Co-operation Obligation in German Transfer Pricing Audits Axel Eigelshoven and Stephan Rasch Deloitte& Touche, Dusseldorf The German Supreme Tax Court in October 2001 issued The German tax authority's interpretation of the tax court its famous landmark decision that taxpayers cannot be sounds very theoretical and, in fact, in practice it is unusual to held liable for failing to document their transfer pricing discuss such precise distinction between the legal practices because German law does not specifically requirements and legal consequences in tax audits. More often, require it. In the aftermath, the German legislature the taxpayer and the tax authorities disagree on the questio question of introduced comprehensive transfer pricing the burden of proot to brineven this discussion is rarely the enacting severe penalties for cases of non-compliance. decisive argument to bring a tax audit to a satisfactory result. In general, it is recommended that taxpayers provide all relevant In Febr half years after the ocumentation that is requested by the tax authorities and that doc is available and to co ctively in tax audits. decision-the Germa Nevertheless, it should be considered th published a letter co obligation und ered that the co-operation Supreme Court tax de The letter, shown in Box A er the former law, ie., the period before the new documentation law has be overleaf, discusses th applicable, is restricted to Tax Court addres provide any existing transfer pricing documentation and to ysis deals with the most impo Ministry o respond to specific questions by the tax authorities, but not to prepare documentation for the tax audit. Mor Finance's letter and p ractical guidance on Supreme Tax Court decided that no obligation exists to provide how to deal how to react third-party information to show that the prices chosen by the to the letter. Summing up, the most important aspects relate to: non-compliance with co-operation obligation in ll. Burden of Proof German tax law; The Federal tax court also decided that-under the old transfer disposition of burden of proof; pricing regime- in the case of non-compliance the tax ■ use of arms' length ranges;and authorities bear the burden of proving the appropriate arm's length transfer pricing. In its letter, the Federal Ministry of requirements on the use of third-party- data under the arm's length test. Finance distinguishes between situations where the taxpayer does not co-operate at all and where the taxpayer provides documentation about the factual background, but is not able to submit information on the arm's length nature of its transte . Non-Compliance with prices. Co-operation Obligation The Supreme Tax Court ruled that if a taxpaye IlI. Basic Principles of Co-operation rdoes no spayer aoe ot comply with its duty to co-operate in the sense of sec. 90, The basic principles could be summarised as follows: para. 2 (see Box B) of Germany's General Tax Code, it must be determined whether the taxpayer's duty refers to the legal The obligation of the taxpayer for pricing of intercompany requirement or to the lega ences of a tax provision. transactions is limited to proving the facts, i.e., to showing which price has been agreed to, how the related If the taxpayer's non-c ers to the legal requirement. parties agreed to th tions and risks the evidence that m ere assumed by which party. H th or the relevant facts by the ording to the tax authorities is reduced. mplance reters to the Federai Tax Court, the taxpayer neith show nor legal consequences, the are in general entitled to to prove that the agreed-to prices are estimate the taxpayer's court states that it is a task that a price is not at a prove The Federal Mir make an letter that such differentiatic of Fiance took the position in its recent adjustment. Therefore, the onsible tax office has to income adjustment pro gal requirements of ble data and has to undertake the egal consequences is not in pricing analysis to sup lin he with the law because there is no basis in the law for such distinction.Th Even if the taxpayer does not co-operate at all in . Ine egal consequences are exclusively assessed explaining how the by the tax authorities without the taxpayer's involvement. e was determined, according to the Federal Tax Court, this will only lead to 07/04 Tax Planning International Transfer Pricing BNA ISSN1472-0841 13
Co-operation Obligation in German Transfer Pricing Audits Box A Finance Ministry Letter, February 26, 2004 Consequences from non-compliance with taxpayer's General Tax Code, the following general principles apply for duty to co-operate according to sec. 90 para. 2 of the testing the appropriateness of the pricing to its foreign parent General Tax Code in case of a transfer pricing audit of company is engaged in transactions with related parties abroad a) Due to the freedom of contract the subsidiary is under civil law- not obliged to set arm's length transfer (sec. 1 of the Foreign Tax Code)-application of the pnces with its parent company. In case the taxpayer federal tax court decision dated October 17, 2001(IR does not comply with the arm's length principle, the 103/01). Letter of the Ministry of Finance dated income tax base has to be adjusted accordingly in the February 26, 2004 taxpayers tax declarations (see sec. 1 of the Foreig Tax Code and sec. 8 para. 3 sentence 2 of the In its decision dated October 17, 2001( R 103/00)the Corporate Income Tax Code)as the taxpayer has to Federal Tax Court has ruled - inter alia- the following provide all necessary information to its best knowledge 1. f a taxpayer does not comply with his duty to sentence 1 of the general Tax Code, in case of cooperate in the sense of sec. 90 para. 2 of the non-compliance the rules on tax fraud according to General Tax Code, it must be differentiated if the eC.369 ff. of the General Tax Code may apply taxpayer 's duty refers to the legal requirement or to the ver, the subsidiary does not bear the burden of gal consequences of a tax provision. If the taxpayer's proof whether the transfer price agreed upon is in fact on-compliance refers to the legal requirement, the at arm's le evidence which must be provided for the relevant facts b) If the subsidiary, contrary to its duty, does not provide by the tax authorities is reduced. if the non-compliance relevant information about factors having refers to the legal consequences the tax authorities are pnces (fact pattern), e. g, type and quality of in general entitled to estimate the taxpayer's income purchased products, market and competitive situation 2. If a domestic subsidiary does not provide information and if therefore the tax authorities are not able to on how transfer prices with its foreign parent company determine arm's length prices, the tax authorities may were set, the tax authorities may solely conclude that estimate the taxpayers income according to sec. 162 the agreed transfer prices were caused by the para. 2 of the General Tax Code. Namely in case the shareholder relationship. However, the agreed transfer ity to cooperate refers to information and evidence pnces can still be at arm's length, The tax authorities which is only available to the taxpayer, negative have to provide evidence for the arms length transfer conclusions may be drawn from the taxpayer's pnces non-compliance In course of estimation according to 3. The determination of an arm's length transfer price for a sec. 162 para. 2 of the General Tax Code, the ta distrbution company cannot be based on the resale authonties duty to ascertain the facts which are ice method if the gross margin can only be derived increasing and decreasing the tax burden are from three independent manufacturers, if the decreased (limited degree of proof); a lack of evidence corresponding purchases do not refer to all years under the taxpayer accounts for, may not be to the advantage onsideration and if the purchases represent only five of the taxpayer( Federal Tax Court decision dated percent of the turnover of the distribution company ary 15, 1989, BStBl l 1989 p. 462 referring to With reference to the discussions with the supreme tax the: "hold back of evidence"). The tax assessment can authonties of the federal states the following applies be based on facts relying on a lower degree of certainty than required under regular circumstances(Federal Tax To 1: The increased duties to cooperate according to sec 90 para. 2 of the General Tax Code refer to the entire fact p 495). In case of a gross offence by the taxpayer pattern relevant to taxation if a hidden profit distribution of a domestic subsidiary to its foreign parent company is under which leads to significant adjustments compared to the facts given in the tax declaration the tax authorities are discussion. Such duties to cooperate shall enable the tax authonties to ascertain whether the legal requirements for generally not only allowed, but even obliged to assess the tax base according to the facts which are least hidden profit distribution are given favourable from the taxpayer's point of view, but which The Federal Tax Courts differentiation between duties to are factually still possible (Federal Tax Court decision cooperate with respect to the ascertainment of the legal dated March 9, 1967, BStBI Ill 1967 p 349). However. requirements of a hidden profit distribution and such duties estimates which have a penal character are not allowed with respect to the legal consequences is not reasonable and Federal Tax Court decision dated December 20, 2000 s not based on the law. the legal consequences are BStBI ll 2001 p, 381). The subsidiary may still disprove assessed by the tax authorities without the taxpayer's the facts the tax authorities based their estimate on nd which are disadvantageous from the taxpayer's point of view, or the subsidiary may attack the To 2. If a domestic subsidiary infringes upon its increased likelihood of the tax authorities' assumptions by duty to cooperate according to sec. 90 para. 2 of the specifying or submitting evidence n704C
Co-operation Obligation in German Transfer Pricing Audits c) In case the subsidiary refuses information on how tax authorities bear the burden of proof for the pnces with the parent company were set, but complies with its duties to cooperate for the rest, the tax assumption of higher profits authonties may assume-with the right of disproval for In case the determination of an arm s length price leads to a the taxpayer-that the pricing is disposed by the range of appropriate values, the price which the taxpayer had shareholder relationship(factual requirement of a set shall be applied if the price is falling within this range. In it is not excluded that the prices actually agreed upon advantageous from its point of view than the range of arm's are arms length. According to sec. 88 of the General length prices, the most likely value within the range of Tax Code an examination is up to the tax authorities approprate prices shall be applied Only in case that there a If the tax authorities are able to determine the arm's are several prices falling within the range, which bear the same likelihood, then the price leading to the lowest tax length purchase price and if this arm's length price is burden for the taxpayer shall be applied lower than the price the subsidiary applied, taxation shall be based on the price determined by the tax in course of a profit estimate for a domestic distribution subsidiary, it should be kept in mind that at a medium term a f the tax authorities are not able to provide evidence an appropiate return on capital invested can be reached for the arm's length price and if there is no factual To 3: Notwithstanding the Federal Tax Courts understanding basis for the assumption that the purchase price the in the case of the decision, the examination of transfer prices ubsidiary paid, compared with the arms length n a specific case shall be based on the most reliable comparable data, which can be submitted or determined a However, in case there exists a serious indication for taking into account the costs of the taxpayer. Schemaveno the assumption that the purchase price is too high (e.g, permanent loss situation, no evidence of mismanagement), but tax authorities are not able to can not be defined. The authenticity of an arms length test provide evidence for the arm's length price, an can only be assessed for each case individually. estimation according to sec. 162 para. 1 of the General Tax Code shall be made. In course of this estimation the minimum profit ("over-all profit )must para. 3 of the General Tax Code for fiscal years beginning De determined, which allows an appropriate return on invested capital (including interest on interest and exist: non-compliance with these specific duties leads to remium)or which allows an appropriate disadvantageous consequences according to sec. 162 para. eration for rendered services based on the 3 and 4 of the General Tax Code for effected taxpayers incurred within the period of estimation. The translated by Deloitte Touche, Dusseldorf the assumption that the price setting was influenced by the shareholder-company relationship. This assumption authorities even in cases where the taxpayer did not use a transfer pricing method at all or used a non-accepted is, however, only one requirement for a transfer pricing djustment and can only give a first indication that the method or a"wrong"method. Even in such cases the pnce that was used might still by accident be at arm's pnce is not at arms length. Nevertheless, an adjustment gth, although the taxpayer did not determine it on any Is only possible if the agreed price is outside the range of economic or scientific basis arms length prices. This has to be determined by the Interpreting Supr rt's opi It is the authors' understanding that the Federal Ministry of Taxpayer Obligation to Co-operate Finance does not principally reject the Supreme Tax Court's opinion. However, the Federal Ministry of Finance obviously Art. 90, Para. 2 of the German Tax Codel nas expenence with audits in which taxpayers declined to (2)If factual circumstances have to be determined and formation, arguing that the assumption ascertained for tax purposes, which relate to events mentioned before only proves the shareholder-company occurring outside the area in which this statute is relationship. Any further information on factors determining the pplicable, the parties involved shalf clarify these price chosen by the taxpayer were denied. For example, the circumstances and shall supply the necessary ax authorities might have to audit whether the pricing of an documentary evidence. In doing so they must exhaust all intercompany transfer of a machine tool was correct. If the the legal and actual possibilities of obtaining evidence taxpayer does not provide any information on the appearance which are open to them. a party involved cannot claim that and workmanship, age and previous physical life, the tax it is not able to clarify factual circumstances or to provide authorities will not be able to determine the arm's length price evidence if, according to the circumstances of the case, in arranging its affairs it could have created or obtained the Summing up, it seems that some taxpayers have interpreted means of doing so the Supreme Tax Court decision in an extensively one-sided way. Therefore, the Federal Ministry of Finance has basically translated by Deloitte Touche, Dusseldorf followed the tax court's finding, but it aimed at stressing that the taxpayer has to provide sufficient information so that the
Co-operation Obligation in German Transfer Pricing Audits tax authorities can assess the arm s length nature of the might only be determined by reference to commodity exchange prices. In other words, to determine a"most likely Again, the taxpayer is well advised to co-operate in order to point within a range means to reduce the range to"one avoid any negative consequences. In case the taxpayer does exclusive correct transfer price. This might only be applicable not co-operate and the tax authorities are not able to in exceptional cases determine the facts and circumstances by themselves, the tax authorities are ultimately authorised to estimate the taxpayer's Vil. Third-Party Data Under the income. a one-sided attitude of refusing any information will Arm's Length Test most likely lead to negative consequences In its decision, the Supreme Tax Court argued that a V. Use of Arm's Length Ranges determination of an arm's length transfer price for a distribution company cannot be based on the resale prce Third, and what concerns the authors the most, are the method if the Ministrys conclusions on the arms length range. The Federal Tax Court accepted in its 2001 decision that price ranges can a gross margin can only be derived from three independent suppliers be used to determine an arm's length price. If it is found that the taxpayer s prce is outside this range and once a range of a corresponding purchases do not refer to all years under acceptable prices has been determined, the question arises as onsideration; and to which point along this range an adjustment can be made a purchases represent only five percent of the turnover of The Federal Tax Court held that an adjustment is only possible he distribution company to the most advantageous point of this range for the taxpayer, These findings of the Supreme Tax Court are probably correct which is either the high or low end of the range. The court in the specific case of the tax court. They are in accordance elieves that no legal basis exists for an adjustment to the ith e.g., U.S. transfer pricing regulations, the OECD midpoint of the range and that German Tax Law does not Guidelines, and also the german administrative principles.5 allow estimates to punish the taxpayer. Any price chosen by However, the Ministry of Finance makes clear that in principle the taxpayer being within the arm's length range, principally is here is no minimum requirement for the number of an am s length price that cannot be adjusted. Subsequently, comparables. Each case has to be viewed separately. it is hardly conceivable why an adjustment of a price outside that range should then go to the mid-point of the range VIll. Conclusion without violating the German legal principle that punishment is Under the new legislation the taxpayer is now forced to only permissible under criminal but not under tax law make at least serious attempts"to provide an arms length Furthermore, constitutional principles support the courts view analysis. Again, it is recommended to prepare such analysis The Tax Law is a major interference with the freedom rights with due care in order to avoid lengthy disputes in tax audits any individual. Such interference is subject to the principle of and severe penalties for all fiscal years, starting after Dec. 31 dequate and proportional interference, which means that if 2003. It should also be taken into account that such analysis there are different measures for the authorities, they have to ight have to bear up in potential mutual agreement choose that measure that least affects citizens' freedoms and procedures. It might thus reduce the efforts to prepare such b Syd arm's length evidence right away. In situations where an arm's length range has been determined and the price is set outside Vl. Most Likely Value Within Range the range, the taxpayer should only accept an adjustment to the most advantageous point within the range However, the new letter argues that a price outside the range should be adjusted to the point within the range that is the Axel Eigelshoven and Stephan Rasch, Ph. D, are with Deloitte most likely value within the range"of appropriate prices. In Touche's European transfer pricing group in Dusseldorf the authors view, this is clearly not in line with existing law Aeige/shoven @deloitte.de The law itself does not provide any guidance for income rasch@deloitte. d e adjustments for such cases where a price is outside a range Thus, the principles set forth in the Federal Tax court udgment and mentioned above needs to be considered Moreover, it remains unclear how the"most likely point within a range"could be determined. Obviously the German Federal Ministry of Finance based its opinion on the Organisation for Economic Co-operation and Development transfer pncing guidelines. Section 1. 48 reads n general, and to the extent that it is possible to distinguish among the vanous points within the range, such adjustments should be made to the point within the range that best reflects the facts and circumstances of the articular controlled transaction Although the oECD guidelines favour some point within the range that fuly reflects the transaction, it seems that this point
