SEPTEMBER/OCTOBER 2004 GERMANY Letter from Ministry of Finance: Cooperation Issues Regarding Transfer Pricing Heinz Klaus Kroppen and Stephan Rasch 1. INTRODUCTION ms length. The tax authorities must provide evi- In the letter of 26 February 2004(hereinafter: the Letter), 3 e if they believe the price is not arm's length the Federal Ministry of Finance(hereinafter: Ministry of Issue 3. The determination of an arm's length transfer Finance)provided an analysis regarding the application of price for a distribution company may not be based on a landmark 2001 decision of the Federal Tax Court(Bun the resale price method if (i) the gross margin can only desfinanzhof) 4 Many regard this decision as the most rec be derived from three independent manufacturers, (ii ognized one in the transfer pricing area in Germany, and the corresponding purchases do not refer to all years the decision was critically discussed in both German and under consideration and (iii) the purchases represent international tax literature. Because the Federal Tax Court only 5% of the turnover of the distribution company ruled that tax law does not provide a legal basis for the obligation to prepare specific transfer pricing documenta- 2.2. Analysis in the letter tion, the legislature subsequently introduced mandatory With regard to Issue 1, the Ministry of Finance asserts that transfer pricing documentation regulations.6 he increased duties to cooperate under Sec. 90(2)of the The new documentation obligation is in force for all fiscal GtC refer to all the facts and circumstances relevant to years commencing after 31 December 2002. However ixation in cases where the subject under discussion is a tax audits for former periods are not covered by the new hidden profit distribution of a domestic subsidiary to its law. Therefore, the Ministry of Finance obviously wanted foreign parent company. Compliance with these duties to to make known its position on the application of the Fed- eral Tax Court decision with regard to these audits cooperate will enable the tax authorities to ascertain 2. CONTENT OF THE LETTER Deloitte, Dusseldorf Senior manager, European Transfer Pricing Group, Deloitte, Dusseldorf. The Letter focuses on three main aspects as discussed by Letter of the Federal Ministry of Finance, IV B 4-S 1300-12/04of 26 the Federal Tax Court in its decision brary 2004. "Consequences of non-compliance with taxpayer's obligation to operate under section 90 paragraph 2 of the General Tax Code [Abgabenord. nung in case of a trans fer pricing audit of a domestic distribution company (cor- 2.1. Federal Tax Court decision of the Foreign Tax Code): Application of the Federal Tax Court decision of I7 Highlights of the Federal Tax Court include the following October 2001 -I R 103/00-, Bundessteuterblatr(hereinafter: BS:BI)(2004)L. 270. For an English translation, see 13 Tax Management Transfer Pricin Issue /. If a taxpayer does not comply with its duty to Rasch, Internationale wirtschafisbriefe(2004), F.3 Deutschland Gr. at 2057 (Abgabenordnung, hereinafter: GTC), it must be 4. Case of 17 October 2001(I R 103/00), BStBL (2004)II, at 171 determined whether the taxpayer's duty relates to the 5. See e.g. H K Kroppen, S Rasch and A Roeder, Tax Notes intemational (2001), at 11I1: H.K. Kroppen, S. Rasch and A. Roeder. internationale legal prerequisite or to the legal consequences of a tax Wirtschafisbriefe(2001),F 3 Deutschland, Gr. I, at 1787: F. Wassermeyer, Der provision. If the taxpayer's non-compliance relates to Betrieb(2001). at 2465: H. Kuckhoff and R. Schreiber. intenational the legal requirement, the level of evidence that the tax Wirischafisbriefe(2002), Fach 3 Deutschland. Gr. 1. at 1863; H Baumhoff. authorities must provide regarding the relevant facts is ntemationales Sieuerrecht(2001 ) at 745: W.D. Hoffmann, GmbH Rundschau reduced. If the non-compliance refers to the legal con- See Sec. 90, Para. 3, and Sec. 162, Paras. 3 and 4 General Tax code equences, the tax authorities are generally entitled to (Abgabenordnung ),BGBL(2003)I at 613; for an English translation see 1ITax estimate the taxpayer's income Management Transfer Pricing Report 24. (16 April 2003), at 108 For a detailed analysis see S. Rasch, in Handbuch international ary information regarding how transfer prices with its for- Schmidt 1997/2001): Chap. 5 OECD Guidelines, 0 5.2 note 4 et seg. A eign parent company were set, the tax authorities may Eigelshoven and R Dawid, Tax Notes International(2004),at 185:HKKrop- solely conclude that the agreed transfer prices were ber 2003). at 642: H K Kroppen and S Rasch, Il Tax Management Transfer n and S Rasch, 12 Tax Management Transfer Pricing Report 13(12 Novem determined based on the shareholder relationship. Pricing Report 20(19 February 2003). at 885; H.K. Kroppen and SRasch, Ta However, the agreed transfer prices may nevertheless Notes International(2002), at 666.SRasch, and ARoeder II Tar Manage anagement Transfer Pricing Report 24(16 April 2003). at 1080 @2004 International Bureau of Fiscal Documentation
223 ITPJ SEPTEMBER/OCTOBER 2004 whether the legal requirements for a hidden profit distri- arms length price, an estimation under Sec bution are present 162(1)of the gtC will be made. In the course of According to the Letter, the distinction between duties to this estimation a determination must be made as cooperate with respect to the ascertainment of the legal to the minimum profit (overall profit)which requirements of a hidden profit distribution and such allows an appropriate return on the invested cap- duties with respect to the legal consequences is not rea- ital (including interest on interest and risk pre sonable and is not based on the la mium)or which allows an appropriate remuner- quences are judged by the tax authorities without the tax ation for rendered services based on the costs incurred within the period of estimation. The tax With regard to Issue 2, the Ministry of Finance provides authorities bear the burden of proof for the pre sumption of higher profits certain general principles that should be applied in testing In addition, the Ministry of Finance claims that in situ- whether the foreign parent company is appropriate. Basically, the Ge ations where the examination of transfer prices leads to an regard to the arms length nature of the price chosen by the used will be accepted if that price falls within this range. If taxpayer. In addition from its perspective than the range of arms length prices about factors having an impact on prices(facts and cir- will be applied. Only if there are several prices falling Icts, market and competitive situation), and as a result being appropriate, the price leading to the lowest tax bur the tax authorities are not able to determine arms den for the taxpayer will be applied length prices, the tax authorities may estimate the tax. Finally, with regard to Issue 3, the Letter deals with the tion and evidence that is available only to the taxpayer, based on the most reliable comparable data, which may be negative conclusions may be drawn from the tax payer's non-compliance. in the course of estimation submitted or determined taking into account the costs to he tax payer. It is not possible to define schematic min facts that increase and decrease the tax burden (limited prices (e.g. minimum number of comparable enterprises he taxpayer may not be to the advantage of the tax- pay 3. ANALYSIS If the subsidiary refuses to provide information on how prices were determined in dealings with the par- It has been argued in literature that the Letter should be ts duties to cooperate rpreted an order of Cd with regard to other requests, there is a rebuttable pre- dungserlass). In the authors'opinion, this is not the case holder relationship (factual requirement of a hidden cia ese the ministry of Finance obviously does not prin capital distribution). Nevertheless, in such cases it is seems that the Ministry of Finance wanted to clarify not excluded that the prices actually agreed may in fact number of issues that have come up in tax audits followed e be arms length. According to the Letter, the tax the decision in 2001 authorities will have to consider the following aspects if the tax authorities are able to determine the 3.1. Distinction between legal prerequisites and arm's length purchase price and if this arms length legal consequences price is less than the price that the subsidiary With regard to Issue 1, the Letter addresses the distinction applied, taxation will be based on the price deter mined by the tax authorities between a taxpayer's non-compliance regarding legal pre if the tax authorities are not able to provide evi- requisites on the one hand, and a taxpayer's non-compli dence regarding the arm's length price and if there ance regarding legal consequences on the other. The Min is no factual basis for the presumption that the pur- is not feasible because there is no legal basis for it in the with /erice that the subsidi S oo high, an adjust- applicable income adjustment clauses (e-g. hidden profit arm's length ment may not be made distribution) however, in cases where there is a serious indica- Although the explicit distinction does not play a decisive tion for the presumption that the purchase price is role in tax audits, the ministry of Fi nance obviously only too high(e.g. permanent loss situation, no evi- wanted to clarify that there are no specific compliance dence of mismanagement). but the tax authorities are not able to provide evidence with regard to the 8. Federal Tax Court decision of 15 February 1989. BSrBL Il(1989), at 462. 2004 International Bureau of Fiscal Documentation
224 SEPTEMBER/OCTOBER 2004 obligations that relate to the legal consequences of an leads to a reduction of taxable income as compared to the income adjustment clause. It should be stressed that the situation in which an arms length price has been paid Ministry of Finance's clarification apparently benefits the Vermogensminderung). Nevertheless, an adjustment is taxpayer In the authors'opinion, it is rather difficult to only possible if the agreed price is outside the range of provide an accurate distinction between legal require- arm,s length prices. This must be determined by the ents and legal consequences. An income adjustment authorities even in cases where the taxpayer did not use a based on, for example, the rules regarding hidden profit transfer pricing method at all, did use a non-accepted distributions should not be justified if the agreed transfer method or did use a"wrong"method. Even in such cases price is in line with the arm's length price. However, the the price that was used might still (by accident)be arm's wo major legal requirements for an adjustment under this length, even though the taxpayer did not determine it on rovision are that any economic or scientific basi the amount of the charged price was agreed or paid In the authors'opinion, the Ministry of Finance does not because of the shareholder-company relationship(ve anlassung im Gesell schaftsverhailtnis); and principally reject the Federal Tax Courts opinion. How this price has led to a reduction of taxable income ever, the Ministry of Finance obviously has had the expe- compared to the situation in which an arm s length rience that in the course of tax audits, some taxpayers have price would have been paid Vermogensminderung declined to provide any information by arguing that the presumption mentioned before only indicates that the In other words, the examination of these legal require- shareholder-company relationship is one legal require ments only makes sense if it is has been determined that ment. It was apparently argued that the tax authorities bear the agreed transfer price was not arm,s length. It thus the"full"burden of proof with regard to the second legal seems that a clear distinction between legal prerequisites requirement and, therefore, taxpayers refused to provide and legal consequences is not always possible. 0 any information. These arguments stressed that the tax In practice, it is unusual to discuss such a precise distinc uthorities would have to positively prove that the agreed tion between legal tequirements and legal consequences in transfer prices led to a reduction of the taxable income tax audits. "It is generally recommended to provide all rel- (Vermogensminderung ). The following example should evant documents which are requested by the tax author llustrate the different interpretations ities and which are available, and to cooperate proactively Example that the cooperation obligation during the period before A German subsidiary sold a machine tool to its foreign parent the new documentation law becomes applicable is company at a certain price. In a tax audit, it is assumed that the mentation and to reply to specific questions raised by the The German subsidiary explained only how the price haole restricted to providing any existing transfer pricing docu- agreed transfer price is not in line with the arms length prind tax authorities. The taxpayer is, however, not required to set(e.g. through negotiation with the parent company).How- ever, the taxpayer refused to provide any information on the prepare specific transfer pricing documentation for a tax age, appearance, workmanship or use of the machine tool, nor moreover, the Federal Tax Court ruled that there is no determining the obligation to provide any third-party evidence to show that It should be assumed that the tax auditors could not determine the prices chosen by the taxpayer are arm s length .3Thes principles are not restricted by the Letter the price without this information. Therefore, it is crucial whether the taxpayer has an obligation to submit the required data. In the authors'opinion, it is not feasible to refuse to provide any infor 3.2. Burden of proof mation related to price-relevant factors. Without this information the tax authorities will not be able to determine the arm's length The Federal Tax Court stated in its decision that if a sumption that the setting of the price is influenced by the share- domestic subsidiary does not provide information on how holder-company relationship if the taxpayer fails to fulfill its obli- transfer prices with its foreign parent company were set, gation to cooperate. This presumption basically leads to a the tax authorities may only conclude that the agreed reduction of the level of proof (Reduzierung des BeweismaB transfer prices were caused by the shareholder relation- that the tax authorities must provide. Otherwise, the taxpayer ship. However, the agreed transfer prices may still be would have an unjustified advantage merely by not fulfilling its arm's length. According to the Federal Tax Court, the bur- legal obligation to cooperate. It should be noted that the Federal den of proof remains with the tax authorities. The basic Tax Court did not rule that with regard to the other legal require principle can be summarized as follows ment for an income adjustment, the reduction of the degree of proof would not be applicable In situations where the taxpayer does not cooperate by failing to explain how its pricing was determined, this w only lead to the presumption that the setting of the price Deutschland Gr I, at 2057, 2058 H.K. Kroppen and S. Rasch, internationale Wirtschafisbriefe(2004)F.3 as influenced by the shareholder-company relationship 10. See also R Seer. Finanzrundschaa (Veranlassung im Gesellschaftsverhailtnis). This presump- 11. See A. Eigelshoven and s Tar Management Transfer Pricing ing adjustment. 4 It only provides a first indication that 2. See Note 7 the further legal requirement of an income adjustment 5 is 14. See.2,2004)IL, at 171.175 STBL.(2 fulfilled. Hence, it needs to be proved that the pricing 15. It is assumed that an income adjustment is based on the most important income adjustment clause, i. e the hidden profit distribution @2004 International Bureau of Fiscal Documentation
225 ITPJ SEPTEMBER/OCTOBER 2004 Summing up, it seems that some taxpayers have tried to analyse their loss periods to ascertain reasons preted the Federal Tax Court decision in a highly which have caused the losses and which were independent sided way. Therefore, the Ministry of Finance has b from the transfer prices used cally followed the Federal Tax Court's finding, but it sought to stress that the taxpayer must provide sufficient information so that the tax authorities can assess the arm' s 3. 4. Concept of the arm s length range length nature of the transaction. 6 Again, the taxpayer is well advised to cooperate reas- arm s length range. stressed that German onably in order to avoid any negative consequences. If the transfer pricing legislation, although explicitly recogniz. taxpayer does not cooperate at all and does not even pro- ing the use of arm's length ranges, does not explain how vide available information and as a result the tax author- to determine the arms length range ities are not able to determine the facts and circumstances Once a range of acceptable prices by themselves, the tax authorities are ultimately author- has perhaps been refined due to mined and ized to estimate the taxpayers income. A one-sided atti- the ques tion arises as to the point in this tude of refusing to provide any information will most ment should be made if it is likely lead to negative consequences taxpayer s transfer price falls outside this range. The Federal Tax Court held that an adjustment is only possible to the most 3.3. Distribution companies with continuing losses advantageous point within this range for the taxpayer, which is either the high or low end of the range. The Court The Federal Tax Court as well as the Ministry of Finance stated that there is no legal basis for an adjustment to the has also addressed the issue of continuing losses suffered midpoint of the range and that tax law does not allow esti by a distribution subsidiary. The discussion had been initi- mates to punish the taxpayer ated through a widely recognized Federal Tax Court deci- However, the Ministry of Finance argues in the Letter that Tax Court had concluded that German distribution com- a price should be adjusted to the point within the range panies of foreign groups should not incur start-up losses which reflects the"most likely value"within the arms affirmed this rule in its 1993 decision and further refined authors opinion-not in line with existing law and is not it the decision of 17 October 2001. Generally, a distribu- acceptable. It is a logical assumption of an arms length range that each price or value within the range is by its tion company should make an adequate total profit within very nature"an arms length price or value". Based on this pond to the functions and risks assumed. The court stated premise, it is mandatory that a price outside the range that at a minimum, the total profit should be an appropri- tageous point within the range which is the high or low ate return on the invested capital based on market interest rates plus an appropriate risk mark-up end of the range. By adjusting a price to the"most likely value "of the range, the Ministry of Finance deals arbitrar The Court further ruled that substantial losses of a distri bution company for three years would lead to a rebuttable presumption that the transfer prices were not arm's length. 16. See H K Kroppen and S Rasch,, Internationale Wirtschaftsbriefe(2004) 3 Deutschland Gr. 1, at 2057. 2061: A. Eigelshoven and S, Rasch. 13 To The taxpayer may rebut this presumption by showing and Management Transfer Pricing Report 3(9 June 2004),at 114,115 proving that the agreed transfer prices were still arms 17 H K Handbuch Internationale Verrechnungspreise, eds. Becker and H.K. Kroppen (Cologne: Verlag Dr. Otto Schmidt 1997/2001) tion to cooperate by demonstrating that the transfer prices (2000). F: 3 Deutschland Gr. 1. at [5817 1602: H. Baumhoff and Sicker. intere are appropriate because the agreed transfer prices are nationales Steuerrecht(1995), at 517. 521: Becker, in Handbuch internationale within an arms length range of transfer prices. If the tax hmidt 1997/2001), note O Tz. 1.52 Anm. 12 et seq. C. Bellstedt, Interna payer demonstrates such appropriateness of its transfer tional Wirtschaftsbriefe F. 2. at 429: M. Famschlader, Internationale prices, the tax authorities then must-in the authors'opin Wirtschafisbriefe F. 2, at 565: R. Schreiber, Internationales Steuerrecht (1994) on- provide"counter-evidence"that the transfer prices at 315 are actually the reason for the losses. In the authors'exper- ience, the tax authorities are not in a position to disprove If a taxpayer does not meet its documentation requirements in the sense of an arm's length range established by the taxpayer. section 90, paragraph 3 in that it does not submit its documentation, or the submitted documentation is of no use. or if it is asserted that the tax In addition, if the taxpayer is not able to show that the payer has not made its documentation in the sense of section 90. paragraph agreed transfer 3. sentence 3 contemporaneously, there is a rebuttable presumption that its ces are within an arms length range. the domestic taxable income for which determination the documentation in the taxpayer may still, for example, show that misinvestment sense of section 90, paragraph 3 is needed, is higher than the income the or mismanagement took place, or that third-party distribu payer has reported itself. tors also incurred long-term losses at the same time because of difficult market conditions. If the taxpayer income can only be determined within a certain range, especially on the can show such reasons, losses may be accepted for a basis of price ranges. this range may be fully used to the disadvantage of the taxpayer in the event of an adjustment period longer than three years. It should be noted that in 20. The Federal Tax Court also emphasized in the decision of 17 Decem existing practical audit defences, taxpayers have alread ber 2001 that a transfer pricing analysis can only lead to a range of acceptable prices based on the available comparable data C 2004 International Bureau of Fiscal Documentation
226 TPJ SEPTEMBER/OCTOBER 2004 ily with the concept of the arm's length range. As men- not exclude the applicability of the prominent decision tioned before, an arms length range consists of arms but provides some analysis based on experiences in tax length values. Provided that the arms length range has audits in the time after the decision was rendered. most of been determined carefully and has been subject to any ne- the statements are in the authors'opinion clarifications on essary adjustment, each point within the range is as much the interpretation of the decision. The taxpayer is well an arm's length value as the other values are advised to fulfill the- limited- cooperation obligations Additionally, it remains totally unclear how such"most for open years before the new law has been introduced. It should be taken into account that the tax authorities are try of Finance refers to Sec. 1. 48 of the OECD Guide. allowed to estimate the taxpayer's income if the taxpayer lines which reads: "In general, and to the extent that it is does not cooperate at all and the tax authorities are not able possible to distinguish among the various points within the to examine the factual background by other means ange, such adjustments should be made to the point However, the authors are most concerned about the Min within the range that best reflects the facts and circum- istry of Finance's interpretation of the arm's length range stances of the particular controlled transaction concept. It is not in line with the Federal Tax Court deci- However, in the authors'opinion, both Sec. 1. 48 of the sion and the existing law. Constitutional principles support the view of the Federal Tax Court. Tax law is a major inter ECD Guidelines and the Ministry of Finances perspe ference with the freedom rights of any individual. Such tive refer to a point within the range that fully reflects the interference is subject to the principle of adequate and pro- be determined through commodity exchange prices. In portional interference which means that if there are differ- existing range to "one"exclusive transfer price. However, zen.21 such exceptional cases, a range does not exist. Therefore, it is not correct to allude to the rm's length range concept 4. CONCLUSION ecker and H K. Kroppen( Cologne: Verlag Dr. Otto Schmidt 1997/2001).o The Letter deals with a limited number of statements made 7.30, note 7. See also H K Kroppen, S Rasch and A Roeder, Tax Notes Inter by the Federal Tax Court. The Ministry of Finance does national(2001), at ILIl
