Function relocation

There was a legal definition of the term “function relocation” in section 1 sub-section 3 Foreign Transaction Tax Act (AStG) in its version valid until 31st December 2021. However, in this form, it was not very helpful in practice. This legal definition is no longer contained in the version which took effect on 1st January 2022. In contrast, the revised section 1 sub-section 3b AStG for the first time provides a legal definition of the term of a “transfer package” as a relocation of the function as a whole. In its reform, the legislator only wanted to implement an editorial adjustment with this reform, cf. Bundesrat printed document 50/21, p. 81.

However, the starting point for every income adjustment was and continues to be section 1 sub-section 1 AStG. This section governs the correction of income from border-crossing business relationships first in general and establishes the applicable principles. In this context, the internationally accepted arm’s length principle is used as the benchmark for income correction. In accordance with this, in business relationships between related persons, the transfer prices have to be determined in the same manner in which these would have been determined in a transaction between independent third parties.

In the event of a function relocation, this principle is applied to such a degree that the transfer price on which a relocation of the function is based is determined as a whole (transfer package). In contrast, in the event of the exclusive change or transfer of use of assets and the provision of services, the transfer price is determined as an individual price.

According to section 1 sub-section 3b AStG, a function relocation applies if a function, including the appertaining chances and risks as well as the transferred or provided assets or other advantages are transferred as a whole (transfer package). The rough definition under section 1 sub-section 3b AStG is supplemented by section 1 sub-section 2 Function Relocation Ordinance (FVerlV). According to this, the transfer of the function must be effected from one company (transferring company) to another, affiliated company (acquiring company). In addition, the function previously carried out at the transferred company must be restricted.

(Note: section 1 sub-section 2 FVerlV refers to section 1 AStG, old version, the relevant reform is still pending).

A function duplication, the exclusive sale or transfer of the use of assets as well as the provision of services are different from a function relocation if these are not part of the function relocation, section 1 sub-sections 6 and 7 FVerlV. 

However, the definition of a function relocation according to section 1 sub-section 3b AStG, section 1 sub-section 2 FVerlV does not consider the profit expectations of the transferring company; this means the question of whether profit expectations increase or decline because of the function relocation at the transferring company is not material, cf. BMF letter dated 13th October 2010, margin number 20.

The above-mentioned BMF letter lists types of function relocations as examples. In the opinion of the fiscal administration, this, e.g., includes:

• conclusion of the work of a fully fledged manufacturer and a related relocation (cf. BMF letter dated 13th October 2010, margin number 201 f).
• Switch from a fully fledged manufacturer to a contract manufacturer (cf. BMF letter dated 13th October 2010, margin number 203 ff.)
• Switch of production to a contract manufacturer (cf. BMF letter dated 13th October 2010, margin number 206 ff.)

If a function relocation applies, a transfer package (which usually increases profits) has to be calculated as a rule in the framework of the profit determination.

In accordance with section 1 sub-section 1 FVerlV, a function is a “... a business activity consisting of a number of similar operational tasks which are carried out by certain offices or departments of a company.  It is an organisational part of a company; however, it does not have to form a corporate division in a tax sense.”

Therefore, a function only constitutes a division of the overall entrepreneurial task. In this context, the question of whether this division exclusively contributes to the company’s value creation is not material.

The following can be functions within the meaning of foreign transaction tax legislation:

• Research and development
• Distribution
• Production
• Administration
• Marketing

A more comprehensive (albeit not conclusive) list of the different functions is provided in the BMF letter dated 13th October 2010 under margin number 15.

It must be possible to separate the respective function from the remaining business activity and it must have a certain level of commercial independence.  In this context, the definition has to be made with regard to activities and assets with the help of the used assets and of the opportunities and risks connected with the function, cf. BMF letter dated 13th October 2010, margin numbers 16 and 18.

The definition of a related person is in line with section 1 sub-section 2 AStG. According to this, both affiliated companies and commercial units can be affiliated persons. According to section 1 sub-section 2 no. 1 lit. a) AStG, every direct or indirect shareholding in a foreign legal entity or a foreign commercial unit which amount to, at least, 25 percent has to be qualified as a related person.

This applies accordingly if a taxpayer is entitled to, at least, 25 percent of the profit or liquidation proceeds of another taxpayer (section 1 sub-section 2 no. 1 lit. b) AStG) or has controlling influence (section 1 sub-section 2 no. 2 AStG).

Other case designs concern shareholdings of an unrelated third party in unrelated companies which are material for the external third party in each case (shareholding level of, at least, 25 percent; section 1 sub-section 2 no. 3 lit. a) AStG)) and/or said party can actually exercise direct or indirect controlling influence (section 1 sub-section 2 no. 3 lit. b) or is entitled to a claim of 25 percent of the profits or liquidation proceeds (section 1 sub-section 2 no. 3 lit. b AStG). In the above-mentioned cases, these companies are treated as related persons.

Independently of the amount of the direct or indirect shareholding, the law defines persons as related in as far as, in agreeing on the terms of a business relationship typical of goods or services, one person can exercise influence on one or both companies outside their specific business relationship - or if one of the companies has its own interest in the other company’s income generation (art. 1 section 2 no. 4 AStG.)

A function relocation is based on the precondition of a restriction or discontinuation of the respective function concerned at the transferring company. This is indicated by a reduction in staff or the transfer of tangible and intangible assets.

Example: A company based in Germany (transferring company) transfers its entire phone service to an affiliate based in Spain (acquiring company).

If all other preconditions for a function relocation are fulfilled according to section 1 sub-section 2 FVerlV, a check also needs to be carried out as to whether a function duplication according to section 1 sub-section 6 FVerlV applies. If this is fulfilled, the legal consequences of a function relocation do not apply.

A function duplication applies if the take-up of a function by a related company does not lead to a restriction of this function at the company which has performed this function previously. This applies, e.g., if production is launched abroad and the current production is continued without any changes within the country. In this process, the question whether there has been a restriction of the function at the current company or whether the function is continued without any changes has to be examined for a period of five years, section 1 sub-section 2 sentence 3 FVerlV and BMF letter dated 13th October 2010, margin number 49.

There is a negligibility provision (reduction in sales because of the restriction of the function of less than EUR 1 million during a five-year period) for minor restrictions at the transferring company, cf. BMF letter dated 13th October 2010, margin no. 48 ff.

If assets were transferred or provided for use and if services were performed in the context of the function duplication, arm’s length transfer prices have to be assessed for these individual services.

As a rule, the exclusive sale or provision of assets for use and the provision of services do not constitute a function relocation.  However, the transfer pricing principles have to be applied with regard to the respective business transaction.

If, in contrast, the sale of assets or their transfer for use and the provision of services transfer a function, the business transaction as such constitutes a function relocation.

If a new business activity is launched, a function relocation does not apply. Background: A function which has not existed before cannot be relocated or restricted; the precondition and restriction of a function constitute preconditions for a function relocation, section 1 sub-section 3b AStG, section 1 sub-section 2 FVerlV.

In principle, a function relocation can also apply if the acquiring company only assumes the function concerned on a temporary basis, section 1 sub-section 2 sentence 2 FVerlV. There is, however, a negligibility limit, cf. BMF letter dated 13th October 2010, marginal numbers 49, 58.

Example: If a foreign subsidiary is temporarily integrated for the production of a product for capacity reasons and if the sales of the domestic company decline by less than EUR 1 million, a function relocation does not apply. As a result, the foreign subsidiary’s assumption of the production has to be compensated at arm’s length.

If a function relocation applies, the function shall be assessed as a whole (transfer package). This transfer package comprises all opportunities, risks, assets, services and benefits of the function relocation. In addition, any possible profit potential is also covered, section 3 sub-section 1 FVerlV.

In line with the assessment of transfer prices, the assessment of transfer packages is also made on a step-by-step basis, cf. BMF letter dated 13th October 2010, margin number 61 (Here, we make reference to our article “Transfer prices”, sub-section: “How are transfer prices established (standard methods)?”):

1. Step: Actual arm’s length comparison with values which can be compared without restriction
2. Step: Actual arm’s length comparison with values which can be compared to a limited degree
3. Step: Hypothetical arm’s length comparison

If, in practice, transfer packages cannot be compared, a hypothetical arm’s length comparison is carried out as a rule. Net-present-value-based procedures, e.g. according to IDW S 1 or IDW S 5, which also considers future profit potential, are suitable as common assessment procedures, cf. BMF letter dated 13th October 2010, margin number 87 ff. The profit potentials must be established in function and risk analyses to be carried out both for the transferring and the acquiring company, cf. BMF letter dated 13th October 2010, margin no. 83.

The minimum price determined by the relocating company and the maximum price established by the acquiring company (each in line with the above analysis) form the agreement range. The price which can be reached with the highest likelihood has to be selected from within this range. If no such value can be credibly demonstrated, the mean value of the agreement range shall be used, cf. BMF letter dated 13th October 2010, margin no. 128 ff.)

In deviation from the principle of the assessment of the function as a whole, an individual assessment can also be carried out, section 1 sub-section 3b sentence 2 and 3 AStG. This is based on the precondition that

• intangible assets or other advantages do not constitute the subject of the function relocation,
• the relocated function is only performed for the transferring company and
• the fee for performing the function is established according to the so-called cost-plus method.

The amendment of the law of 1st January 2022 comprised a tightening of the provision regarding the individual assessment according to which only the provision referred to above applies, in addition to the editorial amendment.  Under the legal situation applicable until 31st December 2021, there were other possibilities under which an individual assessment was possible under certain preconditions: On the one hand, if the total of the individual transfer prices assessed for the assessment of the transfer package as a whole corresponds to the arm’s length principle and, on the other hand, if it can be credibly demonstrated that, at least, one essential intangible asset is the subject of the function relocation and if this can be precisely specified, cf. section 1 sub-section 3 sentence 10 alt.  2, 3 AStG old version.

In addition to the general duties of cooperation according to section 90 sub-section 1 AO [Fiscal Code], there are further duties of cooperation:

• Extended duties of cooperation for border-crossing situations according to section 90 sub-section 2 AO; these comprise the obligations to investigate facts, to procure evidence and to ensure evidence as well as special duties to provide explanations and insurance, under certain circumstances.
• Documentation and submission obligations for business relationships with related persons based abroad according to section 90 sub-section 3 AO; the documentation has to contain the type and content of the business relationship as well as the commercial and legal bases which confirm compliance with the arm’s length principle.

Function relocations constitute unusual business transactions within the meaning of section 90 sub-section 3 sentence 8 AO and, therefore, such have to be documented promptly within a period of 30 days after the request by the fiscal authority. With regard to the documents to be created and submitted in the framework of a field audit, we make reference to the BMF letter dated 13th October 2010, in particular margin no. 157.

In section 162 sub-sections 3 and 4 AO, the legislator has established various sanctions depending on the type and severity of the violation of the documentation and submission requirement:

• Section 162 sub-section 3 sentence 1 AO: Refutable assumption of the existence of higher income than declared by the taxpayer (reverse onus and authority to estimate ),
• Section 162 sub-section 3 sentence 2 AO: Authorisation to use the estimate framework to the disadvantage of the taxpayer,
• Section 162 sub-section 4 sentence 1 and 2 AO: Penal surcharge of 5 to 10percent of the income correction, however, at least EUR 5,000,

Section 162 sub-section 4 sentence 3 AO: Default fine of at least, EUR 100 per day and transaction; the ceiling is EUR 1 million

In the case of a border-crossing function relocation abroad, the profit potential is also taxed - in contrast to a purely national situation or a function relocation to a domestic location; in this respect, the statutory provisions for the assessment of the transfer package exceed the internationally approved arm’s length principle. This could stop companies from transferring functions performed domestically to related foreign companies. Therefore, the conformity of the legal situation with European Union law has to be called into question. In any case, a restriction of the freedom of establishment according to art. 49 and 54 TFEU might apply.  Justifications for this restriction cannot be discerned.

This results in parallels to profit realisation in the framework of exit taxation with regard to which the ECJ established incompatibility with EU law (ECJ of 11th March 2004, case no. C–9/02). In its ruling, the ECJ explains that freedom of establishment bans taxation on grounds of exit since this can deter the taxpayer from moving to another member state. If the provisions regarding the function relocation correspond to the internally accepted arm’s length principle and would only specify these in more detail, the provisions on the function relocation might be in line with EU law, cf. ECJ ruling of 21st January 2010, file no. C-311/08. However, the rules regarding the function relocation exceed the arm’s length principle since the profit potential is taxed.