Germany: 200. Germany Redefines Its Cost Contribution Policy

14.1 Pool solutions

a) Research pools

b) Intra-group services

14.2 Direct Invoicing

In late December 1999, the German tax authorities issued new final regulations on income allocation between internationally associated enterprises by means of cost contribution (cost-sharing) arrangements. Article 201 provides a translation of the new regulations.

The new regulations replace Part 7 of Germany's previous transfer pricing regulations, the so-called Administrative Principles of February 1983. Section 6 of the new regulations, dealing with the consequences of deficiencies in cost-sharing arrangements, will apply to existing cost-sharing arrangements as of December 31, 2000. Hence, the transition period for bringing existing cost-sharing arrangements into line with the new regulations is short.

The magnitude of the necessary changes is likely to be great, however. The new regulations do much more than clarify and refine the old regulations. They establish a system completely different from previous German notions of cost-sharing arrangements. Consequently, the great majority of existing cost-sharing arrangements will have to be redesigned from the ground up – not just adjusted or modified – to comply with the new regulations. The utility of previous commentaries on cost-sharing arrangements is limited to specific sub-areas such as the deductibility of costs.

This article treats only the crucial changes made by the new regulations. Many important aspects – such as the capitalisation of assets, benefit offsets, and the adjustment of cost-sharing arrangements when actual benefits diverge from anticipated benefits – must be reserved for a later article.

Multinational groups frequently cause their group members in various jurisdictions to enter into agreements by which services needed by all group members on a continuous basis (such as legal, accounting, advertising, coordination, financing, or purchasing services) are centrally supplied to group members in a given market area (e.g. Western Europe) by a single group company or division. Furthermore, various members of a corporate group may join to develop tangible or, more often, intangible assets. Such intangibles include patentable inventions, secret know-how, marketing intangibles (e.g. trademarks, logos, or copyrights), and commercial know-how (e.g. a streamlined process for training new executives).

Cost-sharing arrangements are indispensable to the efficient coordination of international operations by vertically and horizontally integrated multinational groups seeking to develop, manufacture, and sell their products, at least on certain market levels, by means of controlled entities instead of independent third parties.

Since individual invoicing of a complex exchange of services on a continuous basis can involve unreasonable administrative cost, and since situations arise, e.g. in the case of advertising for a multi-jurisdictional area, in which it is not easy to divide the service rendered into specific parts allocable to particular national group members, multinational groups frequently seek to allocate charges by applying allocation formula to defined cost blocks rather than by individual invoicing methods.

In addition to their undeniable economic efficiency, formulaic cost-sharing arrangements pose special threats of abusive allocation of charges to high-tax jurisdictions and accumulation of earnings in low-tax jurisdictions. Hence, they are a primary focus of attention by tax authorities the world over.

Since cost-sharing arrangements by their nature involve multiple tax jurisdictions, one of their challenges is to ensure results which are recognised in all of the relevant jurisdictions.

The new German regulations apply solely to formulaic cost-sharing arrangements in the above sense, whether for the purpose of developing assets or rendering services. The regulations make clear that they do not apply to individual invoicing of services between associated enterprises whether these services are priced using a direct-charge or an indirect-charge method (Reg. sec. 1.0).

The new regulations make major changes in the conditions under which the German tax authorities are prepared to recognise the results of such arrangements for tax purposes. The foremost change is the limitation of such arrangements to quasi-partnership pools.

The pool concept is in itself not new to this area of German transfer pricing theory. Under the pool concept, the exchange of goods and services among participants in a cost-sharing arrangement is likened to the contributions of partners to a partnership or joint endeavour (a pool) whose members cooperate out of common interests with a view to a common purpose and jointly share the entrepreneurial risk. By contrast, the internationally prevalent majority view regards formulaic cost allocation as an expedient and efficient simplified form of charging for arm's length exchanges of goods and services (market concept).

The primary consequence of the pool concept is the inadmissibility of a profit mark-up on the exchange of services within the pool, whereas the market concept requires such a mark-up. In keeping with the pool concept, the 1983 transfer pricing guidelines prohibited a profit mark-up where costs were allocated by means of a cost allocation formula (Admin. Principles sec. 7.1.6).

However, numerous exceptions existed to this prohibition. These were created in part by the courts and in part in response to criticism in the literature. The tax authorities allowed profit mark-ups for group management services under a 1984 directive and in general accepted profit mark-ups where the services involved were rendered by a group company having the performance of such services as its sole or virtually sole business activity.

Under the new regulations, a cost-sharing arrangement can no longer include a pure service-provider member since its participants must all perform similar economic functions. A profit mark-up is rejected categorically (Reg. sec. 2.2). The new regulations thus run counter to the international trend and return to the pool concept in pure form.

However, even under the new regulations, essentially contractual flat rate fee arrangements (market concept) may be acceptable where it is difficult to determine an arm's length charge for services rendered or the services can only be valued collectively (cf. Admin. Principles sec. 7.1). The justification for such arrangements should be carefully documented in order to be able to present a convincing case on audit. Situations in which this is possible are expected to be relatively rare.

The new regulations define cost contribution arrangements as "agreements concluded among internationally associated enterprises to obtain or render services in their interest over an extended period of time through participation in a cooperative pool" (Reg. sec. 1.1). Sec. 1.2 states that, for tax purposes, "only enterprises which pursue parallel interests can be recognised as members of a pool, i.e. only those firms which use the pooled services in the same economic manner." The members of the pool are said to constitute a partnership-like association in their dealings among themselves (inter se – so-called Innengesellschaft), without creating a partnership for purpose of dealings with outsiders (no Außengesell-schaft) and without creating any permanent establishments.

By contrast, it was previously possible for associated enterprises to participate in a cost-sharing arrangement on a purely contractual basis irrespective of their "parallel interests" and regardless of whether they constituted a pool in the above sense. In the future, however, arrangements whose members do not form a pool will not be permitted to allocate costs on a formulaic basis and will instead be required to use the more burdensome direct invoicing procedure.

This implications of this change are far-reaching.

A pool will only be recognised for tax purposes where its members pursue parallel interests and utilise the results of the pool in the same economic manner. Participation in a pool is therefore restricted to enterprises which themselves derive like benefits from the services they render to the pool. The interests of holding and patent exploitation companies differ, for example, from those of manufacturing companies. Hence, such companies may not be members of the same R&D pool. Mere contractors, such as contract manufacturers or developers, who themselves derive no benefits from the results of the pool, are also not eligible for pool membership. But they may render services to the pool.

In a horizontal association of marketing subsidiaries cooperating to develop a brand name, the requirement of parallel interests and utilisation of the results of the pool in the same economic manner should not present any problems. However, a vertical association involving a parent company and its subsidiaries is more complicated. Here, even the introduction of uniform software could involve the pursuit of diverse interests, though not where the participants have a joint bookkeeping system.

In keeping with the pool concept, no profit mark-up is allowed on the costs allocated under a cost-sharing arrangement (Reg. sec. 2.2). This constitutes a sharp restriction compared with past practice (see sec. 3 above). As before, direct and indirect costs may be allocated, as may overhead costs and a notional interest charge on the equity used in the venture. This notional interest is calculated at the deposit interest rate for the currency of the country where the pool's business activity is carried out (Reg. sec. 2.1).

On the other hand, non-pool group companies which render services to the pool base their transfer prices on the arm's length principle (Reg. sec. 1.7). Under the cost-plus method, they would include a profit mark-up on their costs. The 5 % limit on such mark-ups originally planned by the tax authorities was not included in the final regulations. These costs, including the profit mark up of non-pool group companies, can be shared between the pool members.

Costs under a cost-sharing agreement are allocated in accordance with the benefit each pool member expects to receive from the pool (Reg. sec. 3.1). While this is not new in itself, new consequences are now drawn from the benefit principle. Documentation is required on the individual anticipated benefit and the means by which the cost allocation formula is arrived at (Reg. sec. 5.1.1 nos. 4 and 5). The taxpayer must choose the cost allocation formula which is most appropriate to the specific situation (Reg. sec. 3.2). Benefit analyses are therefore a required part of every cost-sharing contract, e.g. as appendices, enclosures, or side agreements. The anticipated benefit of a pool member is determined by problem and target analyses and by other means. The benefit derived by other group members not participating in the pool must also be determined and documented. Thorough, carefully documented benefit analyses are henceforth the sine qua non of tax recognition of every cost-sharing arrangement.

The growing number of corporate acquisitions in recent years means that practically every multinational group in Germany is adding new corporations to existing cost-sharing arrangements. The entry provisions of the new regulations have considerable impact in such situations.

Under Reg. sec. 4.1, enterprises are required to pay an entry fee (buy-in payment, balancing payment) if they join an existing pool and in so doing gain access to tangible or intangible results of the pool's prior activities. Entry fees are measured by the value of such results at arm's length rates. The results may consist of intangible assets, work in progress, or know-how. The regulations also state that entering members should make a payment for the pool's prior unsuccessful research. Such payments will, however, be limited to cases where the fact that a particular line of research has failed has value because it is not public knowledge and other companies continue to explore this avenue.

The general criterion is whether or not a prudent and conscientious business manager would have paid for, or demanded payment for, the knowledge involved. Especially with regard to intangible results, valuation is only possible with a view to the future and must be based primarily on a comparison with the earnings of other comparable companies. In Germany, such earnings data is difficult to glean from the available databases. Historical cost is at any rate not an acceptable indicator and can at best be applied as a check on the plausibility of results arrived at by other methods. If the entering firm brings equivalent knowledge with it into the pool, no balancing payment is required.

The new pool member must capitalise any tangible or intangible assets acquired by joining the pool. Non-cash contributions to the pool by the new member are valued by analogy to a lease, not a sale.

Joining an administrative service pool generally triggers no balancing payments since the new member as a rule does not acquire access to intangible assets or know-how. But even here, acquisition of the right to use accounting systems or software programmes developed by the pool would necessitate an entry fee.

The frequent corporate reorganisations in recent years have also caused a large number firms to leave existing pools. Reg. sec. 4.2 addresses withdrawals from pools and provides that they can result in payments from the withdrawing member to the pool or vice versa.

An exit fee is payable by the withdrawing member where his withdrawal identifiably and quantifiably diminishes the pool's value for the remaining members. Under the new regulations, this is the case when the withdrawing member retains control or takes assignment of rights to intangible assets, work in progress, or know-how. Presumably, the regulation only intends to require an exit fee if the value of the rights which the withdrawing member takes with him exceeds that of his share in the pool at the time of withdrawal.

If, on the other hand, the withdrawal confers benefit on the remaining pool members, it is they who must make a balancing payment to the withdrawing member. This will always be the case where the withdrawing member transfers his rights under the cost-sharing arrangement to the remaining pool members.

The valuation problems posed by withdrawal are analogous to those upon entry.

When a cost-sharing arrangement is converted to a licensing agreement, Reg. sec. 4.3 provides that the pool members must be sufficiently compensated. Such compensation is owing where the pool members surrender their rights in favour of the future licensor.

Reg. sec. 4.4 provides that cost allocations are not subject to the withholding tax imposed on royalties by § 50a (4) of the income tax act. Assuming the statutory requirements are otherwise met, withholding tax is, however, owing on a rateable part of the cost allocations paid by a German resident pool member where a foreign pool member makes intangible property available to the pool and hence to the resident pool member. Even though withholding exemptions will often apply under tax treaties (depending on the country of residence of the owner of the intangible property), the new rule represents a major negative change in position on the part of the tax authorities.

Withholding tax imposed by other countries must be credited pro rata to each pool member. This rule poses considerable practical difficulties due to the different tax treaties involved. If foreign withholding tax is credited in toto to a pool member holding legal title to licensed intangible pool assets, this member must compensate the other pool members.

Reg. sec. 5.1.1 establishes stiff minimum requirements for cost-sharing arrangements. Benefit analysis studies must be prepared for each pool member and on the process by which the cost allocation formula was arrived at. These studies must now be part of the contract (e.g. as appendices, exhibits, or side agreements). The contract must also explain the determination and valuation of each member's initial and subsequent cost contributions. Valuation of non-cash contributions is generally a difficult matter. Such contributions are valued by analogy to a lease, not a sale. The contract must also contain provisions dealing with adjustment of the cost-sharing arrangement to new circumstances, contract termination, entry and exit of pool members, and member access to documents and records relating to costs and services.

The documentation requirements of Reg. sec. 5.1.2 are also extensive and burdensome. Benefit analysis is a matter of "special significance" under Reg. sec. 5.1.4. Separate documentation of costs incurred and benefits conferred by the pool is also crucial.

Extensive documentation must be maintained even by pool members who are mere service recipients (as opposed to service providers). This documentation includes not just the contracts themselves, but also an analysis of the anticipated benefit from the cost-sharing arrangement both in itself and relative to the member's share of the costs, that is, relative to the benefit anticipated by the other pool members. The documents must reflect allocation of costs in accordance with their causes and expected benefits. Besides numerous other requirements, service recipients must also provide a detailed list of total costs according to cost centres and a breakdown of direct and indirect costs according to cost type. Finally, services actually received and actual benefit derived are to be documented separately.

If a cost sharing arrangement contains grave deficiencies, no deduction will be permitted for the cost allocations. Under Reg. sec. 6, a cost-sharing arrangement is gravely deficient if a prudent and conscientious business manager would not have consented to become party to it. If a prudent and conscientious business manager would only have entered into the contract provided his payments were reduced, then cost allocations are only deductible to the extent of such reduced payments. If the basic contractual arrangement is sound, but its documentation is inadequate, the tax authorities may determine the deductible amount by estimation.

Compliance with the new pooling concept is theoretically an easy matter for research pools. It is, however, important to make sure that the pool members pursue parallel interests as required by Reg. sec. 1.2. Profit mark-ups are no longer permitted, though a notional interest charge is allowed on the capital used in the pool. It will, however, often be possible to form pools which contract with group companies not party to the pool for research and development services. Since the contract service provider does not belong to the pool in such cases, it is not subject to the prohibition on profit mark-ups.

External contractors can charge the pool for their research services at arm’s length rates. If they use the standard cost-plus method, they will generally charge standard full costs plus a profit mark-up. Within the pool, these costs, including the outside service provider's profit mark-up, are divided among the pool members according to the cost allocation formula. Allocable costs are determined according to the accounting rules recognised in the country of the contract researcher. The profit mark-up is calculated using the profit margins of comparable companies, which can be determined from databases. It should be noted that the full absorption (costing) approach found in Anglo-American accounting systems is often similar to German contribution costing. The profit mark-up must therefore also cover overhead costs. This should be kept in mind when determining the arm's length profit margin.

Group companies with different business purposes such as holding companies or patent exploitation companies may not join the same pool. However, this does not prevent them from contracting with the pool to use its results.

Since the parent corporation of a group does not necessarily pursue the same interests as its subsidiaries, a cooperative pool is permissible only for certain administrative services, such as accounting or information technology. In all other cases, holding companies and parent corporations should render services to the pool as external contractors. All direct, indirect, and overhead costs incurred may be charged to the pool together with an appropriate profit mark-up, as described above, provided the costs are deductible in principle and do not include stewardship expenses. Within the pool, these costs would then be allocated to the pool members.

A direct invoicing system may be selected as an alternative where it is not possible or expedient to have services provided by a group member external to the pool or where the documentation requirements under Reg. sec. 5.1 are prohibitive. Where changes in international cost-sharing arrangements are undesirable because of the negative tax impact in foreign jurisdictions, German corporations can still receive services as non-pool members under a direct invoicing system.

The rights and obligations in such an arrangement can be structured so as to resemble economically those under a cost-sharing contract. Unlike cost-sharing contracts, the services would not only be separately defined, but also individually calculated and invoiced like tangible assets within the framework of a cost-plus system. The cost allocation formula of the existing cost-sharing arrangement would then serve as the formula for allocation of overhead cost. In practice, this approach leads to solutions similar to those found in normal price calculations.

The new cost-sharing regulations permit formulaic cost allocation (cost-sharing arrangements) only among a group of companies constituting a pool. Where the requirements for a pool (in particular, parallel interests of all members) cannot be met, the only alternative is a direct invoicing system. Even where a pool can be formed, the new prohibition on profit mark-ups remains.

Advance benefit analysis studies constitute the core of the new cost sharing system and must be incorporated into the cost-sharing contract. These and extensive documentation and evidence requirements necessitate far more work than before. Fundamental changes also result from new rules on member entry and exit, the capitalisation of assets, the applicability of withholding tax, and the conversion from a cost-sharing to a licensing system.

Where the requirement of parallel interests cannot be met or a profit mark-up is indispensable, cost-sharing pools can contract with group companies not included in the pool for the necessary R&D or administrative services. Alternately, German resident companies can withdraw from existing international cost-sharing arrangements and in the future draw services from the relevant service providers under a direct invoicing system.

However one responds to the new German cost-sharing regulations, considerable reorganisation is likely to be necessary, and the deadline for completing this reorganisation will expire in less than a year's time.

Please address any questions regarding the subjects dealt with in this article to its author:

A slightly modified version of this article first appeared in the March 2000 edition of International Tax Review.

For further information, please send a fax or an e-mail stating your inquiry to KPMG Frankfurt, attn. Christian Looks: Fax +49-(0)69-9587-2262, e-mail cLooks@kpmg.com. You may also send an e-mail to KPMG Germany by clicking the Contract Contributor button on this screen.

This article treats the subjects covered in condensed form. It is intended to provide a general guide to the subject matter and should not be relied on as a basis for business decisions. Specialist advice must be sought with respect to your individual circumstances. We in particular insist that the tax law and other sources on which the article is based be consulted in the original, whether or not such sources are named in the article. Please note as well that later versions of this article or other articles on related topics may have since appeared on this database or elsewhere and should also be searched for and consulted. While our articles are carefully reviewed, we can accept no responsibility in the event of any inaccuracy or omission. Please note the date of each article and that subsequent related developments are not necessarily reported on in later articles. Any claims nevertheless raised on the basis of this article are subject to German substantive law and, to the extent permissible thereunder, to the exclusive jurisdiction of the courts in Frankfurt am Main, Germany. This article is the intellectual property of KPMG Deutsche Treuhand-Gesellschaft AG. Distribution to third persons is prohibited without our express written consent in advance.