tayanalysts tax notes Respectfully disagreeable since 1970. international Volume 39, Number 8 August 22, 2005 智26828-要色6时889品 German versus oeCd Transfer 号83鸟9品 Pricing Principles-a Recipe for Double taxation? by Axel Eigelshoven and Axel Nientimp Reprinted from Tax Notes Intl, august 22, 2005, P 725
German Versus OECD Transfer Pricing Principles—aRecipe for Double Taxation? by Axel Eigelshoven and Axel Nientimp Reprinted from Tax Notes Int’l, August 22, 2005, p. 725 Volume 39, Number 8 August 22, 2005 (C) Tax Analysts 2005. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content
Practitioners -N German Versus OECD Transfer Pricing Principles- A Recipe for Double Taxation? by Axel eigelshoven and Axel nientimp a832938 However. because tax auditors are forced to follow Axel Eigelshoven is a partner and Axel the administrative principles, the rules areimportant Nientimp is a manager with the European in practice, as taxpayers usually follow the guidelines Transfer Pricing Group of Deloitte in Diissel to achieve legal certainty in their tax planning. There dorf, germany. fore, the business community eagerly awaited thenew Copyright o 2005 Deloitte Touche Tohm administrative principles, which are supposed to give tsu. All rights reserved taxpayers practical operating instructions for their transfer pricing documentation. Like most other countries with documentation ires taxpayers to G tive e on April 12, 2005, issued the final administra- new documentation obligations. If a taxpayer can rinciples"for the examination of income allo- prove that its transfer prices are calculated at arms ength, in principle, the tax authorities cannot make cation between internationally related enterprises an income adjustment. The risk of penalties also is with cross-border transactions in respect of income averted to a great extent, even if the documentation tions as well as mutual agreement procedures and taxpayer does not provide any proof of the appropri Tax Notes Int'l, Jan. 10, 2005, p. 197) simple demonstration of the facts, it opens the door for the tax authorities to impose an income estimate That extensive document is the last of a series of That income estimate could be, to the taxpayers hanges to the German transfer pricing regime. disadvantage the most unfavorable point within the While sections 90 and 162 of the German General range of arm s- length prices(section 162(3), AO). Tax Code(AO), in conjunction with the documenta- That normally results in double taxation and penal tion decree law (Gewinnabgrenzungsaufzeich- ties of up to 10 percent of the income adjustment nungsverordnung or GAufzV)(for prior coverage, The taxpayer is therefore well advised to pay par see Tax Notes Int'l, Jan. 12, 2004, p. 185), are ticular attention to the arm s-length test binding both on tax authorities and taxpayers, the new administrative principles and procedures are strictly speaking, merely tax authorities' interpreta- tion of the new legal requirements, and are bindin Except for a potential penalty of E5,000(section 162, only on the tax authorities. paragraph 4, AO) Tax Notes International 2005·725
German Versus OECD Transfer Pricing Principles — A Recipe for Double Taxation? by Axel Eigelshoven and Axel Nientimp Germany’s Federal Ministry of Finance (BMF) on April 12, 2005, issued the final administrative principles ‘‘for the examination of income allocation between internationally related enterprises with cross-border transactions in respect of income adjustments, investigation and compliance obligations as well as mutual agreement procedures and EU arbitration proceedings.’’ (For prior coverage, see Tax Notes Int’l, Jan. 10, 2005, p. 197.) That extensive document is the last of a series of changes to the German transfer pricing regime. While sections 90 and 162 of the German General Tax Code (AO), in conjunction with the documentation decree law (Gewinnabgrenzungsaufzeichnungsverordnung or GAufzV) (for prior coverage, see Tax Notes Int’l, Jan. 12, 2004, p. 185), are binding both on tax authorities and taxpayers, the new administrative principles and procedures are, strictly speaking, merely tax authorities’ interpretation of the new legal requirements, and are binding only on the tax authorities. However, because tax auditors are forced to follow the administrative principles, the rules are important in practice, as taxpayers usually follow the guidelines to achieve legal certainty in their tax planning. Therefore, the business community eagerly awaited thenew administrative principles, which are supposed to give taxpayers practical operating instructions for their transfer pricing documentation. Like most other countries with documentation requirements, Germany requires taxpayers to prepare an arm’s-length test, which is the core of the new documentation obligations. If a taxpayer can prove that its transfer prices are calculated at arm’s length, in principle, the tax authorities cannot make an income adjustment. The risk of penalties also is averted to a great extent, even if the documentation is otherwise basically insufficient.1 However, if the taxpayer does not provide any proof of the appropriateness of its transfer prices, or provides only a simple demonstration of the facts, it opens the door for the tax authorities to impose an income estimate. That income estimate could be, to the taxpayer’s disadvantage, the most unfavorable point within the range of arm’s-length prices (section 162(3), AO). That normally results in double taxation and penalties of up to 10 percent of the income adjustment. The taxpayer is therefore well advised to pay particular attention to the arm’s-length test. 1 Except for a potential penalty of €5,000 (section 162, paragraph 4, AO). Axel Eigelshoven is a partner and Axel Nientimp is a manager with the European Transfer Pricing Group of Deloitte in Düsseldorf, Germany. Copyright © 2005 Deloitte Touche Tohmatsu. All rights reserved. P C ractitioners’ orner Tax Notes International August 22, 2005 • 725 (C) Tax Analysts 2005. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content
Practitioners Corner German tax authorities traditionally followed a Under section 2, paragraph 2, of the GAufzV, transactional approach to transfer pricing and op taxpayers are obligated to document only one posed the use of profit-oriented methods. Eventu- method, in accordance with the OECD guidelines ally, the legislature abandoned that view and al- and practices in many other countries. Taxpayers lowed the use of the net margin and profit-split must choose the method that provides the best methods. However, tax authorities now have fol- comparability and the greatest reliability in light of lowed up with a unique view on the application of available third-party data. However, even if a tax profit-oriented methods, and again have tried to payer has documented its transfer prices with a limit their use reasonable method, tax authorities can adjust the income if they apply an alternative method and the probability of those results seems higher. In general, the transactional net margin method should be applied Net Margin Method only to companies with routine As stated above, the standard transfer pricing functions and risk that do not own methods generally are preferred in Germany. How- ever, because of the lack of data for the application of any nonroutine intangibles the standard methods, profit-oriented transfer pric- ing methods, especially the transactional net margin Tax authorities take the opportunity in the ad- method (TNMM), have become common in interna tional transfer pricing practice. In general, the ministrative principles to comment in detail about TNMM should be applied only to companies with many issues regarding transfer pricing document routine functions and risk that do not own any tion requirements. But on the core subject the nonroutine intangibles. It is regularly applied to arm's-length test the BMF presents partially companies in the value chain with simpler function contradictory, hardly practicable, and internation and risks. The German tax authorities partly as ally uncoordinated opinions that have been pub- those ideas when they classify three types of compa lished despite the substantial concerns of the busi- nies for the application of profit-based method ness community. Taxpayers trying to implement those principles will incur legal insecurities and The first group of companies performs only rou- substantial tax risks. Following is an analysis of the ine functions(for example, as stripped distributors most important provisions of the administrative or contract manufacturers). For those companies principles dealing with the arms-length test one could find comparable companies relatively eas- ily. 4 The German tax authorities assume that this Transfer Pricing Methods type of company will always derive a profit from its activities. For this group of companies the TNMM is Overview fully applicable, and it appears that there is a preference for that method According to the administrative principles and The second group of companies consists of so- procedures, generally all transfer pricing methods called entrepreneurs or strategy leaders. Because may be used for the arm's-length test-specifically, those companies own substantial nonroutine intan the comparable uncontrolled price method, the re sale price method, and the cost-plus method. Until gables, their profits are determined by those specific now. the bmf has been reluctant to allow the use of intangibles. Therefore, no reliably comparable com- panies are available for the application of the profit-based methods. It opposed the 1995 OECD TNMM 5 Usually, an entrepreneur cannot serve as a guidelines, announcing in a July 1995 press release tested party; however, German tax authorities allow that tax authorities could use profit-oriented meth he use of budget data to set transfer prices. As will ods only as a test and for income estimation, and not be shown below, this approach is surpr allows the use of profit-oriented methods. However income, but cannot be the tested part the resic as a general transfer pricing method. In principle, that the entrepreneur usually receives the bmf has now given up that view and explicitly the traditional transactional or standard transfer pricing methods are still preferred. On the other hand, tax authorities frequently question the stan SSection 3.4.20(d), administrative principles dard methods if they result in domestic losses or high profits abroad. 2 SEction 3.4.10.3(b), administrative principles ACcording to section 3.4.10.2(b)of the administrative principles, the profit is residual. However, according to sec- tion 3.4. 12.6, net margin methods based on budgets could also be used for entrepreneurs. Section 3.4. 10.3 states that for 2See, for example, section 3.4.20(b), last paragraph, admin transactions with two entrepreneurs, a profit split could be applicable 726· August22,2005 Tax Notes International
German tax authorities traditionally followed a transactional approach to transfer pricing and opposed the use of profit-oriented methods. Eventually, the legislature abandoned that view and allowed the use of the net margin and profit-split methods. However, tax authorities now have followed up with a unique view on the application of profit-oriented methods, and again have tried to limit their use. In general, the transactional net margin method should be applied only to companies with routine functions and risk that do not own any nonroutine intangibles. Tax authorities take the opportunity in the administrative principles to comment in detail about many issues regarding transfer pricing documentation requirements. But on the core subject — the arm’s-length test — the BMF presents partially contradictory, hardly practicable, and internationally uncoordinated opinions that have been published despite the substantial concerns of the business community. Taxpayers trying to implement those principles will incur legal insecurities and substantial tax risks. Following is an analysis of the most important provisions of the administrative principles dealing with the arm’s-length test. Transfer Pricing Methods Overview According to the administrative principles and procedures, generally all transfer pricing methods may be used for the arm’s-length test — specifically, the comparable uncontrolled price method, the resale price method, and the cost-plus method. Until now, the BMF has been reluctant to allow the use of profit-based methods. It opposed the 1995 OECD guidelines, announcing in a July 1995 press release that tax authorities could use profit-oriented methods only as a test and for income estimation, and not as a general transfer pricing method. In principle, the BMF has now given up that view and explicitly allows the use of profit-oriented methods. However, the traditional transactional or standard transfer pricing methods are still preferred. On the other hand, tax authorities frequently question the standard methods if they result in domestic losses or high profits abroad.2 Under section 2, paragraph 2, of the GAufzV, taxpayers are obligated to document only one method, in accordance with the OECD guidelines and practices in many other countries. Taxpayers must choose the method that provides the best comparability and the greatest reliability in light of available third-party data. However, even if a taxpayer has documented its transfer prices with a reasonable method, tax authorities can adjust the income if they apply an alternative method and the probability of those results seems higher.3 Net Margin Methods As stated above, the standard transfer pricing methods generally are preferred in Germany. However, because of the lack of data for the application of the standard methods, profit-oriented transfer pricing methods, especially the transactional net margin method (TNMM), have become common in international transfer pricing practice. In general, the TNMM should be applied only to companies with routine functions and risk that do not own any nonroutine intangibles. It is regularly applied to companies in the value chain with simpler functions and risks. The German tax authorities partly follow those ideas when they classify three types of companies for the application of profit-based methods. The first group of companies performs only routine functions (for example, as stripped distributors or contract manufacturers). For those companies, one could find comparable companies relatively easily.4 The German tax authorities assume that this type of company will always derive a profit from its activities. For this group of companies the TNMM is fully applicable, and it appears that there is a preference for that method. The second group of companies consists of socalled entrepreneurs or strategy leaders. Because those companies own substantial nonroutine intangibles, their profits are determined by those specific intangibles. Therefore, no reliably comparable companies are available for the application of the TNMM.5 Usually, an entrepreneur cannot serve as a tested party; however, German tax authorities allow the use of budget data to set transfer prices. As will be shown below, this approach is surprising, given that the entrepreneur usually receives the residual income, but cannot be the tested party. 2 See, for example, section 3.4.20(b), last paragraph, administrative principles. 3 Section 3.4.20(d), administrative principles. 4 Section 3.4.10.3(b), administrative principles. 5 According to section 3.4.10.2(b) of the administrative principles, the profit is residual. However, according to section 3.4.12.6, net margin methods based on budgets could also be used for entrepreneurs. Section 3.4.10.3 states that for transactions with two entrepreneurs, a profit split could be applicable. Practitioners’ Corner 726 • August 22, 2005 Tax Notes International (C) Tax Analysts 2005. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content
Practitioners Corner The third group of companies are the so-called Comparable Profits Method middle companies. It seems that full-fledged dis tributors and a manufacturer licensing its intellec The administrative principles do not allow tax tual property fall into that category. The TNMM is payers to use the comparable profits method.10Ac- not applicable to those companies, according to Ger- CorN rle and use it is not based on a transactional man tax authorities, 6 allegedly because no compa rable data is available. 7 If no other method can be approach, and because no comparable companies used, the arm s-length price must be determined are used to determine the arms-length profit. These based on the company's budget data. Otherwise, arguments are at least incorrect for the CPm under the taxpayer might be exposed to penaltie the U.S. regulations. Those regulations deal in de lems, as the German viewpoint clearly deviates from be found 11 Again, the taxpayer is threatened with harsh sanctions under the law is represented by section 3.4.12.6 of the administra tive principles, which incorporates the hypothetical arms-length test based on budget data as a solution The legislature wanted to ensure for insufficient third-party data. According to that that tax authorities can check the opinion, the taxpayer should determine its transfer validity of a taxpayer's transfer pricing based on budget figures and conservative profit forecasts. But even if a taxpayer complies, ta prices by having access to that uthorities ask for third-party data that need to be data considered in the forecasts. Three methods are men- tioned Transfer pricing practitioners must be surprised ag品38 First, tax authorities again suggest using net by german tax authorities'view, as there appear to margins of comparable companies. That is some- be no reasonable arguments for their position. If the what irritating, because one assumption for that tax authorities imply that a TNMM analysis can be approach is that no comparable data is available rejected if poor or inaccurate comparable data is hat would allow an arms-length test. 9 It seems that used, one could follow their argument. However, it is the German tax authorities believe they can en- then inappropriate to use, in conjunction with insuf hance the reliability of the arms-length test if the ficient data, the CPm terminology of the U.Sregu- taxpayer uses budget data within a net margin lations. Because of the german tax authorities rejection of the CPM, there is a danger that U.s otion that its entrepreneurial activities lead to a result in insufficient documentation in Germany. In higher profit as an investment on capital markets taking into account the risks embedded in the replaced with TNMM in a U.S. documentation re vestment. From a general point of view, that method port. In theory, that should prevent any misunder is a net margin method as well. Unfortunately standings with German tax authorities explicit rules on how to calculate the margins are Profit-Split Methods missing. Definitely, a risk adjustment on the risk German tax authorities also accept the profit- fied and documented for the auditor. The tax au- split methods, which are particularly applicable for thorities sometimes use risk adjustments ranging entrepreneurs(that is, for companies that own non- from 50 percent to 100 percent on a risk-free interest routine intangibles). The administrative principles rate. However, tax authorities say that general rules refer to note 3.5 of the OECd guidelines, which of thumb will not be allowed describe two methods: the contribution analysis The third method is a contribution analysis ac- (note 3. 17), and the residual profit analysis(note cording to notes 3. 16 to 3. 18 of the oecd guidelines 3.19) but based on budgets Interestingly, German tax authorities mention the residual profit analysis only briefly, focusing more heavily on the contribution analysis. That is surprising, given that the contribution analysis is 6Sections 34.10.2(c)and 3.4.10.3(b), administrative prin- rarely used in transfer pricing practice because BY 1Section 3.4.10.3(b), administrative principles sEctions 3.4.10.2(c)and 3.4.10.3(b), administrative prin 10Section 34.10.3(d), administrative principles Section 3.4.10. 3(b), administrative principles. ee U.S. Treas. reg. section 1.482-5(c). Tax Notes International 2005·727
The third group of companies are the so-called middle companies. It seems that full-fledged distributors and a manufacturer licensing its intellectual property fall into that category. The TNMM is not applicable to those companies, according to German tax authorities,6 allegedly because no comparable data is available.7 If no other method can be used, the arm’s-length price must be determined based on the company’s budget data.8 Otherwise, the taxpayer might be exposed to penalties. That qualification will lead to significant problems, as the German viewpoint clearly deviates from international standards. The core of those problems is represented by section 3.4.12.6 of the administrative principles, which incorporates the hypothetical arm’s-length test based on budget data as a solution for insufficient third-party data. According to that opinion, the taxpayer should determine its transfer pricing based on budget figures and conservative profit forecasts. But even if a taxpayer complies, tax authorities ask for third-party data that need to be considered in the forecasts. Three methods are mentioned. First, tax authorities again suggest using net margins of comparable companies. That is somewhat irritating, because one assumption for that approach is that no comparable data is available that would allow an arm’s-length test.9 It seems that the German tax authorities believe they can enhance the reliability of the arm’s-length test if the taxpayer uses budget data within a net margin analysis. Second, the taxpayer also could try to justify the notion that its entrepreneurial activities lead to a higher profit as an investment on capital markets, taking into account the risks embedded in the investment. From a general point of view, that method is a net margin method as well. Unfortunately, explicit rules on how to calculate the margins are missing. Definitely, a risk adjustment on the riskfree interest rate must be made, economically justified, and documented for the auditor. The tax authorities sometimes use risk adjustments ranging from 50 percent to 100 percent on a risk-free interest rate. However, tax authorities say that general rules of thumb will not be allowed. The third method is a contribution analysis according to notes 3.16 to 3.18 of the OECD guidelines, but based on budgets. Comparable Profits Method The administrative principles do not allow taxpayers to use the comparable profits method.10 According to German tax authorities, the CPM is not applicable because it is not based on a transactional approach, and because no comparable companies are used to determine the arm’s-length profit. These arguments are at least incorrect for the CPM under the U.S. regulations. Those regulations deal in detail with the comparability standard for the use of the CPM, and no contradictions to the TNMM could be found.11 Again, the taxpayer is threatened with harsh sanctions under the law. The legislature wanted to ensure that tax authorities can check the validity of a taxpayer’s transfer prices by having access to that data. Transfer pricing practitioners must be surprised by German tax authorities’ view, as there appear to be no reasonable arguments for their position. If the tax authorities imply that a TNMM analysis can be rejected if poor or inaccurate comparable data is used, one could follow their argument. However, it is then inappropriate to use, in conjunction with insufficient data, the CPM terminology of the U.S. regulations. Because of the German tax authorities’ rejection of the CPM, there is a danger that U.S. transfer pricing reports based on the CPM could result in insufficient documentation in Germany. In practice, it is advisable that the designation CPM be replaced with TNMM in a U.S. documentation report. In theory, that should prevent any misunderstandings with German tax authorities. Profit-Split Methods German tax authorities also accept the profitsplit methods, which are particularly applicable for entrepreneurs (that is, for companies that own nonroutine intangibles). The administrative principles refer to note 3.5 of the OECD guidelines, which describe two methods: the contribution analysis (note 3.17), and the residual profit analysis (note 3.19). Interestingly, German tax authorities mention the residual profit analysis only briefly, focusing more heavily on the contribution analysis. That is surprising, given that the contribution analysis is rarely used in transfer pricing practice because 6 Sections 3.4.10.2(c) and 3.4.10.3(b), administrative principles. 7 Section 3.4.10.3(b), administrative principles. 8 Sections 3.4.10.2(c) and 3.4.10.3(b), administrative principles. 9 Section 3.4.10.3(b), administrative principles. 10Section 3.4.10.3(d), administrative principles. 11See U.S. Treas. reg. section 1.482-5(c). Practitioners’ Corner Tax Notes International August 22, 2005 • 727 (C) Tax Analysts 2005. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content
Practitioners Corner taxpayers often have difficulty finding third-party might be the case if, for example, there are remark data to support the relative value of each step in the able variances compared to actual results. Forecasts value chain also must be justified in detail. 16 Within the scope of the contribution analysis, tax The taxpayer also must keep monthly and quar- authorities state that the added value of the parties terly reports and justify variances between its plan comprehensively. 12 However, they are vague in their tial resources because, in practice, this kind of comments about how the contribution analysis variance analysis is not necessarily compiled in should be carried out. As a rule, the contribution written form analysis should be based on budgeting data Another point is a potential price adjustment, if there is a variance between the plan and the actua Application of Budgeting Data results. The adjustment must take place immedi Section 1, paragraph 3, sentence 4, of the GAufzv ately 18 In light of that fact, the taxpayer should requires that taxpayers keep records of internal consider whether third parties have adjusted the data. The legislature wanted to ensure that tax prices because of variances in the budget Obviousl authorities can check the validity of a taxpayers considerations about adjustments have a large po- transfer prices by having access to that data. If, for tential for conflict between the taxpayer and the example, a taxpayer uses the resale price method in auditor addition to the gross profit margins generated by Tax authorities contend that documentation of a8m associated distribution companies and with third taxpayers planning data is reasonable because the parties, net margins, prices, and realized cost-plus taxpayer can revert to its own records. However, markups must be made available to tax authorities while it is true that many companies draw up In general, the data will already be available in the budgets, detailed written reasons and a variance taxpayers accounting record analysis are not always compiled addition to the application pro oblems. there is In principle, a taxpayer could question regarding the practical use of planning and budgeting data Experience has shown that in most freely negotiate transfer prices, cases, tax authorities base their transfer pricing use a price with an unacceptable audits on actual results, and not on the company's method, or even set transfer prices planning and budgeting process. Only exceptional on a purely arbitrary basis. effects could potentially be determined from plan- ning and budgeting data. Therefore, it could only be used if, for example, the net margins realized by the 3 Entrepreneurs and middle companies also should taxpayer are beyond the range of net margins of ase their price setting on budgeting data. 13 An third parties. The documentation of planning and extensive analysis will be compiled within the scope budgeting data is therefore applicable only in excep of the planning process. tional cases The taxpayer must compile planning and budget ng data and provide back-up information on how Price Setting Versus Testing of the budgets were determined. 14 The tax payer must Transfer prices compile its forecasts based on past experience and economically sound presumptions. The administra- Tax authorities misunderstanding regarding the tive principles state that the tax auditor should application of planning data also raises the question correct the planning and budgeting data, if the of whether the taxpayer is obligated to set transfe es with a certain method ex ante. or whether the nable.15 That taxpayer has only to prove the length charac ter of the transfer prices ex post facto. In the descrip- tion of the planning and budgeting data require Section 3.4.11.5, administrative principles ment of the administrative principles, tax authorities give the impression that it is the taxpay According to sections 3. 4.10. 2 and 3.4 12.6 of the admin. er's obligation to determine transfer prices with a istrative principles, taxpayers generally are allowed to use section 3.4.12.6(a), that method is designed mainly for middle mpanies, whereas the TNMM should not be permitted Therefore, for those companies, it seems to be the only method Section 3.4. 125(b), administrative principles, based on a allowed Federal Tax Court decision of Feb. 17. 1993 Section 3.4.12.6(b), administrative principles 1Section 3.4. 125(e), administrative principles Section 3.4.20, administrative principles 18Section 34.20(c), administrative principles. 728· August22,2005 Tax Notes International
taxpayers often have difficulty finding third-party data to support the relative value of each step in the value chain. Within the scope of the contribution analysis, tax authorities state that the added value of the parties involved in the transaction should be demonstrated comprehensively.12 However, they are vague in their comments about how the contribution analysis should be carried out. As a rule, the contribution analysis should be based on budgeting data. Application of Budgeting Data Section 1, paragraph 3, sentence 4, of the GAufzV requires that taxpayers keep records of internal data. The legislature wanted to ensure that tax authorities can check the validity of a taxpayer’s transfer prices by having access to that data. If, for example, a taxpayer uses the resale price method in addition to the gross profit margins generated by associated distribution companies and with third parties, net margins, prices, and realized cost-plus markups must be made available to tax authorities. In general, the data will already be available in the taxpayer’s accounting records. In principle, a taxpayer could freely negotiate transfer prices, use a price with an unacceptable method, or even set transfer prices on a purely arbitrary basis. Entrepreneurs and middle companies also should base their price setting on budgeting data.13 An extensive analysis will be compiled within the scope of the planning process. The taxpayer must compile planning and budgeting data and provide back-up information on how the budgets were determined.14 The taxpayer must compile its forecasts based on past experience and economically sound presumptions. The administrative principles state that the tax auditor should correct the planning and budgeting data, if the underlying presumptions were unreasonable.15 That might be the case if, for example, there are remarkable variances compared to actual results. Forecasts also must be justified in detail.16 The taxpayer also must keep monthly and quarterly reports and justify variances between its plan and its actual results.17 That might tie up substantial resources because, in practice, this kind of variance analysis is not necessarily compiled in written form. Another point is a potential price adjustment, if there is a variance between the plan and the actual results. The adjustment must take place immediately.18 In light of that fact, the taxpayer should consider whether third parties have adjusted the prices because of variances in the budget. Obviously, considerations about adjustments have a large potential for conflict between the taxpayer and the auditor. Tax authorities contend that documentation of a taxpayer’s planning data is reasonable because the taxpayer can revert to its own records. However, while it is true that many companies draw up budgets, detailed written reasons and a variance analysis are not always compiled. In addition to the application problems, there is a question regarding the practical use of planning and budgeting data. Experience has shown that in most cases, tax authorities base their transfer pricing audits on actual results, and not on the company’s planning and budgeting process. Only exceptional effects could potentially be determined from planning and budgeting data. Therefore, it could only be used if, for example, the net margins realized by the taxpayer are beyond the range of net margins of third parties. The documentation of planning and budgeting data is therefore applicable only in exceptional cases. Price Setting Versus Testing of Transfer Prices Tax authorities’ misunderstanding regarding the application of planning data also raises the question of whether the taxpayer is obligated to set transfer prices with a certain method ex ante, or whether the taxpayer has only to prove the arm’s-length character of the transfer prices ex post facto. In the description of the planning and budgeting data requirement of the administrative principles, tax authorities give the impression that it is the taxpayer’s obligation to determine transfer prices with a 12Section 3.4.11.5, administrative principles. 13According to sections 3.4.10.2 and 3.4.12.6 of the administrative principles, taxpayers generally are allowed to use budgeting data to determine transfer prices. According to section 3.4.12.6(a), that method is designed mainly for middle companies, whereas the TNMM should not be permitted. Therefore, for those companies, it seems to be the only method allowed. 14Section 3.4.12.6(b), administrative principles. 15Section 3.4.20, administrative principles. 16Section 3.4.12.5(b), administrative principles, based on a Federal Tax Court decision of Feb. 17, 1993. 17Section 3.4.12.5(c), administrative principles. 18Section 3.4.20(c), administrative principles. Practitioners’ Corner 728 • August 22, 2005 Tax Notes International (C) Tax Analysts 2005. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content
Practitioners Corner certain method under German law. At first glance, ments of the controlling shareholders(such as ret the question seems academic. However, in practice reactivity) are limited by article 9 of the OECD the problem is of great importance. It applies par- model. 20(For related coverage, see Tax Notes Int'l ticularly to companies whose management is evalu- ated based on local profits. The transfer prices of competent authority and eu arbitral procedures those groups must fulfill not only the tax objectives the bmf does not seem very confident about its but also the managing and controlling aspects. opinion of the formal criteria, and does not want to In fact, there is no legal obligation to determine let the arm's-length principle be set aside. In the tax audit report for the preparation of a competent a taxpayer could freely negotiate transfer prices, use authority or EU arbitration procedure, it must be fer prices dictated by the parent company, or-as an extreme example -even set transfer prices on a ties give reasons for an adjustment based on formal purely arbitrary basis. Indeed, within the scope of criteria.2 Apparently, tax authorities feel that they its obligation to cooperate, the taxpayer is required cannot impose their opinion internationally. In prac- only to document an arms-length range for tax tice, competent authority negot purposes. Moreover, it must control whether the insufficient agreement does not justify a transfer transfer prices are in the arms-length range. If its pricing adjustment. 22 Therefore, German tax au- transfer prices are not within the arm's-Iength thorities will not be disposed to reduce the income of range, the taxpayer must report a hidden profit a domestic taxpayer if a foreign tax authority cor distribution or hidden capital contribution in its tax rects a transfer price that is at arms length, only return because formal criteria have not been meet a832938 Year-End Adjustments Conclusion Some taxpayers agree, explicitly or implicitly The new administrative principles are extensive only on temporary transfer prices, and adjust them but unfortunately, they are hardly practical for to a compre rehensible and empirically justified arm's- taxpayers. Their complexity, inconsistency, and mul length price at the end of the year. For example, titude of undefined terms and references complicate related parties agree when performing services that their application, both by taxpayers and auditors the services are charged based on actual costs, using the cost-plus method at the end of the year(so that German tax authorities would have been well 8 an arms-length cost-plus markup is reached), or the advised to first discuss their new views regarding profits of a distribution company are transferred to the determination of transfer prices and the appli the arms-length range of operating margins Under cability of the TNMM with the oecd to ensure article 9 of the OECD model income tax treaty, any international consensus. The differing views of the variation in prices is allowed, as long as the final concerned tax authorities now must be settled in a price is within the arms-length range. In practice, very time-consuming way through mutual agree many countries accept year-end adjustments ment procedures. Hopefully, tax auditors will use German tax authorities allow year-end adjust. good judgment in applying the new administrative ments only in exceptional cases: 19 ex post adjust icular must be agreed to in advance The bMf does not believe that the formal require Section 6.1.1, administrative principles sEction 3.4. 12.8, administrative principles 2See also note 7. 18, OECD guidelines Tax Notes International 2.2005·72
certain method under German law. At first glance, the question seems academic. However, in practice, the problem is of great importance. It applies particularly to companies whose management is evaluated based on local profits. The transfer prices of those groups must fulfill not only the tax objectives, but also the managing and controlling aspects. In fact, there is no legal obligation to determine transfer prices using a certain method. In principle, a taxpayer could freely negotiate transfer prices, use a price with an unacceptable method, accept transfer prices dictated by the parent company, or — as an extreme example — even set transfer prices on a purely arbitrary basis. Indeed, within the scope of its obligation to cooperate, the taxpayer is required only to document an arm’s-length range for tax purposes. Moreover, it must control whether the transfer prices are in the arm’s-length range. If its transfer prices are not within the arm’s-length range, the taxpayer must report a hidden profit distribution or hidden capital contribution in its tax return. Year-End Adjustments Some taxpayers agree, explicitly or implicitly, only on temporary transfer prices, and adjust them to a comprehensible and empirically justified arm’slength price at the end of the year. For example, related parties agree when performing services that the services are charged based on actual costs, using the cost-plus method at the end of the year (so that an arm’s-length cost-plus markup is reached), or the profits of a distribution company are transferred to the arm’s-length range of operating margins. Under article 9 of the OECD model income tax treaty, any variation in prices is allowed, as long as the final price is within the arm’s-length range. In practice, many countries accept year-end adjustments. German tax authorities allow year-end adjustments only in exceptional cases;19 ex post adjustments in particular must be agreed to in advance. The BMF does not believe that the formal requirements of the controlling shareholders (such as retroactivity) are limited by article 9 of the OECD model.20 (For related coverage, see Tax Notes Int’l, Aug. 18, 2003, p. 667.) Indeed, within the scope of competent authority and EU arbitral procedures, the BMF does not seem very confident about its opinion of the formal criteria, and does not want to let the arm’s-length principle be set aside. In the tax audit report for the preparation of a competent authority or EU arbitration procedure, it must be demonstrated to what extent the remuneration complies with the arm’s-length price, even if tax authorities give reasons for an adjustment based on formal criteria.21 Apparently, tax authorities feel that they cannot impose their opinion internationally. In practice, competent authority negotiations show that an insufficient agreement does not justify a transfer pricing adjustment.22 Therefore, German tax authorities will not be disposed to reduce the income of a domestic taxpayer if a foreign tax authority corrects a transfer price that is at arm’s length, only because formal criteria have not been meet. Conclusion The new administrative principles are extensive, but unfortunately, they are hardly practical for taxpayers. Their complexity, inconsistency, and multitude of undefined terms and references complicate their application, both by taxpayers and auditors. German tax authorities would have been well advised to first discuss their new views regarding the determination of transfer prices and the applicability of the TNMM with the OECD to ensure international consensus. The differing views of the concerned tax authorities now must be settled in a very time-consuming way through mutual agreement procedures. Hopefully, tax auditors will use good judgment in applying the new administrative principles. ◆ 19Section 3.4.12.8, administrative principles. 20Section 6.1.1, administrative principles. 21Section 6.2.1, administrative principles. 22See also note 7.18, OECD guidelines. Practitioners’ Corner Tax Notes International August 22, 2005 • 729 (C) Tax Analysts 2005. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content