As part of the German Act to Modernise Withholding Tax Relief and Capital Gains Tax Certification (AbzStEntModG), the provisions on the arm's length principle have been restructured and adapted to the current OECD transfer pricing guidelines. In this context, the regulations on the transfer of functions were also revised and transferred to a new paragraph 3b of Section 1 of the German Foreign Tax Act (Außensteuergesetz). The resulting new version of the Functional Relocation Ordinance (FVerlV) of 18 October 2022 has been in force since 26 October 2022.

The new FVerlV introduces a number of stricter requirements and applies retrospectively to all completed transfers of functions for assessment periods beginning on or after 1 January 2022.

The aim of the new version of the FVerlV was to remove ambiguities, ensure greater legal certainty and, moreover, not to lead to any change in compliance costs. In reality, however, some of the extensive changes represent a significant tightening of the previous rules - with far-reaching consequences for taxpayers affected by the taxation of the transfer of functions. The main new rules and their practical implications for taxpayers are summarised below.

Redefinition of the term "relocation of functions"

The term " relocation of functions " is newly defined in Section 1 (2) sentence 1 FVerlV. According to this, a relocation of functions exists if a function including the associated opportunities and risks as well as the assets or other benefits are transferred. The previous rule required a simultaneous transfer or assignment of assets and other benefits. As a transfer of functions will generally only take place if it is advantageous, the new definition has significantly lowered the threshold for the existence of a transfer of functions and is likely to lead to increased discussion in the context of external tax audits.

In addition, the previous criterion of a restriction of the functions of the transferring entity is no longer a constituent element of a transfer of functions. It is now only a question of whether the receiving company is capable of performing the transferred or assigned function in whole or in part or of expanding an existing function. This represents a significant tightening of the rules and is also not in line with the OECD's view.

In addition, it is no longer necessary for a function to be transferred or ceded in its entirety; instead, a partial transfer or cession is sufficient to meet the definition of a transfer of functions. As a result, an increasing number of transactions that did not meet the definition of a transfer of functions in the past may qualify as a transfer of functions in the future.

Cancellation of exemptions

The previous regulation contained a number of negative definitions where no transfer of functions was presumed, including intra-group services and intra-group secondments (Section 1 (7) FVerlV old version). The explanatory memorandum to the new FVerlV states that the existing provisions ensure that there is no transfer of functions in the relevant cases. In practice, however, the removal of these restrictions may lead to considerable legal uncertainty, as a result of which a transfer of functions could be assumed even in cases that were previously explicitly excluded.

Elimination of escape clauses in the FTC

The deletion of two of the three existing escape clauses in Section 1 (3) FTC (old version) also represents a change to the detriment of taxpayers in the taxation of function transfers. In certain cases, individual transfer prices could be determined for the assets concerned instead of an income-based valuation of the transfer package. With the new version of Section 1 FTC, two of the three previous regulations have been repealed without replacement. However, it is still possible to dispense with the overall valuation of the transfer package under certain conditions if the taxpayer can credibly demonstrate that neither significant intangible assets nor other benefits were the subject of the transfer of functions.

Distinction between transfer for sale and transfer for use

Previously, in cases of doubt as to whether the transfer package or individual parts thereof were to be regarded as a transfer for sale or a transfer for use, a transfer for use could be assumed at the taxpayer's request (Section 4 (2) FVerlV old version). A transfer for use is advantageous for the taxpayer as it is generally more favourable than the valuation of the transfer package and the associated immediate taxation of the expected future profit. The so-called licence option, which is frequently used in practice, has been abolished without replacement. It was previously used in particular in cases where it was unclear whether all the criteria for a transfer of functions were met. The abolition of this provision, for which there is no longer any justification, is likely to lead to increased discussions in the context of external tax audits regarding the release of existing hidden reserves in the case of transferred assets.

Aspects to be considered when evaluating the transfer package

• In future, the valuation of the transfer package will have to take into account transfer-related tax and amortisation effects (§ 2 sentence 1 FVerlV). The so-called exit tax and the so-called tax amortisation benefit can significantly influence the minimum and maximum price in the valuation of the transfer package. The new FVerlV thus merely enshrines in law the view of the tax authorities, already expressed in the BMF letter of 13 October 2010 (Admnistrative Principles on busines function relocation), that tax effects must be taken into account in the valuation of the transfer package.
• When determining the capitalisation interest rate, a risk premium derived from the capital market must be taken into account in future (Section 4 FVerlV). The risk premium must be determined on an arm's length basis, i.e. it must correspond to the risk premium that third parties would use in a comparable transaction. The company-specific risk situation is no longer taken into account, which will have a significant impact on the respective present value calculation and thus on the overall valuation of the transfer package. Simplified approaches to determining the capitalisation rate, which have been widely used in the past, will no longer be applicable. This will also increase the administrative burden, as the determination of risk premiums customary for third parties in the planned form will be more time-consuming and in many cases may no longer be possible without consultation.
• When determining the present values for the transfer package, a unlimited capitalisation period is still generally assumed. The capitalisation period can only be shortened if the taxpayer can provide evidence of such reasons (Section 5 FVerlV). Whereas the previous version of the FVerlV only required the taxpayer to provide credible support for a limited capitalisation period, the taxpayer is now required to provide evidence. This tightening of the burden of proof to the detriment of the taxpayer may in individual cases lead to a significant increase in the transfer package and thus to an increase in the tax burden for the taxpayer.

Cancellation of the regulation on the temporary relocation of functions

As a result of the abolition of the regulation on the temporary transfer of functions (assumption of a function), it must be examined in each individual case whether a transfer of functions is involved (Section 1 (2) sentence 2 FVerlV old version). This can be disadvantageous for the taxpayer, as the time limit for the valuation of the transfer package generally has a tax-reducing effect for the transferring company, as the present value of the financial surpluses is lower with a shorter capitalisation period.

Application of the FVerlV for permanent establishment cases

The new version of the FVerlV clarifies that the provisions on the taxation of the transfer of functions also apply to transactions between a taxpayer's parent company and its permanent establishment located in another country (Section 8 of the FVerlV). Therefore, if a function is transferred from the domestic parent company to a foreign permanent establishment, the relevant provisions of the FVerlV must be observed.

Expected practical implications

The new version of the FVerlV leads to some tightening and also to new legal uncertainties. Of particular note is the redefinition of the transfer of functions, which is likely to result in more cross-border transactions being classified as transfers of functions in the future. In addition, it is explicitly clarified that the new FVerlV also applies to permanent establishments. The abolition of the licensing option will also be of great practical importance. There are also a number of changes to be considered when assessing the transfer package. In particular, the partial introduction of a burden of proof instead of the option of prima facie evidence leads to an increase in the burden of proof and represents a significant change to the detriment of taxpayers.

New legal uncertainties arise in particular from the removal of previous clarifying provisions, such as the absence of negative delimitations. The deletion of two escape clauses in the new Section 1 AStG also removes further relief for taxpayers.