DFK International Tax Committee Newsletter May 2017

DFK International has a new guideline that sets out professional standards expected of DFK members in relation to the facilitation and promotion of tax avoidance. To download the guideline, click here or visit the members site.

The German Ministry of Finance (BMF) has issued the final version of the Administrative Principles on the Profit Attribution to Permanent Establishments (Administrative Principles). The Administrative Principles include details and clarifications concerning the application of the Authorized Organization for Economic Co-operation and Development (OECD) Approach (AOA) as required by Section 1, subsection 5 of the Foreign Tax Act (FTA) and the Regulation for the Profit Attribution to Permanent Establishments (PE Regulations).

The Administrative Principles have an indirect impact on the taxpayer as they reflect application guidance for the German tax authorities only unlike the legal provision in the FTA and the PE Regulations which have a direct binding impact on the taxpayer. The Administrative Principles represent the typical third element in the German tax legislative process. Although not binding to the taxpayer, the Administrative Principles, as additional support for the interpretation and illustration of the legal provisions, are of significant importance for the taxpayer in practice.

It should however, be noted that the final version of the principles only contains minor variations from the draft version.

In the Administrative Principles, the German Tax Authorities describe in detail, their perspective of the correct application of the above-mentioned attribution rules by means of examples and associated calculations including certain definitions for terminologies used in the German law, the PE regulations and the Administrative Principles.

For the attribution of assets, etc. to a PE respectively to the remaining enterprise, the structure of the Administrative Principles is that first a basic principle is defined, then deviations from the basic principle are further explained and alternative principles are established to solve cases of doubt in line with the Administrative Principles.

The new PE regulations including the Administrative principles address certain key aspects concerning where they deviate from the previous guidelines such as:

• Significant people functions independent of hierarchy and formal decision making competency and basic attribution rules for assets.
• Additional attribution rules for intangible assets
• Attribution of participations and investments
• Assumed Contractual Relationships (“Dealings”)
• Attribution of endowment capital
• Additional transfer pricing documentation requirements for Pes

The three-tier structure of the domestic AOA implementation results in the following step-by-step application:

• Section 1, subsection 5 FTA is fully applicable for financial years beginning after 31 December 2012.
• The PE Regulation (auxiliary calculation, endowment capital, liabilities, financing expenses, etc.) applies for financial years beginning after 31 December 2014.
• Accordingly, the Administrative Principles apply as a clarification of the PE Regulation for financial years beginning after 31 December 2014.

With the implementation of the AOA into domestic law and the finalization of the Administrative Principles as application guidance for the German tax authorities, higher scrutiny is to be expected in future tax audits of PEs. This is particularly true given the changing international regulatory landscape with a significantly lower threshold to establish a PE. Hence, taxpayers should consider the following:

• For existing PEs, one should perform an AOA review to examine whether the PE profit determination complies with the German PE Regulations for all financial years beginning after 31 December 2012.
• To manage exposure of potential double taxation, a special focus should be put on situations where the German PE regulations deviate from the OECD regulations. It might be helpful to discuss in advance any identified potential double taxation risk with the respective tax authorities.
• The comprehensive documentation requirements demand the timely implementation of efficient processes to ensure proper attribution decisions can actually be made (to the extent possible for a taxpayer), for the preparation of the auxiliary calculation and the transfer pricing documentation. The underlying attribution decision including the function and risk analysis should be documented carefully and contemporaneously for tax return preparation purposes of the PE. This should support the taxpayer in a future tax audit to assign the burden of proof to the German tax authorities as well as to limit the room for interpretation with respect to the underlying attributions.
• In addition, the establishment of internal policies and guidelines with respect to internal dealings and the profit determination for the PEs including the governance of the documentation processes and responsibilities is advisable.

On March 6, 2017, President Trump issued a revised Executive Order (“Order”), which restricts the admission to the United States of certain individuals from one of six designated countries for 90 days. As of the effective date of this newly issued Order, the prior Executive Order will be revoked. The new Order was issued to address some of the concerns raised by the original Executive Order and subsequent litigation. Among other things, the newly issued Order removes Iraq from the list of designated countries, clarifies that US Lawful Permanent Residents (“green card” holders) from the six banned countries will be exempt from the travel restrictions, as well as dual nationals.

In addition to the new Executive Order, U.S. Citizenship and Immigration Services (USCIS) announced that it will temporarily suspend Premium Processing for all H-1B Petitions filed on or after April 3, 2017. Premium processing is a service offered by USCIS that allows for some application types to be adjudicated on an expedited basis.

The new executive order lays emphasis on the following aspects:

• Foreign nationals of the six designated countries who are outside the United States on the effective date of the order did not have a valid visa will not be eligible to travel to the US for an initial 90-day period.
• Non applicability to citizens or nationals of the six designated countries who are:
  
  • Dual US citizens
  • Lawful Permanent Residents of the US
  • Foreign nationals admitted or paroled into the US after the effective date of the Order
  • Foreign nationals already granted asylum or refugee status in the US before the effective date of the Order
  • Dual nationals so long as they are traveling on a passport issued by a non-designated country
  • Individuals currently in the United States.
• Suspension of the Visa Interview Waiver Program (VIWP), which may require that more individuals attend in-person interviews. Suspension of the VIWP may increase delays and costs to obtain visas to enter the United States.
• Additional security screening standards developed in the coming weeks are likely to add significant cost and time delays to visa applications.
• The suspension affects all I-129 petitions seeking H-1B classification, including extensions, amendments, change of employer, cap exempt petitions and FY18 Cap subject lottery cases.
• Canadian landed immigrants who hold passports from one of the designated countries are eligible to apply for a visa, and a waiver, in Canada.
• Any prior cancellation or revocation of a visa that was solely based on the prior Order shall not be the basis of inadmissibility for a future immigration benefit.
• USCIS will continue to process pending naturalization and permanent residence applications from citizens of one of the designated countries.
• Provisions have been made for individuals to apply for a waiver of the travel ban.

While this newly issued Executive Order more clearly lays out those who are impacted and those who are exempted from the travel ban, it still restricts the ability to travel to the US for many foreign nationals. For instance, even those foreign nationals from designated countries who meet the criteria for visa issuance but whose visas expire after the effective date will likely be impacted as it has not yet been made clear whether the U.S. Department of State will re-issue visas to those individuals.

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The US Tax Court came forward with a ruling in favor of Amazon US in respect of TP adjustments amounting to $8.3mn and $225mn for 2005 and 2006 made by IRS on account of transfer of intangible assets required to operate Amazon’s European website business to its Luxembourg subsidiary.

In 2005 and 2006, Amazon.com, Inc., and its domestic subsidiaries (“Amazon US”) transferred to Amazon Europe Holding Technologies SCS (“AEHT”), a Luxembourg subsidiary, the intangible assets required to operate its European website business. The IRS determined deficiencies in taxpayer’s Federal income tax of $8.3 mn and $225 mn for 2005 and 2006 respectively, arising from substantial transfer pricing adjustments on account of transfer of intangible assets which were made by reallocating income from Amazon US from AEHT.

The two main issues to be settled by the court were:

• The amount of AEHT’s Buy in obligation; and
• The volume of costs properly treated as Intangible Development Costs. (IDC’s)

Facts of the case
Amazon.com, Inc began its operations as an online retailer in 1995 through Amazon.com and related websites. Amazon’s initial operations were strictly restricted to trading services. Eventually, Amazon allowed third party vendors to sell their products on the portal through a branch of their business named Marketplace.

Amazon initially expanded its business in Europe with wholly owned subsidiaries in UK, France and Germany. In 2004, Amazon US formed AEHT, the Luxembourg headquarters entity that would serve as the holding company for all of the European businesses. Amazon Luxembourg would perform various functions essential to operation of the European businesses including holding title to the inventory sold in Europe, licensing Amazon’s intellectual property, housing the servers, and maintaining call centers.

In a series of transactions in 2005 and 2006 Amazon US transferred to AEHT three groups of intangible assets:

i.software and other technology required to operate its European websites, fulfillment centers, and related business activities;
ii.marketing intangibles, including trademarks, tradenames, and domain names relevant to the European business; and
iii.Customer lists and other information relating to its European clientele.

The Buy-in Payment
While the taxpayer reported a buy in payment to be amortized over seven years assuming each group of tangible assets to have a seven year useful life valued separately under the “Comparable Uncontrolled Transaction” (CUT) method, the IRS contended that the transferred property had an indeterminate useful life, and it had to be valued, not as three distinct groups of assets, but as integrated components of an operating business and Discounted Cash Flow (DCF) methodology needed to be allied in this respect.

The court’s viewpoint
The Court noted that as per the regulations, the buy-in payment represented compensation solely for the use of preexisting intangibles, whereas the compensation for subsequently developed intangible property was covered by future cost sharing payments, whereby each participant payed its ratable share of ongoing IDCs. The Court thus noted that adjustments are permitted only to ensure that

i.an arm’s-length buy-in payment is made for preexisting intangible property; and
ii.each participant pays its appropriate share of ongoing IDCs.

The Court firstly held that Revenue’s expert, by assuming a perpetual useful life, had failed to restrict his valuation to the “pre-existing intangible property” that Amazon US actually transferred to AEHT in 2005.

The Court further held that the value of subsequently developed intangibles had been improperly included in the buy-in payment. The Court observed that Amazon’s projections for the European business were based on extremely high growth rates that Amazon had achieved in the past, which could be sustained only through constant innovation, including innovations concerning new products and services.

The Court also rejected Revenue’s arguments that adoption of a business enterprise valuation was supported by the “aggregation” principle wherein the preexisting intangibles and subsequently developed intangibles were improperly aggregated or the “realistic alternatives” principle wherein the court was of the opinion that the cost sharing elections, which was explicitly made available to the taxpayers would be rendered meaningless.

The Court observed that for comparison of intangibles involved in controlled and uncontrolled transactions, both intangibles must be “used in connection with similar products or processes within the same general industry or market” and must have “similar profit potential.” The Court thus agreed with taxpayer that the CUT method provides the best method for determining the fair market value of all three species of intangible property, however, proceeded to make certain adjustments under CUT method.

Marketing Intangibles
Amazon used CUT method for determining ALP of marketing intangibles using licensing information reported in ktMINE database, which includes 15000 intangible agreements and allows user to conduct customized search. Amazon’s expert identified 6 comparable agreements with royalty rates ranging from 0.125% to 1% of sales, and selected the median of these rates, or 0.59%, as his base rate, which was then reduced to reflect a volume discount.

The Court also observed that the European Subsidiaries also owned and operated the physical infrastructure supporting the European websites. This entailed complete responsibility for the warehouses, inventory, and fulfilment. The ultimate value of the European Portfolio hinged on the European Subsidiaries’ ability to fulfil Amazon’s promise of fast and accurate delivery.

Customer Information
The customer information that Amazon US made available to AEHT consisted of data regarding European retail customers who had transacted with the European Subsidiaries before May 1, 2006. This data included names, email addresses, phone numbers, credit card information, and purchasing history. By making this information available to AEHT, Amazon US in effect was referring its existing European customers to AEHT and furnishing it with certain information about them.

Consequently, the Court determined ALP for customer information based on average spend by customers referred by other websites taking period of 10 years.

With respect to the cost sharing payments, the Court noted that the T&C category costs included mixed costs. The Court also noted taxpayer’s argument that on treatment of 100% of T&C costs as IDC, AEHT’s future cost sharing payments would be so large as to produce a negative buy-in payment under income method analysis.

Stock Based Compensation
The CSA defined IDCs to “include all direct and indirect costs (including Stock-Based Compensation Costs)” relating to intangible development. The parties elected to take into account “all stock-based compensation in the form of stock options in the same amount, and as of the same time, as the fair value of the stock options reflected as a charge against income” in either party’s financial statements. However, the taxpayer questioned the validity of this regulation.

Accordingly, the Court held that stock-based compensation was correctly included in the cost pool and CSA’s claw back provision was not yet operative.

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