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Table of Contents
1. Introductory
2. Outline of the draft directive
3. Permanent establishment as nexus for taxation
3.1 Permanent establishment concept in domestic and treaty law
3.2 Foreign tax attributes and nexus to tax ("isolated analysis")
3.3 Required duration of a permanent establishment
3.4 Consolidation of building sites
3.5 Auxiliary and support functions
3.6 Bookkeeping requirements for German permanent establishments
3.7 Bookkeeping requirements for foreign permanent establishments
3.8 Agency-based permanent establishments under tax treaties
4. Consequences of a permanent establishment under a tax treaty
4.1 General rule: exclusion of profits of a foreign PE
4.2 Exceptions to the exclusion method
4.3 Loss treatment
5. Profit attribution: basic matters
5.1 Separate enterprise approach
5.2 Internal transactions - in general
5.3 Internal transactions - exceptions
5.4 Methods of profit apportionment
5.5 Attribution of assets and liabilities to permanent establishments
5.6 Equity attributable to a permanent establishment
5.7 Capital endowment for PEs of banks and insurance companies
6. Apportionment of revenue and expense
6.1 General (section 2.7, pp. 27 - 29)
6.2 Expense of creation and discontinuation of a permanent establishment
6.3 Specific expenses, esp. market penetration expense
7. Currency conversion issues
8. Transfer of assets between domestic and foreign permanent establishment
8.1 Outbound transfers
8.1.1 Outbound Category 1
8.1.2 Outbound Category 2
Fixed assets
Current assets
Intangible assets
8.1.3 Outbound Category 3
8.1.4 Outbound Category 4
8.1.5 Outbound Category 5
8.2 Inbound transfers
8.2.1 Inbound Category 1
8.2.2 Inbound Category 2
8.2.3 Inbound Category 3
8.2.4 Inbound Category 4
8.2.5 Comments on inbound transfers
9. Partnerships
9.1 Attribution of permanent establishments to partners
9.2 Domestic and foreign partnerships
9.3 Bookkeeping for foreign and domestic partnerships
9.4 Partner's obligations to provide documentation and information
9.5 Contractual relationships between partner and partnership
9.6 Loans by partners to partnerships
9.7 Consortiums
9.8 Partnership equity
10. Other issues
10.1 Documentation and information
10.2 Independent services
10.3 Transition provisions
10.4 Superseded administrative pronouncements
11. Concluding remarks
Draft Administrative Guidelines on the Taxation of Permanent Establishments
1. Introductory
In mid-June of this year the German Federal Ministry of Finance released the first public draft of the guidelines on the taxation of permanent establishments on which it is known to have been working for some time. The draft was cleared in advance with the tax administrations of the various German states. Private sector comments were invited. Contrary to the original expectation, the draft was made public without first awaiting the release of the guidelines being prepared by the OECD on the same subject. (For a summary of present German transfer pricing policy in general, see article no. 51, sec. 4)
The new draft directive is comparable in length to that issued by the Federal Ministry of Finance in February 1983 dealing with transfer pricing between associated independent enterprises. The draft directive often endorses broad principles (such as the "separate enterprise" approach for attributing profits to a permanent establishment), the application of which to particular cases depends on what is "reasonable" or "appropriate" under the specific circumstances. Under the German transfer pricing philosophy, minute regulation is regarded as counter-productive and there is instead a preference for relying on the sound judgement of taxpayers and tax auditors alike to reach results which are reasonably precise and in accordance with the arm's length standard.
Previously, Germany has had no comprehensive guidelines related specifically to permanent establishments. The tax authorities have instead dealt with permanent establishment issues by applying the 1983 intercompany transfer pricing guidelines by analogy. The new draft combines scattered existing administrative pronouncements and the holdings of leading court cases into a single document and espouses in writing many positions which the tax authorities have long taken in practice. The Official Commentary of the OECD Model Tax Convention is often cited in support of such positions. (Germany has tax treaties in force with some 55 countries, including all major trading nations.)
The new rules seldom stray from the beaten path, but nevertheless contain certain surprising inconsistencies and questionable positions on significant issues. The draft covers both outbound and inbound transactions, that is to say, both permanent establishments set up by German entities in foreign countries and those maintained by foreign entities inside Germany. In its final form, the directive will contribute greatly towards legal clarity by establishing a fairly comprehensive framework within which both taxpayers and tax auditors can work.
The following is a selective summary of matters of likely interest. The selection relies in part on comments contained in the letter of 20 August 1997 from the Institute of German Auditors (IDW) to the Federal Ministry of Finance (WPG 1997, 641). We also note the article on the draft directive recently published by Drs. Strunk and Kaminski (IStR 1997, 513).
2. Outline of the draft directive
The draft directive is divided into six parts of varying length. The following outline, not followed for purposes of this article, shows the main parts together with the sections into which each is divided. The various sections are broken down into subsections (not shown). Contrary to normal practice in German tax directives, these subsections in many cases extend over several pages, thus making precise citation of passages in the directive unnecessarily difficult. For this reason, we provide the page number in addition to the section or subsection number when citing the draft directive.
Part 1 Legal basis for the taxation of commercial permanent establishments
1.1 Domestic tax law
1.2 Tax treaties
Part 2 Apportionment of income and [business] property
2.1 General
2.2 Basic apportionment principles
2.3 Profit apportionment methods
2.4 Attribution of assets
2.5 Permanent establishment share of the equity of the overall entity (dotation capital)
2.6 Transfer of assets
2.7. Apportionment of expense and revenue
2.8. Conversion of permanent establishment profit/loss into German marks
2.9 Creation and discontinuation of a permanent establishment
2.10 Contribution of a permanent establishment to a corporation
Part 3 Specific issues regarding the apportionment of income and property
3.1 Services
3.2 Advertising and market penetration
3.3 Interest and similar payments
3.4 Management expense, general administrative expense, and related costs
Part 4 Permanent establishments is special cases
4.1 Banks
4.2 Insurance companies
4.3 Construction projects and assembly work
4.4 Monitoring and coordination offices
4.5 Operation of ships at sea and on domestic waterways
4.6 Ocean-going ships
4.7 Prospecting for and extracting natural resources in international waters
4.8 Exploration [for natural resources]
4.9 Transportation facilities
5. Procedural matters
5.1 Obligations to document and provide information
5.2 Scope of the obligation to provide information
5.3 Legal consequences of failure to provide adequate information
6. Other matters
6.1 Independent services
6.2 Transitional provisions
6.3 Revocation of other administrative pronouncements
Appendix
Tax treaty tables
i. Permanent establishment requirements
ii. Construction projects and assembly work
iii. Permanent representative
iv. Presence deemed not to constitute a permanent establishment
[End of outline of draft directive]
3. Permanent establishment as nexus for taxation
3.1 Permanent establishment concept in domestic and treaty law
The term "permanent establishment" (Betriebsstaette) exists in German domestic tax law (sec. 12 AO - tax procedure act) as well as in tax treaty law and performs similar functions under the income and trade tax laws. Income from trade or commerce is generally not German source income, hence not taxable to non-residents, unless derived through a domestic permanent establishment or a domestic permanent representative. In other words, a commercial activity conducted by a person or entity not liable to tax in Germany on its world-wide income (a foreign resident entity) is as a rule only taxable in Germany if and to the extent the activity is carried out through a German permanent establishment maintained by the foreign resident or through a domestic permanent representative (sec. 49 par. 1 EStG). (Exceptions exist with regard to the sale of German real property and material interests in German corporations, the operation of ships and aeroplanes, and respecting artistic, athletic, or similar performances.) The definition of "permanent establishment" under German domestic law (sec. 12 AO) is similar to, though broader than, that under most of Germany's tax treaties (which generally follow the OECD model treaty). Under German domestic law, a permanent representative does not constitute a permanent establishment for the principal. Nevertheless, the concept and consequences of a domestic permanent representative under German domestic tax law (sec. 13 AO) resemble those under Article 5 par. 5 and 6 of the OECD model treaty. While German statutory law regards any permanent representative, whether of an independent or a dependent status, as creating a sufficient nexus to tax, administrative regulations (R. 222 (1) EStR) have long provided that independent agents (commission agents, brokers, and, under certain conditions, commercial representatives) acting in the normal course of their business do not cause the profits of their foreign principal to become subject to German tax.
3.2 Foreign tax attributes and nexus to tax ("isolated analysis")
The IDW recommends deletion of the last sentence of section 1.1 on p. 5 in the draft directive, which currently provides that account is to be taken of the foreign activities of a foreign entity whenever this would cause the foreign entity to derive German source income from trade or commerce. The relevance of foreign activities is the subject of dispute in the German literature. The IDW takes the position that foreign activities (or foreign tax attributes) are irrelevant as a basic matter and that it would therefore be improper to consider them in order to cause a foreign entity to earn German source income from trade or commerce. Strunk and Kaminski support the draft directive on this point (IStR 1997, 513, 514/1).
3.3 Required duration of a permanent establishment
As is clearer from the English term than from the German one, a temporary establishment is not a permanent establishment. This does not mean, however, that activities which are by their nature of limited duration can never constitute a permanent establishment. As section 1.1.1 on p. 5 of the draft directive correctly states, to constitute a permanent establishment a fixed place of business need only be "designed to be of appreciable duration" (auf gewisse Dauer angelegt). The draft directive then goes on to provide that a fixed place of business is always "designed to be of appreciable duration" if it remains in existence for more than six months.
The IDW correctly takes exception to the tax authorities' attempt to create an irrebutable presumption. The six month limit is taken from the second sentence of sec. 12 AO (tax procedure act), which provides that construction and assembly work creates a permanent establishment if it goes on for more than six months. The Federal Tax Court has held that while exceeding the six month limit is evidence that a facility possesses the required degree of permanence, it is only conclusive on the issue with regard to construction and assembly work.
3.4 Consolidation of building sites
The six month limit during which construction and assembly work does not constitute a permanent establishment under German domestic tax law is extended to one year under many of Germany's tax treaties. Article 5 (3) of the OECD model convention permits several simultaneous and/or successive discrete building sites to be consolidated and treated as a single site for purposes of determining a site's scope and duration only if they are objectively related and geographically proximate.
Section 4.3.4 on p. 51 of the draft directive establishes an absolute limit of 50 km as the crow flies for purposes of determining geographic proximity. The IDW correctly points out that the question of geographic proximity should be answered based on the individual facts and circumstances without reference to a rigid limit not found in the OECD model treaty.
3.5 Auxiliary and support functions
Under the OECD model convention, fixed places of business used for carrying out auxiliary and support functions do not create a permanent establishment. The tax treaty permanent establishment concept is more restrictive than that under German domestic tax law (sec. 12 AO) in this respect.
Citing a recent decision involving an underground oil pipeline (BFH BStBl II 1997, 12 - 30 Oct. 1996), the draft directive provides that railroads and pipelines constitute permanent establishments. In the decision relied on, the transportation of crude oil and oil production was the principal business activity of the pipeline's operator. The IDW correctly points out that transportation facilities would not constitute a tax treaty permanent establishment if they are not related to the operator's principal business activity. The relevant passage should be amended to make this clear.
3.6 Bookkeeping requirements for German permanent establishments
The German permanent establishment of a foreign entity is required to keep separate books and records in Germany if the permanent establishment constitutes a "branch establishment" (Zweigniederlassung) within the meaning of sec. 13 HGB (commercial code) or if the permanent establishment exceeds certain turnover or profit limits and is specifically requested to keep books by the tax office (sec. 13d - 13g HGB; sec. 238 HGB and sec. 140, 141 AO). The tax authorities have discretion to permit the books to be kept abroad and to grant other relief from the normal bookkeeping obligations (sec. 148 AO). Special recordkeeping requirements exist for VAT purposes under sec. 22 UStG. The draft directive repeats these principles in its section 1.1.2 (p. 8). Strunk and Kaminski note that the draft directive incorrectly cites sec. 13b HGB instead of sec. 13d ff. HGB (IStR 1997, 513, 514/2).
The IDW correctly points out that the European Court of Justice (ECJ) recently held that an EU entity cannot be required to keep the books and records for its German permanent establishment inside Germany (decision of 15 May 1997 - DB 1997, 1211; see article no. 87). A corresponding amendment of the final version of the draft directive is therefore recommended.
3.7 Bookkeeping requirements for foreign permanent establishments
The accounting and recordkeeping requirements of German resident persons apply to their entire business operations and thus cover foreign permanent establishments as well. It makes no difference whether the profit or loss from the foreign permanent establishment is excluded from the German domestic tax base or not. For foreign permanent establishments which comply with requirements under foreign law to keep books and records, the draft directive provides, however, in section 1.1.3 (pp. 9, 10), that it is sufficient to incorporate the results (account balances) of this accounting system into the accounting of the domestic enterprise. The adjustments necessary to comply with German tax accounting principles must be identified as such.
If no separate accounting system exists for the foreign permanent establishment, the directive provides that its transactions must be recorded in the accounting system of the domestic enterprise in such a way as to enable them to be identified.
The draft directive also cites various relevant provisions of German tax procedural law (sec. 90, 97, 146 (2) - (4), 200 AO, sec. 16 AStG), which define the taxpayer's obligations to provide information and other forms of cooperation.
3.8 Agency-based permanent establishments under tax treaties
The draft directive adopts the familiar distinction between dependent and independent agents but provides disappointingly little guidance as to the many issues in this area (section 1.2.1. p. 14 ff.). Somewhat obliquely, the draft directive makes reference to the three factors needed in order for an agent to constitute a permanent establishment under Article 5 (5) of the OECD model convention:
Dependency of the agent on the foreign principal
Authority to contract for the foreign principal and regular use of this authority
Engaging in activities beyond those of a preparatory or auxiliary nature.
Concerning the first requirement, it is stated that the failure of the agent to bear the economic risk of his activities is an indication of his dependency. The IDW appropriately recommends that a sentence be added providing that the determination of the agent's compensation under any of the standard transfer pricing methods, including the cost-plus method, shall not be interpreted as meaning that the agent does not bear the economic risk of his activities.
With regard to the existence of authority to contract, the draft directive states that such authority exists if the agent can bind his principal "either legally or economically" (section 1.2.1, p. 14). The IDW is justly critical of the vague concept of "economically binding authority" and suggests deleting this expression and instead quoting from Official Commentary no. 32 on the OECD treaty provision in question to the effect that authority to contract exists when the agent is authorised to negotiate all elements and details of a contract in a way binding on the enterprise even if the contract is signed by another person in the country in which the enterprise is situated.
When a corporation acts as the agent of its parent company (or presumably of any other group company), the draft directive states that the parent-subsidiary relationship (or presumably any other affiliation) is irrelevant as such to whether the agent constitutes a permanent representative.
The draft directive is silent as to whether an agent is dependent on its principal merely because all of the agent's revenue is earned by acting for a single principal (or persons controlled by or under common control with this principal). It is KPMG's opinion that this should not be the case.
Under Article 5 (6) of the OECD model convention, an independent agent can constitute a permanent establishment for his principal if he acts outside of the normal course of his business. Citing the Federal Tax Court decision reported on in article no. 12 (BFH BStBl II 1995, 238 - 14 Sept. 1994), the draft directive appears to shift the emphasis from the normal course of the agent's specific business to the normal course of the general type of business in the particular industry. The decision cited would not appear to support this position.
4. Consequences of a permanent establishment under a tax treaty
4.1 General rule: exclusion of profits of a foreign PE
The consequences of the existence of a permanent establishment are dealt with under subsections 1.2.2. and 1.2.3 of the draft directive (pp. 15 - 17). As between two treaty states, the right of taxation of an entity's business profits is reserved exclusively to the entity's country of residence unless the entity maintains a permanent establishment in the other treaty state, in which case that state (the source state) may tax the profits properly attributable to the permanent establishment and the state of residence must adjust its taxation of those profits so as to avoid double taxation thereof.
Where Germany is the state of residence, its tax treaties generally avoid double taxation by excluding the profits of a foreign permanent establishment operated by a German resident entity from the tax base. The property attributable to the permanent establishment is also excluded for purposes of net worth taxation. (Net worth taxation ended in Germany at the start of this year; see articles no. 58 sec. 7 and no. 76.) In the case of individuals, including partners in partnerships, the income exclusion is subject to a so-called "progression clause" (Progressionsvorbehalt) meaning that the average tax rate is that which would have applied without the exclusion, resulting in application of a higher tax rate to the base from which the permanent establishment profits have been excluded.
The draft directive notes in section 1.2.2 on p. 16 that interest and royalties are only part of the excluded business profits of a foreign permanent establishment if the respective debt claim or intangible asset is "effectively connected" to the permanent establishment. No guidance is provided in interpreting the term "effectively connected," but reference is made to a decision of the Federal Tax Court on point (BFH BStBl II 1996, 563 - 30 August 1995). (The draft directive does not mention dividends in this context, but should have.)
4.2 Exceptions to the exclusion method
On pages 16 and 17 of section 1.2.2 the draft directive calls attention to a variety of situations in which Germany avoids taxation under the credit method instead of the exclusion method:
Under certain tax treaties, the exclusion is subject to an activity clause, meaning that it is only granted if the foreign permanent establishment is engaged in an "active" trade or business (as defined in the particular tax treaty).
Certain German tax treaties contain subject-to-tax clauses denying the exclusion when the other treaty state does not in fact exercise its right of taxation under the tax treaty (see article no. 74). (Under most of the treaties in force, potential or "virtual" taxation by the source state is sufficient to qualify for the exclusion.)
The international transactions tax act overrides Germany's tax treaties with respect to certain passive income (e.g. interest) from low-tax jurisdictions (sec. 20 (2) AStG). A low-tax jurisdiction is one in which the effective rate of tax is under 30 % of the tax base determined under German tax principles.
4.3 Loss treatment
German domestic tax law generally prevents the deduction of foreign losses on the domestic tax return (sec. 2a (1) EStG). Non-deductible foreign losses are carried forward indefinitely and may be set off against later profits on a country-by-country basis.
Foreign permanent establishment losses may be deducted without time limit just like losses from domestic operations provided the foreign permanent establishment meets certain activity requirements (sec. 2a (2) EStG).
Where a tax treaty exists, losses ("negative income") generated by foreign permanent establishments are, like profits, generally excluded from the German domestic tax base under tax treaty law. In the case of individuals, including partners in partnerships, the general prohibition on use of foreign losses contained in sec. 2a (1) EStG applies for "progression clause" purposes as well (no negative progression). For progression clause purposes only, such losses may also be carried forward indefinitely and set off against later profits on a country-by-country basis. If the losses are generated by a permanent establishment meeting the activity requirements of sec. 2a (2) EStG, the general prohibition on deduction of foreign losses does not apply, hence the foreign losses should be counted immediately for progression clause purposes (negative progression).
Provided the foreign permanent establishment meets certain activity requirements, the taxpayer may, however, elect to deduct the otherwise excluded losses on his German tax return (sec. 2a (3) EStG). In this case, subsequent profits are subject to German tax to the extent of losses previously deducted.
The draft directive makes superficial reference to the provisions set forth above (sec. 1.2.2, p. 16). Its description of the operation of a tax treaty progression clause in the event of foreign losses is not just inadequate, but incorrect as well in one respect (the draft directive states on p. 16 that negative foreign income which is exempt under a tax treaty will count for progression clause purposes unless generated by an active commercial permanent establishment, where it should state that the negative progression clause will operate provided the income is generated by an active commercial permanent establishment).
5. Profit attribution: basic matters
5.1 Separate enterprise approach
The draft directive endorses the so-called "separate enterprise" approach to determining the profits of a permanent establishment (cf. OECD model convention Article 7 (2)). Under this approach, one attributes to the permanent establishment the profits which it would have earned had it performed the same or similar functions as a separate enterprise on an arm's length basis (section 2.2, p. 18).
There are two major differences between the "separate enterprise" or "arm's length" approach as applied to permanent establishments and the allocation of profit and loss among independent associated enterprises. The first is the general prohibition on profit markups for internal transactions between permanent establishments (see sec. 5.2 below), the second is the allocation of expense of all types, including general administrative expense, irrespective of where it is incurred (see below, last paragraph of sec. 6.1).
5.2 Internal transactions - in general
The draft directive in effect departs from the separate enterprise approach as regards internal transactions, stating that no profit markup is permitted on transactions between the permanent establishments of the same enterprise (section 2.2, p. 18). This position is repeated with specific regard to notional interest in section 3.3.1 (p. 37).
The reason given is that the same enterprise is legally incapable of contracting with itself. Of course, it is equally impossible for a particular permanent establishment to contract independently in its dealings with third parties. The contract with the third party is always on behalf of the enterprise as a whole. Nevertheless, the separate enterprise approach is applied with respect to such contracts. The grounds for refusing to follow the separate enterprise approach with regard to internal transactions thus appear formalistic and illogical.
The IDW is likewise critical of this logical inconsistency. The failure to allow a profit markup on the exchange of all goods and services between the head office (principal place of management) and the various other permanent establishments of the same enterprise means that, as to these exchanges, profits are not being determined on an arm's length basis as if the permanent establishments involved were separate enterprises. The rejection of profit markups with respect to internal transactions introduces a major difference between the allocation of profits among the various subsidiaries of a controlled group (where profit markups are not only permitted, but also required) and the allocation of profits of a single enterprise to its various permanent establishments, despite the fact that the economic functions of permanent establishments may well be identical to those of subsidiaries.
5.3 Internal transactions - exceptions
The draft directive does, however, allow certain exceptions to the general prohibition on profit markups between permanent establishments:
Where services are rendered by one permanent establishment to another and the performance of such services constitutes the principal activity of the permanent establishment is question, an arm's length profit markup is not only permitted, but required (section 3.1.1, p. 35). If the arm's length profit cannot be determined, the draft directive states that use of the cost plus method with a markup of 5 % to 10 % is acceptable. The above is not to apply, however, in the case of management and general administration services as described in section 3.4 (pp. 38, 39). According to the directive, these services are governed by the general rule.
A markup is on the other hand permitted, but apparently not required, for advertising services performed by a permanent establishment for other permanent establishments as the principal function of the service provider (section 3.2.1, p. 36).
A permanent establishment which manufactures products for the head office according to the latter's specifications (Lohnfertigung, verlaengerte Werkbank) is entitled to the profit normally earned at its location for performing such a function (sec. 3.1.2, p. 35). Presumably, it would make no difference if the function was performed for another permanent establishment instead of for the head office.
For lending institutions (banks), internal interest payments between permanent establishments are to be recognised on the grounds that money is the goods in which banks trade (sec. 4.1.4, p. 43).
The contradictory position taken by the draft directive on this important issue reflects a similar contradiction running through the Official Commentary on Article 7 of the OECD model convention.
5.4 Methods of profit apportionment
The draft directive states that the profits of an enterprise attributable to a particular permanent establishment may be determined either by a "direct" method based on analysis of functions performed and transactions engaged in or by an "indirect" method, by which is meant some form of formulary apportionment. A preference is expressed for the direct method, especially where the head office and the permanent establishment perform different functions. Profits are then to be determined "on the basis of its accounts and the German profit determination provisions" (section 2.3.1, p. 19). The strong implication is that the separate accounts of the permanent establishment (see sec. 3.6 and 3.7 above) will form the starting point for review of the result reported.
Under the indirect method (sec. 2.3.2, p. 20), the profit or loss of the enterprise as a whole is apportioned between the permanent establishment and the head office "on the basis of an appropriate formula". Reference is also made to "function formulas" which are to approximate as closely as possible "the economically appropriate result". (The term "function formulas" [Aufgabenschluessel] is probably a misprint for "apportionment formulas" [Aufteilungsschluessel].)
Despite the theoretical preference for the direct method, the draft directive specifies acceptable apportionment formulae for certain cases in which the permanent establishments involved perform the same functions and have the same internal structure. The "approved" formulae are as follows:
Turnover (sales) for enterprises providing services and trading in goods
Revenue from premiums for the insurance business
Share of working capital for banks
Wage and salary expense for manufacturing enterprises.
The IDW appropriately recommends adding language to the final version making clear that the cited formulae are merely examples of acceptable apportionment factors, not an exhaustive list.
5.5 Attribution of assets and liabilities to permanent establishments
The attribution of positive assets and negative assets (liabilites) to a permanent establishment can have considerable impact on its profits as well as its net worth. (The latter aspect diminishes in significance after 1996 in view of the discontinuation of net worth taxation.) The draft directive provides in its section 2.4 (pp. 20, 21) that assets intended for exclusive use and exploitation by the permanent establishment are to be attributed to it. The same applies for income-producing assets when the permanent establishment has made the predominant contribution to earning the income yielded. Assets used by both the permanent establishment and the head office may be attributed to either one, but the related revenue and expense is to be apportioned in light of the relative actual use. Capital gains on disposition of assets are also to be apportioned on the basis of use. Strunk and Kaminski are strongly critical of this latter provision (IStR 1997, 513, 515/2).
The enterprise's funds (Finanzmittel) are to be attributed to the head office "as a rule," but not "excess funds" generated by the permanent establishment. The IDW rightly notes the vagueness of the expression "excess funds" and recommends clarifying this point. Interests in other companies are also "as a rule" attributable to the head office, unless they support the operations of the permanent establishment.
Assets need not be attributed to a permanent establishment by reason of their temporary use if they would have been rented or leased between independent parties. The same applies to assets used by several permanent establishments simultaneously or successively if a procedure exists for apportioning the related expense and revenue among the various parts of the enterprise.
5.6 Equity attributable to a permanent establishment
In section 2.5.1 (p. 22), the draft directive defends the position that a permanent establishment must have an arm's length "equity dotation" or "equity endowment" (Dotationskapital). At issue here is the extent to which interest expense paid to third parties is properly attributable to a particular permanent establishment. The high German tax rates may incline a German entity with foreign permanent establishments to seek to reduce their share of interest expense by providing them with a percentage of equity in excess of that of its German permanent establishments. Foreign entities may assign little or no equity to their German permanent establishments for the same reason.
In response, the IDW correctly emphasises the discretion enjoyed by a businessman in determining how to fund his business. Relying on a case cited in the draft directive (BFH BStBl II 1987, 550 - 1 April 1987), the IDW notes that the court held that the decision of a businessman (as reflected for example in the company's books) is to be respected for tax purposes unless it conflicts with what is "commercially and economically necessary." This standard is a generous one allowing considerable leeway to the business in question. The IDW furthermore notes that "the amount of equity which is customary in a particular industry cannot be determined and is in particular not reflected by the statistical average equity in an industry".
The draft directive instructs tax authorities to apply the arm's length standard to the equity issue, emphasising the limitations on managerial discretion, not its wide scope. If no appropriate external comparables can be discovered, the directive provides in sweeping terms that "there is no objection to apportioning the equity of the enterprise as a whole by means of an estimate in light of the relative functions of the head office and the permanent establishment" (p. 23). If the head office and the permanent establishment perform the same functions, the debt-to-equity ratio of the head office is cited as possibly appropriate for the permanent establishment as well.
In the event a permanent establishment's debt is found to be excessive, the directive provides that reclassification of debt as equity shall begin with the loans bearing the highest rate of interest (section 2.5.1, p. 22). The IDW justly criticises this arbitrary procedure and suggests looking instead to the order in which the loans were incurred, which would presumably mean treating the most recent loans as equity.
5.7 Capital endowment for PEs of banks and insurance companies
The draft directive fixes minimum capital endowments for the domestic permanent establishments of banks and insurance companies. For European Union banks, these depend on the bank's balance sheet amount and begin at DM 2 million for balance sheet amounts up to DM 100 million. For balance sheet amounts from DM 1 billion to DM 2 billion, a minimum capital of 1 % of the balance sheet amount applies. This minimum percentage then declines as the balance sheet amount rises (section 4.1.3, p. 41). For the permanent establishments of U.S. banks, the same rules apply except that the minimum capital begins at ECU 5 million (p. 42). For non-EU banks, the capital required under bank regulatory law applies (p. 43).
For the domestic permanent establishments of insurance companies, the directive likewise requires the minimum capital prescribed by regulatory law (section 4.2.2, p. 46).
6. Apportionment of revenue and expense
6.1 General (section 2.7, pp. 27 - 29)
The draft directive states generally that the apportionment of revenue and expense between the various permanent establishments is to follow the cost accounting principles of business management and permits use of the taxpayer's cost accounting as a starting point if the following conditions are met:
Comparability of the cost accounting systems used by the head office and the permanent establishment
Existence of differentiated and easily verified cost accounting records
Complete coverage of the permanent establishment
Periodic review of the cost accounting system and adjustment to account for changed circumstances
The draft directive permits allocation of expense and revenue on a lump-sum basis or after consolidating costs into certain blocks provided either of two conditions is met:
i. the allocation system meets the above requirements, takes account of the specific functions performed, and leads to results which are sufficiently close to those which allocation of the individual revenue and expense items would yield
or
ii. allocation of the individual revenue and expense items is impossible or unreasonably difficult.
The following are cited as frequently necessitating adjustments of the results reported by the taxpayer:
i. Transfer of fixed and current assets between permanent establishments
ii. Expenses booked to a domestic permanent establishment but in fact attributable to a foreign permanent establishment
iii. Attribution to foreign permanent establishments of an inappropriately small share of the following expenses incurred by the domestic main office:
general management and administration expense including stewardship and coordination expenses
advertising expense
research and development expense
interest expense.
The allocation of expenses to permanent establishments differs from that to subsidiaries in that all types of general expense (including stewardship expenses and general interest expense) are in principle allocable irrespective of where incurred and without any contractual basis provided the permanent establishment is at least indirectly benefited thereby. Expense and revenue items exclusively related to a specific permanent establishment will of course be attributed to it alone.
6.2 Expense of creation and discontinuation of a permanent establishment
The draft directive (section 2.9, pp. 33, 34) provides that expense related to the creation of a permanent establishment is to be allocated to the permanent establishment. The same applies for the expense of discontinuing a permanent establishment up to the end of the year following that in which it ceases to exist. Thereafter, such expense is to be allocated to the head office.
The IDW criticises this arrangement as unnecessarily complex and suggests instead allocating all expense prior or subsequent to the existence of the permanent establishment to the head office.
6.3 Specific expenses, esp. market penetration expense
Sections 3.2 - 3.4 (pp. 36 - 39) of the draft directive deal with the following types of specific expenses:
advertising and market penetration expense
interest expense
management and general administrative expense.
With regard to market penetration expenses (section 3.2.2, pp. 36, 37), the draft directive repeats positions taken in the 1983 transfer pricing guidelines for associated enterprises, the general thrust of which is to impose the costs of market penetration on the domestic marketing subsidiary. Parts of this passage appear to be inspired by the case reported on in sec. 4.4 of article no. 51 (BFH BStBl II 1993, 457 - 17.02.1993), particularly the emphasis on advance documentation, including profitability analyses, showing that the domestic marketing permanent establishment will reach a break-even point within three years of start-up. The draft directive also repeats the position of the 1983 guidelines that price reductions or similar actions intended to defend or increase the existing market share are as a basic matter to be borne by the manufacturing permanent establishment, not the marketing permanent establishment. This appears inconsistent with the position on market penetration, the basic requirement of which is that the marketing permanent establishment must earn an adequate profit.
7. Currency conversion issues
The draft directive contains fairly detailed and complex provisions on this subject (section 2.8, pp. 29 - 33) on which we do not comment at this time.
8. Transfer of assets between domestic and foreign permanent establishment
The draft directive deals at length with transfers of assets between a domestic (German) and foreign permanent establishments (section 2.6, pp. 23 - 27).
8.1 Outbound transfers
The draft directive treats outbound transfers differently depending on which of the following five categories they fall into. It is unclear whether these categories are to apply to transfers between the domestic and the foreign permanent establishments of the same partnership. Conceivably, Categories 1 - 4 could cover such transfers. Probably, however, Category 5 is intended to apply to such transactions.
8.1.1 Outbound Category 1
Transfer of fixed or current assets from the domestic head office to a foreign permanent establishment in a country with which Germany either has no tax treaty or a tax treaty under which it avoids double taxation by the credit method.
The draft directive provides that such transfers have no tax consequences because eventual taxation of the profits from the asset is still ensured (section 2.6.1, p. 23).
The draft directive apparently assumes (for purposes of this and other outbound transfer categories) that the entity in question will be subject to tax on its worldwide income if its head office is in Germany. "Head office" is defined by the draft directive to mean the permanent establishment where the principal place of management is located (section 2.2, p. 18). On first impression, the assumption appears to hold as a matter of German domestic tax law (though possibly not under some of its tax treaties) in the case of corporations. It seems unclear in the case of an individual (sole proprietor) and unwarranted in the case of partnerships.
8.1.2 Outbound Category 2
Transfers from the domestic head office to a foreign permanent establishment in a country with which Germany has a tax treaty under which it avoids double taxation by the exclusion method.
Fixed assets
An outbound transfer of a fixed asset results in revaluation of the asset at its arm's length price on the books of the transferring domestic head office. After subtraction of the previous book value from the arm's length price, a negative difference is recorded as loss. A positive difference (profit) is, however, neutralised for tax purposes by recording it as a special item on the liabilities side of the balance sheet. This entry is then progressively reversed (debit revenue, credit special item) over the remaining useful life of the asset in the foreign permanent establishment, thus spreading the profit realised by the transferring head office over this period.
Current assets
An outbound transfer of a current asset is treated similarly except that the special item entered on the righthand side of the balance sheet to neutralise any profit on the transaction is not reversed until the asset in question is disposed of (e.g. sold) by the foreign permanent establishment.
For both fixed and current assets the taxpayer may opt for immediate realisation of any gain on transfer.
Intangible assets
For outbound transfers of intangible assets, the draft directive applies the same rules with the important exception that any special item still on the books of the transferring domestic head office ten years after the outbound transfer must be completely reversed and the resulting profit realised. The IDW correctly states that there is no basis in law for this unfavourable treatment of intangible assets and recommends its elimination.
8.1.3 Outbound Category 3
Transfers from a foreign permanent establishment the profit of which remains subject to German taxation because no tax treaty applies to a foreign permanent establishment the profit of which is excluded from the German tax base by virtue of a tax treaty (subsection (2.6.1 (d), p. 25).
One must read between the lines to discern that the draft implicitly refers to transfers from the foreign permanent establishment of a German resident (person subject to tax in Germany on his worldwide income). Making this explicit would improve the clarity of the provision.
It is unclear from the relevant subsection whether the transferring foreign permanent establishment must be located in a country with which Germany has no tax treaty, as the subsection's heading implies, or can be located in a treaty country as long as Germany avoids double taxation by the credit method, as the logic of Category 1 would seem to dictate.
The draft directive provides that the rules for Outbound Category 2 will apply here as well.
8.1.4 Outbound Category 4
Transfers from a domestic permanent establishment not constituting the head office and a foreign permanent establishment (including the head office - section 2.6.3, p. 26).
The draft directive denies deferred taxation treatment to this category of outbound transfers on the grounds that the assets in question have completely left the German tax sphere.
In Category 2 and 3 transfers, profits from the asset in question remain subject to German taxation in principle because they are attributable to a person subject to tax in Germany on his worldwide income (German resident person), even though they are excluded from the tax base under a tax treaty.
We concur with the recommendation of the IDW that deferred tax treatment be extended to Category 4 outbound transfers to a permanent establishment located within the European Union to avoid discrimination against EU resident persons by allowing them the same deferral as German residents.
8.1.5 Outbound Category 5
Transfers of an asset held as "domestic business property" (inlaendisches Betriebsvermoegen - a term which would include property held in the domestic permanent establishment of a partnership) to a "foreign partnership" (section 2.6.4). The provision makes no mention of the location of the permanent establishment of the receiving partnership. However, it does state that it is to apply to transfers of "special business property" (Sonderbetriebsvermoegen) as well as to property legally owned by the partnership.
The draft directive denies deferred taxation on transfers of domestic business property to "foreign partnerships".
Section 1.1.4 (p. 10) of the draft directive defines a "foreign" partnership as one which is "formed" in a foreign country. Category 5 would hence not apply to transfers of domestic business property to a "domestic partnership," i.e. one formed in Germany. Since the place of formation of a partnership is freely manipulable, unlike the locations of its permanent establishments, either Category 5 or the term "foreign partnership" (or both) would not appear to be sensibly defined (see also sec. 9.2 below).
It appears probable that Category 5 is meant to apply to transfers from a partnership's domestic permanent establishment to its foreign permanent establishment. However, such transfers would arguably not constitute transfers "to" a partnership because the same partnership would own the asset before and afterwards.
In our opinion, outbound transfers between the permanent establishments of the same partnership (including transfers of special business property), should be covered by Categories 1 - 4, which should be reworded to refer to transfers from permanent establishments maintained by or attributable to German residents or non-residents, as the case may be. References to transfers to and from the "head office" should be deleted.
Transfers between different business entities belonging to the same person constitute a transfer to which Category 5 is clearly meant to apply. For example, let us assume that a German resident individual wishes to contribute an asset he has for years used in his domestic commercial business to the foreign permanent establishment of a newly formed partnership in which he is a partner. Let us further assume that the partnership in question was formed in a foreign country, so that it constitutes a "foreign" partnership in the not very logical sense defined by the draft directive. The transfer would be covered by Category 5.
If, instead of contributing the asset to the partnership, its owner merely gave the partnership the right to use the asset, e.g. under a long term lease, this would cause the asset to become special business property (Sonderbetriebsvermoegen) of the respective partner under German domestic tax principles. The transaction would likewise fall under Category 5. By its terms, Category 5 would also apply if the transfer were to the domestic (German) permanent establishment of a "foreign partnership". However, under the so-called "Co-entrepreneur Directive" (Mitunternehmererlass - 20. Dec. 1977, BStBl II 1978, 8), transfers of assets between two different domestic commercial businesses of the same taxpayer, including transfers to a partnership in which he is a partner, do not trigger tax.
The IDW comments critically on Category 5, although mainly because it believes that the Co-entrepreneur Directive should apply to transfers of the sort described whether the receiving permanent establishment is domestic or foreign.
8.2 Inbound transfers
Inbound transfers are covered by section 2.6.2 on p. 26 of the draft directive. The second paragraph of section 2.6.3 on p. 27 also deals with inbound transfers. Again, there are several categories of transfers to consider. Basically, assets received in inbound transfers which cause an asset to become subject to German taxation (Verstrickung) will be entered on the books of the receiving German permanent establishment (including the head office) at their arm's length value. If the asset was already subject to German taxation before the inbound transfer, it will be taken onto the books of the receiving German permanent establishment at its prior book value. In neither case is gain or loss realised in Germany.
8.2.1 Inbound Category 1
Re-transfer to the domestic head office of an asset previously transferred by the head office to a foreign permanent establishment in a country with which Germany has a tax treaty under which it avoids double taxation by the exclusion method (prior Outbound Category 2 transfer)
The transaction causes a tax exempt asset to re-enter the normal German tax sphere. The asset is revalued at its arm's length price on the books of the foreign permanent establishment. The foreign permanent establishment realises gain or loss accordingly (which is exempt in Germany under the tax treaty). The receiving head office takes the asset onto its books (debit: entry of new asset, credit: equity, i.e. no profit realisation) at the arm's length price, subject to two adjustments. Firstly, if a special item is still on its books by reason of the original Outbound Category 2 transfer, this item is offset against the arm's length price, so that the excess thereof over the special item becomes the new value of the asset on the books of the head office. Secondly, the value of the asset on the books of the head office may not exceed its historical cost.
The relevant passage of the draft directive (first paragraph of section 2.6.2) speaks generally of re-transfer to the domestic head office of assets previously transferred to a foreign permanent establishment. The passage would be easier to understand if it was amended to refer to re-transfer of assets previously transferred to a foreign permanent establishment located in a country with which Germany has a tax treaty under which it avoids double taxation by the exclusion method. Only from context is it possible to infer what is meant.
8.2.2 Inbound Category 2
Transfers to the domestic head office of assets purchased (or presumably produced) by a foreign permanent establishment located in a country with which Germany has a tax treaty under which it avoids double taxation by the exclusion method.
The transaction causes a tax exempt asset to enter the normal German tax sphere. Again, the asset is revalued at its arm's length price on the books of the foreign permanent establishment prior to the transfer, causing it to realise gain or loss, which is however exempt from tax in Germany under the tax treaty. The domestic head office takes the asset onto its books at the arm's length price without realising profit. The draft directive does not state whether historical cost again applies as an upper limit.
8.2.3 Inbound Category 3
Transfers of assets to the German permanent establishment of an entity with a foreign head office (irrespective of whether the transfer comes from the foreign head office or another foreign permanent establishment - 2nd paragraph of section 2.6.3).
Here, the transaction causes an asset which was completely outside of the German tax sphere to enter the normal German tax sphere. The asset is entered on the books of the German permanent establishment at its arm's length value. The transfer has no German tax consequences for the transferring foreign permanent establishment.
8.2.4 Inbound Category 4
Transfers or re-transfers of assets to the domestic head office from a foreign permanent establishment located in a country with which Germany has no tax treaty or a tax treaty under which it avoids double taxation by the credit method.
The transaction involves movement of an asset inside a single legal entity inside the normal German tax sphere. The asset in question is booked off the balance sheet of the transferring foreign permanent establishment and entered at the previous book value on that of the receiving domestic head office without realisation of gain or loss either in Germany or abroad. (If a re-transfer is involved, the prior outbound transfer will have been an Outbound Category 1 transfer.)
8.2.5 Comments on inbound transfers
The draft directive does not explicitly deal with re-transfer of assets following an outbound transfer of the types 3 - 5. Since Outbound Category 3 transfers are subject to the same rules as Outbound Category 2 transfers, it would appear logical to treat an inbound transfer which reverses an Outbound Category 3 transfer under the rules for Inbound Category 1 (which cover reversals of Outbound Category 2 transfers). Reversals of Outbound Category 4 transfers would appear to be similar to Inbound Category 3 transfers. The rules for Inbound Category 3 transfers would also appear appropriate to reversals of Category 5 outbound transfers the way the draft directive is now written. (This would no longer be the case if changes were made in the treatment of Category 5 outbound transfers.)
It would be helpful for the final version of the draft directive to fill in the gaps in its treatment of inbound transfers. Instead of a confusing multiplicity of categories, which becomes even harder to keep straight when an inbound transfer reverses a previous outbound one, it would appear better to articulate general principles which can then apply to all inbound transfers. As in the case of outbound transfers, specific comments on the treatment of partnerships are also needed.
9. Partnerships
9.1 Attribution of permanent establishments to partners
The draft directive affirms under section 1.1.4 (p. 10) the long-standing German position that an interest in a commercial partnership is deemed to constitute a pro rata permanent establishment with respect to each permanent establishment maintained by the partnership. This principle applies to both general and limited partners and to "German" as well as "foreign" partnerships.
9.2 Domestic and foreign partnerships
The draft directive defines a partnership as "German" (domestic) or "foreign" depending on where it was "formed" (errichtet - sec. 1.1.4, p. 10). No explicit mention is made of the law under which a partnership is organised (which should usually coincide with the law where it was formed) or the law which governs the partnership's internal affairs under German conflict-of-law principles (law at location of the principal place of management, which can of course change with time). The directive appears to assume that all partnerships will be created by a formal constitutive act, the location of which will be easily determinable, for instance on the basis of the entry of the partnership in a commercial register. While this may be true of most limited partnerships, it is not necessarily the case for general partnerships. Whether easily determinable or not, the place of formation would in all events appear to be easily manipulable and hence relatively meaningless for tax purposes.
There are thus several passages in the draft directive where one doubts whether its drafters have adhered to their own definition of "domestic" and "foreign" partnerships. A case in point is the discussion of the important matter of interest payments by a partnership to a partner (section 1.2.1, page 15; see sec. 9.5 below). In section 2.6.4 (p. 27), the draft directive also refers to outbound transfers to a "foreign partnership" where it probably means transfers to the foreign permanent establishment of any partnership, whether domestic or foreign (see sec. 8.1.5 above).
With respect to partnerships, the location of their permanent establishments is of far greater tax significance that whether they are "foreign" or "domestic" in the sense defined by the draft directive.
9.3 Bookkeeping for foreign and domestic partnerships
The directive states that the distributive share of a domestic partner in a foreign partnership is to be determined on the basis of the accounts of the partnership as maintained in accordance with foreign law. Appropriate adjustments are to be made to the foreign accounts in order to bring them into line with German law, notably sec. 15 (1) sent. 1 no. 2 EStG. It is, however, not necessary for the foreign partnership to maintain separate accounts in accordance with German law. The determination of profits is to be made under sec. 4 (1) EStG; sec. 5 EStG does not apply. The inapplicability of sec. 5 EStG in general simplifies tax accounting, but is otherwise seldom of practical significance.
The distributive share of a foreign partner in a foreign partnership from the partnership's German permanent establishment is to be determined under sec. 4 (1), 5, and 15 (1) sent. 1 no. 2 EStG, the primary difference being the applicability of sec. 5 EStG. (It is unclear whether the above would apply as well for the distributive share of a German partner from the German permanent establishment of a foreign partnership.)
The draft directive correctly states that foreign partners are not liable to German tax on their share of the profits of a "German" partnership's foreign permanent establishment merely because the partnership was formed in Germany (section 1.1.4, pp. 11, 12). The profits attributable to foreign permanent establishments of German partnerships are thus not taxable to foreign partners. This is a necessary consequence of the pro rata attribution of permanent establishments to the partners.
9.4 Partner's obligations to provide documentation and information
Section 1.1.4 on p. 11 of the draft directive provides that partners are generally required to provide all necessary information and to produce the partnership's accounts, the year-end financial statements, and other business records as necessary, subject to the limits of what is reasonable to expect of the partner and appropriate in light of the amounts involved.
The IDW justly criticises the draft directive for failing to consider the limitations to which limited partners in particular are generally subject with respect to their rights against the partnership to information and production of documents. The IDW recommends amending the passage in question to state that no partner is required to do more than excercise those rights which he has as a partner.
9.5 Contractual relationships between partner and partnership
German domestic law treats interest on loans granted by partners to their partnerships as part of the profits of the partnership, thus denying tax recognition to these relationships (sec. 15 (1) sent. 1 no. 2 EStG). Similarly, rents and royalties paid by a partnership to a partner are also added back to the profits of the partnership. This rule exists essentially to prevent depletion of the trade tax base in the case of partnerships engaged in trade or commerce. Without the special rule, the partnership income subject to the trade tax on earnings could be reduced by payments from the partnership to the partners. With respect to the trade tax on capital, a similar rule applies which in effect treats assets belonging to the partners as partnership property if the asset is used to a sufficient extent in the partnership (so-called "special business property" - Sonderbetriebsvermoegen).
In a tax treaty context, these rules have caused considerable controversy. It was argued that the assimilation to partnership earnings of interest paid by a partnership to a partner applied for tax treaty purposes as well when a domestic partner makes a loan to a partnership the sole permanent establishment of which is located in another treaty state. Accordingly, the interest paid by the partnership to the domestic partner should, so the argument ran, be added back to the profits of the partnership, attributed to its foreign permanent establishment, and excluded from the German tax base. This would result often in a double exclusion for the sums involved, since the country where the permanent establishment is located will as a rule recongnise the loan to the partnership and treat the interest paid to the German partner as a deductible expense in computing the profits of the partnership. The interest payment to the foreign partner by the partnership is often exempt from tax in the source state under the terms of the applicable tax treaty.
The Federal Tax Court has held in cases involving the tax treaty with the U.S. in force prior to 1990 that the interest paid in such situations does not constitute business profits within the meaning of the tax treaty (even though it would constitute income from trade or commerce under German domestic law). The court instead applied the interest article of the treaty to the payments, permitting Germany to tax them as interest received by one of its residents (BFH 27 Feb. 1991 - BStBl II 1991, 1709 and 31 May 1995 - BStBl II 1995, 683).
The draft directive cites these principles under section 1.2.1 on page 15. However, in cases involving a reverse situation, i.e. one in which foreign partners in a partnership maintaining a permanent establishment only in Germany make loans to the partnership, the draft directive appears to state that the interest payments will not be deducted in computing the profits attributable to the permanent establishment and so will remain fully taxable in Germany. Attention is called to this conspicuous inconsistency by the IDW as well. (The passage in question is apparently misworded, hence one can only conjecture as to its intended meaning.)
It seems obvious that the "inbound" transaction involving the German permanent establishment of a partnership with foreign partners must be treated the same way as an "outbound" transaction between a German partner and a partnership with a foreign permanent establishment. A distinction in the treatment of these transactions can only be based on asymetrical provisions in the tax treaty in question. However, there are few such treaties, if any.
Recognition of contractual relationships (loans, rental of tangible property, license agreements) between foreign partners and their domestic pro rata permanent establishments can be of great practical significance, especially when one recalls that the thin capitalisation rules of sec. 8a KStG do not apply to partnerships. Affected is not only the income taxation of the persons involved, but also the trade tax on earnings and potentially that on capital as well. Despite the trade tax add-backs, the potential savings are great.
It will be interesting to see how the final version of the draft directive deals with this issue.
9.6 Loans by partners to partnerships
Citing a decision of the Federal Tax Court of 22 January 1981 (BStBl II 1981, 427), the draft directive provides that "a loan by a partner to a partnership of unusually long duration results in reclassification of the [partner's] debt claim as dotation capital of the permanent establishment for tax purposes" (section 2.7.2, p. 29).
Obviously, this provision can only be intended to operate when a tax treaty prevents the add-back of interest paid by a partnership to a partner under the general German domestic tax rule described in the preceding subsection. It will be recalled that, with regard to German permanent establishments attributable pro rata to foreign partners, the draft directive appears to take the position that the general German rule would continue to apply. If so, a certain contradiction would exist between sections 1.2.1 and 2.7.2 of the draft directive since the application of the general German rule with respect to a partnership's German permanent establishments would mean that the reclassification of debt as equity under section 2.7.2 could only take place with respect to the foreign permanent establishments of a partnership having German partners. Since the result of such a reclassification would be to increase the earnings of the partnership's foreign permanent establishment and to destroy the German right of taxation with regard to the interest, it is hard to believe that the drafters of the draft directive had this in mind.
The IDW is also critical of section 2.7.2, albeit on the grounds that dotation capital is impossible in the case of a partnership as a theoretical matter.
It may be supposed that the issue will be clarified in the final version of the draft directive.
9.7 Consortiums
Particularly in connection with large construction projects, it is common for firms to form single-purpose consortiums or joint ventures for the purposes of bidding for a contract and performing it. Such combinations as a rule constitute civil law partnerships from a German point of view. The draft directive points out that a consortium may be required to keep separate accounts for its German permanent establishment even if the profit of each of the member companies is determined separately with respect to the company's individual revenues and expenditures (section 1.1.2, p. 8 and section 4.3.6, pp. 51, 52).
9.8 Partnership equity
The draft directive provides that when interests in a German partnership are acquired by non-resident persons, an arbitrary reduction of the capital accounts (presumably by means of withdrawals) will not be permitted since the level of equity previously in the partnership will be regarded as a benchmark for what is necessary from a business perspective (section 2.5.2, p. 23). The IDW is critical of this provision, stating that the amount of equity in a partnership is purely a matter of the relevant company law and hence that a partnership has no "dotation capital" (Dotationskapital) to begin with. We also believe that the arguments raised by the IDW with regard to minimal equity in permanent establishments in general (see sec. 5.6 above) apply in the context of partnerships as well. It is well established under German tax law that a businessman may fund his business with equity or debt to any extent he chooses unless he exceeds the limits of what is "economically necessary". These limits are broad. There is no legal basis for the attempt by the draft directive to establish a presumption that any diminution of the amount of capital in a partnership at the time of its purchase by a non-resident person would conflict with what is "economically necessary".
10. Other issues
10.1 Documentation and information
Like the 1983 transfer pricing guidelines for associated enterprises, the draft directive contains no specific documentation or information requirements. Section 5 of the draft directive (pp. 63 - 65) reminds the taxpayer of his basic obligation to cooperate and provide information, and that this obligation is heightened under sec. 90 AO (tax procedure act) in situations involving foreign countries. The standard position of the tax authorities is repeated that a taxpayer is required to produce not only all documents and information within his actual control, but also all that to which he, by exercise of reasonable foresight, could have secured access or a right of access under the circumstances. The legal consequence of inadequate cooperation or inadequate documentation by the taxpayer is denial of relevant deductions and/or estimation of tax owing by the tax authorities (sec. 160, 162 AO). No fines or other special penalties exist.
10.2 Independent services
Section 6 of the draft directive (p. 65) provides for its application by analogy to independent services under Article 14 of the OECD model convention.
The IDW rightly objects that the issues here involved are too complicated to be taken care of simply by an instruction to 'apply the above mutatis mutandis,' and appropriately recommends either expanding the document to deal with these issues in detail or eliminating section 6 entirely.
10.3 Transition provisions
The draft directive states in section 6.2 that changes made by taxpayers in the structure of their activities during the three years following issuance of the directive shall not as such give rise to legal inferences detrimental to the taxpayer. The idea is apparently that the fact that a taxpayer has restructured his operations shall not be taken to be evidence that his old structure was not in compliance with tax law (or did not yield an appropriate allocation of profits). Any challenge to the old structure would have to ignore the fact of its abandonment.
This would not seem to rule out the possiblility of calling attention to existing problems as a practical matter by making changes.
10.4 Superseded administrative pronouncements
Section 6.3 (p. 66) of the draft directive provides that the following administrative pronouncements shall lapse upon publication of the new directive:
Directive of 12 Feb. 1990 (BStBl I, 72) on the transfer of assets to and from a foreign permanent establishment the profits of which are excluded from German taxation under a tax treaty;
Directive of 24 Aug. 1984 (BStBl I, 458) on the treatment of monitoring and coordination offices maintained by foreign corporate groups in Germany;
Directive of 29 Nov. 1996 (BStBl I, 136) on the dotation capital of the domestic permanent establishments of foreign lending institutions (banks).
11. Concluding remarks
The taxation of permanent establishments is of fundamental importance for the taxation of international operations. The detail of this report on the draft directive is commensurate with the significance of the subject matter. Numerous omissions were nevertheless necessary. The parts of the draft directive dealing with currency conversion issues, the permanent establishments of banks and insurance companies, construction and assembly work, monitoring and coordination offices, ships, and mining operations have in particular been dealt with highly selectively or not at all.
We will of course report further on this subject as developments warrant.
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