Global Tax Alert (News from Transfer Pricing) | 9 March 2017

German Ministry of Finance issues final version of Administrative Principles on the Profit Attribution to Permanent Establishments

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Executive summary

The German Ministry of Finance (BMF) has issued the final version of the Administrative Principles on the Profit Attribution to Permanent Establishments (Administrative Principles). The Administrative Principles include 168 pages of details and clarifications concerning the application of the Authorized Organisation for Economic Co-operation and Development (OECD) Approach (AOA)1 as required by Section 1, subsection 5 of the Foreign Tax Act (FTA) and the Regulation for the Profit Attribution to Permanent Establishments (PE Regulations). The Administrative Principles have an indirect impact on the taxpayer as they reflect application guidance for the German tax authorities only. (The legal provision in the FTA and the PE Regulations, as contrasted with the Administrative Principles, have a direct binding impact on the taxpayer.) The Administrative Principles represent the typical third element in the German tax legislative process. Although not binding to the taxpayer, the Administrative Principles, as additional support for the interpretation and illustration of the legal provisions, are of significant importance for the taxpayer in practice.

It should be noted that the final version of the Administrative Principles only contains minor deviations from the draft version published on 18 March 2016.

This Alert summarizes the key content of the Administrative Principles. Specific rules for profit attribution to permanent establishments (PEs) of banks and insurance companies as well as construction and exploitation sites are not covered.

Detailed discussion

Autonomous profit determination for PEs treated as fully separate entities in several steps

The PE has to be hypothesized as a separate and independent enterprise in order to apply the arm’s length principle for the profit determination of PEs according to Section 1, subsection 5 FTA. The following steps are required:

  • Performance first of a function and risk analysis for the business activity of the PE.
  • Based on the functions performed, assets owned or used, opportunities and risks assumed, significant people functions (not natural persons/employees) are identified and allocated to the head office or PE. Assets, opportunities and risks, an appropriate share in the free capital and other liabilities are attributed to the head office or PE based on the identified significant people functions accordingly. Eventually, business relationships with other entities as well as with related parties have to be allocated. Transfers of assets between the head office and its PE – even if a fictitious transfer – have to be considered following standard German tax principles and may require to be considered at fair market value.
  • From a legal perspective, contractual relationships between separate parts of the same enterprise are not possible. Following the separate legal entity approach in German tax law, cross-border transactions between a PE and the remaining parts of the enterprise constitute a so-called “assumed contractual relationship” (similar to the OECD wording “dealing”). Such dealings include but are not limited to the supply of goods, a service provision and even licensing arrangements. The transfer price has to be determined by means of a comparability analysis and is to be based on domestic and internationally accepted transfer pricing regulations following the arm’s length principle.
  • The domestic PE of a foreign entity as limited German taxpayer or the foreign PE of a domestic entity as unlimited German taxpayer has to prepare an “auxiliary calculation” on a financial year basis following the steps described above. Based on the final auxiliary calculation (to be updated during the fiscal year), the income attributable to the PE can be determined at the end of the fiscal year. It is now explicitly clarified that profits as well as losses can be attributed to a PE notwithstanding the total result of the enterprise. Generally, the auxiliary calculation is to be prepared analogously to a financial statement consisting of balance sheet and profit and loss statement.

Overview of key aspects of the Administrative Principles

In the Administrative Principles, the German Tax Authorities describe in detail their perspective of the correct application of the above-mentioned attribution rules by means of examples and associated calculations including certain definitions for terminologies used in the German law, the PE regulations and the Administrative Principles.

For the attribution of assets, etc. to a PE respectively to the remaining enterprise, the structure of the Administrative Principles is that first a basic principle is defined, then deviations from the basic principle are further explained and alternative principles are established to solve cases of doubt in line with the Administrative Principles.

The following outlines certain key aspects of the new PE regulations including the Administrative Principles and also indicates where these deviate from the previous (rather limited) guidance in German tax law for determining the profit allocation between a PE and its head office. Also listed are areas to note that may assist in determining key aspects of these new rules depending on the specific facts and circumstances.

Significant people functions independent of hierarchy and formal decision-making competency and basic attribution rules for assets
  • The determination of the significant people functions performed by a PE and its head office is fundamental for the attribution of assets, liabilities and capital (i.e., profits).
  • Whether a people function of a PE is considered significant needs to be determined on the basis of the specific underlying facts and circumstances.
  • A people function that is not part of the business activity of the PE and is performed only for a short period (less than 30 days) is generally not considered significant.
  • According to the Administrative Principles the reference of a people function to a specific asset is generally the key determinant of its significance and not the hierarchy level and formal decision-making competency (e.g., strategic board decision). Likewise, people functions with merely a supporting nature are not significant.
  • In the example mentioned in the Administrative Principles the people function of “actual planning of a project” is considered significant whereas the formal approval by the board is considered formal in nature, only, and therefore less significant.
  • In certain cases e.g., where a personal function is executed simultaneously or together with different people in different PEs, a clear attribution of an asset, etc. to a PE and its head office may not always be possible.
  • Generally the Administrative Principles state that one should attribute an asset to the PE or the head office based on the most significant personal function considering the actual facts and circumstances (qualitative and under certain circumstances quantitative criteria to be applied).
  • Essentially this means in situations of doubt, the taxpayer is given a certain discretion in attributing the asset. For example, for tangible assets such cases can result in an attribution deviating from the place of use (e.g., toll manufacturing).
  • Additionally, such attribution has to be substantiated and properly documented.
  • The decision with respect to the attribution has to be taken into account for the preparation of the “auxiliary calculation” as basis for the tax return and should ideally be consistent with the attribution for purposes of the income taxation abroad.
  • Also, each asset needs to be attributed to either the PE or the head office. Any additional people function may trigger additional intercompany transactions or dealings.
Additional attribution rules for intangible assets
  • The attribution of intangible assets follows primarily the people function that is responsible for the creation or acquisition and actively manages and controls the associated risks (i.e., not just formally involved in approval).
  • The people function with respect to the use, management, further development and protection of the intangible asset is only considered of secondary importance.
  • Contrary to material assets, in cases of doubt a pro-rata attribution of the intangible asset has to be assumed.
  • The attribution of intangible assets can be challenging. Particularly, where research and development activities are carried out in mixed teams being part of different PEs or legal entities and the significant people have overlapping responsibilities. The Administrative principles and PE regulations do not address various other related income tax issues in this regard, as such performing research and development activities in a PE structure resulting in significant intangible assets constitutes a significant risk of double taxation.
Attribution of participations and investments
  • Participations or investments are attributed with respect to their functional relationship to the business activity of the PE or other parts of the enterprise primarily according to qualitative aspects.
  • This is a significant change to the previous German law where the central function of the head office was considered “significant” and all participations and investments were primarily attributed to the head office.
Attribution of endowment capital
  • Deviating from general accounting principles for legal entities, the endowment capital (pro-rata equity to be attributed to the PE) has to be determined based on specific rules and is in particular not determined as a residual figure.
  • An asymmetric approach is stipulated in the German law, i.e., different methods are applicable in the determination of the capital attributable to domestic and foreign PEs.
  • The capital allocation method has to be applied for domestic PE’s while for foreign PEs the application of the minimum capital method is required.
  • This is a deviation from the previous PE regulations and attribution mechanism in Germany where the endowment capital was considered a residual figure. Also this area is of particular interest for companies with highly leveraged business operations for whom the attribution of tax deductible interest expenses is key to avoid double taxation.
Assumed Contractual Relationships (“Dealings”) and Comparability Analysis
  • From a legal perspective, contractual relationships between separate parts of the same enterprise are impossible. Instead, cross-border transactions between a PE and the remaining parts of the enterprise constitute a so-called “assumed contractual relationship” or “dealing” that has to be remunerated on an arm’s length basis.
  • Such dealings are identified by a detailed analysis of functions performed and risks assumed by the PE or other parts of the enterprise and include, but are not limited to the purchase and sale of tangible goods, rental and lease arrangements, service provisions and licensing arrangements of intangible assets.
  • The Administrative Principles stipulate certain minimum standards for a dealing and refer to an actual and identifiable occurrence (economic event) regularly related to certain people functions and which is significant enough to assume that third parties would have concluded contractual relationships or claimed a certain right.
  • Cost pooling arrangements in line with the respective German administrative principles2 are explicitly accepted as “dealings,” whereas finance transactions (e.g., loans and guarantees) between different parts of the same enterprise are explicitly excluded as “dealing.”
  • For the identified dealings, transfer prices have to be determined in line with the arm’s length principle based on the generally acceptable transfer pricing methods, i.e., prices include a profit element instead of a mere cost allocation as required by the previous German PE regulations. This may result in a changed profit attribution between the PE and the remaining enterprise as a result of fictitious business income and business expenses. Consequently, a PE can be profitable or loss making, irrespective of the income of the enterprise it belongs to.
  • The identification and final assessment of dealings can be rather difficult in practice, e.g., a change in attribution of an asset between different parts of the enterprise can result in realization of built-in gains in the asset, i.e., result can be the taxation of a fictitious business income without corresponding revenue and cash flow.
  • It is also important to note that a change in attribution of profits may trigger the German transfer of function regulations due to the start of a permanent activity in a PE by an employee who previously performed the same activity for the head office.
  • The lack of written agreements for dealings often raises questions, as such documentation of certain dealings in written intercompany policies should be considered.
Preparation of “auxiliary calculation” required
  • For financial years beginning after 31 December 2014, a taxpayer has to prepare an “auxiliary calculation” on a financial year basis (at the latest on the respective tax return filing date) for purposes of the determination of taxable income.
  • Such auxiliary calculation is prepared with respect to the assets, the capital, the remaining liabilities and the revenues and expenses attributable to the PE including deemed revenues and expenses resulting from internal dealings (calculation of taxable income of the PE). As such, the auxiliary calculation is a schedule of assets and liabilities as well as income and expenses (similar to a balance sheet and a profit and loss statement).
  • The Administrative Principles do not provide a template for the auxiliary calculation but include certain simplifications regarding form and extent that can be applied by the taxpayer under certain conditions.
Additional transfer pricing documentation requirements for PEs
  • In addition to the general German transfer pricing documentation requirements, a taxpayer that operates a PE in Germany is required to document the reasons for the respective attribution decision with regard to the positions of the auxiliary calculation as well as reasons for the assumed contractual relationships (dealings) including the associated treatment abroad.
  • German transfer pricing documentation is only to be submitted to the tax authorities upon their request, which usually occurs in a tax audit context. However, from a practical perspective, preparation of the documentation simultaneously with the tax return for which the auxiliary calculation is prepared is recommended in order to avoid inconsistencies and make best use of any discretion available to the taxpayer. Furthermore, the burden of proof is with the German tax authorities assuming appropriate documentation in line with the specific PE Regulations can be presented.
  • The legal deadlines for the preparation of transfer pricing documentation remain unchanged, but the auxiliary calculation as basis for the tax return and the related decisions made with respect to the respective attributions cannot be changed at a later point in time when the German transfer pricing documentation is typically prepared. In practice, this requires an adaption of the documentation process from a documentation process that was rather in a tax audit context to a more contemporaneous documentation process.
Other important areas of note in the Administrative Principles
  • Relation of Section 1, subsection 5 FTA to double tax treaties: The Administrative Principles clarify that the application of the AOA following Section 1, subsection 5 FTA (domestic tax principles only), allows the taxable income of a German taxpayer to be increased only. However, if the AOA is applied following an applicable double tax treaty (international tax principles), the taxable income of a German taxpayer could be increased but also be decreased.
  • Application to partnerships: The Administrative Principles clarify that the PE profit attribution principles under the AOA do not apply to the determination of profits of a PE created through a partnership for its partners under a double tax treaty. However, the rules apply for PEs that a partnership itself operates in another jurisdiction.
  • Start-up costs and income and expenses after its termination are not attributable to a PE: According to the Administrative Principles, start-up costs of a PE (due to lack of people functions) which arise before the establishment of a PE as well as income and expenses incurred after the termination of a PE (due to the fictitious assumption that all assets and dealings are sold to the remaining enterprise at the termination date) cannot be attributed to the PE and consequently are to be borne by the remaining enterprise.
  • Credit Rating: A PE has the same credit rating as the remaining enterprise.
  • Permanent representative PEs: According to the Administrative Principles, the provisions of the AOA can analogously be applied on permanent representatives as these typically establish a representative PE. The Administrative Principles generally assume the allocation of a “zero result” to a representative PE in situations where a legally independent entity operates as permanent representative on behalf of another enterprise. This shall be different for the establishment of a representative PE in particular by an own employee in the other country and is in line with the most recent OECD discussion draft with respect to Action 7.3

The three-tier structure of the domestic AOA implementation results in the following step-by-step application:

  • Section 1, subsection 5 FTA is fully applicable for financial years beginning after 31 December 2012.
  • The PE Regulation (auxiliary calculation, endowment capital, liabilities, financing expenses, etc.) applies for financial years beginning after 31 December 2014.
  • Accordingly, the Administrative Principles apply as a clarification of the PE Regulation for financial years beginning after 31 December 2014.

The initial application of the AOA may lead to changes in the attribution of assets to a PE and its head office compared to the previous regulations. This may potentially trigger a taxation of fictitious capital gains. Should this be the case, a taxpayer might be able to apply for certain simplification measures if all conditions were fulfilled.


With the implementation of the AOA into domestic law and the finalization of the Administrative Principles as application guidance for the German tax authorities, higher scrutiny is to be expected in future tax audits of PEs. This is particularly true given the changing international regulatory landscape with a significantly lower threshold to establish a PE (see also OECD Base Erosion and Profit Shifting (BEPS) Report with respect to Action 7). Hence, taxpayers should consider the following:

  • For existing PEs, one should perform an AOA review to examine whether the PE profit determination complies with the German PE Regulations for all financial years beginning after 31 December 2012 and whether applications are necessary in order to benefit of certain simplification measures.
  • To manage exposure of potential double taxation, a special focus should be put on situations where the German PE regulations deviate from the OECD regulations, in particular asymmetric determination of endowment capital for domestic and foreign PEs, attribution of liabilities and areas of doubt. It might be helpful to discuss in advance any identified potential double taxation risk with the respective tax authorities.
  • The comprehensive documentation requirements demand the timely implementation of efficient processes to ensure proper attribution decisions can actually be made (to the extent possible for a taxpayer), for the preparation of the auxiliary calculation and the transfer pricing documentation. The underlying attribution decision including the function and risk analysis should be documented carefully and contemporaneously for tax return preparation purposes of the PE. This should support the taxpayer in a future tax audit to assign the burden of proof to the German tax authorities as well as to limit the room for interpretation with respect to the underlying attributions.
  • In addition, the establishment of internal policies and guidelines with respect to internal dealings and the profit determination for the PEs including the governance of the documentation processes and responsibilities is advisable.


1. The AOA is already implemented in Sec. 1 para. 5 of the Foreign Tax Act and the Regulation for the Profit Attribution to Permanent Establishments.

2. German Federal Ministry of Finance, Administrative Principles for the Examination of Income Allocation in the Case of Internationally Related Enterprises with respect to Cost Pooling Agreements, 30 December 1999.

3. Public Discussion Draft, BEPS Action 7, Additional Guidance on the Attribution of Profits to Permanent Establishments, 4 July – 5 September 2016.

For additional information with respect to this Alert, please contact the following:

Ernst & Young GmbH, Düsseldorf
  • Oliver Wehnert
    +49 211 9352 10627
Ernst & Young LLP, EMEIA Transfer Pricing, New York
  • Maren Holtz
    +1 212 773 5820
  • Ronny Waldkirch
    +1 212 773 9192

EYG no. 01071-171Gbl