment would lead to a reversal of the valuation approach introduced in the 2008 corporate tax reform act, as the transfer package approach would no longer constitute the standard, but rather the exception.

However, it remains to be seen whether and how the German Federal Ministry of Finance will interpret the change in law. Although the amendment of section 1 Foreign Tax Code should generally reduce the taxpayers' time and effort in evaluating a compensation for a transfer of functions, according to reports representatives of the Federal Ministry of Finance are raising doubts whether the evaluation on a single asset basis actually excludes a residual value such as goodwill. Therefore, further guidance from the Federal Ministry of Finance is to be expected that will hopefully provide legal certainty in this respect.

The changes in section 1 Foreign Tax Code become effective retroactive to 1 January 2008.