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In June of this year the OECD Tax Committee approved a new chapter VIII on cost contribution arrangements for addition to the 1995 OECD Transfer Pricing Guidelines. This has refocused attention on cost contribution arrangements (CCAs) as an instrument for the development of intangible assets. Three months prior to the OECD action, Professor Berndt R. Runge, a senior official in the German Federal Ministry of Finance who represents Germany vis-a-vis the OECD, published an article in Intertax entitled "The German View of Cost Contribution Arrangements". The similarities between the new OECD chapter on CCAs (cited below as "OECD Ch. VIII" with paragraph number) and Professor Runge's article indicate certain changes in the German position on CCAs. At the same time, it is evident that considerable differences continue to exist between the OECD/German approach and that taken by the United States in the final regulations on CCAs which it published in December 1995 (U.S. Reg. sec. 1.482-7). The current German regulations on CCAs are found in section 7 of Germany's 1983 transfer pricing guidelines (the so-called Administrative Principles).
1. Cost contribution arrangements in general
A CCA is a contractual agreement between two or more associated enterprises (possibly in conjunction with independent enterprises) by which they share the cost of rendering services to the participants or the cost of developing one or more assets (usually intangible assets) for separate use by each participant (without further charge such as the payment of royalties). The cost contribution amounts are determined by a contractual cost allocation formula. Research and development CCAs have clear economic advantages as vehicles for pooling risk, expense, physical resources, and expertise. However, the use of CCAs is not limited to the development of patentable inventions or secret know-how. They can be used to develop any sort of intangible asset including marketing intangibles (trademarks, logos, and copyrights) and commercial know-how (such as a streamlined process for training new executives). This article concentrates on CCAs used to develop intangible assets (intangible asset CCAs as opposed to service-provider CCAs).
For corporate groups, intangible asset CCAs present two main tax advantages. Firstly, by involving the future users of the intangible asset in the development stage, deductions for the related expense can be allocated on a current basis. Since the development of intangibles can be a lengthy process, immediate deductions by various entities throughout a corporate group are often preferable to incurring the entire expense in a single entity which may not be able to use it to the group's maximum global tax advantage. Secondly, by replacing future royalty payments with current cost contributions, CCAs avoid the often complicated transfer pricing problems associated with setting royalties at levels which will be recognised by all tax jurisdictions involved. While it is true that one instead faces the task of devising a cost contribution arrangement which is acceptable to several taxing authorities, this may well be the easier of the two tasks.
Rejection by the OECD and Germany alike of the U.S. "commensurate with income" approach to CCA transfer pricing should perhaps be listed as a third main advantage. Under the OECD/German rules, cost contributions are fixed prospectively by estimating the relative future benefit which each participant will derive from use of the asset or assets being developed. Even significant divergence of actual benefit, determined using hindsight, from forecast benefit does not give rise to an automatic adjustment. Significant divergence may, however, indicate that the original estimates of future benefit were not reasonable and/or lead to adjustments in the terms of participation in the CCA (OECD Ch. VIII par. 20, 11). These important issues are discussed in more detail below.
2. Tax recognition of an intangible asset CCA
To be a participant in an intangible asset CCA, an enterprise must have a reasonable expectation of benefiting from the intangible to be developed either directly (through use of the intangible in its business) or indirectly (through licensing the intangible to others). An enterprise which provides services to a CCA (e.g. contract R&D services) without any expectation of benefit, because the terms of the CCA deny it the right to use the fruits of the CCA or because direct or indirect exploitation of the interest nominally assigned to it is impossible (or implausible) as a factual matter, is not a "participant" and should not bear any share of development costs.
Tax recognition of a CCA will mean deduction by each participant of its share of development costs in accordance with the tax law of its country of residence. Development cost payments will not be treated as royalties. In Germany, the prohibition on capitalisation of self-developed intangible fixed assets means that such cost is deducted in the year incurred. Tax recognition also implicitly excludes treatment of the CCA as a partnership for tax purposes. Unlike the U.S. regulations (Reg. sec. 1.482-7 (a) (1)), neither OECD Chapter VIII nor the German regulations contain explicit assurance on this subject. However, from a German perspective the basic idea of development of an intangible for exploitation by each of the participants independent of the others rules out treatment as a partnership. Accordingly, even if the enterprise or enterprises performing the actual development work participate in the CCA, they will not be treated as pro rata permanent establishments of the other participants.
Denial of tax recognition would mean a refusal to permit deduction for tax purposes of cost contributions paid or accrued to associated enterprises.
3. Requirements for tax recognition of a CCA in Germany
The following list follows the German 1983 guidelines with comments as appropriate based on recent developments:
1. CCAs are permissible for research and development activities including basic research and for management services.
Prof. Runge states in his article (p. 81/2) that these limits are too narrow and that a CCA may relate to other services as well. The new OECD guidelines define a CCA broadly as a framework for "developing, producing, or obtaining assets, services, or rights". The statements by Prof. Runge and the OECD indicate that "development activities" within the meaning of the German guidelines is to be interpreted broadly and certainly encompasses the development of any sort of intangible asset which would be capitalisable (potential commercial value, capability of independent valuation, and transferability) but for the prohibition on capitalisation of self-developed intangible fixed assets.
2. The intangible asset(s) to be developed must be related to a participant's economic activities so that it anticipates making use of and deriving benefit from the intangible(s) in question.
The new OECD guidelines specify that the expectation of indirect use through licensing or sale to associated or to independent enterprises is sufficient to support a CCA (OECD Ch. VIII par. 10). The U.S. regulations, on the other hand, require that the intangible be used actively in a trade or business and specifically exclude transfer or license of the intangible from such active use where this is the "principal purpose" for participating in the CCA (Reg. sec. 1.482.7 (c) (1 - 3)). While the 1983 German guidelines do not comment explicitly on this issue, it is clear that they are in line with the OECD position and contain no "active use" requirement in the U.S. sense. Prof. Runge emphasises that the benefit derived by the participants in a CCA can only be assessed on a long-term basis (p. 83/1).
3. Impossibility or excessive difficulty of individual allocation of the costs in question.
Prof. Runge states (pp. 81/2, 82/2) that this requirement should be dropped. Neither the new OECD guidelines nor in the U.S. regulations contain such a requirement.
4. Advance conclusion of a clear and detailed cost contribution agreement between all related party participants and actual performance (over several years) of the agreement in accordance with its terms.
Prof. Runge adds that the advance agreement must be in writing because, for evidentiary reasons, independent enterprises would never participate in such arrangements except on the basis of a written agreement. The new OECD guidelines discuss these issues under the section on structure and documentation of a CCA (OECD Ch. VIII par. 40 - 42).
5. The costs to be allocated must be determined under generally accepted accounting methods on a full cost basis (direct and indirect costs); they must be incurred in fact in the accounting year, accurately defined, and easy to verify.
Prof. Runge states that a CCA may provide for provisional cost allocation on the basis of budgeted costs provided adjustment is later made as actual cost figures become available (p. 83/1).
6. Double-charging (e.g. later payment of royalties for use of the intangibles in question) is not permitted. Furthermore, the costs to be shared must be allocated net of any outside income from the development activity derived by an associated service-performing enterprise and net of any development-related expenditure by a participant; such expenditure must be allocated to the general cost pool and shared among the participants.
7. The cost allocation formula must reasonably reflect the relative benefit which each participant expects to derive from the intangible(s) being developed.
Prof. Runge emphasises the freedom which enterprises should enjoy in choosing an allocation formula, stating however that the "most suitable [criterion] must be chosen for a specific case" (p. 84/1). While this is reminiscent of the "most reliable estimate" rule which is explicit in the U.S. regulations (Reg. sec. 1.482.7 (f) (3)), it is unclear whether Prof. Runge would permit German tax authorities to disregard an allocation formula which reasonably reflects anticipated benefits on the grounds that another formula would be better. The OECD guidelines likewise stop short of formulating any specific "best method" rule. While they mention "the allocation key most relevant" to the particular CCA (OECD Ch. VIII par. 22), the emphasis of the discussion of the subject in par. 19 - 22 is on finding a reasonable measure of anticipated benefit. Probably, the German and the OECD position is to recognise the allocation formula chosen by the taxpayer unless, at the time of contracting, another measure was clearly better. Even under the U.S. rules there is freedom of choice between two equally reliable measures of anticipated benefit.
8. Costs incurred by associated enterprises must be allocated without any profit markup. However, it is permissible to charge a reasonable rate of interest on the capital committed to the endeavour.
Prof. Runge defends the denial of a profit markup where the associated enterprise incurring the expenditure is also a participant in the CCA on the grounds that such "service-provider participants" are sufficiently rewarded by their participation in the pooling arrangement (i.e. their later anticipated use of the intangible being developed) at no risk to themselves. Where the related-party service provider is not itself a participant in the CCA, Prof. Runge advocates permitting a profit markup (p. 83/2). This position mirrors that taken by the OECD (OECD Ch. VIII par. 12) but is not in line with the current wording of the German guidelines on point, which make no such distinction (par. 7.1.5 thereof). A significant change in the German position would thus appear to be in the offing.
9. If an intangible development CCA and a service-provider CCA are combined in a single contract, the allocable cost and allocation formula must be separably verifiable for each of the CCA's two basic elements. Offsets with benefits and burdens foreign to the allocation process are not allowed.
Prof. Runge perhaps goes further here in recommending that "package deals" which lump together basically different types of services (e.g. management services and use of intangibles) should not be recognised for tax purposes (p. 84/1).
10. The CCA agreement must be adjusted in accordance with changed circumstances.
Prof. Runge goes further and states that the agreement must include an adjustment clause (p. 81/2). The new OECD guidelines make clear that the purpose of such adjustment clauses is to prevent significant long-term discrepancy between anticipated benefit and actual benefit from the intangibles in question, stating that "it may be appropriate ... for a CCA to provide for possible adjustments of proportionate shares of contributions over the term of the CCA on a prospective basis to reflect changes in relevant circumstances resulting in changes in shares of benefits" (OECD Ch. VIII par. 20, emphasis added). The OECD Guidelines all but require that the CCA contract provide either for prospective adjustment of future contributions "to reflect changes in proportionate shares of expected benefits" or that past contributions be adjusted retroactively by so-called "balancing payments" (OECD Ch. VIII, par. 41 (e)). However, neither the German nor the OECD guidelines contain a retroactive adjustment provision akin to the U.S. plus-or-minus 20 % divergence rule (Reg. sec. 1.482.7 (f) (iv) (B), which requires retroactive adjustments whenever actual benefit diverges by more than 20 % from forecast benefit. The OECD guidelines state that substantial discrepancy between forecast and actual benefit may lead the tax authorities to examine closely the reasonableness of the initial forecast, but that they are to conduct this examination "without using hindsight" (OECD Ch. VIII par. 20). Further down, they state however that "a tax administration may disregard part or all of the purported terms of a CCA where over time there has been a substantial discrepancy between a participant's proportionate share of contributions ... and its proportionate share of benefits" (OECD Ch. VIII par. 30). No guidance is provided as to what is meant by "substantial discrepancy," nor is this statement qualified with regard to what was reasonably to be expected at the time of contracting. It is unclear whether the provision is meant to apply to cases in which the forecast benefits were unreasonable to begin with or to cases in which targeted benefit, while originally reasonable, diverged in fact from actual benefit over a span of several years without any prospective adjustment on the taxpayer's part.
4. Reasonableness of cost allocations
The German transfer pricing guidelines provide that the cost allocation formula chosen must reflect the anticipated actual benefit which the participants will later derive from the intangible(s) being developed. Such later benefit is to be estimated using business management principles with the care of a prudent business manager. This in effect means that an allocation system can be accepted as long as it makes sound economic sense. There is, however, a strong implication in the German guidelines that sales (turnover) are seldom an appropriate allocation criterion. Prof. Runge makes this clear in his article as well (p. 84/1).
The OECD position (Ch. VIII par. 19 ff.), while expressed in more detail, is essentially the same. Although the examples given by the OECD appear to be inspired by the U.S. regulations (Reg. sec. 1.482.7 (f) (3)), the OECD avoids categorising these into "primary" methods and "other methods" which, by implication, are seldom the right method to use. As discussed under section 3.7 above, if there is a "most reliable method" rule, it is by no means so overt as in the U.S. regulations. Naturally, the allocation formula need not necessarily be based on a single factor. Among the possibilities discussed by the OECD are the following:
1. Projected additional net income from the intangible
2. Projected net cost saving from the intangible
3. Units used, produced, or sold
4. Sales (turnover)
5. Gross profit
6. Operating profit
7. Number of employees
8. Capital invested
Prof. Runge suggests other possible allocation formulae or factors such as output rates for a new product, value added, wages and salaries, working capital, assets, cost of materials, forecast business indicators, and machine hours. He emphasises that, whatever criterion is chosen, its effects must be assessed in the long run.
The OECD notes in this connection that determination of the relative value of each participant's actual contribution "is unlikely to be a straightforward matter" because this contribution may well include property (or the full or part-time use thereof) and services, all of which pose additional transfer pricing issues (OECD Ch. VIII par. 13 ff.).
5. CCA Entry, Withdrawal, or Termination
Chapter VIII contains a lengthy section (par. 31 ff.) on the above issues, which are not mentioned in the German guidelines. Arguably an associated enterprise which joins an intangible asset CCA "in progress" should sometimes compensate the other members for the work done so far (obviously not appropriate if this work is of no value). Whether a withdrawing enterprise should receive a payment from those which remain if it relinquishes its rights to the fruits of the CCA, or should make a payment to them if it takes rights with it, is another subject of consideration. Germany would resolve these issues on a case-by-case basis under the arm's length principle.
Upon termination of an intangible asset CCA, par. 39 of OECD Chapter VIII implies that the interests which the various participants retain in the developed intangibles should be realigned in accordance with their contributions over the term of the arrangement. It is doubtful whether Germany would follow this suggestion, as the interests assigned to the participants by the CCA contract are the basis for review of the cost allocations. In the event of any misalignment, the appropriate response would appear to be to treat excessive allocations charged to German resident enterprises as constructive dividends and disallow the related deductions.
6. Documentation of a CCA
As noted above (cf. section 3.4 above), tax recognition of a CCA presupposes the existence of an advance agreement governing the CCA. Prof. Runge argues, we think persuasively, that the nature of an intangible asset CCA is such that parties dealing at arm's length would never dispense with a written agreement (p. 82/1). Indeed, one might add here that they would insist on a considerable level of detail in the contractual agreement.
The final section of Chapter VIII (par. 40 ff.), entitled "Recommendations for Structuring and Documenting CCAs," is in our opinion likely to become a checklist for German tax inspectors when they audit CCAs in the future. Central to any CCA are provisions on the interests assigned to the participants in the intangibles to be developed, the nature and valuation of their contributions, the cost allocation formula, and above all the adjustment clause. A contractual procedure for handling entries and withdrawals would also appear necessary.
In addition, it will obviously be necessary to support the reasonableness of the cost allocation structure chosen. This will entail documentation and analysis of the existing relationships and conditions including projections as to future business development so as to determine the terms on which independent parties dealing at arm's length would have agreed to divide costs and benefits. It appears advisable to prepare an advance formal written study on these issues, including documentation as to why the cost allocation formula chosen was considered superior to other alternatives.
Documentation on the performance of the CCA will likewise be necessary. With regard to the accounting necessary to identify the costs to be allocated, the German transfer pricing guidelines grant discretion to the German tax authorities to waive production of documentation located abroad provided a German auditor or tax consultant has certified that costs were segregated and allocated in accordance with the CCA agreement (Admin. Principles sec. 7.4.1).
It also appears necessary to monitor the actual development of the factors deemed important for determining the relative anticipated benefit to be derived by the various participants from the intangibles under development. Divergence of actual development from development assumed at the time of contracting must at some point trigger an adjustment in the CCA.
Prof. Runge notes that the German tax authorities may disallow deductions or allow deductions based on their own estimates (as opposed to the taxpayer's figures) in the event the taxpayer is unable to present the documentation which a prudent and conscientious business manager would have available to him. Here, it is important to remember that the German tax courts have held that a taxpayer may not escape responsibility for non-production of documentation on the grounds that the relevant documents are not in his possession or control if the taxpayer, by exercise of reasonable care, could have secured access to those documents, e.g. by making a right to access part of the relevant contract with other parties (cf. Admin. Principles sec. 9.1.3). It should also certainly not be regarded as a coincidence that the new OECD Guidelines state in this connection that "application of prudent business management principles would lead the participants in a CCA to prepare or obtain" extensive information on the CCA including "the details of the activities to be conducted under the CCA, projections on which the contributions are to be made and expected benefits determined, and budgeted and actual expenditures of the CCA activity" (OECD Ch. VIII par. 41, emphasis added).
Nevertheless, as Prof. Runge points out, "the duty of enterprises, especially service recipients [as opposed to service providers] to provide information ... is not ... unlimited: the limits are set by what is reasonable. Tax administrations should therefore not make any unreasonable demands on enterprises" (p. 82/2).
Intangible asset CCAs have both economic and tax reasons to recommend them. Release of the new Chapter VIII of the OECD Transfer Pricing Guidelines dealing with CCAs has focused attention on such arrangements and promoted understanding of the associated tax issues. Judging by Prof. Runge's recent article, Germany is in substantial agreement with the OECD position on CCAs and is by all means prepared to accept such arrangements for tax purposes as long as they are prepared and executed with an appropriate degree of care.
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