Germany: 242. Transfer Pricing: Cross-Border Secondment Regulations

Dr. Arwed Crüger and Volker Schmitt, KPMG Frankfurt

The German Federal Ministry of Finance issued transfer pricing regulations for cross-border secondments in November 2001 (Grundsätze für die Prüfung der Einkunftsabgrenzung zwischen international verbundenen Unternehmen in Fällen der Arbeitnehmerentsendung), published in BStBl. 2001 I, 796. The administrative regulations address the allocation of secondment-related expenses among internationally associated companies for purposes of German taxes on business profits (primarily the trade tax on earnings and the corporate income tax). They do not deal with the expatriate's personal income tax or with social security issues.

The critical income allocation question is whether and to what extent the transferring company and/or the host company (receiving company) have a business interest in the secondment. Income is adjusted where the allocation of income is not commensurate with business interest.

The secondment regulations apply when a host company signs a contract with a transferred employee (legal test) or is treated as the employee's "economic employer" (economic test). The economic test is met when:

• the host company is authorized to direct or control the employee's job activities,
• the employee is integrated into the host company's business operations, and
• the host company bears the economic burden of the employee’s salary.

The regulations are presumed to apply to secondments lasting more than three months. However, they also apply when an expatriate is assigned to a host company for shorter durations if such assignments recur regularly over an extended period of time. The regulations permit no profit markup with respect to employee secondment in the defined sense.

The new regulations do not apply to arrangements by which personnel of an associated enterprise enter the premises of another group company to render services or perform specified work in the context of an inter-company contract (examples: permissible commercial employee leasing; construction contracts). Charges for work performed under such contracts are governed by the arm's length principle and thus typically include a profit component.

Audits of cross-border secondments follow the system outlined by the Federal Tax Court (FTC) in its decision of 17 October 2001 (see article in KPMG German News no. 1/2002 p. 2 = article no. 239). This FTC decision requires a qualitative as well as a quantitative analysis. In the course of qualitative analysis, a determination is made whether the secondment was exclusively in the business interest of the host company, or whether the transferring company also expected to benefit from the transfer. Where the secondment serves the interests of both companies, the related expenses must be appropriately divided between them.

The regulations state that the allocation of secondment expense to a transferring German resident enterprise requires a showing that the German enterprise has an economic interest in the secondment.

Quantitative analysis seeks to determine whether the total expense that a company incurs in its own business interest exceeds that which a "prudent and conscientious" manager of an uncontrolled company would have incurred for a similar employee. All direct and indirect costs are counted as long as they (i) reduce the income of the host company or the transferring company and (ii) are economically connected to activities during the secondment period, regardless of whether such costs reflect earnings taxable to the expatriate. The expatriate’s salary represents just one of several elements that comprise total secondment expense. Thus, it is not sufficient to determine only whether the salary is at arm's length.

Income is adjusted where expenses are not allocated in accordance with the business interests of the relevant companies or where a company bears expense in excess of the arm's length amount.

Taxpayers may bear the burdens of production and persuasion on secondment issues and should therefore be prepared to meet these burdens. Contracts, business travel expense reports, and time sheets are cited in the new regulations as possible evidence, as are the following analytical documents:

• Studies of comparable salaries in the local labor market
• Cost/benefit analysis with regard to wage expenses and profit contributions of the expatriate
• Profit forecasts of the host company

The new regulations invite taxpayers to apply for advance rulings with regard to secondments involving large numbers of expatriates. It may be possible to obtain an advance ruling (APA) from the tax authorities that allocates all secondment expense according to fixed percentages.

Two points should be stressed with respect to the new secondment regulations. First, the bad news: The regulations provide the tax authorities with stricter analytical guidelines and thus considerably tighten the requirements for acceptance of taxpayer secondment expense allocation structures. However, the good news is that the tax authorities have expressly indicated willingness to enter into advance pricing agreements in this area. It even appears possible to conclude such arrangements with retroactive effect in certain cases. Taxpayers should avail themselves of this opportunity to neutralise the increased risks created by the new regulations.

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