Germany: 163. Knowledge and Know-How Exchange: Acute Transfer Pricing Risks for German Subsidiaries of Foreign Multinationals

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Over the last eighteen months, numerous major multinational groups have announced, embarked upon, or claimed to have already made significant progress with ambitious plans to streamline their international organisations so as to increase group efficiency and enhance shareholder value. One key element of these plans is a detailed division of labour within the global group to enable each of the various group entities to concentrate on its core products and develop its core areas of competence to the fullest possible extent. This results in greater interdependence among the various group members and leads to increased exchanges of goods and services between them.

Of equal importance, however, is the broadest possible exchange of knowledge and know-how between group members with the goal of avoiding duplication of effort, unlocking synergy effects, and making group knowledge and know-how available in all locations in which it can be used to advantage. As economic structures and operations become more complex, the availability and effective use of knowledge and know-how are becoming the decisive factors in the formula for economic success.

The reorganisation measures necessary to implement structures in which the various group members can concentrate on their core areas of competence raise a host of potential capital gains issues. These are, however, not the subject of this article. We instead focus on the transfer pricing problems - one might even speak of a transfer pricing catastrophe in the making - created by the sweeping exchanges of knowledge and know-how into which, by their own admission, the world's multinationals have plunged.

Knowledge and know-how which originates inside an entity in one tax jurisdiction cannot be provided free of an arm's length charge to a related entity in a different jurisdiction. The attempt to do so will trigger adjustments of profits under standard transfer pricing principles. Competent authority procedures, which function bilaterally or at most trilaterally, are unlikely to be adequate to the task of coping with the resulting transfer pricing problems, which will be multilateral and interdependent in nature.

The new OECD Guidelines released starting in 1995 deal only with individual transfers of valuable knowledge and know-how. They do not specifically address the appropriate tax consequences of the massive and comprehensive exchanges contemplated by the world's multinationals because the conceptual planning which underlies these exchanges is of too recent date. The 1983 German transfer pricing guidelines (the so-called Administrative Principles) are of course silent on this subject as well. Nevertheless, both the OECD and German guidelines can be applied to the contemplated exchanges of knowledge and know-how, with similar results. Under the German guidelines, this means adjusting the profits of the transferring entity in accordance with sec. 1 AStG (International Transactions Tax Act) for transfers from a German parent to its foreign subsidiary and assessing a constructive dividend in the case of transfers from German subsidiaries to their foreign parents or affiliates.

The German Federal Office of Finance (Bundesamt fuer Finanzen) is known to be keenly interested in the above issues, which are highly visible thanks to numerous lengthy published interviews and newspaper articles stemming from high-ranking corporate officials.

While patents are the classic example of intellectual property, know-how is today its pre-eminent form. Although the importance of know-how is generally recognised, attention has so far been focused on its traditional manifestations such as individual secret processing methods or specific inventions formally transferred pursuant to a know-how licence agreement. However, comprehensive operational knowledge and know-how has far greater importance than such specific forms of know-how. Comprehensive operational knowledge and know-how is transferred whenever multinational corporations establish manufacturing companies in foreign jurisdictions (in order to minimise costs, improve access to local markets, enjoy lower tax rates, etc.). This widespread practice is typically accompanied by significant transfers of know-how from a group entity in another tax jurisdiction to the entity in the low cost jurisdiction.

The bulk of the information transferred is not secret know-how. Rather, the transfer encompasses a complex body of knowledge, experience, techniques, organisational structures, and the like which the multinational has assembled in another jurisdiction in the process of developing its products, improving its quality-control systems, and implementing lean production structures. The resulting practical mastery of a complex body of logistical and manufacturing problems, including virtual warehousing and just-in-time procedures, with respect to specific operations will be the dominant form of intellectual property in the 21st Century. None of the know-how involved need be patented or indeed even patentable.

Comprehensive operational knowledge and know-how is not limited to production know-how, however. Also relevant in this connection is marketing and sales know-how, financial know-how such as cash-pooling techniques, and the enormous know-how residing in proprietary computer programmes and house-engineered computer solutions to control financial, marketing, and production processes and operate communications networks. Here again, it is not the quality of such computer solutions as such or their non-duplicability by others which counts, but rather the proven or anticipated functionality of such programmes in co-ordination with a host of other industry-specific and product-specific factors. Viewed in isolation, a particular network solution may be worthless. What counts is its functionality as part of a much larger production concept.

In some cases, product-specific production know-how is developed and tested (in the form of pilot production runs) at one of the multinational's high-tax locations with the intention of using the know-how exclusively in low-tax low-cost foreign production jurisdictions. Such multinationals maintain only research and development facilities in the high-tax locations and shift all production operations to low-tax jurisdictions. However, the object of such research and development operations is not merely product creation and design in the narrow sense, but rather the development of the sort of comprehensive operational know-how discussed above.

In numerous areas (cars and trucks, trains and public transport, tyres, pharmaceuticals, chemicals, machines and machine tools including precision machines, etc.), manufacturing enterprises, both large and small to medium-sized, continue to dominate German economic activity, which has not veered nearly so sharply towards the services sector as has been the case in certain other industrialised nations. German companies thus possess and are constantly developing and refining an enormous body of valuable production knowledge and know-how.

This production know-how is by no means limited to German-based multinationals. Many German companies possessing such production knowledge and know-how are subsidiaries of foreign multinationals which have used their German subsidiaries over the years to generate new products and production solutions for export to other group members.

German business management theory and corporate culture has traditionally regarded objective product characteristics and production technology as the central or even virtually exclusive value-generating factor in business operations. Image promotion, name recognition, advertising, trademark and logo development, and other aspects of marketing technology have been relegated to a distinctly subordinate status.

This bias towards production technology in German corporate culture finds its counterpart in a production-centred orientation on the part of German tax officials. It can be very difficult to convince these officials that the success of a group affiliate in another jurisdiction using production technology stemming from Germany is due to anything but this technology, for instance, to imaginative local marketing.

So far, German knowledge and know-how owners have been able to export information at virtually no tax cost. The German accounting prohibition against capitalisation of self-developed intangible assets has been of help in this context. The know-how here under discussion is not only intangible by nature, but also invisible from an accounting perspective. Furthermore, it is difficult to define and value as a practical matter. Above all, its transfer is not directly perceptible and hard to measure.

One attention is focused on the problem, however, it is possible to identify objective indicators of knowledge and know-how transfer. Secondment of executives to foreign companies, organisation of training programmes, providing management services (for which the fees typically cover only the hourly rates of the personnel involved, not the value of the knowledge transferred), and distributing handbooks and manuals are but a few of the telltale signs. Furthermore, the transfer pricing methods devised in the United States over the last fifteen years for intangibles have now been refined and yield passably good results.

Leaving aside the above for the moment, let us examine the tax consequences of transfer of valuable knowledge and know-how by a German parent to its foreign subsidiary (reserving for the time being the similar issues raised when a German subsidiary makes such transfers to its foreign parent or affiliate). The initial question posed is whether a discrete asset has been transferred. From a German perspective, the answer to this question is probably negative. The subsidiary does not acquire exclusive control of the production know-how, nor is the know-how transferred for use during a defined or definable period of time. Under these circumstances, the subsidiary would seem to acquire only a use benefit, not a discrete asset.

This is probably positive from the point of view of the parent. If an individual asset is contributed by a parent to its subsidiary , this is a taxable event under the prevailing view. Contribution in return for new shares in the subsidiary is regarded as a quasi-exchange (asset for shares), resulting in gain to the extent of the excess of the asset's fair market value (gemeiner Wert) over its book value (which is zero in the case we are considering). Contribution without issue of new shares (disguised contribution) results in gain as well under the majority view. In either case, the parent would realise the full value of the know-how as taxable profit.

Even if no contributable asset is transferred, the arm's length principle would still appear to require that the parent receive compensation from its subsidiary for the know-how which the subsidiary is permitted to use. While this is preferable to immediate realisation of the full value of the know-how, one is left in a situation in which the profits of the parent may be corrected to take account of deemed royalty payments from the subsidiary for know-how transferred.

The same principles apply when a German subsidiary transfers knowledge or know-how to one of its foreign affiliates.

As a practical matter, the attention paid by the German tax authorities to intra-group transfers of knowledge and know-how by the German subsidiaries of foreign-based multinationals will probably be disproportionate to these subsidiaries' relative economic weight.

A transfer by a German subsidiary to its foreign affiliate without adequate compensation will trigger a constructive dividend from the German subsidiary to its foreign parent, not to the affiliate (with all the consequences flowing from a dividend under the German imputational system of corporate taxation). The constructive dividend will be valued with respect to a periodic hypothetical royalty payment.

Practical experience shows that German tax auditors are already adjusting the profits of globally operative German parents and assessing constructive dividends against the German subsidiaries of foreign multinationals with scant regard for theoretical justification when they suspect that Germany has not received its "fair share" of the group's worldwide profits. So far, transfers of knowledge and know-how are not a prime source of such suspicions, but this may soon change.

The assessments are in some cases not made with the expectation that they will stand up in court, at least not without considerable refinement and revision of argumentation. Instead, they are seen by the tax authorities as a means of forcing the taxpayer onto the defensive and possibly extracting concessions. If the taxpayer is unyielding, the delay in finalisation of the tax assessments which results from the usually protracted and expensive ensuing litigation may well keep the case open until there has been a major shift in German transfer pricing methodology towards the new margin-based methods. Under these new methods, the tax authorities feel they will be in a superior position with regard to globally operative enterprises.

While there are advocates of profit-based methods in the fiscal administration, the statistical data necessary to apply these methods has so far not been assembled.

Germany's transfer pricing policies are still conservative. Senior German tax officials have consistently stated that comparable profit methods (CPM) and transactional net margin methods (TNMM) are unacceptable and that profit splits are only acceptable in rare instances as a method of last resort. They have also expressed their opposition to U.S.-style economic analysis and even voiced reservations concerning advance pricing agreements (APAs).

Objections of principle to APAs have since been withdrawn. There are also indications that a major change of position may soon occur with respect to profit splits and TNMM. For instance, the application of a profit split method to global trading by banks was advocated in an unofficial internal advisory letter issued to the German tax authorities on May 11, 1998 by a senior official in the Federal Ministry of Finance. Furthermore, senior tax officials at the national and state levels are increasingly urging the use of TNMM to resolve transfer pricing problems.

Instead of merely waiting to see if the tax authorities raise challenges based on the sorts of know-how transfers here discussed, the taxpayer may adopt at least three mutually compatible risk-control strategies:

• Detailed assessment of knowledge and know-how actually transferred in the past and being transferred on an ongoing basis in order to gauge the associated risk and be prepared to refute excessive adjustments made by the tax authorities. Unfortunately, this type of analysis is likely to be time-consuming and expensive. It essentially amounts to compiling the information necessary for a transaction-based determination of an arm's length price.
• Conclusion of an APA with the key taxing jurisdictions involved. While this is also a costly process, it would appear to provide maximum security against unexpected adjustments to profits.
• Entry into a knowledge and know-how exchange arrangement (KKEA).

As a practical matter, there is probably no alternative to a KKEA for multinationals which intend to "streamline" their worldwide groups in the manner described at the outset of this article. At least de facto, a KKEA would be a component part of any conceivable APA. The basic concept of a KKEA must be the intentional set-off of advantages and disadvantages flowing from the exchange of knowledge and know-how within a global group. The KKEA can be modelled after cost contribution arrangements for the development of intangible assets. Whereas a CCA relates to an asset yet to be created, the essential task of a KKEA would be to regulate the exchange of existing knowledge and know-how. The key features of a KKEA, which must of course be entered into prior to the transfers it regulates, might include the following:

• The KKEA must be multilateral in nature and, for instance, permit the benefit of know-how transferred by A-Corp. to B-Corp. to be equalised by a transfer from C-Corp. to A-Corp. The current German transfer pricing guidelines recognise only bilateral set-off agreements, however.
• An entity can only be a "participant" in a KKEA if it expects both to transfer and to receive knowledge and know-how. Entities which only receive or only transfer knowledge and know-how would have to make or receive appropriate payments, as the case may be. A mark-up would be appropriate with respect to such payments. On the other hand, no mark-up would apply to knowledge and know-how exchanged among participants in a KKEA.
• The knowledge and know-how to be exchanged would have to be specifically identified and valued. This task, while formidable, is not impossible. The transfer pricing methods developed in the United States for intangible property in principle provide an adequate framework. Any imbalance of benefits conferred and benefits received would have to be equalised by balancing payments.
• Just as the cost allocation formula is the heart of a CCA, it may well be possible to install a "benefit claims formula" at the centre of a KKEA. The worldwide increased profits from the KKEA could be quantified and pooled, at least in part. Net contributors of knowledge and know-how would have claims against the profits pool in proportion to their pro-rata shares of total know-how pooled. This system might avoid or minimise the need for fixed balancing payments.
• The arrangement must be examined to make certain that the knowledge and know-how received by a particular entity are of actual benefit to that entity. Furthermore, it would appear necessary to verify actual transfer of the knowledge and know-how, as opposed to mere creation of a contractual right to receive such.
• Since exchange of knowledge and know-how is an ongoing process, the agreement should contain provisions for transfers of knowledge and know-how not yet in existence and/or not yet needed by potential recipients.
• An adjustment clause is probably indispensable. There must be continual monitoring of the actual benefit received to ensure that it remains roughly commensurate with the value of knowledge and know-how transferred. Again, an imbalance would give rise to balancing payments.

Free exchange of operational knowledge and know-how is one of the central aspects of the "streamlining" of the global operations of multinational groups. This exchange is economically necessary in order to avoid duplication of effort and permit each member of a multinational group to concentrate on its core areas of competence. However, free exchange of knowledge and know-how raises the spectre of massive corrections to reported profits by the tax authorities.

German tax authorities are especially interested in this area because they correctly identify German companies as being net exporters of operational knowledge and know-how. While such information need not be limited to production knowledge and know-how, this would appear to represent the bulk of Germany's "exportable" operational knowledge. The German subsidiaries of foreign-based multinationals are also often repositories and generators of highly valuable knowledge and know-how. The German tax authorities can be expected to subject transfers of knowledge and know-how by the German subsidiaries of foreign multinationals to particular scrutiny. Whereas transfers by German parents to their foreign subsidiaries which are not supported by arm's length consideration will result in adjustments to the parent companies' profits under sec. 1 AStG (International Transactions Tax Act), transfers by German subsidiaries of foreign-based multinationals to related parties will trigger constructive dividends.

Short of relinquishing the benefits of free exchange of knowledge and know-how, multinationals can avoid these consequences only by setting up a multilateral advance agreement for know-how and knowledge exchange between group members.

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