The transfer of functions (Funktionsverlagerung) is a central component of international tax law, particularly German foreign tax law (Außensteuerrecht). It addresses the tax consequences when an economically independent function is transferred from a domestic company to a foreign related company. This transfer involves the relocation of assets, opportunities, and risks and is governed in Germany by specific statutory regulations and ordinances.
Legal Basis
The basis for the tax treatment of transfers of functions in Germany is found in § 1 Abs. 3b of the Außensteuergesetz (AStG - Foreign Tax Act). This provision regulates the adjustment of income arising from the transfer of functions between related parties under non-arm's length conditions.
- § 1 Abs. 3b AStG: This provision stipulates that the transfer of a function, including the associated assets, advantages, opportunities, and risks, must be valued at an arm's length price. This so-called transfer price must be determined in accordance with the hypothetical arm's length principle if no comparable market prices are available.
- Funktionsverlagerungsverordnung (FVerlV - Transfer of Functions Ordinance): This ordinance specifies the statutory requirements of the AStG and provides detailed regulations on the valuation and treatment of transfers of functions. The FVerlV of 18.10.2022 replaces the earlier 2008 version and applies to transfers of functions starting from 2022, see also § 21 Abs. 5 AStG.
- Verwaltungsgrundsätze Funktionsverlagerung (VWG FVerl - Administrative Principles on Transfer of Functions): These principles, set out in the BMF-Schreiben dated 13 October 2010 (2010/0598886), provide further guidelines for the practical implementation of the statutory requirements.
- The BMF-Schreiben dated 22 December 2023 specifies the application of the Foreign Tax Act, emphasizing the importance of the arm's length principle and the consideration of double taxation agreements in transfers of functions to avoid double taxation.
Definition of Transfer of Functions
A transfer of functions occurs when a function, including the associated opportunities and risks as well as the corresponding assets and other advantages, is transferred to another company so that the transferee company can exercise this function or expand an existing function (§ 1 Abs. 2 S. 1 FVerlV).
- Function: A function is defined as a business activity consisting of a combination of similar operational tasks performed by specific positions or departments of a company (§ 1 Abs. 1 FVerlV). Examples of such functions include research and development (R&D), production, sales, financing, management, and organisation.
- Transfer: The transfer can be full or partial and may also be temporary. Individual transfer processes that do not constitute a transfer of functions when viewed in isolation can be aggregated into a single transfer of functions if they occur within five years (§ 1 Abs. 2 S. 3 FVerlV).
Types of Transfer of Functions
Transfers of functions can occur in various forms:
- Function Outsourcing (Funktionsausgliederung): This refers to the complete transfer of a function with all entrepreneurial profit opportunities and risks, for example, the physical relocation of production abroad.
- Function Reduction (Funktionsabschmelzung): This involves the partial transfer of a function, such as converting a full-fledged manufacturer into a contract manufacturer.
- Function Duplication (Funktionsverdoppelung): This occurs when a function exercised domestically is additionally set up abroad without restricting the domestic function. However, a transfer of functions can be assumed if the domestic function is restricted within five years after the relocation abroad.
- Function Segregation (Funktionsabspaltung): Here, a function is transferred abroad while the essential profit opportunities and risks remain domestically. The distinction of "Funktionsabspaltung," which existed under the old legal framework, has been removed in the new FVerlV from 2022.
The Finanzgericht (Tax Court) of Lower Saxony clarified in its ruling of 16 March 2023 (Ref.: 10 K 310/19) that a transfer of functions does not exist if neither assets nor other advantages or business opportunities are transferred, and there is no causal link between the transfer of advantages and the capability to exercise a function. In the case at hand, there was no transfer of intangible assets, know-how, or customer bases, and the transferee company was already capable of exercising the respective function prior to the relocation.
According to § 1 Abs. 5 AStG, no transfer of functions occurs if, despite the transfer of a function abroad, the domestic function is not restricted. However, if it is restricted within 5 years, this is detrimental. This does not apply if causality is lacking and this is made plausible.
The de minimis rule (Bagatellregelung) according to § 1 Abs. 7 FVerlV and the Administrative Principles for Transfer of Functions (VWG FVerl) items 48 and 49 states that a transfer of functions does not exist if the restriction of the function is minor. Minor meant that the drop in turnover in the last full fiscal year was less than 1,000,000 euros. However, this regulation was removed in the Administrative Principles on Transfer Pricing 2023 (VWG VP 2023) item 3.99. This means that the current version of the administrative principles no longer explicitly contains this de minimis rule, which represents a change in the handling and valuation of transfers of functions.
Transfer Package and Hypothetical Arm's Length Comparison
The so-called transfer package (Transferpaket) comprises the function as a whole, including the transferred assets, advantages, opportunities, and risks. The value of the transfer package is determined by the hypothetical arm's length comparison if no comparable market prices are available.
- Bargaining Range (Einigungsbereich): The bargaining range is defined by the price floor (minimum price of the transferring company) and the price ceiling (maximum price of the transferee company). This range represents the framework within which the transfer price must be set (§ 1 Abs. 3a S. 5 AStG).
- Determination of the Transfer Price: The transfer price is set at the median of the bargaining range unless the taxpayer can demonstrate that another value corresponds to the arm's length principle with a higher degree of probability (§ 1 Abs. 3a S. 6 AStG).
- Capitalisation Rates and Periods: To calculate the bargaining range, expectations of financial surpluses, capitalisation rates (risk-free base rate plus risk-adequate surcharge), and capitalisation periods must be taken into account (§ 4 and § 5 FVerlV).
Special Features of the Price Floor
The price floor in transfers of functions is the minimum price that the transferring company must charge to avoid suffering economic disadvantages.
Ordinance on the Application of the Arm's Length Principle according to Section 1 Paragraph 1 of the Foreign Tax Act in Cases of Cross-Border Transfers of Functions (Transfer of Functions Ordinance – FVerlV)
§ 6 Determination of the Bargaining Range FVerlV
(1) For a transferring company that expects financial surpluses from the function, the lower limit of the bargaining range (minimum price) within the meaning of Section 1 Paragraph 3a Sentence 5 of the Act results from the compensation for the loss or reduction of financial surpluses plus any closure costs incurred. The present value is decisive. Actually existing courses of action (alternatives) that the transferring company would have as a company independent of the transferee company are to be taken into account without questioning the entrepreneurial freedom of disposal of the transferring company.
(2) In cases where the transferring company is no longer able to exercise the function itself with its own resources for legal, factual, or economic reasons, the minimum price corresponds to the liquidation value.
(3) If a company transfers a function from which it does not expect any long-term financial surpluses, it may correspond to the conduct of a prudent and conscientious business manager of the transferring company to accept a fee for the transfer of the function as a minimum price that only partially covers the incurred closure costs, or to make a compensation payment to the transferee company for taking over the source of the loss.
(4) The present value of the expected financial surpluses of the transferee company from the transferred function is regularly the upper limit of the bargaining range (maximum price) within the meaning of Section 1 Paragraph 3a Sentence 5 of the Act. Actually existing courses of action that the transferee company would have as a company independent of the transferring company are to be taken into account without questioning the entrepreneurial freedom of disposal of the transferee company.
(5) Even in the cases of paragraphs 2 and 3, in which the minimum price of the transferring company is zero or below, it must be examined according to the arm's length principle which price an independent third party would be prepared to pay for the takeover of the function.
There are three special scenarios:
- Surplus Situation: The price floor includes the lost or reduced financial surpluses plus closure costs (present value). This is relevant if the function is not continued domestically (§ 6 Abs. 1 FVerlV).
- Loss Situation: In cases where the transferring company generates losses, these can be compensated by partial coverage of closure costs or by a compensation payment (§ 6 Abs. 3 FVerlV).
- Liquidation Value: If the company can no longer exercise the function domestically for legal or factual reasons, the liquidation value of the assets forms the price floor (§ 6 Abs. 2 FVerlV).
These special features ensure that the transferring company receives an appropriate value for the transferred functions and resources even in the event of transfers of functions.
Example of Determining the Bargaining Range for a Transfer of Functions
Initial Situation: M-GmbH produces garden tools in Germany and generates an annual profit of 200,000 euros. The GmbH decides to relocate production to the USA, where its 100% subsidiary, T-Corp., is to take over production. After the transfer, M-GmbH's profit drops to 50,000 euros, while T-Corp.'s profit increases from 10,000 euros to 240,000 euros.
Before the Transfer:
- M-GmbH (Germany):
- Annual profit: 200,000 euros
- Capitalisation rate: 10%
- Capitalised earnings value: 200,000 euros / 10% = 2,000,000 euros
- T-Corp. (USA):
- Annual profit: 10,000 euros
- Capitalisation rate: 4%
- Capitalised earnings value: 10,000 euros / 4% = 250,000 euros
After the Transfer:
- M-GmbH (Germany):
- Annual profit: 50,000 euros
- Capitalisation rate: 5%
- Capitalised earnings value: 50,000 euros / 5% = 1,000,000 euros
- T-Corp. (USA):
- Annual profit: 240,000 euros
- Capitalisation rate: 12%
- Capitalised earnings value: 240,000 euros / 12% = 2,000,000 euros
Calculation of the Bargaining Range
The bargaining range is determined between the price floor and the price ceiling:
- Price Floor (§ 6 Abs. 1 FVerlV):
- Capitalised earnings value M-GmbH before the transfer: 2,000,000 euros
- Capitalised earnings value M-GmbH after the transfer: 1,000,000 euros
- Price Floor: 2,000,000 euros – 1,000,000 euros = 1,000,000 euros
- Price Ceiling (§ 1 Abs. 3a S. 5 AStG):
- Capitalised earnings value T-Corp. after the transfer: 2,000,000 euros
- Capitalised earnings value T-Corp. before the transfer: 250,000 euros
- Price Ceiling: 2,000,000 euros – 250,000 euros = 1,750,000 euros
Determination of the Transfer Price
The transfer price is typically determined as the median between the price floor and the price ceiling:
- Median (§ 1 Abs. 3a S. 6 AStG): (1,000,000 euros + 1,750,000 euros) / 2 = 1,375,000 euros
Result: The transfer price for the transfer package comprising the transfer of functions is 1,375,000 euros. This example shows how the provisions of the Foreign Tax Act (§ 1 AStG) and the Transfer of Functions Ordinance (FVerlV) are applied to determine the bargaining range and the transfer price.
Escape Clause and Price Adjustment Clause
- Escape Clause (§ 1 Abs. 3b S. 2 and 3 AStG): This clause allows for dispensing with the determination of the bargaining range on the basis of the transfer package if no essential intangible assets or other advantages are included in the transfer of functions. This applies in particular if the transferee company exercises the function exclusively for the transferring company and the compensation is determined using the cost-plus method.
- Price Adjustment Clause (§ 1a AStG): This clause applies if the actual profit development in the first seven years after a transaction deviates significantly from the original calculation (more than 20%). In such cases, the transfer price can be adjusted retrospectively (in the 8th year) to reflect economic realities. The same principles must be applied for the recalculation. The adjustment includes the difference between the original and new transfer prices.
Case Studies:
Transfer of Functions – S-GmbH and Sack Ltd.
Case: S-GmbH relocates its production from Stuttgart to Ireland to its 100% subsidiary Sack Ltd. Despite the profits during production, closure costs amounting to 10,000 euros are incurred.
Solution according to the general scheme:
- Establishment of Participation and Business Relationship:
- § 1 Abs. 2 S. 1 Nr. 1 lit. a AStG: S-GmbH and Sack Ltd. are related parties as S-GmbH holds 100% of Sack Ltd.
- § 1 Abs. 4 S. 1 Nr. 1 AStG: A business relationship exists because the transfer of production has a contractual character.
- Examination of whether a Transfer of Functions exists:
- § 1 Abs. 2 FVerlV: A transfer of functions exists because production is transferred as a function from S-GmbH to Sack Ltd., which includes the transfer of assets, opportunities, and risks.
- Adjustment of Income according to § 1 Abs. 1 S. 1 AStG:
- If the transfer occurs under non-arm's length conditions, S-GmbH's income must be adjusted.
- Determination of the Transfer Price:
- § 1 Abs. 3 S. 5-7 AStG: Since no comparable values are available, the valuation is carried out within the framework of the hypothetical arm's length comparison based on the transfer package.
- Determination of the Bargaining Range:
- Price Floor of S-GmbH (§ 1 Abs. 3a S. 5 AStG):
- Capitalised earnings value before the transfer: 300,000 / 0.1 = 3,000,000 euros
- Capitalised earnings value after the transfer: 100,000 / 0.05 = 2,000,000 euros
- Closure costs (§ 6 Abs. 1 S. 1 FVerlV): 10,000 euros
- § 6 Abs. 1 S. 1 FVerlV: Closure costs increase the minimum price.
- Price Floor: 1,010,000 euros
- Price Ceiling of Sack Ltd. (§ 1 Abs. 3a S. 5 AStG):
- Capitalised earnings value before the transfer: 10,000 / 0.04 = 250,000 euros
- Capitalised earnings value after the transfer: 200,000 / 0.1 = 2,000,000 euros
- Price Ceiling: 1,750,000 euros
- Price Floor of S-GmbH (§ 1 Abs. 3a S. 5 AStG):
- Application of the Transfer Price (§ 1 Abs. 3a S. 6 AStG):
- Bargaining Range: 1,010,000 euros to 1,750,000 euros
- Median (auxiliary): (1,010,000 euros + 1,750,000 euros) / 2 = 1,380,000 euros
- § 1 Abs. 3a S. 6 AStG: Since no other value within the bargaining range is or can be made plausible, the median is to be applied.
- Further Considerations (§ 1 Abs. 3b S. 2 and 3 AStG):
- § 1 Abs. 3b S. 2 and 3 AStG: The escape clause, which excludes the valuation of the transfer package in certain cases, is not applicable as essential intangible assets are transferred.
**Note
**This article serves for general information and was carefully prepared by the Lexo.Tax editorial team. Personal tax advice can only be provided within the framework of membership with Lexo.Tax – and exclusively to the extent legally permitted under § 4 Nr. 11 StBerG (Tax Consultancy Act).