: Transfer Pricing in Germany Dr. Heinz-Klaus Kroppen, LLM Axel Eigeshoven .r. Achim Roeder,ma Extract from: Feinschreiber, Robert: Transfer Pricing International: A-Country-by-Country Guide, New York 2000 CHAPTER 24 Germany Heinz-Klaus Kroppen Axel Eigelshoven Achim Roeder 24.1 Introduction (a) U.S.Impact (b)German Tax Audits ()Arbitration and Tax Changes 24.2 Provisions for the Determination of Transfer Prices (a)Administrative Principles for Transfer Prices (b)Hidden Profit Distributions (c) Hidden Capital Contribution (d) Section 1 of the Foreign Tax Code (e) Article 9 of the Tax Treaties 24.3 Relevant Principles to Derive the Arm's Length Price (a) Comparability Analysis (b) Contractual Relationship as a Starting Point (c)Range of Prices (d) Aggregation of Transactions and Multiple-Year Analysis 24.4 Acceptable Methods in Germany (a)Standard Methods ndaro (b) Transactional Net Margin Method/Comparable Profit Method (c)Profit Split Method (d)Choice of Methods 24.5 Practical Areas of the Application of Transfer Pricing Rules () Distribution Companies (b) Contract Manufacturing (c) Provision of Services 24-1
Germany (d) Transfer and Use of Intangibles (e) Cost Sharing Agreements 24.6 Documentation (a) Prior Approaches (b) Standard Questionnaire (c) Audit Respons 24.7 Unilateral Rulings and Advance Pricing agreements (a) Basic Issues (b) Advance Pricing Agreement Administration 24.1 INTRODUCTION Transfer pricing is now becoming one of the main tax issues, if not the predom- inant tax issue of multinational enterprises operating in Germany. This develop ment is being driven by the german tax authorities who are focusing on transfer prices in almost every tax audit of a multinational enterprise. The tax auditors of- ten believe that profits are shifted artificially abroad due to the high tax rates in Ger- many, but the development of transfer pricing in Germany must also be seen in ar international context (a) U.S. Impact The increasing attention German tax auditors have given to transfer pricing started after the release of the final U.S. Regulations in 1994. After the release of the U.S. Regulations, many European countries adopted a similar regulatory framework and increased pressure on multinational companies by introducing doc umentation requirements, penalties and by shifting the burden of proof to the tax payer. In Europe, Germany is one of the last major Organization for Economic Co- operation and Development(OECD)members that has not changed its transfer pricing regime in the last two or three years Thus, from a regulatory point of view, Germany fell behind countries like the United Kingdom, France, Belgium, and Denmark. The German Ministry of Finance has finally started its review of the 1983 administrative principles" in earnest after some standstill due to the withdrawal of experienced staff in the wake of German reunification. Meanwhile, the Ministry has issued a new version of the regulations covering cost sharing agreements. It is widely believed that a complete overhaul of the regulations by the German Ministry of Finance will follow in due course Some parts of this article are extracted from Kroppen/Eigelshoven, in I BFD, Tax. Treatment of Transfer Pric- ing, Germany 'Decree of the Federal Ministry of Finance dated February 23, 1983, BStB1 I 1983, p: 218, see Kroppen/Eigelshoven, in: IBFD: Tax Treatment of Transfer Pricing, Germany, pp 102 ff. for an English translation. SCf. Transfer Pricing Report, March 13, 1996, p. 732 Decree of the Federal Ministry of Finance, December 30, 1999 Cf. Transfer Pricing Report, November 27, 1997, p 465
24.2 Provisions for the determination of Transfer prices 24-3 (b German Tax Audit Issues At the same time, the German tax authorities'audit staff is increasingly becom- ing more aware and sophisticated as relates to transfer pricing matters. For exam- ple, in the mid 1990s, the German tax authorities started to improve the audit staff's transfer pricing training. Some senior tax inspectors recently announced that audits will focus on transfer pricing in the future Another recent development is the increasing aggressiveness of the tax audit staff, who are less prepared to negotiate audit results and increasingly are willing to test their position in the tax courts instead. The aim of this strategy is to use court rulings to establish a dense regulatory framework and precedent for their audit work. The auditors are encouraged by tax court decisions that in the past have re- sulted in sweeping judgments against taxpayers; for example, the Federal Tax Court ruled that distribution companies should in general not incur losses longer (c) Arbitration and Tax Changes a The taxpayer is well advised to find a solution through competent authorities and itration procedures instead of the court proceedings. Especially in Europe, arbitration procedure has proven to be a very powerful tool to avoid double taxa tion. Even the existence of the arbitration procedure is often very fruitful to achiev ng a solution at the audit level. It is not likely that the pressure on the taxpayer will decrease after the govern- ments tax reform plans will be implemented in 2001. However, the new legisla- tion will reduce the incentive for the taxpayer to shift profits abroad. According to the German government, it plans to reduce the effective tax rates from 56 percent in 1998 to about 39 percent beginning in 2001. The reduction in taxes will be fi nanced through a broader tax base. This regulatory framework will probably be ac- companied by increased audit activity. Thus, transfer pricing will remain a main concern of the taxpayer. 24.2 PROVISIONS FOR THE DETERMINATION OF TRANSFER PRICES (a) Administrative Principles for Transfer Prices The German Tax Administration issued guidelines in 1983 desig narize the principles governing the allocation of income between internationally related taxpayers under the provisions contained in Germany's domestic and treaty law. The administrative principles were intended to outline the view of the Kuckhoff/Schreiber, Verrechnung spreise in der Betriebspriifung, Munich: Beck, 1997, P. 8 See Federal Tax Court, February 17, 1993, BStBl. 1993, p. 457 ates are based on nondistributed profits, including municipal trade tax and solidarity surcharge, see press of the Federal Ministry of Finance, December 21, 1999
German tax authorities and to provide tax auditors with guidance on the exami- nation of cross-border transactions. Compared to the 1994 U.S. Regulations and the 1995 OECD Guidelines, the German administrative principles are less com- prehensive, but these principles still provide the taxpayer with helpful guidance Though taxpayers follow the administrative principles in order to receive legal ertainty, they are binding on neither the taxpayer nor on the tax courts, but only on the tax administration Hidden Profit Distributions The most frequently used provision to adjust income in Germany is section, 8 paragraph 3, sentence 2, of the Corporation Tax Code. This provision determines that"hidden profit distributions(verdeckte Gewinnausschuittung) should not de- crease the income of a corporation. "Thus, section 8 of the Corporation Tax Code distinguishes between payments made based on contractual agreements and those based on the shareholder relationship. However, section 8 of the Corporation Tax Code does not provide for a definition or a further explanation. Instead, the tax courts have defined what is deemed to be a dividend by this provision. G Prudent Business Manager Standard. From an intemational tax per- spective, it would have been obvious to use the arm,'s length standard to evaluate whether the company would have agreed to the same conditions if it had dealt with unrelated parties. However, section 8 of the Corporation Tax Code historically fo- cused on domestic aspects. The courts developed the so-called prudent business manager standard, which is derived from German commercial law. Under this standard, an income adjustment is justified if a prudent business manager--in deal ing with a nonaffiliated person-would not have agreed to the conditions of the In the past, practitioners discussed whether the prudent business manager stan- dard is different from the arm's length principle. Practitioners argued that the pru- dent business manager standard is a one-sided approach, in that it focuses only on the question of whether the business manager of the corporation would have agreed to the conditions of the transaction. The question of whether the other party to the transaction would have adhered to such conditions was not considered Gii) Arms Length Criteria Distinguished. The prudent manager standard is very different from the arm's length principle, which ideally looks at both sides of a contract This difference in approach became obvious when the federal tax court ruled that a prudent business manager would not accept losses for more than 9See, for example, Federal Tax Court, February 2, 1989, BStB 1. II 1989, p 522; Federal Tax Court,December 1995,BStB1.m1996,p. iOSee, for example, Federal Tax Court, February 11, 1987, BStBl I 1987, p. 461; Lower Tax Court of Hessen October 17, 1988, EFG 1989, P. 200
24.2 Provisions for the determination of Transfer Prices 24-5 three years. The taxpayer provided evidence that a third party bought the same products for the same price, but the court did not analyze this transaction, arguing that it would have been irrelevant for the intercompany transaction in the light of the loss situation However, recent court rulings indicate that the federal tax court now seems to have changed its view. In these more recent rulings, the tax court elaborated the prudent business manager concept in such a way that the conditions of a transac tion would have to be agreed upon by two prudent business managers with oppos- ing interest. 2 This is now called the theory of the doubled prudent business man- nger, meaning that there are two business managers facing each other in a transaction (ii Eliminating the Distinction. Based on this most recent tax court rul- ng, it now appears that the substance of section 8 of the Corporation Tax Code is identical to the intermational standard. however, there is still a decisive difference in formality standards. In addition to the arms length test, the deductibility of a payment requires that it is based on contractual agreements that were entered into in advance, in clear and unambiguous terms. This condition is based on jurispru- dence developed by the Federal Tax Court in the context of business relationships between individuals belonging to the same family. This relationship standard was later expanded to cover payments made to controlling shareholders The relationship standard basically amounts to an antiavoidance measure. As such, it is designed to prevent a group of related taxpayers from rearranging their have adjusted the income even if the transactions have been at arm's lengtourts tax situations to their advantage using the benefit of hindsight. Thus, the (e) Hidden Capital Contribution The rules governing hidden capital contributions are found in section 4, para- graph 1, of the Income Tax Code in conjunction with section 8, paragraph 1, of the Corporation Tax Code. A hidden capital contribution(verdeckte Einlage)can be as- sumed if a shareholder or a related party of the shareholder makes a contribution to the corporation without proper consideration and the reason for this contribution can be found only in the shareholder relationship Like the principles that apply to hidden profit distributions, the rules governing hidden capital contributions were developed by jurisprudence ISee Federal Tax Court, February 17, 1993 Federal Tax Court, May 17, 1995, BStB1. II 1996, P. 204; Federal Tax Court, December 6, 1995, BStBl.II 1996,p.383 poppen, in: Becker/Kroppen(eds ) Handbuch In rechnungspreise, Cologne: Schmidt, 1999,n. w97: Baumhoff, in: FS Flick, pp 633 ff. Wassermeyer, DB 1994, pp. 110 ff.; Becker, DB 1996, 14See Federal Tax Court, April 26, 1989, BStB1. I 1989, p 673 See, for example, Federal Tax Court, October 12, 1995, BFH/NV 1996, p. 266
Germany The courts ruled that there is a hidden capital contribution because of the corporation-shareholder relationship of a third party(nonshareholder). Here, the court applied the prudent business manager standard. The nonshareholder would not have agreed to the conditions of the transaction if the nonshareholder had dealt with the com In the case of a hidden capital contribution, the income of the parties to the trans action must be adjusted accordingly. This adjustment takes place on the recipient side, reducing the income. The adjustment takes place on the side of the parent company, increasing the asset for the investment in the subsidiary and the income It is important to note that only tangible or intangible property can be subject to a contribution. The use of property or the rendering of services to the company is not within the scope of the provision (d) Section 1 of the Foreign Tax Code According to section 1 of the German Foreign Tax Code, the income of a tax payer is increased if such income was diminished in the course of a business rela- tion with a related party abroad. The income of the taxpayer is increased if the terms and conditions of the transaction deviate from those that an unrelated party would have agreed to under the same or similar circumstances. In such a case, the income should be increased to a level that is commensurate with third-party con ditions. This section of the Foreign Tax Code is the only provision in German tax law that explicitly mentions the arms length standard The intention of section 1 of the German Foreign Tax Code was to expand do mestic law to enable the tax administration to increase the income of a domestic taxpayer for all non-arms length transactions. In this context it should be noted that section 1 of the Foreign Tax Code can be used only to increase domestic in come(e.g, German parent gives royalty-free license to a subsidiary). This prov sion cannot be applied to reduce a taxpayer's German income(e. g. foreign parent gives royalty-free license to German subsidiary) In practice, this reduction provision plays a minor role since section l of the ge man Foreign Tax Code states that the rules for hidden profit distribution and rules for hidden capital contribution take precedent. Most cases covered by the provi sion deal with problems that do not apply to the rules for a hidden capital contri bution. Examples of such situations include where the benefit received by a foreign subsidiary does not constitute tangible or intangible property or where the defini- tion of a related party is broader than under the provisions dealing with hidden profit distribution or hidden capital contribution See Corporation Tax Regulations, 8 36a, Federal Tax Court, February 28, 1956, BStB1 III 1956, p. 154: Fed eral Tax Court, October 26, 1987, BStB1. II 1988, p. 348 1See Wassermeyer, in: Flick/Wassermeyer/Baumhoff(eds), Aussensteuevrecht, 6th ed, Cologne:Schmidt 1999,31 AStG, n. 76; Kroppen/Ltibker, ITPJ 1999, P 33
24.3 Relevant Principles to Derive the Arm's Length Price 24-7 (e) Article 9 of the Tax Treaties Germany has an extensive treaty network with more than 70 countries. Germany has agreed to the use of the arm,s length principle in virtually all its tax treaties. The tax treaties are not directly applicable to the taxpayers as such, but the treaty provisions have to be converted into federal law. Therefore, once the statutes have been enacted, the tax treaties principally have the same legal equality as domestic gislation Since treaty law is lex specialis to domestic law, it is argued that article 9 of a tax treaty limits the application of domestic tax law. The tax administration seem ingly expressed a different view in the administrative principles. According to sec- tion 1. 2. 1. of the administrative principles, the allocation provisions of german tax law also remain applicable in those cases of related interest that are not covered by he allocation provisions of the tax treaties The administrative principles argue that it would be inconsistent with the sense and purpose of the tax treaties if the treaty prevented income adjustments required by the particular case. However, if this view was correct, article 9 would have no legal effect, since domestic law would govern the rules on how to allo- cate the income. Obviously, this approach would circumvent the intention of the tax treaties 24.3 RELEVANT PRINCIPLES TO DERIVE THE ARMS LENGTH PRICE (a) Comparability Analysis The comparison of transactions between related and unrelated parties is the cor- nerstone for applying the arms length standard. It is critical for the comparison that the transactions between related and unrelated parties be generated under the same or similar conditions. All factors affecting the transfer price should therefore be taken into consideration(e. g, functions, risks, contractual terms, markets). Dif- ferences may influence the prices between related and unrelated transactions. In OECD Guidelines and the U.S. Regulations ag that event, it is necessary to adjust the prices accordingly. The administrative prin ciples basically give a wide variety of possible factors that might require an ad- justment. The German view is very similar to the comparability standards under the However, in practice, it is often decisive to what extent the tax authorities be- lieve that adjustments are necessary and how such adjustments can be made This analytical process often results in the application of different methods across te Schaumburg, Internationales Steuerrecht, Pp, 25 ff Sicker, in: Debatin/Wassermeyer, Doppelbesteuerung, article 9 MA, n, 185 ff. Kroppen, in: Becker/Kroppen, le verrechnungspreise, n. w13 ff. 20 See OECD Guidelines 55 1.15-1.35; U.S. Regulations, 5 1.482-1(d)
248 Germany countries analyzing the same transaction. The difference in application and the view of the German tax authorities and tax courts became very obvious in a recent tax court decision 21 Here, the court used the gross margin of a transaction to unrelated suppliers to determine the arm's length gross margin for the transactions to the parent company f a German distribution company. The transaction between the unrelated parties amounted to 5 percent of the total products received by the distributor compared to 95 percent received from the parent company. Moreover, the German distributor bore inventory risk for the products purchased from related parties. The German distributor did not bear any inventory risk for its parents products. In the United States, one would most probably dismiss the applicability of such a transactional method due to a lack of comparability and would likely rely on a profit-oriented method instead The ruling by the court in the aforementioned case is in line with the view of the jerman tax administration. The tax authorities require that taxpayers make appro- priate adjustments and apply a transactional method rather than by default apply profit-oriented method, which are generally not accepted by the German tax au- thorities. The taxpayer of course should make sure, that its analysis generates rea tend to disregard transactions if a distributor incurs losses for several years, 22 0Fs sonable results. As described earlier, the Federal Tax Court as well as tax aud (b) Contractual Relationship as a Starting point The starting point for the determination of an arms length price is a comparison of the terms and conditions agreed to by the related parties, unless the actual con duct of the parties deviates from the stated agreements. This principle is essential to avoid the risk of double taxation. If a country did not follow this principle, a multinational enterprise might be exposed to a risk of double taxation, since both tax investigators might then substitute the actual transactions by one that best suits its respective fiscal interest. Moreover, it would be unclear in that situation what conditions should replace the conditions agreed to even if these are unusual. In the face of a constantly chan ing bu ole to deter what is usually agreed to or to determine if third parties had actually agreed to the same conditions. The German tax authorities basically accept the above- mentioned principle. The company must determine an arms length price, based on the conditions agreed to by the parties The tax administration investigates Lower Tax Court of Dusseldorf, December 8, 1999, DStRE 1999, 792: for a detailed discussion, see Kuck hoff/Schreiber, IStR 1999, p. 515; Kroppen/Eigelshoven, IWB Fach 3, Gruppe 1, pp. 1594 ff 22See Federal Tax Court, February 17, 1993, BStB1 I 1993, p.457 2See also OECD Guidelines 3 1.36; Sieker, ITPJ 1998, P.20 2Kroppen, in: Becker/Kroppen, Handbuch Internationale Verrechnungspreise, n wy
24.3 Relevant Principles to Derive the Arms Length Price 24-9 whether the transfer price under those conditions is determined in compliance with the prudent business manager standard or with the arm's length standard The structure chosen by the taxpayer might be recharacterized only if it deviates from the economic substance of the transaction or if it falls under the antiabuse provision of section 42 of the German General Tax Code (Abgabenordnung) Sec tion 42 of the German General Tax Code applies if the taxpayer chooses a particu lar structure solely to avoid taxation and if this structure itself is unreasonable in the face of the object of the structure. This might be the case, forinstance, in a trans action involving an interposed company that has no economic function and leads to an unnecessary and artificial complication of a transaction. Afurther exception to the above mentioned principle might be seen in section 8a of the corporatie Tax Code--Germany's thin capitalization rule. Under this provision, it is possible to recharacterize interest payments in distributions c) Range of Prices Market conditions are often not completely transparent and may create uncer tai ren in transactions between unrelated parties. Therefore, due to the lack of price information that can be observed in the market, a range of prices exists rather than one single price. The OECD often refers to the fact that transfer pric ing is not an exact science and in many cases it would therefore not be possible to determine a single arms length price, but rather to determine a range of accept able prices. This principle is very important in the determination of transfer prices because it allows the prudent business manager to be more flexible in set- ting prices The concept of price ranges is also accepted by the German Tax Administra- tion. The Tax Administration normally can not challenge transfer prices that are within the market-derived price range if independent parties doing business in the same or a similar market negotiate their prices for individual transactions on a case-by-case basis within that range. However, this approach will be disallowed in two situations 1. Related parties use this flexible range-of-prices approach in such a way that he parties systematically determine the prices to be charged between them to be at the upper or lower limits of such a range 2. There is no commercial justification for this"consistent"approach The artificially deflated profits of the disadvantaged corporation will be ad- justed accordingly. Thus, the notion of flexibility becomes not only a shield of See, for example, Federal Tax Court, January 28, 1992, BStB1. II 1993, P 84: Federal Tax Court dated March 5 1986,BSB1,Ⅱ1986,p.496 tSee OECD Guidelines 5 1.45 2 Administrative principles s 2.1.9, exampl
2410 Germany the taxpayer but also a sword of the tax auditors as the requirement of consistency is itself limited by the criterion of abus The administrative principles do not provide for a certain concept of price anges, as for instance an interquartile price range under the U.S. Regulations. 29 However, if the taxpayer chooses a range of third party gross or net margins, it should be considered to exclude companies in the lower or upper end of the range of net or gross margin, since information is rather limited and extraordinary influ ences are often difficult to determine (d Aggregation of Transactions and Multiple-Year Analys The German tax administration has a clear preference for a transactional ap proach. Section 2. 1. 2. of the administrative principles emphasizes that the transfer price analysis should be based on every single transaction. If one would follow the wording of the administrative principles, this would go much further than the oECD, which also allows companies to aggregate certain transactions. However it is fair to assume that German principles allow for aggregation. since in many cases aggregation could be the only feasible approach to determine the transfer price. This is especially true in cases where the transactions are interrelated, mul- tiple transactions take place in a short period of time, or several transactions are part of a package deal Multiple-year analysis under certain conditions is supported by the OECD as well as by the U.S. tax administration. The multiple-year analysis is seen as a tool to analyze the effects of business or product life cycles and other business risk fac tors or influences that might have an effect on the transfer prices. These influences might better be judged over a longer period of time The administrative principles do not deal with multiple-year analysis. Such nalysis sometimes is rejected by tax auditors with the argument that it is agains a fundamental precept of German tax law that requires tax to be based on the nual accounting period(Prinzip der Abschnittsbesteuerung). Therefore, in ap- plying this analysis, the taxpayer and the tax auditor have to make sure that the profit situation of other closed periods does not lead to the conclusion that in come is too high or too low in the period under review. However, if the multiple year analysis is seen as a tool to judge the transfer prices of the current year( e. g for judging start-up losses, a market penetration strategy, or the long-term influence of currency risks), multiple-year analysis should not cause such See U.S. Regulations, $1.482-1(e)(2)(ini(c 3Kuckhoff/Schreiber, Verrechnungspreise in der Betriebspriifung, p. 74 3I See oECD Guidelines 31.42 32See OECD Guidelines 35 1.49-1.51; US Regulations, 3 1.482-I(f(2)(iii)
