26 ITPJ JANUARY/FEBRUARY 2004 Transfer Pricing in Practice GERMANY Interpretation of the Arm's Length Principle under Art. of the OECD Model Tax Treaty: Does the Arm's Length Principle Cover Formal Requirements? Heinz-Klaus Kroppen' and Stephan Rasch2 1.INTRODUCTION the GmbH access to labs, offices, and production sites When auditing the transfer prices of multinational entities, of PPD in order to familiarize them with the technical the tax authorities have often based their findings on for- malistic, rather than substantive, arguments. On 16 July PPD granted for the term of the Agreement the right to 2002 he Lower Tax Court of Munich issued a decision use specific trademarks of P or certain specified regarding a German subsidiary of an Italian parent com- licensed trademarks6 in Germany for its products or pany. This ruling is of particular importance because it sale thereo relates to the Germcability ore ration of the arm's length PPD granted to the Gmb nces to the patents, registered mo and other and the international interpretation of Art. 9 of the OECD Is, advan- Model Treaty 2. TAX COURT OF MUNICH DECISION ent on the 2.1. Facts The issue in this case is whether payments that the plain- tiff, a German GmbH to own com- llation roup. Deloitte en de IR2703. are as follows see Eigelshoven and Nientimp, Der Betrieb 2003. at 2307. PPD agreed to provide full knowledge and, upon request of the Gmb he anne Listed in Table I of the annex to the Agreement. appropriately qualified personnel on a short Agreement, Part 7. to the GmbH, as well as to provide to the personnel of 9. ld.. Part 3. G2004 Internationai Bureau of Fiscal Documentation
JANUARY FEBRUARY 2004 ITPJ 1991 and 734 workdays in 1992. In the course of the field the contract was in fact not executed as stipulated in audit, it was concluded on the basis of travel expense state the contract. with regard to the services the contract ments, that the Italian employees of PPD were in Germany suggested that a cost allocation scheme was to be used for 311 days in 1991 and 41 days in 1992. Also in the However, in fact, the company took a fixed percentage course of the field audit, the total duration of stay in 1990 of sales as compensation for the services was determined to be 432 days Nevertheless, the tax office allowed a deduction for the expenses incurred for a certain amount of workdays for 2.2. Decision which the taxpayer provided evidence that Italian person nel were present in Germany. The Court concluded that The Lower Tax Court of Munich concluded that thethe estimate of the tax office of the expenses did not GmbH's complaint was unfounded. First, the Tax Court infringe the rights of the taxpayer analysed the relationship between the German rules on hidden profit distributions and Art. 9 of the Italy-Ger many income tax treaty(hereinafter: the Treaty). The 3. ANALYSIS Court held that Art. 9 of the Treaty is not self-executing but does limit domestic law. This view is also supported in The decision of the Lower Tax Court of Munich highlights German tax literature. The Court also held that German the importance of the use of written intra-group agree law is fully in line with the international interpretation of ments. However, having a written contract is only going the arms length principle halfway. The tax authorities emphasize that it is of vital importance to actually effect ones transactions in accord long-standing jurisprudence of the Federal Tax Court on ance with the relevant underlying agreement. If the tax- ment is justified if a prudent business manager would not written agreement, the tax authorities will often challenge have agreed to the terms of the contract). a hidden profit the clear and explicit wish of the contractual partners to be distribution arises where a company accepts terms in its bound under the intra-group agreement. transactions with related parties that differ from those In the present case, it seems-from the available informa- unrelated parties would have agreed upon under similar tion- that the taxpayer drafted a merely pro forma agree conditions. In addition, there is a requirement with regard ment without following the basic terms (e. g. instead of to transactions between a company and its majority share- paying the agreed 0.8% licence fee, a licence fee of 1.0%0 holder, that such transactions be based on contractual was paid). This obviously raised a red flag for the tax agreements that are entered into in advance, in clear and authorities. However, the tax authorities based their deci- unambiguous terms sion on the analysis of the Agreement; they did not con cts and sider whether the remuneration was arm's length. This cer- dent business manager would not have agreed to the con- tainly raises, the question of whether the arms length tract. The Court based its conclusion on the following rea- soning: compared to the internationally accepted principles under the contents of the contract must be clearly defined Art. 9 of the OECD Model Treaty. and both parties must clearly understand their rights only agree to pay a royalty of 0.8% i eger would 3. 1. Interpretation of the arm's length principle and obligations. A prudent business man clear, legally valid agreement in advance. Where this It is now the prevailing opinion in German tax literature is not the case, one can assume that the conditions that Art. 9 of OECD Model Treaty(hereinafter: Art. 9 have been "imposed"by the parent company does not have a self-executing effect; the provision merely if a contract is based on a percentage of turnover, a limits the application of domestic tax law. Thus, Art. 9 prudent business manager would insist that the obliga- would limit the application of domestic law if the applica- tract. It was contractually not ensured that the licensee However, the tax authorities expressed a different wcm.t. tions of the licensor be clearly described in the con- tion of an applicable treaty would lead to a higher tax could influence the deliverables such that the contract was more or less influenced by the parent company. In ght of these factors the Court reasoned that it was not 10. Sec. 8(3)Corporate Income Tax Act necessary to verify whether the licence fee is reason men, eds. Becker et al. (Herne- able Berlin: Verlag Neue Wirtschafts-Briefe, 1996). Art. 9 note 85: Rasch, Konger with regard to the technical assistance services re verrechnungspreise im nationalen, bilateralen und europischen Steuerrechr (Cologne: Verlag Dr, Otto Schmidt, 2001). at 187: Schaumburg. Ini not permissible if the services were for the administra- 12. See Eigelshoven, in Doppelbesteuerungsabkommen, eds. Vo tion, management, or control by the parent, or in the Lehner (Munich: Verlag C.H. Beck, 2003).Art. 9, note 18: Schaumbu case of consultancy or simiiar services. Because such Wassermeyer, in Doppeibesteuerung, eds. Debatin and Wassermeyer expenses were incurred in the interest of the share- Verlag C.H. Beck, 2002), Art. 9, note 4 and 103; Becker, in Doppel- holder (PPD), these expense are not deductible at the besteuerungsabkommen, eds. Becker et al(Herne-Berlin: Verlag Neue level of the subsidiary; and Wirtschafts-Briefe, 1996). Art. 9. note 66: Rasch, Konzen im nationalen, bilateralen und europischen Steuerrecht(Cologne Otto Schmidt, 2001), at 192. o 2004 International Bureau of Fiscal Documentation
JANUARY/FEBRUARY 2004 the Administrative Principles. Under the Administrative ferent measures. In addition to the arms length standard, Principles 1983, the allocation provisions of German tax the deductibility of a payment is contingent upon its beir law are also applicable in those cases of related interests based on contractual agreements that were entered into in that are not covered by the allocation provisions of Ger- advance, in clear and unambiguous terms. This condition man tax treaties. 4 The Administrative Principles argue is based on jurisprudence developed by the Federal Tax that it would be inconsistent with the meaning and purpose Court in the context of business relationships between of tax treaties if income adjustments required in a particu- individuals belonging to the same family, and was later lar case were prevented by an applicable treaty. However, expanded to cover payments made to controlling share if this view were correct, Art. 9 would have no legal effect holders. It basically turns out to be an anti-avoidance because domestic law would set forth rules on how to allo- measure and is designed to prevent a group of related tax intent of tax treaties tage by using the benefit of hindsight. 8 As a consequence Tax auditors often see a difference between the standard of the courts have adjusted income even if the transactions the prudent business manager and the arm's length princi- have been at arms length ple, especially when a company incurs losses over several As these additional measures are treated as sub-criteria of years.Moreover, there is a difference in the formal the arm's length principle, one must distinguish between requirements of the two standards. As mentioned above it formal and substantive sub-criteria. The formal sub-crite- is necessary under domestic law to have clear and unam- rion requires that contractual agreements be entered into in biguous agreements in advance. This seems not to be in advance in clear and unambiguous terms The substantive line with Art. 9 of the OECD Model Treaty and most of the sub-criteria look to the"seriousness"(Ernstlichkeit)20 of German treaties that follow Art. 9 of the OECD Model the agreement, the actual performance of the agreement Treaty. In contrast to the German interpretation of the and the consideration to determine whether the transaction arms length principle, Art. 9 only requires that the prices is in line with common practice(Ublichkeit). 2I be charged at arm's length, regardless of the formality(or lack thereof) of the agreements 3.3. Applicability of the sub-criteria under Art. 9 of D Model Treaty 3. 2. Arm's length principle under German tax law In the authors'opinion, it is not helpful to make use of 3. 2.1. Prudent business manager standard these sub-criteria because, for example the consideration For almost 30 years the courts have based the decision of of whether a transaction is customary is not a reliable whether payments made between related parties are yardstick in determining the appropriate transfer price. In so-called prudent business manager standard I5 Much dis Therefore, transactions that seem to be unusual because cussion can be found in the tax literature regarding they are not entered into regularly or are performed for the whether this test could be consistent with the internation first time should not a priori be treated as not being in line tion of other countries and in income tax treaties as well with the arm's length principle as in another German allocation provision, namely Sec. 1 Moreover, Art. 9 of the OECD Model Treaty provides that of the Foreign Tax Code. The main argument was that the the arms length principle is subject to conditions"made' prudent business manager standard, which was developed or "imposed"between two associated enterprises. It is 1967, 6 is a one-sided approach, investigating only therefore only decisive whether services are rendered to whether a"prudent and diligent business manager"of the the benefit of the recipient and if so, whether the consider company would have agreed to the transaction. This approach fails to take into account the view of the other 13. Decree of the fed party to the transaction, which is significant because the ry of Finance, 23 February 1983, BMF 5 S1341-4/83, Federal Tax Bulletin 1983 I, at 218. For an English translation negotiation process of a transaction is basically shaped by see Kroppen and Eigelshoven, the Germany chapter in Tax Treatment of Trans- the conflicting interests of both parties to the transaction. 7 yer Pricing (Amsterdam: IBFD Publications BV, loose-leaf), June 2002, at 8.2 The Federal Tax Court recognized this problem and intro- 15. For a detailed analysis, see Kroppen, Roeder and Eigel duced the standard of the so-called doubly prudent busi- Pricing Intermational: A Country-by-Country Guide,ed.Robert Feinschreiber ness manager, which standard looks to both parties to a (2nd ed. )(New York: John Wiley, 2002), Sec. 24 transaction. As a result, it is widely accepted that in gen- 16. Sce the decision of the Federal Tax Court, 16 March 1967. BStBL 1967 IIL. eral the latter standard is in line with the internationa at b sor a detailed analysis, see Kroppen, in Handbuch Internationale Verrech- arms length principle Cologne: Verlag Dr. Otto-Schmidt Der Betrieb 1994 at 1105: Rasch. kon 3.2.2. Additional criteria under the german arm's length 18. See Federal Tax Court, 26 April 1989, BStBI. II 1989, at 673 Although there is a consensus that the doubly prudent 19. See e. g. Federal Tax Court, 12 October 1995, BFH/NV 1996, at 266 business manager test is basically in line with Art. 9 of the 21. See e.g. Federal Tax Court. 13 July 1994, BFH/NV 1995. at 548t622 LO. See e.g. Federal Tax Court, 13 November 1996. BFH/NV 1997, OECD Model Treaty, German case law on the application 22. For a detailed analysis, see Kroppen, in Handbuch Internationale Verrech of the arms length principle provides for a number of dif- gspreise, eds. Becker and K poppen( Cologne: Verlag Dr. Otto-Schmid 2004 international Bureau of Fiscal Documentation
JANUARY /FEBRUARY 2004 ITPJ ation for the services is arms length. Any other criteria merely indicative and not conclusive. 26 It needs to be would not be feasible under Art. 9 of the OECD Model determined whether the actual conditions of the respective Treaty. Because Art. 9 limits the application of domestic transaction are in line with the arms length principle. The tax law, any sub-criteria would be inapplicable under Federal Tax Court also follows this interpretation. Accord domestic tax law ing to the jurisprudence of the Federal Tax Court, not only This seems to be very different to the German approach to the formal aspects, but the totality of objective circum- use the prudent business manager principle that is also stances must be taken into account in dete mentioned in several sections in the ruling of the Lower appropriateness of the taxpayer's transfer pricing. In fact, Tax Court of Munich. For example the Court takes n the authors'opinion, that is the main point where the imposed"conditions or missing appendices as an indic Lower Tax Court of Munich failed, because it did not tion of non-arm's length transfer prices. Under the logic of yse the amount of the licence fee. 27 the Court, a prudent business manager would not be will- It should also be mentioned that the sub-criteria have all ing to pay consideration for its contractual obligations. been developed in German case law dealing with the rela Because of these reasons, the Court explicitly rejects test- tionship of a company and a natural person as a share ing whether the charges were arm's length. However, this holder of that company. In particular, the courts had exam- is not backed by the internationally accepted arms length ined the salary of a company's managing director who the prices might be imposed by the parent company, the pricing, however, focuses on the relationship between two only crucial determination is-again- whether the price arm s leng thus doubtful whether the sub-criteria, which might b Moreover, from a practical perspective the tax authorities correct in the aforementioned case of natural persons as shareholders, should in fact be used for the determination having jurisdiction over the other party to a transacton of transfer prices in the relationship between related enti likely will not be willing to grant a corresponding adju ment if services were in fact rendered and if the consider- ation is arms length. Again, the non-existence of a con- tract or the failure to meet a certain form will not be 4. CoNCLUSION accepted by the tax authorities of another country as a rea- son for reducing taxable income in their jurisdiction. 24 If this were to be the case, missing or incorrect agreement The formal requirements under German case law interfere could be used by the taxpayer as a planning tool. For with the interpretation of Art. 9 of the OECD Model Treaty. If tax auditors base an adjustment on the mere fact for management services in the country of the service that the taxpayer has not complied with formal require- provider would simply not conclude any contracts. The ments, there should be reasonable grounds for filing an country of the recipient would not allow a deduction at appeal against the findings of the tax authorities, provided year end and the country of the service provider could not that the transfer pricing is arm's length challenge the transfer prices because of the non-existence f a contract. 25 One additional argument needs to be considered. Even if 23. See also Federal Tax Court, 17 October 2001, DB 2001, 2474, Ill. A 2 d) the taxpayer provides a written agreement, the tax author- bb) ities are not barred from examining whether the transfer Cf. Eigelshoven and Nientimp. Der Betrieb 2003, at 2306, 2309 pricing is in line with the arm's length principle. There- Berlin: Verlag Neue Wirtschafts-Briefe, 1996), Art. 9. note 116: bellstedt fore, the taxpayer's compliance with the formal require- Finanzrundschau 1990. at 65: Eigelshoven and Nientimp, Tax Notes Inter- ments does not lead to positive evidence that the transfer national 18 August 2003, at 667: Schaumburg, Internationales prices are appropriate. On the other hand, there is also no Cologne: Verlag Dr. Otto Schmidt, 1998), Sec. 16.291;Knobbe-Keu evidence that the transfer pricing is incorrect solely d Unternehmenssteuerrecht(9th ed. )( Cologne: Verlag Dr. Otto 3). at 695; Schnieder, internationales Steuerrecht 1999. at 65 because the taxpayer has not prepared a written agree Federal Constitutional Court, 7 November 1995-2 BvR 802/90("Oder- ment. In both cases, it is important only that the transfer Konto-BeschluB"). Neue Juristische Wochenschrift 1196. at 833; see also pricing be arms length. As a result, one can conclude that Rasch, Konzernverrechnungspreise im national it is irrelevant whether the formal requirements have been Steuerrecht(Cologne: Dr. Otto-Schmidt Verlag, 2001), at 42 fulfilled, provided that the price is arms length. This pos See decision of Lower Tax Court of Munich, 16 July 2002, 6 K 1910/98 ition is also backed by the Federal Constitutional Court, Nientimp, Der Betrieb 2003, at 2306 and 2300> .953. See also Eigelshoven and which has emphasized that formal requirements are 28. See also Eigelshoven and Nientimp, Der Betrieb 2003. at 2306 and 2310 @2004 International Bureau of Fiscal Documentation
