Valuing the transfer of functions between affiliated companies: Navigating controversies, German legislation and valuation principles

Deviating from the customary and internationally recognized principle of individual valuation has been a subject of debate for nearly two decades. CLA Global member firm DHPG examines the latest developments and references a specific case involving the transfer of production by a GmbH to subsidiary company founded in Bosnia-Herzegovina by the company’s managing director and sole shareholder.

According to the statutory provision (currently Section 1 (3b) AStG), in the event of a transfer of functions, the appropriate transfer price for the function as a whole is applied. This so-called transfer package includes the total of all individual assets that are the subject of the transfer, as well as other benefits, for instance synergies or positive goodwill.

Since its introduction, Germany’s transfer of function provisions have been regarded by experts as controversial, repeatedly leading to tax audit disputes. With little case law to reference, the first Federal Fiscal Court decision was issued recently dealing with elements of how to attribute value to transferred assets, as well as the ensuing legal uncertainties.

Case analysis: Relocating production abroad
This dispute concerns a German limited liability company (GmbH) active in a multi-stage production process involving labor-intensive cutting and machining processes. The parts made were primarily sold to the automotive sector.

As a result of high wages, in 2007 the GmbH faced strong pressure to establish a subsidiary and move production to Bosnia-Herzegovina. The labor-intensive production processes were outsourced to this company, with the GmbH company using its buying power to source and supply the Bosnian company with materials. These deliveries were processed as sales of materials.

On completion of the work, the products were sold back to the GmbH. Some of these products were semi-finished and shipped to Germany for further processing. Others were delivered direct to the end customer from the company located in Bosnia. In 2013, the Bosnia company started to generate its own sales, bypassing Germany and selling direct to customers.

Federal Fiscal Court judgement
After the tax office made the transfer price adjustments between both companies in the form of hidden profit distributions, the GmbH filed an action with the Munich Fiscal Court. The appeal subsequently lodged by both parties was successful; the Federal Fiscal Court overturned the judgement and referred the case back to the Fiscal Court for a hearing and decision.

Although the legal issue hasn’t been completely resolved, the Federal Fiscal Court's decision does provide some important insights for tax and transfer pricing practitioners:

• It reaffirms that Section 1 AStG only applies on a subsidiary basis to other income correction provisions (in this instance, hidden profit distribution) and also only applies if, and to the extent, that the other provision orders corrections to a lesser extent.
• It confirms that in the case of contract manufacturing, the supply of materials by the client and the repurchase of the finished products can be recognized as part of an overall assessment. Also, the material costs do not have to be included as non-value-adding costs in the assessment basis when applying the cost-plus method.
• In contrast to the tax authorities, the Federal Fiscal Court appears to assume a less detailed interpretation of the term "function". The Federal Fiscal Court only wants to regard production for a customer as a relevant function if this is regarded as independent production within the company; therefore making it an organic part of the company.
• Finally, the Federal Fiscal Court also comments on the consideration of location advantages and requires an allocation based on the respective functions performed, risks borne, assets used, and alternative courses of action, if realistically available. However, it remains unclear whether this involves a deviation from the statutory presumption of orientation towards the "mean value of the area of agreement".

Fiscal Court sets a precedence
It should be noted that this is the first time that the German Federal Fiscal Court has taken a position on controversial issues relating to the transfer of functions. From a company perspective, it is viewed as especially encouraging that the Federal Fiscal Court appears to interpret the essential criterion of "organic part" for the delimitation of a function in the sense of independence. Unfortunately, explanations on this topic remain rather brief.

Further decisions by the highest German tax court are likely to follow. An appeal to the Federal Fiscal Court is pending under case number I R 43/23.

The most recent revision of section 1 AStG occurred in 2021 with the Withholding Tax Relief Modernization Act. This incorporates concepts from the OECD such as the DEMPE approach. However, the most recent revision to the definition of what constitutes a function were published in 2023 and included in the Business function relocation ordinance as well as the general Administrative Principles on Transfer Pricing.

For further information
Benno Lange
Senior Partner
DHPG
https://www.dhpg.de/en/company/team/detail/benno-lange

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