PERSPECTIVE Transfer Pricing Planning in Germany Dr Heinz-Klaus Kroppen engage in lengthy court proceedings or in tedious com- Deloitte Touche gmbh petent authority procedures to avoid double taxation DUsseldorf The state of transfer pricing in Germany makes it Axel Eigelshoven imperative for companies doing business there to be Deloitte &Touche LLP fully informed of the rules. In keeping with the general Washington, D.C. OECD approach, the two fundamental transfer pricing tioners in germany over the last several years that the pricing methods that are acceptable to the german transfer pricing issues have caught the attention of taxing authorities and insuring that their transfer prices are:properly documented; The following article reviews the German tax administration. Germany is following the current status of both methods and documentation, an international trend that started in the 1980s, when Japan significantly increased their transfer pricing stated officially they are prepared (t /scshorities baing the tax administrations in both the United States and and also outlines the: potential role of advance pricing efforts, and has continued with the Organisation for Economic Co-operation and Development 's release of Acceptable method transfer pricing guidelines in 1995 and 1996 A, In addition, Germany's high corpor for companies te income tax The 1983 German Administrative Principles, which tes are believed to provide an incent are curr ently under review by the tax authorities set arm's-length transfer prices, thereby increasing the scru- prices. Those principles are not legally binding for the taxpayers or the courts, but only for tax administration transfer prices are a. major issue in almost all audit of. itself. Taxpayers nevertheless follow the principles to German companies that have international dealings. As. reduce the risk of income adjustments. The German-tax a result of this increased scrutiny, transfer pricing.. authorities haye an explicit preference for the transac planning is becoming a more crucial issue for companies tional transfer pricing methods--comparable uncon. doing business in: Germany. If it appears on audit that a trolled price(CUP), resale price, and cost plus--over such company often is faced with long and burdensome. (TNMM) and profit split-which did not change with negotiations that can result in a significant adjustment. the german government's approval of the methods set The adjustment, in turn, can require the company to forth in the OECd guidelines issued in 1995 There is no order of priority for the standard meth- s, so long as the company chooses the method that The Organisation for Economic Co-operation and Development comes closest to the conditions under which arms- sued oct. 1, 1997 guidelines for cost contribution arrangements length prices are established in economically compara Pricing Report 207; 8/2/95; 4. Transfer Pricing Report ble markets. As with the U.S. rules; the availability 793, 4/10/96; 6 Transfer Pricing Report 340, 10/1/97) and reliability of data has to be: considered by the company when it chooses its transfer pricing method although in practice the standard for comparability is "Dr. Heinz-Klaus Kroppen is director of probably lower than in the United States. transfer pricing services for Deloitte Touche gmbH in Dusseldorf. Axel Eigelshoven is a a See Administrative Principles on Transfer Pricing of Feb 23, 1983 icing analyst with Deloitte & Touche BStBL. I 1983, p. 218(in the following: Administrative Principles). gmbH in Dusseldorf and currently is on special The updated guidelines had been expected to be released sometime assignment for Deloitte Touche LLP in istry finalize the revision on the regulations for permanent establishments (7 Washington, D.C. The authors wish to thank Transfer Pricing Report 464, 10/12/9 Barbara Mantegani of Deloitte Touche LLP See press release of the Ministry of Finance of July 13, 1995, IStR in Washington, D.C., for her assistance See Sec. 2.4.1. b)Administrative Principles; Regs. 31.482 6-17-98 o 1998 Tax Management Inc, a subsidiary of The Bureau of National Affairs, Inc. 3206998/0+51.00
PERSPECTIVE 105 German tax auditors cannot challenge the method affirmed the use of these secret comparables, and the itself, rather they make their review from the com- auditors do, in fact, use the database in many cases.'In pany's own calculation of its transfer prices. The practice, the benefit of the database for the tax audi German tax authorities are entitled to apply an alter- tors is often limited since the data only- providesthe diligent business manager misuses its discretion. The rates, some of which have been published in an article German regulations do not require companies to ex- written by a government official. The article mentions plain why the company had not used alternative the royalty rates for certain technologies and industries methods , which is in contrast to the " best method and might provide companies with rough guidance requirement of the U.s. 8482 rules The resale price method is the preferred method in Germany for foreign-controlled distribution companies Transactional Methods In practice the comparison of external margins is often difficult since the access to public information is limited The CUP method is used if the company can identi- Only about 25% of companies comply with the obliga fy uncontrolled transactions involving the same prod- tion to submit annual reports to the court 's register. uct, either between itself (or a related party) and a. Business descriptions also are not as readily available as third party (internal comparables)or between third in the United States, so obtaining that information can parties(external comparables). In most cases: it is not be a costly procedure with no guarantee that the com- possible to use external comparables since only a fer pany will be successful in finding comparable margins goods are commonly traded. The most significant con- Therefore the method is mostly used in cases where straint on using the CUP method, however, is that such internal comparables are available. This seemingly is method requires a: high degree of comparability be. tween the controlled and uncontrolled products, which lso acknowledged in a 1996 tax court decision. 0 The court in this case did not use the gross. margin is almost impossible to achieve when looking at exclu- suggested by the tax office, since it was unclear sively third-party transactions The application of the CUP method in practice is courts applied a(full)cost-plus approach to estimate which the taxpayer sells the same products to related and unrelated parties. In such cases, the taxpayer must Two German auditors have recently published a take into account the comparability of markets, e.g. if In the book a case study from an actual audit review the product is sold from the United States to a related is presented, in which the auditors compare the mar- party in Germany and an unrelated party in france, the gins of a German wholesaler of upscale clothing with taxpayer must consider any market differences, that three unrelated third parties in the same indust exist between France and Germany. It is expected that The comparables were identified by using a publicly with the common European currency th e: chance fo available database. So far the practice corresponds to using internal comparables within Europe will increase. the U.S. practice using external comparables tor a be lower(e.g. the company will not incur currency risk) third-party data for the identified com from'the of capital is equal within the countries)., respective local tax authorities and not through pub- mesp tdeirtece, in benG eriticul ti and musis ate cba the auditors to perform all necessary functional ad- developed a database that allows it to use the Cup to tre not entitled to reveal any taxpayer information en under German tax law at the Federal Tax office Bundesamt fur Finanzen ). If tion and was not able to verify whether the compara- the royalty rate is within the range of the third-party bles were chosen appropriately, functional adjust comparables the tax auditors do not challenge the ments were calculated correctly, or whether other payment. Otherwise, they might use the comparables to adjustments would have been necessary estimate the arm s-length remuneration Under German law the information is not disclosa See Federal Tax Court, Oct. 27. 1993 1994,p210;we ble to the taxpayer, however, the federal tax court has will discuss the issue of secret comparables ter detail below Bocker, StBp 1991, p. 73; other figures erience are published by gross, BB. 1995,p. 885: McGavock, Ta SSee Sec. 2.4. 1. b)Administrative Principles; Becker, in: Becker/ K- Special Report No.31/6/93: Silva,(6 Transfer errechnungspreise, to Sec. 2, 4. 1. Administrative Principles. ee lower Tax Court Decision of Saarland of Dec 18, 1996, EFG Regs.§1482-1(c)(1)Regs.1.6662-6(d)(2)(in)(B)(S ee Sec. 5.2.2 Administrative Pri See Kuckhof/Schreiber, Verrechnungspreise in der: Betriebspril- Finance, Circular Letter of April 29, 1997, BStBL. I 1997, p. 541 1063-2069980+5100
TRANSFER PRICING The tax auditors justified this proceeding with a e cos or standard decisionof the federal tax court in 1984 2 The tax ing on what basis is most reasonable cost, deyn courts have approved the use of confidential informa- However, although the Administrative Principles tion, if the information can be kept confidential. It is seem to allow flexibility with respect to the cost base doubtful, however, whether the tax administration can in practice on the field level cost approach very in all cases keep third-party data confidential. First, often is applied. 7 most companies know their competitors and can identi- fy them from certain pieces of information, Second Profit-Based Methods every corporation and some partnerships are obliged to As mentioned above, profit based methods. are. not publish at least few items of the balance sheet and accepted by the German tax authorities.However, the income statement, e. g, fixed assets and operating prof- profit split is mentioned in the Administrative Principles it. Even if one assumes that the tax auditors could twice. First, it is acknowledged that a profit split then limit the taxpayers ability to argue against the proach might be chosen, if certain transactions do not occur: between unrelated parties This might: be, rel- The most important argument against the auditor's eyant in cases where third parties agree on a partnership or a joint venture as described in Para. 3. 5. of the OECD proceeding, however, is that the tax authorities should guidelines." Although being explicitly mentioned in the not base their analysis on facts that are not accessible Administrative Principles, the profit split historically to the taxpayer at the time the transfer prices are has not been used for the supply of tangible goods determined At this point, it is not clear whether the Second, the profit-split is used by the tax auditors to approach presented by the two auditors will be fol- lowed by other tax auditors, but in light of the strong timate the arm s-length character of royalty pay. ments, although the: Administrative Principles: do not arguments against the use of secret comparables, it is clearly acknowledge the use of the profit split method M to be hoped that the German tax authorities will rely The regulation suggests only three methods for deter- mining an arms-length royalty rate, the comparable financial information uncontrolled s price, the- cost plus, and profit oriented The cost plus method is commonly used for setting methods: According to the regulation, the: CUP method the transfer price for semi-finished goods, long-term should be used as a first choice. The cost-plus method supply contracts (e.g. contract manufacturers); provi- should-be considered. only in exce tional cases or to instance the tax administration suggests for coordina- Since internal comparables are only available. if the company: licenses the: property tosan unrelated third method with a mark-up of: 5% to: 10% on the full party, a profit split apportionment: is: considered quite cost, The Administrative Principles also require frequently by the tax office i mite: 1( y>,, 7 companies performing insubstantial functions to re ceive a cost-oriented remuneration. 15 In practice: the tax auditors use the Knoppe-Formu- la" to determine the ratio: for: the split. 2: According to The principles are flexible concerning the kind of this rule; the licensor should receive 25% to33-1/3%,of partypricesintheabsenceofanythird-par:isecomarrm'slengthForanarm's-lengthcalculationthe.com- actions, the company should alternatively trans- legitimate method to determine whether a royalty rate is mon business principles. Thus, the company should be pany has to make a much more detailed. analysis allowed to use either a full or a partial cost approach The partial cost can be variable costs or direct cost considering the functions performed and risk borne by :,) (e. g. cost of goods sold). The cost calculation does ne have to follow accounting standards for the statutory Seein more detail Kotschenreuther, in: vogele, Handbuch der books and the company can therefore choose to base N pSee, critique of this practice. by: Kroppen, in: Becker/Kroppen, 2.Federal: Tax Court Decision of Dec. 18, 1984, BStBL. 11= 1986 26, see also Ministry of Finance, Circular Letter of April: 7, 1986, a9 Comp. also Becker, in: Becker/ Kroppen, Kommentar zum Aussen- StBI: 1 1986, P 128. Tipke/Kruse, s 30.No 15. 4 Is3325-329: Commercial Code (Han etzbuch)and§39,15 The application for those cases was recently also suggested-by a high Disclosure Code( Publizitatsgesetz) ranking tax official (6 Transfer Pricing Report 464, 11/12/97) M Ministry of Finance, Circular Letter of Aug. 24, 1984, BStBl. I 2 See Secs 5. 2. 3. Administrative Principles 1984, ie Besteurung der. Lizenz- und Kno 令m 24.3, entar zum Aussensteuerrecht, Band IV trage,1972,p.102 nale v ngspreise, to Sec. 2.1.3. Administrative Unternehmen, 1992. C 360 6-17-98 o 1998 Tax Management Inc, a subsidiary of The Bureau of National Affairs, Inc. 2069/98/$0+$1
PERSPECTIVE each entity, as well as the contractual terms and the earned in the industry, in most cases only the operating economic circumstances margin,as a profit level indicator. However, the audi. For example, a company that is licensing an almost tors do not state how they derive those margins and to Inknown brand name, which has to be developed in a which companies they refer. The tax courts are- seem market, will bear quite different risks, and perform ingly willing to follow these rules of thumb and do not quite different functions than if it were licensing an ask the tax authorities to reveal how the margins were established brand name. It therefore would seem to be derived For instance the Tax Court of Saarland in completely contrary to the arms-length standard to 1996. applied a 5% operating margin to a German apply the same profit split to those two situations wholesaler, using a federal tax court decision of 1980 Likewise, when the licensee suffers losses, under the that accepted an operating margin for wholesalers of 3- Knoppe-Formula the licensor would receive no royal- 5% as support for the result. 24 ty. Ultimately, third parties usually agree on a per For companies engaged in transfer pricing planning centage of sales, rather than profit, because the licen- in Germany, the foregoing means that while the sor would not allow the business efficiency of the comparable profit method cannot be used to deter- licensee to have an influence on its royalty rate. mine prices it can be used to gauge the likelihood of a Although there are good arguments against the tax audit. When the company's prices are below the Knoppe-Formula, the company should be aware of it industry benchmark, the company. can insure that for its transfer ing, since it is used by tax there is adequate documentation to justify the prices auditors and might have to be rebutted at audit This is especially true if the company shows a history The TNMM and the comparable profits method of losses. If the tax administration attempts to use the (CPM) are not mentioned in the Administrative Prin- operating margin to shift the burden of proof to the ciples, but the German tax authorities explicitly re- axpayer, the taxpayer can then use its own analysis jected their use. Therefore the methods are commonly to show that the tax administrations evidence is not not employed by companies in their transfer pricing appropriate. If successful, the taxpayer would avoid planning. However, that does not mean that those having the burden of proof imposed on it, which in methods are irrelevant for German transfer pricing many cases can be a decisive advantage practice. There are three ways that auditors use such For its transfer pricing planning,. however, the com- profit-based analysis pany should always use the transactional methods The tax offices often use a comparison of the although that might be difficult if comparable trans- operating margin to test whether transfer prices should actions do not exist within the group. Since the be further investigated when they start an audit German comparability standards are somewhat less strict than the U.S. standards, it may be easier to lThen, if the taxpayer does not provide the tax identify comparable transactions, keeping in mind auditors with arguments for the arm's-length character that adjustments must be made f low profits (or losses) as prima facie evidence to Documentation of Transfer Prices low that the transfer prices are not at arms length German taxpayers are legally obligat be noted that the existence of low profits or losses alone ate with the tax authorities to assess. the tax basis may not be sufficient for shifting the burden of proof, ("the compliance rule"). As part of this obligation to and therefore the tax auditors in most cases try to cooperate, taxpayers are expected to provide all the deliver further supporting evidence. facts and evidence that support the tax position taken D If the burden of proof is shifted to the taxpayer on a return. Thus, while there is no detailed documen- and the taxpayer fails to convince the tax office or the tation requirement such as in the United States, pricing policy, the tax authorities are required to esti- specific information that in many ways is quite simi mate the income based on the standard methods. 2 If lar to that required in the United States In addition, as in the United States, the taxpayer standard methods is not available to the tax adminis- cannot justify the lack of information on the basis: that tration this estimate might not always be feasible. In it does not have the legal authority to force a: foreign such cases Art. 1 Para. 3 of the foreign income tax act parents cooperation. Rather, the tax authoritiesi'and courts have usually required the taxpayer to make sure (Aussensteuergesetz)acknowledges that the tax office in its contractual relationships with other parties that it is allowed to use the operating margin or the return capital to estimate an income adjustment can obtain the information relevant to its tax case than the more sophisticated CPM used in the United make requests that are h, the tax authorities must The German approach is in practice much simpler To obtain informatio necessary and suitable with States. The German auditors use common margins See Lower Tax Court Decision of Saarland of Dec 18, 1996. ErG a See $162 General Tax Code(Abgabenordnung) 1997,p.485 6-17-98 ansfer Pricing 063-2069/98/$0+$100
TRANSFER PRICING respect to the transaction under audit. The possible required there to be clear and unequivocal agreements benefit of the information must be weighed against the between related parties regarding their transactions. 29 cost to the taxpayer to provide that information More- The object of this rule is to prevent profit shifting over, the compliance rule does not refer to information Although: a shareholder is in principle free'in his sources, for instance public data or through coopera- sell something to the company or make a contribution tion with other authorities ( e.g. through the informa- the courts require that he makes that decision before 们 have questioned whether the administration transactions have been at arm's length2时的 tion exchange procedure in the double tax treaties) the transaction takes place and not afterwards whe In practice, the extent of the information sought by. the company has made a profit that does not the tax administration has become controversial, and Thus, the: courts have adjusted inco exceeds the taxpayers compliance obligation. The This strict rule, however, has been: reversed by the court decisions refer to single cases and it is often courts for long- term contracts and the: Administrative difficult to apply those cases on the special information Principles acknowledge that this rule does not apply request of the tax office. However, if the taxpayer is in the course of normal transactions between related unable or unwilling to comply, the tax authorities are parties. . The tax administration nevertheless has required to investigate the facts to their best ability. If sisted: on this rule in cases of unusual or unique it is not possible to come up with the actual facts, the transactions This position has changed recently, since tax office is entitled to evaluate the facts considering the German tax: authorities. have found it hard in the highest probability. competent authority negotiations to sustain adjust If the taxpayer virtually ignores its compliance ments made solely on this formality standard, which obligation, the auditors have the power to sanction the is not recognized in the OECD model treaty taxpayer by considering unfavorable facts as a basis However,for tax planning purposes it is still adv IS- for their estimate. 7 able to prepare written agreements for transfers of The compliance rule is the legal basis for the goods and services, distribution agreements and li- ax authorities have developed a standardized ques sions with respect to the" formality rule, mentioned tionnaire which apparently is presented at every tax above. Moreover, the transactions are not subject to audit of companies with cross-border transactions interpretation of the tax authorities, since the tax The questionnaire asks for a wide range of informa- administration has to use the agreements between the tion, including: taxpayer. and the affiliated company, unless the actual D General background information (e. g organiza- conduct of the related parties deviates from their legal situations, contracts with affiliated companies tional charts, company 's statute, recent changes in the agreements(substance over. form). n addition, the courts have set documentation stan- B A description of the transfer- pricing method or dards for German distribution with a lor methodsand history of losses. 2: Such companies must provide bud- 3- Detailed information about possible comparable gets and business plans explaining why the company transactions and companies stayed, in certain markets despite the losses. Generally The:auditors seek information: on functions per- the budgets and business plans have to: show. a reason formed, risks borne: by each party, contractual terms able expectation of turning a profit after a reasonable of the transactions and. economic conditions M lore- time. The company should also provide documentation over,companies in Germany are regularly asked for on why it failed to meet the expectations. moreover, it documentation prepared in other jurisdictions. In par- is helpful if the company is able to quantify the impact ticular, auditors request documents prepared to com- of shortfalls on the loss ply with the U.S. transfer pricing rules. Since these documents can be disclosed through the exchange of mene ategically, it is advisable to prepare one's docu- tion in advance of audit for two reasons. first information provision of the U. S -German tax treaty, waiting until the audit reduces the amount of time axpayers generally do not challenge those requests. available to complete the very detailed questionnaire German-law on documentation has also developed and can result in inadvertent errors Tax audits usual- in. part: through its courts, which have historically ly start three to five years after fiscal year end, when il1992, BStBI: II 1978p.234. although this evaluation should not lead to a penalty See Sec. 1. 4. 1. Administrative Principles. Federal Tax Court Decision of Feb. 15, 1989, BStBl. IT 1989, p.462 See Para. 1. 37 of OECD Guidelines see also Becker, in: Becker/- HOppner/Grotherr/Kroppen, DBA-Kommentar, ar transfer pricing(6 Transfer Pricing Report 772, 2/25/98)and Kuck See Federal Tax Court Decision of Feb. 17, 1993, BStBL 11 1993 etriebspruifung, P. 176. 17-98 @1998 Tax Management Inc, a subsidiary of The Bureau of National Afairs, Inc
PERSPECT/VE 109 it is more difficult to go back and find evidence of the Despite these limitations, it may be argued that the facts that supported the transfer price at the time it tax office should be amenable to using the procedure was set. For instance, certain market influences for transfer pricing rulings, since taxpayers seeking should be documented early, if they have an impact advance rulings in the transfer pricing area generally on the company's business success. It is often very are not aiming to reduce their income abusively, bi difficult to document those situations (major market- rather are merely seeking legal certainty and attempt ing campaign of competitor, competitor cuts prices by ing to minimize the risk of double taxation. s 25%, etc. )several years after the audited year. In 1994 and 1995 two states released circular letters Second, and more importantly, if a company an- in coordination with the other states, in which the wers the questions diligently at the outset, it has the German tax administration announced that they were opportunity to prepare a coherent strategy for its willing to participate in bilateral APAs. tHus, the transfer prices and have a more successful audit bove mentioned constraints for unilateral rulings will Advance Pricing Agreements not apply for bilateral APAs. Moreover, the administra- tion acknowledges that on a bilateral basis the prod Germany does not have special regulations dealing dure can be coordinated by the competent authorities th advance pricing agreements (APA), but the It should be noted that the bilateral procedure is not German tax offices are able to grant general rulings yet in general use, and the tax authorities have noted based on a circular letter from the Ministry of Fi- that they will issue an APA request only in exceptional nance published in 1987. 3 To obtain a ruling the cases because of a lack of personnel. As a practical taxpayer has to describe a certain tax problem and matter, APA negotiations in Germany have been quite tach its own legal opinion. Taxpayers use the proce- difficult because many different levels of the German dure quite frequently to receive legal certainty for tax authority participate. In particular, members of the sophisticated tax issues, but the procedure usually is audit teams are involved in the process, and this can not used for transfer pricing issues because it is not make it difficult to reach a conclusion that is satisfac- designed to solve transfer pricing problems with its tory to the taxpayer. There is no indication that this special concerns and its need for flexibility situation will change in the near future The first problem with the existing procedure is that the taxpayer is not allowed to determine the limits of the conduct of diligent business manager"which Conclusion plays a central role in determining the appropriate transfer price under German tax law. This restriction Planning for transfer pricing is becoming a more was intended to limit the taxpayer's ability to use the significant issue in German tax planning because the procedure repeatedly for the same transaction, as a German tax administration is focusing more attention sting ground for determining the most favorable on cross-border transactions. Thus, consistent planning result that would be acceptable to the tax office for transfer prices can help to reduce the exposure to Second, the taxpayer is not allowed to ask for facts income adjustments and might lower costs triggered by being"alternatively structured or based on presump- long-lasting audits and competent authority negotia- ions. "Rather, the taxpayer is bound by the facts as tions. The tax planning should always be accompani described in the request and if the actual facts and by documentation that shows the arms-length charac circumstances differ from the request in any material ter of the transfer pricing policy. APAs are not a tool respect, the tax office is not bound by the ruling. Since. in transfer pricing planning yet, but it remains to be transfer pricing issues with the dynamic impact of the seen whether, if APAs become more prevalent in market are often subject to change, this restriction Europe, the tax authorities will attempt to make them limits the use of the ruling procedure considerably. easier to obtain in Germany 3See Ministry of Finance; Circular Letter of June 24, 1987, BStBL. M See also critique of the limitation of Tipke/Kurse, Vor $204, N I1987,P.474. M See Sec. 2.1.1. of the Administrative Principles; Federal Tax Streck, GmbHR 1987, p R Court Decision of July 12, 1972, BStBl. II 1972, p 802; Federal Ta urttemberg, Circular: Letter of ourt Decision of April 16, 1980, inistry of Finance of Bavaria Court Decision of Aug. 6, 1985, BStBL. 11 1986, p 19. Circular Letter of Jan. 9. 19 1995,p.241 Transfer Pricing