Report will include three possible specifi cations, which can be combined New German Regulations First. the tax authorities can directly access the taxpayers on Access to Digital Data electronically saved data, but chey are only permitted to have During Tax Audits Have read-only access using the taxpayers hard-and software Transfer Pricing (direct data access). This read-only access includes Consequences reading, filtering, and sorting the data supported by the analysis options available by Dr Heinz-Klaus Kroppen, LL. M within the taxpayers data and marc schnell processing system. Second. the tax authorities will Dr. Heinz-Klaus Kroppen, LL. M. and Marc Schnell are with be in a legal position to Deloitte Touche in Diisseldo demand from the taxpayer an electronic read-only analysis of che data based on their partic ular criteria and on the data processing system used by the I Background audit. Thus, taxpayers must make taxpayer (indirect data Ge ermany's Tax Reform Act of available, at a minimum, data 23 October 2000 introduced a relating to financial, asset, and e Third. the tax authorities will be able to demand that saved new provision into the german wage accounting. Taxpayers also General Tax Code that allows tax must provide data from other documents be stored on authorities access to digital data parts of their data processin g mechanically utilizable data media(data media delivery) contained in taxpayer EDP systems to the extent systems as part of a tax audit. The relevant for tax purposes In consideration of the principle German tax authorities published Taxpayers will be responsible for f reasonableness, the taxpayer determining whether information generally will bear the costs that sets forth their int is fiscally relevant; however, if the arise from these obligations the new provision As a result authorities believe the distinction German taxpayers will face new made by a taxpayer is not correct II. Transfer Pricing they can request access to those obligations regarding their liability data the taxpayer has classified as for cooperating with the ta authorities in the course of a tax The new ordinance will have audit conducted after 31 December gnificant implications from a It is easy to anticipate that the 2001. German transfer pricing perspec classification of data as relevant tive. Obviously, transfer pricing The Federal Ministry of Finance will be a major item of disagree- emprise more than states in the ordinance that it ment between the tax auditor and financial, asset, and wage perceived the need to adjust its the taxpayer. Experience shows current tax audit methods to that field auditors have always affected by a variety of aspects modern accounting techniques interpreted the term "relevant"in regarding the exchange of good growing significance of paperless have often classified board meeting unrelated parties. Therefore,ltp 9 and to take into account the a broad sense. For example, they and services between related minutes and supervisory board fairly predictable that the tax au- tion of the ordinance and the new meeting minutes as relevant infor- thorities will try to include almost section 147, paragraph 6 of the mation. The same is true for all all data available as relevant for General Tax Code will facilitate planning and budget information pricing and, therefore, also for tax more efficient and contemporary and internal segmental reporting purposes. tax audits If the authorities are able to According to a recent german IL. Sc sustain their position, a taxpayers Supreme Tax court decision, affairs will become totally trans Tax authorities will be entitled parent for the auditor. transfer pricing documentation requirements are limited under to access digital data that is The legal authorization for tax current german tax law, because fiscally relevant during a tax authorities to access digital data the law does not explicitly contain Tax Notes International 1 October 2001
I. Background Germany’s Tax Reform Act of 23 October 2000 introduced a new provision into the German General Tax Code that allows tax authorities access to digital data contained in taxpayer EDP systems as part of a tax audit. The German tax authorities published an ordinance 16 July 2001 that sets forth their interpretation of the new provision. As a result, German taxpayers will face new obligations regarding their liability for cooperating with the tax authorities in the course of a tax audit conducted after 31 December 2001. The Federal Ministry of Finance states in the ordinance that it perceived the need to adjust its current tax audit methods to modern accounting techniques, and to take into account the growing significance of paperless business dealings. The introduction of the ordinance and the new section 147, paragraph 6 of the General Tax Code will facilitate more efficient and contemporary tax audits. II. Scope of Access Tax authorities will be entitled to access digital data that is fiscally relevant during a tax audit. Thus, taxpayers must make available, at a minimum, data relating to financial, asset, and wage accounting. Taxpayers also must provide data from other parts of their data processing systems to the extent these are relevant for tax purposes. Taxpayers will be responsible for determining whether information is fiscally relevant; however, if the authorities believe the distinction made by a taxpayer is not correct, they can request access to those data the taxpayer has classified as not relevant. It is easy to anticipate that the classification of data as relevant will be a major item of disagreement between the tax auditor and the taxpayer. Experience shows that field auditors have always interpreted the term “relevant” in a broad sense. For example, they have often classified board meeting minutes and supervisory board meeting minutes as relevant information. The same is true for all planning and budget information and internal segmental reporting. If the authorities are able to sustain their position, a taxpayer’s affairs will become totally transparent for the auditor. The legal authorization for tax authorities to access digital data will include three possible specifications, which can be combined: First, the tax authorities can directly access the taxpayer’s electronically saved data, but they are only permitted to have read-only access using the taxpayer’s hard- and software (direct data access). This read-only access includes reading, filtering, and sorting the data supported by the analysis options available within the taxpayer’s data processing system. Second, the tax authorities will be in a legal position to demand from the taxpayer an electronic read-only analysis of the data based on their particular criteria and on the data processing system used by the taxpayer (indirect data access). Third, the tax authorities will be able to demand that saved documents be stored on mechanically utilizable data media (data media delivery). In consideration of the principle of reasonableness, the taxpayer generally will bear the costs that arise from these obligations. III. Transfer Pricing Aspects The new ordinance will have significant implications from a German transfer pricing perspective. Obviously, transfer pricing issues comprise more than financial, asset, and wage accounting. Transfer pricing is affected by a variety of aspects regarding the exchange of goods and services between related and unrelated parties. Therefore, it is fairly predictable that the tax authorities will try to include almost all data available as relevant for pricing and, therefore, also for tax purposes. According to a recent German Supreme Tax Court decision, transfer pricing documentation requirements are limited under current German tax law, because the law does not explicitly contain Tax Notes International 1 October 2001 • 1 Special Reports New German Regulations on Access to Digital Data During Tax Audits Have Transfer Pricing Consequences by Dr. Heinz-Klaus Kroppen, LL.M. and Marc Schnell Dr. Heinz-Klaus Kroppen, LL.M. and Marc Schnell are with Deloitte & Touche in Düsseldorf
Special Reports transfer pricing documentation Furthermore, the draft adminis- a description of the transfer rules(Supreme Tax Court decision trative principles stated that ng method applied dated 10 May 2001, DB 2001, p. taxpayers should consider before 1180).However, following state- fixing prices, whether the transfer an explanation regarding ments from the tax authorities, it prices are in line with the conformity of the transfer is expected that the German legis- arms-length principle and, thus, prices with the arms-length explicitly include detailed transfer According to the administrative lation will be changed shortly to prepare adequate documentation standard. an analysis of intragroup pricing documentation require- principles, the documentation transactions and transactions ments(see Kroppen/Eigelshoven, should be sufficient to provide IWB Fach 3 Gruppe 1, 1745 with third parties applied by che taxpayer considering th Kroppen/Eigelshoven, Transfer decisionmaking process for comparability of functions Pricing Journal 2001, No 6(to be transaction and the resulting risks, contractual terms (terms published)). If these new documen- pricing For each individual case the documentation should of payment, delivery, and the tation requirements follow the like), the use of intangible requirement stipulated in the Draft Administrative Principles on property (know-how, customer base, patents, and trademarks) transfer pricing documentation described below, taxpayers will be confronted with additional obliga- market conditions tions regarding the archiving and disposition of digital data in If transfer prices are det connection with fiscally relevant mined based on financial data of circumstances in the transfer unrelated parties, all information relevant to the pricing decision pricing area. should be readily available. Infor The Ministry of financ The new ordinance will mation on particular factors(such ublished on 24 August 2000 have significant as business strategy) should also administrative principles on docu mplications from a be made available. as the tax mentation requirements that have auditors might request these not been finalized because of the German transfer pricing records during a tax audit. while uncertainty created by the above perspective at the beginning of an audit the mentioned Supreme Tax Court auditors will try to gather infor decision, which can be seen as nation on a more general basis denying the basis of the adminis- he tax auditors will analyze the trative principles. According to the taxpayer in depth during the audit draft administrative principles, on the date a tax audit is fixed by the tax authorities the tax auditors Regarding other sources, the will request the following taxpayer must provide planning documents to focus their audit. and budget process documents, including explanations of the organizational charts; a description of the business deviation between plan/budget and activity(such as products actual results, and a description of annual reports and balance the remedial measures taken by the amount of business trans he taxpayer. These documents dependence report of the actions with foreign affiliated must demonstrate that the managing board; companies(such as transfers of taxpayer planned for a reasonable goods, rent and lease of profit within an appropriate tangible assets, use and timeframe following the intro- assignment of intangible pro duction of a new product. . information about advance erty, and lending activities ); Therefore, the taxpayer shoule take into account that, in general, documentation relating to description of the value-added planning documents generated for transfer pricing that has chain: internal management purposes already been prepared for the information regarding the will likely be requested by the tax tax authorities of other decisionmaking proces authorities. Taking the tax author- countries: and ities extensive documentation information on price negotia- wish list contained in the adminis- internal transfer pricing guide tions regarding the determi trative principles on documenta- lines (if they exist nation of transfer prices; tion as an indication of what the 2·1 October2001 Tax Notes International
transfer pricing documentation rules (Supreme Tax Court decision dated 10 May 2001, DB 2001, p. 1180). However, following statements from the tax authorities, it is expected that the German legislation will be changed shortly to explicitly include detailed transfer pricing documentation requirements (see Kroppen/Eigelshoven, IWB Fach 3 Gruppe 1, 1745; Kroppen/Eigelshoven, Transfer Pricing Journal 2001, No. 6 (to be published)). If these new documentation requirements follow the requirement stipulated in the Draft Administrative Principles on transfer pricing documentation described below, taxpayers will be confronted with additional obligations regarding the archiving and disposition of digital data in connection with fiscally relevant circumstances in the transfer pricing area. The Ministry of Finance published on 24 August 2000 administrative principles on documentation requirements that have not been finalized because of the uncertainty created by the above mentioned Supreme Tax Court decision, which can be seen as denying the basis of the administrative principles. According to the draft administrative principles, on the date a tax audit is fixed by the tax authorities, the tax auditors will request the following documents to focus their audit: organizational charts; annual reports and balance sheets; dependence report of the managing board; a list of contracts; information about advance pricing agreements; documentation relating to transfer pricing that has already been prepared for the tax authorities of other countries; and internal transfer pricing guidelines (if they exist). Furthermore, the draft administrative principles stated that taxpayers should consider, before fixing prices, whether the transfer prices are in line with the arm’s-length principle and, thus, prepare adequate documentation. According to the administrative principles, the documentation should be sufficient to provide evidence regarding the decisionmaking process for a transaction and the resulting pricing. For each individual case, the documentation should comprise: a description of the business activity (such as products, services); the amount of business transactions with foreign affiliated companies (such as transfers of goods, rent and lease of tangible assets, use and assignment of intangible property, and lending activities); description of the value-added chain; information regarding the decisionmaking process; information on price negotiations regarding the determination of transfer prices; a description of the transfer pricing method applied; an explanation regarding conformity of the transfer prices with the arm’s-length standard; an analysis of intragroup transactions and transactions with third parties applied by the taxpayer considering the comparability of functions, risks, contractual terms (terms of payment, delivery, and the like), the use of intangible property (know-how, customer base, patents, and trademarks); and market conditions. If transfer prices are determined based on financial data of unrelated parties, all information relevant to the pricing decision should be readily available. Information on particular factors (such as business strategy) should also be made available, as the tax auditors might request these records during a tax audit. While at the beginning of an audit the auditors will try to gather information on a more general basis, the tax auditors will analyze the taxpayer in depth during the audit process. Regarding other sources, the taxpayer must provide planning and budget process documents, including explanations of the deviation between plan/budget and actual results, and a description of the remedial measures taken by the taxpayer. These documents must demonstrate that the taxpayer planned for a reasonable profit within an appropriate timeframe following the introduction of a new product. Therefore, the taxpayer should take into account that, in general, planning documents generated for internal management purposes will likely be requested by the tax authorities. Taking the tax authorities’ extensive documentation wish list contained in the administrative principles on documentation as an indication of what the 2 • 1 October 2001 Tax Notes International Special Reports The new ordinance will have significant implications from a German transfer pricing perspective
Report authorities regard as relevant products to prove that a taxpayer V. Conclusions eveals how broadly the data has not complied with the access requirements could be arm s-length test in those areas. Following the introduction of interpreted by the authoritie the new law on access to digital Another area of potential IV. Other Aspects data during tax audits, taxpayers will be confronted with new obliga cess Is 60-called intranets operated within tions should be mentioned briefly. risks. Taxpayers should be international groups. Through First, the new ordinance might repared to meet the demands these intranets, German personnel lead to the likely situation that the under the new regulations within and management have access to tax authorities access the informa a reasonable time frame. They various data generated by the tion processing systems of the should identify the data that is group. The question arises whether the data access of the cessing systeml. t er d sk the the tax relevant for taxation, and collect it authorities may also ask the entrally in an appropriate data authorities also covers such data taxpayer to delin ata media, the processing system to avoid the that is available to german nformation pro- costs of a subsequent and time personnel but is not necessarily s are affected by the consuming classification process kept in Germany. It cannot be taxpayer. The new regulations do Regarding direct digital data ruled out that those data, such as access for the tax authorities, an cost data of a foreign parent, will effective system based on access be classified as relevant for authorizations should be imple German tax purposes by the mented to secure a limited German authorities. The german read-only access, as far as legally tax authorities might try to argue possible. Archived digital informa that to apply a common test in tion and the respective software German tax law, namely deter- should be organized analogously mining what an independent It is easy to anticipate and actual access by the tax managing director would have that the classification of auditor could be recorded with the done in a similar situation, they data as relevant will be a the taxpayers legal position. alyo aid of suitable programs to protect need the same information the managing director had when he major item of measures taken by the taxpayer to made his decision disagreement between meet the new requirements should One aspect be technically feasible, but it is Supreme Tax Court decision the tax auditor and the safe to say that they will require mentioned above could become taxpayer significant investments and obsolete because of the increased increase the costs of a tax audit for possibilities of access to data. The the taxpayer. court has held that a german From the tax authorities point subsidiary of a foreign parent does of view, access to digital data will not need to provide certain significantly improve their documents solely in the parents position. The volume of data to possession. However, whether that review is likely to increase corre- is also true if the german spondingly, and the identification personnel could have access to of errors and inconsistencies such data through the group not address the liability aspects of within the taxpayer's data process intranet is not clear mproper data losses or damage to the respective data processing ing systems will be simplified. In addition to direct access to systems Moreover the tax authorities could certain data, another pe Ise the know ledge gained to create danger is the tax authorities'legal It should also be mentioned that statistical data collectio right to utilize the analysis the ordinance might require the an be used for the plausibility features contained in the heavy involvement of the assessment of transfer pricing or taxpayers EDP system. Because taxpayers resources, who must other related tax issues modern software packages include bear additional archiving costs and ncreasing analytic features, tax must assign qualified personnel to VI Summary authorities might use these to assist the tax auditor. The Under the new regulations calculate results that they consider taxpayers archiving obligations taxpayers will be confronted with relevant for transfer will be augmented because it not additional burdens regarding example, they might run analyses only must keep the digital infor- participation requirements on the profitability of some mation, but also the necessary Although transfer pricing aspects segment or product lines or software to access the data are not explicitly mentioned, the Tax Notes International 1 October 2001
authorities regard as relevant reveals how broadly the data access requirements could be interpreted by the authorities. Another area of potential concern regarding data access is so-called intranets operated within international groups. Through these intranets, German personnel and management have access to various data generated by the group. The question arises whether the data access of the authorities also covers such data that is available to German personnel but is not necessarily kept in Germany. It cannot be ruled out that those data, such as cost data of a foreign parent, will be classified as relevant for German tax purposes by the German authorities. The German tax authorities might try to argue that to apply a common test in German tax law, namely determining what an independent managing director would have done in a similar situation, they need the same information the managing director had when he made his decision. One aspect of the recent Supreme Tax Court decision mentioned above could become obsolete because of the increased possibilities of access to data. The court has held that a German subsidiary of a foreign parent does not need to provide certain documents solely in the parent’s possession. However, whether that is also true if the German personnel could have access to such data through the group intranet is not clear. In addition to direct access to certain data, another potential danger is the tax authorities’ legal right to utilize the analysis features contained in the taxpayer’s EDP system. Because modern software packages include increasing analytic features, tax authorities might use these to calculate results that they consider relevant for transfer pricing. For example, they might run analyses on the profitability of some segment or product lines or products to prove that a taxpayer has not complied with the arm’s-length test in those areas. IV. Other Aspects Other aspects of the new regulations should be mentioned briefly. First, the new ordinance might lead to the likely situation that the tax authorities access the information processing systems of the taxpayer. However, because the tax authorities may also ask the taxpayer to deliver data media, the tax authorities’ information processing systems are affected by the taxpayer. The new regulations do not address the liability aspects of improper data losses or damage to the respective data processing systems. It should also be mentioned that the ordinance might require the heavy involvement of the taxpayer’s resources, who must bear additional archiving costs and must assign qualified personnel to assist the tax auditor. The taxpayer’s archiving obligations will be augmented because it not only must keep the digital information, but also the necessary software to access the data. V. Conclusions Following the introduction of the new law on access to digital data during tax audits, taxpayers will be confronted with new obligations, additional expenses, and risks. Taxpayers should be prepared to meet the demands under the new regulations within a reasonable time frame. They should identify the data that is relevant for taxation, and collect it centrally in an appropriate data processing system to avoid the costs of a subsequent and time consuming classification process. Regarding direct digital data access for the tax authorities, an effective system based on access authorizations should be implemented to secure a limited read-only access, as far as legally possible. Archived digital information and the respective software should be organized analogously, and actual access by the tax auditor could be recorded with the aid of suitable programs to protect the taxpayer’s legal position. All measures taken by the taxpayer to meet the new requirements should be technically feasible, but it is safe to say that they will require significant investments and increase the costs of a tax audit for the taxpayer. From the tax authorities’ point of view, access to digital data will significantly improve their position. The volume of data to review is likely to increase correspondingly, and the identification of errors and inconsistencies within the taxpayer’s data processing systems will be simplified. Moreover, the tax authorities could use the knowledge gained to create statistical data collections, which can be used for the plausibility assessment of transfer pricing or other related tax issues. VI. Summary Under the new regulations, taxpayers will be confronted with additional burdens regarding participation requirements. Although transfer pricing aspects are not explicitly mentioned, the Tax Notes International 1 October 2001 • 3 Special Reports It is easy to anticipate that the classification of data as relevant will be a major item of disagreement between the tax auditor and the taxpayer
Special Reports new regulations require the the future, the amount of digital ments and to minimize costs and presentation of all digital informa- data to be disclosed in tax audits risks. It is at least questionable tion related to tax relevant circum- will increase correspondingly. hether taxpayers will benefit stances. As the scope of Taxpayers would be well advised from the new regulations, but it documentation requirements to reorganize their information an certainly be expected that the regarding transfer pricing issues is processing systems at an early tax authorities will improve their likely to significantly expand in tage to meet the new require- oSition 4·1 October2001 Tax Notes International
new regulations require the presentation of all digital information related to tax relevant circumstances. As the scope of documentation requirements regarding transfer pricing issues is likely to significantly expand in the future, the amount of digital data to be disclosed in tax audits will increase correspondingly. Taxpayers would be well advised to reorganize their information processing systems at an early stage to meet the new requirements and to minimize costs and risks. It is at least questionable whether taxpayers will benefit from the new regulations, but it can certainly be expected that the tax authorities will improve their position. ✦ 4 • 1 October 2001 Tax Notes International Special Reports