156 ITPJ JULY/AUGUST 2000 Case Notes GERMANY Tax Court Ruling on Transfer Prices and External Gross Margin Analyses! Dr Heinz-Klaus Kroppen2 and Axel Eigelshoven3 I. INTRODUCTION lated ing in the same industry. T The determination of arm's length transfer prices and the comparables were, however, not disclosed to the tax- OF SECRET COMPARABLES before the ne amount of the construc- le price method, with DSIRE)20 der vogele, have not been literature. T ther analysed tax o between th tributor on the
JULYIAUGUST 2000 ITPJ 157 the appropriate gross margin being determined based on the taxpayer was deprived of the possibility to put forward an external comparison of four distributors operating in its own arguments in support of its position. the same market as the taxpayer. Initially, comparable Ger database i as wel as industry codes and company profiles. were deleted. The Court also rejected this proposal available on a limited basis in the database. After identify f comparability and the tax office could influence the ing the comparable companies, the tax auditors obtained selection of comparable companies to the disadvantage of more detailed inform ffices which was then further analysed the taxpayer The efforts of the tax office to detemine appropriate trans- C. Position of the tax authorities and the OECD ate comparables are, in principle, to be welcomed In prac- In the opinion of the tax authorities, comparable com- n operating margins, even if the taxpayer has fully dis- anies can be used in court proceedings without disclosing the identity of the companies concerned. The tax author- closed all required information to the tax office, so that an ities. hence, follow the established practice of the Federal estimate is not admissible. The operating margins are not Tax court. l4 However, the Ministry of Finance deems the are often based on(inadmissible) rules of thumb. In the right to be heard before the courts to be violated if the files maintained regarding comparable companies are only dis- authors expenence, arm's length prices have so far hardly closed to the lax Court rather than to all participants in the ever been determined by tax auditors using a theoretically Court proceeding. Therefore, the ruling in the Dusseldorf databases). The main reason for this may be the lack of the Federal ministry of Finance. Yet, that ruling goes one (financial statements and balance sheets are currently only when used to determine transfer prices in Tax Court pro- available for 10,000 to 15,000 companies). In addition, both a lack of resources to the tax authorities and insuffi cient experience on the part of tax auditors in performing The oECd does not analyse in detail the issue of secret sis. However, in the case at hand the main concen is that Pricing Guidelines(hereinafter: OECD Guidelines ) the the tax auditors'determination is based on data that could oeCd discusses the net margin method, clearly rejectin not be disclosed to the taxpayer because of tax secrecy le he use of data that are not available to the taxpayer. It is gislation pressly made clear that these rules should be applicable to all transfer pricing methods, which would include the B. Holding of the Lower Tax Court of Dusseldorf resale price method. The OECD justifies its objection by The Dusseldorf Tax Court first stated that a disclosure of defang that the taxpayer must have the possibility to courts would otherwise not be ensured. The oeCd. like data of comparable companies to the taxpayer in the court the Lower Tax Court of Dusseldorf, therefore also goes proceedings would lead to a violation of the tax secrecy of the comparable companies. The Court noted that the tax- payer has the right to be heard before the Court, 0 and this ncludes the right to access to all evidence and facts rel- 6.. See Administrative Principles on Transfer Pricing of 23 February 1983 evant to the case. In the opinion of the Court, however, of the text, see Heinz-Klaus Kroppen and Axel Eigelshoven, cl there is no conflict between the taxpayer's right to access in The Tax Treatment of Transfer Pricing (Amsterdam: IBFD, 1987),1 all information and the strict tax secrecy legislation. Tipke and Heinrich Kruse,(Koln: Dr. Otto Schmidt Verlag, 1996), Sec. 162 AC crecy or the disclosure of data of the comparables, mey r d uers eurn hof keun: tr tko, schn ida verlig. 9a ess respectively, cannot be justified by the obligation of the AStG, note861 ourt to grant the taxpayer the right to access the Court' s 7. See also wolf-Dieter Hoffmann and edgar Schnitzer, "Globale file Kroppen, in Jahrbuch der fachanwdlte fir Steuerrecht 1999(Herne/Berlin The Court also rejected an exclusive disclosure to the Tax Neue Wirtschafts-Briefe, 2000), at 51 s y gl at 191 for an example. Court, which was suggested by the tax office. 12 The Tax 3. However, see Harald kuckhoff and rof schreiber, errechnungspreise in Court reasoned that the tax secrecy was, on the one hand also binding on the Court and, on the other, the exclusive 10 'Tax Court Code, Sec.96, Para.2. disclosure to the Court would again violate the taxpayer's 11. Tax Court Code, Sec. 78 right to access the files. moreover, the duty to grant the 12. This view differs from the Federal lesteuerblatt(hereinafter:BSiBL)I taxpayer the right to be heard before the Court was Court dated 18 December 1984, Bund (1986),at229 designed to put the parties in an equitable position in the 13. Letter of the Federal Ministry of Finance dated 7 April 1986, BSIBL I proceedings. This right would be infringed if the Tax (1986), at 128 Court had to rule on the comparability of companies and 14. See Federal Tax Court Opinion dated 24 September 1976, BSiBL n(1977), at 196; Federal Tax Court Opinion dated 21 May 1982, BStBL I (1982), at 604 eral Tax Court Opinion dated 18 December 1984, BStBL. I (1986), at 226 C 2000 IBFD Publications BV
ITPJ JULY/AUGUST 2000 further than the German tax authorities by generally which information deficits are inherent. The determination rejecting secret comparables made by the tax auditors must, therefore, be based exclu sively on the same information that is available to the tax D. Position of the german courts and tax literature ayer at the time the contract is concluded. This is also acknowledged by the OECD, because a range of prices rather than one price are deemed to be appropriate. 9 ceedings, the prevailing opinion in German tax literature is Assuming that prio re formed in perfect markets(where assured that the data do not allow any reference to the tax- would be no evident justification for a range of prices, e that only anonymous data, if any, may be used. '5 It must be there is by definition only one equilibrium price),ther payer who is protected through tax secrecy legislation. 6 For these reasons, with respect to the dusseldorf Tax The right to be heard before the courts and the taxpayer's Court case neither the tax auditors nor the tax office could right to access facts and evidence of the court can by no use information that was not available to the taxpayer at means justify a violation of the tax secrecy. 7 An exclusive the time the contract was concluded. In addition. the disclosure to the court would lead to a violation of the tax- OECD and the Dusseldorf Tax Court are correct in stating payer's right to be heard before the court and would be a that if secret comparables are used, there is a risk that the reason for an I under Section 119 No. 3 of the Tax tax office will only use information that is favourable for Court Code. 8 Therefore, the only controversial issue is the tax authorities. 20 Some German tax auditors. however whether anonymous data can be used as a basis for an hold in the tax literature that in the Dusseldorf Tax Court case an arbitrary selection had been excluded because the es comparable companies were objectively identified. The in principle not admissible. However, this does not apply selection modes could have been verified by the tax to anonymous comparative data in the public domain (e.g. payer:. The selection process is, however, no means the official list of average rent prices( MietspiegeD, offi- objective. This is supported by experiences in the United cial value surveys for land(Bodenrichtwertsatze), surveys often focus on differences in opinion regarding which on industry averages, and lists of managing directors salaries). These data are publicly available in Germany companies should properly be included as comparables.In and are sometimes even generated by state institutions. addition it is to be remembered that if an identification of such data are not protected by tax secrecy legislation. the"secret comparables"could be made on the basis of publicly available databases, this would mean a loss of the The difference between the data sources can be illustrated tax secrecy of the comparable companies by the following example: A limited liability company sells a company car to its parent company abroad. The The use of anonymous data would therefore require that DEM 15,000 on the basis of the so-called <ar to be the data be altered or that specific information not be dis- managing director determines the value of the closed. If the courts would allow such a procedure, this List",which is often used in Germany by car dealers for would leave t determining prices. Other information is not available to possible for both the Tax court and the taxpayer to verify the managing director. The tax auditors are aware of other the comparability standards and the need for adjustments car sales by another company under audit, where a com- based on complete and unaltered data. parable car(same model, age, mileage, etc. was sold for a Of course, the tax office is free to determine the audit ice of DEM 18, 000 to an unrelated party. Therefore, the requirement through comparison with transactions that are tax auditors intend to assume a hidden profit distribution not disclosed to the taxpayer. For the determination of in the amount of dEm 3, 000 arm's length transfer prices, this means, for example, that The admissibility of determinations of an arm's length the licence database used by tax auditors to collect third price on the basis of anonymous comparative data (in the party royalty rates(which is not publicly accessible)can troversialin ple, the Schwacke List)is not likely to be con- only be used for sampling purposes. 2 It must not, how- above the case described above, since this is a com- ever, be used independently to determine or estimate an mon means of valuing cars in Germany. In addition. arm,'s length royalty nobody would suggest to analyse the comparable transac- tions on which the Schwacke List is based On the other hand, determinations made using comparable transactions that are known only to the tax auditors are inadmissible. Tipke and Heinrich Kruse (koln: Dr. otto Schmidt verlag, 1996) Sec. 30, note price differences. The reason for the price differences is 16. See Federal Tax Court dated 27 October 1993, BSIBL I(1994), at 210 the imperfectly competitive environment. due to the lack 17. Heinrich Kruse, in Abgabenordnung/Finanzgerichtsordnung, eds. Klaus of information, market participants cannot determine the "true market price". If it would be admissible for the tax 18. Federal Tax Court dated 18 December 1984, BStBL Il(1986)at 229 did, auditors to use more information than the normal market however, not show this opinion participant can use for its analysis, the tax auditors would 19. See OECD Guidelines, note 1.45. and Administrative Princip be in a better position than a market participant. This 2.1.9 US Treas. Reg. Sec. 1. 482-)(e) would mean that the price determined by the tax office 20. See OECD Guidelines, note 3 would have nothing to do with the" true market price, in /StR 16(1999), at 521 21. See Harald Kuckhoff and Rolf Schreiber, Quo vadis Fremdvergleich", 8 22. See Kroppen and Eigelshoven, supra note 6, at 50. C 2000 IBFD Publications B\
JULY/AUGUST 2000 ITPJ E. Determining appropriate gross margins based on It must then be clarified how comparability can be guaran blicly available industry averages teed without conflicting with the taxpayer's right to inspect the files or the taxpayer's right to be heard before Tax auditors have often used industry averages to estimate the courts. If the taxpayer is able to prove satisfactorily third party gross margins. In our opinion, industry average that the structure of its enterprise differs from that of the compar ables, a gross margin comparison will presumably admissible in determining arm s length gross margins, be completely unreliable(if it could even be determined because the data(e.g. the Schwacke List, the official list of Alternatively, a net margin comparison could be made average rent prices, and the official value surveys for land) because net margins are usually less dependent on differ are also accessible to the taxpayer Apart from admi ences in terms of functions and risks 8 Of course the tax bility, there would seem to be a question as to whether the payer would be free to furnish evidence of company spe- data are appropriate to be used in determining a specific cific reasons for deviating from industry average transfer price. In this context, a distinction must be made In the area of transfer pricing for multinational enterprises, between a determination of appropriate transfer prices and the estimation under Section 162 of the General Tax code it is, however, normally impracticable and inadmissible to or Section 1 Paragraph 3 of the Foreign Tax Code use average gross margins of an industry. Compared with smaller enterprises included in the collected comparative Market prices are to be determined according to the arm's data of the Federal Ministry of Finance ( e.g. for hair- length principle. Under this rule, statistical empirical data dressers and butcher shops), these enterprises regularly or average values in the public domain must only be used show a variety of special features. Particularly, functions if third parties also determine their prices based on such risks and capitalization differ widely. However, these fac- data. This applies in Germany, for example to the use of tors have an important influence on the determination of value surveys for land, the Schwacke List, or the official an appropriate gross margin. According to the established list of average rent prices. On the other hand, it is not in practice of the Federal Tax Court, the objective of an est- line with the arms length rule to determine appropriate however, be to determine the tax base that is gross margins based on industry averages. These average most probably correct. It seems to be highly doubtful that data normally cover too broad a range of gross margins. an average value of a whole industry could comply with are based on a very diversified group of enterprises with use of industry statistics efore has rightfully rejected the This is due to the fact that industry-related average values this rule. The OECd the quite difierent functions and risks, Independent parties Finally, it should be noted that the use of industry averages an appropniate gross margin on the basis of functions and for determining and estimating appropriate gross margins instead of industry averages 24 lated average values can at best be used for sampling purposes Another issue relevant to the use of industry averages is hether such averages can be used for an estimate under Section 162 of the General Tax Code and Section 1 Para. 3 of the Foreign Tax Code. First, it is to be noted that in Ger- man tax law an estimate of the tax base is only admissible if the taxpayer failed to comply with its duty to cooper ate." This limitation on use is mandatory, on account of the prohibition to tax based on suspicion(Verbot der ver- e: Richtsatz -Sammlung 1998(Herne/ office must first apply the standard methods, whereas an 24. See oEcD Guide lines, note. 2. 21 estimate on the basis of operating margins or return on 25. Administrative Principles, Sec. 93.1 assets is only admissible in exceptional cases. 26 nung/Finanzgerichtsordnung, eds. Klaus Tipke and Heinrich Kruse [Koln: Dr Oto Schmidt Verlag, 1996), Sec. 162 AO, note 6: Franz Wa Therefore, it is to be considered whether the use of indus- in Ai echt, eds. Hans Flick, Franz Wassmeyer and Hubertus try averages for the application of the resale price method Baumhoff (Koln: Dr. Otto Schmidt Verlag, 1996), Sec. 1 AStG, note861;Klaus is admissible. This could only be justifiable if the taxpayer wrirtscha is- Brief., ser set. AS (G, nte 254.g et a- (HermelBer and the comparable companies form a relatively homo-. 26. Franz wa in AuBensteuerrechf, eds. Hans Flick, Franz wass geneous group (i.e. the enterprises concerned have similar and Hubertus Baumhoff (Koln: Dr. Otto Schmidt Verlag, 1996), Sec. 1 ASIG, functions, risks, and capital structures). This type of est AuBensteuergesete, eds. Klaus Brezing et al. imate, however, already turms out to be difficult if the tax- (Heme/Berlin: Neue Wirtschafts-Briefc), 1991, Sec. 1 AStG, note 258 payer or the tax office claims that the cost, capital, or risk 28. See OECD Guidelines, note 3.2 structure differs from that of the comparables and that 29. Federal Tax Court opinion dated 18 June 1960, BSIBL. m(19 therefore an estimate based on these data would not lead to sB(1986),at2 an appropriate solution. For example, in a ruling of the ederal Tax Court dated 18 December 1984,the tax and 28 Heinrich Kruse(Koln: Dr. Otto Schmidt Verlag, 1996), Sec. 162 AO, notes 2 office argued that the restaurant that had been subject to an 30. OECD Guidelines, no also Harald Kuckhoff and rolf estimate realized lower food sales than the comparable Schreiber,"Quo 8 IStR 16(1999), at 519: Helmut company taken into account in the industry avera Becker. "Commen Handbuch internationale verrech nungspreise, eds Becker and Heinz-Klaus Kroppen (Koln: Dr. Ott 2000 lBFD Publications BV
ITPJ JULY/AUGUST 2000 II. COMPARABILITY ANALYSIS IN APPLYING gross margins to be applied to fashionable articles. The THE RESALE PRICE METHOD appropriate gross margin as determined by the tax auditors was therefore 28 per cent. According to the statement of A. Relationship between resale price method and the facts by the Court, this was justified by the tax auditors comparability analysis on the grounds that Apart from the formal aspects of the case, the Tax Court of the plaintiff sold fashionable wear which was predomi Dusseldorf also dealt with the substance of the arm's nantly manufactured in Italy and, hence, in a country which was used to quite different standard sizes because south length principle. For determining an appropriate transfer European people were normally smaller than central Euro- price, both the tax office and the Tax Court applied differ pean people. Also, it was to be taken into account that the ent approaches; however, these approaches were always manufacturer was located in a country which had the repu based on the resale price method. An analysis appears tation for delivering ordered goods either with defects, with interesting because the Court and the tax auditors have a delay, or not at all. In addition, it was to be taken into been confronted with difficulties similar to those experi account in determining an appropriate margin that the plain enced by the taxpayer in applying the resale price method tiff was engaged in the trading of high-price fashionable The Tax Court of Dusseldorf case is typical, in so far as in wear which was only purchased by very few customers practice there are often only transactions with unrelated This meant that the plaintiff had only a limited growth potential because it could only deliver its goods to selected suppliers that are barely comparable. The problem of retailers.Also, enterprises distributing high-priced luxury barely comparable transactions draws attention to another articles were more likely to be more strongly affected by issue related to the determination of transfer prices political and economic crises than enterprises distributing namely the appropriate application of the comparability goods for everyday demand. 2 analysi Given the above circumstances the tax auditors deter The term comparability analysis was coined by the OECD. mined a five per cent premium on the gross margin of 23 It means that in comparing a transaction between related per cent as provided by the industry average, resulting in a and unrelated companies, all economically relevant differ- gross margin of 28 per cent ences are to be adjusted. 1 A direct comparison of the First, it is remarkable that this computation is not meant to transactions (i.e. without adjustment) is only possible in be an estimate but a determination of an appropriate trans exceptional cases This means that the comparability ana- fer price, considering that the administrative principles lysis is of crucial importance in determining the appropr require a transactio obas ed analysis . Therefore, the shift in two steps. In the first step, all differences between the must first be justified. This shift can be reasonable if the There may be differences in functions performed (e.g. tions are performed over time or differences in specific advertising, service or transport), risks (e.g. inventory, transactions can be ignored for reasons of practicality.34 price,currency,credit or collection risk), contractual terms Although the administrative principles generally do not (e. g. terms of payment or delivery), economic circum- allow an aggregation of transactions, it seems to be fair stances(e.g. property of trademark rights or geographic that an aggregation should be admissible in the Dusseldorf markets), and business strategies. In a second step, exist- Tax Court case. Thus, the question of comparability will ing differences must be quantified and adjusted accord- arise ngly As discussed above all differences must be identified and In the Dusseldorf Tax Court case, there were also consid uantified, although the OECD emphasizes that only those erable differences between the transactions to be com- differences that impact the margin are to be adjusted, 35The ared. For this reason, it is interesting to see how adjust ax auditors'analysis, however, also provides for the ments are to be computed in the opinion of the tax adjustment of differences that are of minor importance within the scope of the resale price method. For example, the tax auditors emphasized that on account of smaller B. Resale price method applied by the tax office standard sizes in Italy, the German distributor was likely to realize a higher gross margin than an average distributor The constructive dividends were determined by the tax However, an advantage of the resale price method(as office using an external gross margin comparison, follow- compared with the comparable uncontrolled pr nce metho ing two approaches. The first approach was based on that product differences play a much less significant role industry averages, while the second(as already described (if any at all). 3 Furthermore, the tax auditors did not take above)was based on gross margins realized by four into account the comparative group(i.e. German distribu wholesalers in the same indust tors)that probably distributes the same standard sizes In the first approach, the appropriate gross margin was determined on the basis of publicly available industry averages collected by the tax authorities. According to the 31. See OECD Guidelines, notes 1.15-1.35: US Treas Reg. Sec. 1.482-1(d) tax auditors' file of wholesalers in the textile industry 2. See sTrE20(1999),at788 appropriate gross margins range from 17 per cent to 23 per 33. See Administrative Principles, Sec. 2. 1.2. cent.The industry data, however, also allowed higher 35. See OECD Guidelines, note 1.15 36. See OECD Guidelines, note 2. 17: US Treas. Reg. Sec. 1. 482-3(c)(3(II(B) 2000 IBFD Publications BV
JULY/AUGUST 2000 ITP 161 The adjustment to the comparative group is furthermore ferences that justified an adjustment. First, the payment justified by the higher distribution risk. The unreliable term granted by the affiliated supplier to the distributor delivery behaviour and the limited clientele in the upper was 120 days longer than the term granted to P. Second, market segment would, in the tax auditors'opinion, invoices to customers for intergroup transfers of products sk This is correct in principle because. were prepared by the parent, whereas this function was an independent distributor would request a risk premium performed by the distributor for P's products. The Court for a higher risk exposure in the market and therefore. estimated the allowance for the additional functions to be would also be likely to realize a higher gross margin. It is, four per cent, resulting in a comparable gross margin for however, not obvious to what extent the tax auditors this transaction of 24 per cent. The two other transactions examined whether the supplier was actually unreliable or with Q and O, for which the distributor realized gross mar- hether the adjustment was due only to a general preju- gins of 26 per cent and 30 per cent, respectively, were sim- dice ilarly estimated by the Court. The Court established that for these transactions, the distributor also performed addi In addition, it remains to be seen if the comparative group tional functions The time for payment agreed with the differs from the enterprise under review or whether enter prises included in the industry average possibly have a unrelated companies was shorter, but the distributor also Similar risk exposure. For example, most wholesalers are had to bear packaging costs and the cost of distribution to the customer. This difference was estimated by the Court likely to purchase their goods from low-wast finally, it to be two per cent. In the opinion of the Tax Court, the dis- which tend to have a lower delivery reliability. tribution risk related to O's products was, however, higher should be noted that the selection of the differences seems such that an allowance of four per cent was made arbitrary and that the quantification of these differences at five per cent is by no means substantiated. A reader of the The detailed description of the Court's analysis should justified in this case. However, the description of the audi- prices by using the resale price method, the Tax Court did tor's tax review provides a good insight for taxpayers of not perform a thorough comparability analysis. The the potential arbitrariness in everyday tax audits in Ger D emphasizes that all differences between transac tions with related and unrelated enterprises must be identi Apart from this approach, the tax auditors'result was also fied and quantified, 37 The Tax Court's analysis was, how differences; the selection again seems to be arbitrary. In inadmissible for formal legalistic reasons. However, the particular, the following differences, which would have to correctness of the procedure seems doubtful also for other be taken into account under both the administrative princi reasons. The analysis is based on only four comparative ples and the OECD Guidelines, were deemed to be irrele- enterprises. As gross margin is very sensitive to differ- vant ences in terms of functions, risks, and capitalization, it volume diferences. The transactions with the three seems doubtful that an analysis based on such a small sam ple would allow one to draw conclusions conceming the of the taxpayer ' es accounted for only five per cent he taxpayer s gross margin. In the this difference in purchase volume would not also authors'experience, the tax authorities have deemed ana result in a different gross margin. In this context, two lyses done by taxpayers to be inappropriate because the adverse effects should be taken into account: First, the comparative group was comprised of only 15 to 20 enter wholesaler may be willing to distribute additional products even if, with a relatively low gross margin no profit or only a low profit is realized with these oducts. From a business perspective, this can be rea- C. Resale price method applied by the Tax Court onable, for example if the products improve the repu tation of the distributor's product range or comple- The Tax Court rejected the determination of the transfer ment the product range, or if the distribution of the price by the tax auditors, and therefore determined the product contributes to cover fixed cost. Depending on onstructive dividends on the basis of its own considera- the market situation and the market structure the dis tions. The determination of the Court was also based on tributor could, however, also be in a position to nego- the resale price method, but the Court analysed the tax- tiate higher discounts(and correspondingly a higher payer's transactions with unrelated parties. The distributor gross margin). Whether and to what extent these purchased goods, to a very limited extent, from three unre- effects apply to the Dusseldorf Tax Court case was not lated companies. The Tax Court recognized the necessity to further discussed by the Court. According to prevail- adjust for differences between the transactions and also per- ing opinion, however, volume differences can have an formed a comparability analysis, The Tax Court analysed nfluence on market prices. Presumably, in order to three transactions with the unrelated parties O, P and Q The gross margin realized by the distributor for the trans- 37. See OECD Guidelines, note 1.15. See also US TreasReg. Sec. 1.482 action with P was 24 per cent. After adjusting for the cash 1(d)(1) discount granted to the taxpayer by P, the margin was SIR 16(1999), at519 8. See Harald Kuckhoff and Rolf Schreiber, "Quo vadis Fremdvergleich",8 increased to 28 per cent. Comparing the transaction with 39. See administrative Principles, Sec. 3.1.1 OECD Guidelines, notes 1.19 (d)()ii A)and(C); Heinz-Klaus Krop- pen, in Handbuch Internationale Verrechnungspreise, eds. Helmut Becker and 2000 IBFD Publications BV
ITPJ JULY/AUGUST 2000 ully comply with the OECD approach, the Tax Court generally deemed not to be comparable to transactions that would at least have to analyse the reasons why an account for a much more significant percentage of total djustment was not deemed to be necessary; evenue. adjustments are also difficult if there are consid- inventory holding. According to the taxpayer, the Ger- erable differences in terms of risks, because these differ man distributor performed the warehousing function ences are often difficult to quantify for the unrelated the parent. If the. wholesaler performs additional one considers the alternatives to the gross margin method actions if transfer mined throu sonnel expenses, cost for warehouse space, and cap: gross margin comparison, the comparable profit method would inevitably have to be applied(because also in most cases the comparable uncontrolled price method and the housing usually involves a variety of risks, notably the cost-plus method are excluded on the side of the manufac- turer). The reliability of the comparable profit method is in risk of shrinkage, obsolescence and price risk. These large part an issue of comparabilit opposed to a service provider with selling functions, this view will change in future o yy standards. Yet this is risks are a main characteristic of a distributor hardly discussed in germany it remains to be seen if uch as, for example a commission agent. The ques tion is whether an adjustment for these types of risk can be made at all or whether it is impossible to anal se the transaction due to a lack of appropriate adjust- V. APPLICABILITY OF THE COMPARABLE PROFIT METHOD ments In addition, the quantification of the differences deter- A. Current discussion mined by the Tax Court seems to be arbitrary, as there is no obvious substantiation. 41 For example, it would have been The Dusseldorf Tax Court ruling revived the discussion ossible to adjust the different payment terms by adjusting about the admissibility of the comparable profit method, Court would have had to analyse the expense items in the application of this method in Germany. 42 profit and loss account in order to ensure an appropiate The comparable profit method, unlike the standard trans- determination of the functional differences. The suspicion actional methods, looks at a comparison of net margins, therefore arises that the Court intended to reach a compro- for example the operating margin, retum on asset s, or the mise at the expense of a full consideration of the impact of berry ratio. From a German perspective, the main weak clusions drawn in the unpublished sections of the Court ruling discloses that, with a gross margin of 24 per cent. profits of a company depend on a variety of influences, whereas the transfer price is the Court is almost exactly in the middle of the plaintiff's ber of factors. Hence, the profits of an enterprise do, not line with past court decisions in the area of transfer pric- comparable profit method is often treated as equivalent to n individual transaction but on the total profit of an enter- D. Conclusion regarding the application of the prise or a product segment). This objection, however, also resale price method applies to some degree to the resale price and the cost-plus The detailed discussion of the insufficient comparability analysis illustrates that transfer prices normally cannot be reliably determined on the basis of industry averages, ald Kuckhoff and Rolf Schreiber, "Quo vadis Fremdvergleic".8 ISIR 16 because comparability with unknown average enterprises (1999), at 519. But for a diffe Comr, 617 F2d, 942(2d Cir. 1980), rev'g 36TC M. 586(1977)(here a trans- cannot be properly established. In most cases a transac- action with an unrelated party accounting for only five per cent of intercompany tion-based analysis can be properly performed only if, transactions was deemed to be comparable he specific circumstances of the transaction (internal 42. Berndt runge, "Quo vadis, internationaler Verrechnungspreise, cui bono, gross margin comparison). Should comparable transac er OECD-Verrechnungspreisbericht?4 IStR 11(1995), at 507: Thomas tions be available, the question of the degree of compar- Borstell and Michael Prick, Grundsatzentscheidur ability arises. The comparability standards are generally aten in der Prufung von verrechnungspreisen". 8 IStR 10(1999), at 306; Klaus interpreted in a very tolerant manner. The Tax Court of (anchen: Beck verlag, 1999). Ar. 9 MA, note 260; Hubertus Baumhoff,in rucial importance for the planning of transfer pricing sy Baumhoff,(Koln:Dr. Otto Schmidt Verlag, 1996), Sec. 1 Astg. note 550: Moris tems: How and to what extent can adjustments for differ- Lehner, in Doppelbesteuerungsabkommen, ed. Klaus Vogel(Munchen: Beck nces between transactions of related and unrelated parties be properly made? In the United States, transactions: /StR 16(1999), at 527: Heinz-Klaus Kroppen and Axel Eigelshoven,"Die Be- accounting for up to five per cent of the total revenue are immun angemessener Vermechnungspreise mit Hilfe des extemen Betriebs- ergleichs", nWB 1(2000): Fach 3 Gruppe 1 Deutschland, at 1601 - 2000 1BFD Publications Bv
JULYIAUGUST 2000 ITPJ methods. Finally, it is claimed that independent parties comparables. Yet the availability of Us data is undeniable aling at arm's length do not negotiate profits but always Therefore, based on the Courts ruling it can at best be concluded that the application of comparable profit meth Guidelines,the Federal ministry of finance also rejected sible, whereas the issue of their general admissibility can- cases of sampling and estimation. However, the press In addition, one might consider whether European com- release flicts with the administrative principles, panies can be used as comparables for a profit comparison which- similar to the OECD Guidelines recognize a Although both the administrative principles and the profit comparison as a"last resort"s The administrative OECd Guidelines expressly emphasize the comparabilit principles specify that profit based methods are applicable of markets, it is another question how a market is to be if"on account of specific circumstances [. ] the applica- defined. A geographic market does not necessarily have to tion of the standard methods would not generate appropri- correspond with the national territory of a country. In a ate results".46 After the publication of the adn ninistrative variety of industries it would seem justified, when seeking principles, however, it was always made clear by the tax German comparables, to refer to data from other eU coun- thorities that the standard methods would in virtually all tries as well. Notably, on the European market, transaction cases generate appropriate results so that, in the end, the costs between the different countries decreased due to the exemption was meaningless abolition of customs duties and the establishment of a uni form currency, so that profits and prices between the coun- However, the official approach of the tax authorities tries should tend to align. In addition, similar economic stands in sharp contrast to the practice in tax audits, where the profit comparison often plays a central role. 47 The tax cycles are to be observed in a variety of industries. Euro- auditors use profits to determine whether an audit is pean comparisons are, however, inappropriate if the required with respect to transfer pricing. If a taxpayer real- results are distorted through accounting differences or izes losses or unusually low profits, the insufficient result through different competitive conditions( e.g. in the medi- is often regarded as prima facie evidence of inappropriate cal technology or telecommunications industry) transfer pricing. If the taxpayer fails to convince the tax. Eventually, it can be concluded that comparable profit ditors or the courts that the transfer pricing is appropri- methods are generally admissible and possible in Ger- ate, an estimate is often made on the basis of the operating many. However, the Court seems to be very tolerant with margin. For example, in its ruling dated 18 December respect to the comparability standards within the scope of 1996. the Tax Court of Saarland estimated a wholesaler's the methods and suggests that, hence, the com transfer prices through reference to an operating margin of para fit method is a method of last resort and of five per cent, which it considers to be common in the minor importance industry. 48 In a ruling concerning a loss-generating distri bution company, the Federal Tax Court also took a result oriented approach, completely ignoring a comparable transaction of the distributor with an unrelated party. 4g B. Statements of the dusseldorf tax court 43. See OECD Guidelines, notes 3.27-3.33(a further discussion ): Klaus er, in Doppelbesteuerung, eds. Helmut Debatin and Franz Wassermeyer The Dusseldorf Tar Court ruling does not focus on the (Munchen: Beck verlag, 1999). Art.9 MA, notes 260 and 261 acceptability of comparable profit methods. From the 44. Press release of the Federal Ministry of Finance dated 13 July 1995, 4 ISIR Courts perspective, the admissibility did not have to be 8, at 384 verified because the Court was able to properly determine See OECD Guidelines note 3. 50; see also Klaus Sieker, in Dop. the amount of the transfer prices by applying the resale verlag. 1999). Art. 9 MA, mote 25s9 and franz Wassermeyer,(Munchen:Beck price method. Nevertheless, the Court emphasized in an 46. See adminis obiter dictum that profit-oriented methods could also be 47. Heinz-Klaus Kroppen and Axel Eigelshoven, Transfer pricing planning in applied in determining appropriate transfer prices, so In this Germany", 7 Tar Management Transfer Pricing Report.4(1998),at 107; Eugen respect the ruling follows the oeCd Guidelines and the Bogenschutz, Verdeckte Gewinnsausschuttung, verdekte Einlage, Verrech- in Jahrbuch der Fachanwalte fiir Steuerrecht 199711998 administrative principles because it accepts the admissibil-.(Heme/Berlin: Neue Wirtschafts-Briefe, 1998). at 655: Wolf-Dieter Hoffmann ity of comparable profit methods. 1 nd Edgar Schnitzer, " Globale Gewinnschatzung im Aussensteuerbereich"8 at 74 Some authors, however, drew the conclusion from the rul- 48. EFG 1997. at 486 ing that a profit comparison was not admissible in Ger- 49. See Federal Tax Court Opinion dated 17 February 1993, BSrBL I(1993), many. 2 This conclusion was reached based on the rejec- at 457 tion of secret comparables and the lack of publicly available financial information in Germany. However, the verrechnungspreise in Deutschland?", 8 / 16(1999),at 524 method does not necessarily have to be applied to German ables", 10 Intemational Tax Review 4(1999),at l court bans secret compar- e comparable pre 2. Thomas Borstel and Michael Prick, "Germa enterprises. If, for example, a German manufacturer dis- 53. See also Stephan Schnorberger, "Unzulassingkeit gewinnvergleichender tributes its products via a Us distributor, the comparable errechnungspreis in Deutschland, 8 /StR 16(1999), at 524 profit method could properly be applied on the basis of Us eds. Helmut Becker and Heinz-Klaus Kroppen, (K]in: Dr. Otto Schmidt verlag, 1999), note W 24: US Treas Reg. Sec. 1.482-1(d)(3)(iD)(A). 2000 IBFD Publications BV
ITPJ JULYJAUGUST 2000 C. Practical experience approaches come close to the comparable profit meu od because eventually transfer prices are determined based on The practical relevance of the comparable profit method net margins.56 will increase in germany in the future for two reasons First, an increasing number of countries apply comparable profit methods and/or the transactional net margin meth- V. CONCLUSION ods and the german tax authorities are becoming more and more isolated in their objection to profit- oriented methods. The Federal Tax Court dealt with a variety of fundamental In the case of multinational enterprises, it is not accept issues that have so far not sufficiently been clarified in tax able, and in some cases almost impossible, to take into practice. This applies particularly to issues concerning the account national features in planning a worldwide transfer admissibility of secret comparables, comparability stan pricing system. This applies especially if an OECD Mem- dards, and the admissibility of the comparable profit ber country wants to deviate from the compromise reached method. Finally, the controversy resulting from the within the scope of the OECD Guidelines. In light of this, Court's ruling illustrates the impon ne Tax court did not ke advantage of the profit compan]son The priority of attach a fundamental importance to this decision and dis- the standard methods remains completely unaffected allowed an appeal. Therefore it is to be hoped that the Fed- Furthermore, it should be considered that the application eral Tax Court will seize this opportunity to comment of profit comparisons in tax audits might have both advan upon the core issues of the ruling and that it will admit the tages and disadvantages for the taxpayer. Tax auditors ften deal with distributors that face considerable difficul- For taxpayers, however, one lesson should be learned from ties in their markets. These companies are affected by low the Court' s ruling and from other court decisions concen- profits or even have to suffer losses, sometimes even over ing transfer pricing. No court has ever ruled 100 per cent several years. The tax auditors argue that the manufacturer in favour of the taxpayer. The courts have been unwilling bears these types of risk and that a prudent and diligent to develop sophisticated arguments, which are often ne- business manager always tries to achieve an appropriate cessary in light of the difficult issues linked with transfer profit. Loss periods of more than three years are not re- pricing cases. The taxpayer should therefore consider rely ognized by the auditors, being backed by the Federal Tax ing on competent authority or EU arbitration rather than Court ruling dated 17 February 1993. Empirical studies on court proceedings. The Court's decision also highlights on the basis of external analyses could provide evidence the arbitrariness of some German tax auditors, which is that other third party distributors also incurred losses for evidenced on a daily basis. Taxpayers should therefore try nore than three years or that other companies also gener- to provide sound documentation at the outset of an audit in used to more or less grant a profit guarantee to distributors a profit guarantee would be uncommon between unre- lated parties. Specific reasons for losses suffered by a tax payer must be thoroughly taken into account in applying mparable profit method Finally, an extemal analysis within the framework of note 6. a28-30 transfer pricing can also be performed in order to deter -. 56. See also Harald Kuckhoff and Rolf Schreiber, " Quo vadis Fremdver- mine appropriate cost plus mark-ups or to derive an arms gleich",8 IStR 16(1999), at 517. length gross margin for the resale price method. These See supra nou 9 2000 IBFD Publications BV