Special Reports this case. the auditor identified German Federal Tax Court the taxpayer using the markus Issues landmark Transfer the tax files of the c refine his analy Pricing Decision case for an adjustment. He presented the analysis to the Tax Court, without disclosing the by Dr. Heinz-Klaus Kroppen, Dr. Stephan Rasch, names of the companies, or and Dr Achim roeder the Tax court Dr. Heinz-Klaus Kroppen, LL.M, Dr. Stephan Rasch, and Dr. The Federal tax Court had to Achim Roeder, M.A. are with Deloitte Touche in Dusseldorf. decide whether the procedure was Copyright o Deloitte Touche, 2001 roper. The court held that if the four companies'files had been submitted to the Tax court the taxpayer would have been entitled have access to the files. under G the fairness principles in the ermany's Federal Tax Court to 1987, and 24 percent for 1988 to German Constitution. The Federal on 17 October rendered a 1990. The tax auditors did not Tax court also cited articles 1.12 landmark decision on how to accept that margin and adjusted it and 3.30 of the OECD Transfer determine transfer prices between to 28 percent for 1981 to 1985 and Pricing Guidelines, even though related parties. The court also addressed the rights of the tax 26 percent for 1986 to 1990, based the legal validity of the guidelines on an analysis of four other in germany is unclear, proving authorities and taxpayers during a apparel distribution companies the that the court is willing to take transfer tax audit auditor found comparable additional coverage, see p. 1068) them into account This is a rare decision in which Transfer Pricing the federal tax court had an Adjustment few transfer pricing cases ha p.p opportunity to express its thoughts In germany, the most important regarding transfer pricing, beca legal basis for making a transfer ISee decision of Dusseldorf Tax Court at made it to court pricing adjustment, for prices paid first instance. dated s Dec. 1998.6K from a subsidiary to its parent 661/93. Deutsches steuerrecht The case has a long procedural company, is section 8, para. 3 of the Entscheidungsdienst, hereinafter DStRE history. Several courts have issued Corporate Tax Law, which permits 20(1999), pp 787 ff.; for a detailed analysis different decisions in the a deemed dividend. The federal preliminary and the main2 Tax Court emphasized that the icing Journal 2000, pp. 156 ff proceedings. The Federal Tax two major requirements for Borstell and Prick, International To Court has now overruled a prior making an adjustment under that Review 4(1999), pp 9 ff. Kuckhoff decision by the Tax Court of provision are that: Dusseldorf and has sent the case hereinafter: IStR, 1999, pp 515 ff. back to the Tax Court for further the amount of the charge price Kroppen/Eigelshoven, Internationale fact gathering and a new decision vas agreed, or paid, because of Gruppe i Deutschland., pp. 1587f dEcision of Federal Tax Court of 10 Facts May 2001, I S 3/01, Der Betrieb, here the led to a reduction of inafter: DB 2001, pp 1180 ff. with which The taxpayer is a german taxable income compared to the taxpayer ap gmbh formed in 1980. It distrib- This decision of the Federal Tax Court has uted apparel and fashionable he situation in which an accessories in germany and other arms-length price is paid terature, see: Kroppen/Eigelshoven, IWB Fach 3 Deutschland Gruppe 1, pp. 1745 ff. European countries. From 1980 to 1990 the taxpayer had loss years Secret Comparables land, pp 1765 ff Strunk/Kaminski, IWB for the most part. The total loss for In germany, taxpayer data and Fach 3 Gruppe 1 Deutschland, pp 1749 the entire period was approxi files are protected by the Tax mately DM 400,000. The Secrecy Law. The tax authorities taxpayers gross profit margin are not allowed to disclose Dr. Otto fluctuated between 18 percent for taxpayer information. During the Schmidt 1980 to 1984, 20 percent for 1985 audit and the court proceedings in Vorbemerkungen I, notes 5 ff. Tax Notes international 10 December 2001 1111
Germany’s Federal Tax Court on 17 October rendered a landmark decision on how to determine transfer prices between related parties. The court also addressed the rights of the tax authorities and taxpayers during a transfer pricing tax audit. (For additional coverage, see p. 1068.) This is a rare decision in which the Federal Tax Court had an opportunity to express its thoughts regarding transfer pricing, because few transfer pricing cases have made it to court. The case has a long procedural history. Several courts have issued different decisions in the preliminary 1 and the main2 proceedings. The Federal Tax Court has now overruled a prior decision by the Tax Court of Düsseldorf and has sent the case back to the Tax Court for further fact gathering and a new decision. Facts The taxpayer is a German GmbH formed in 1980. It distributed apparel and fashionable accessories in Germany and other European countries. From 1980 to 1990 the taxpayer had loss years for the most part. The total loss for the entire period was approximately DM 400,000. The taxpayer’s gross profit margin fluctuated between 18 percent for 1980 to 1984, 20 percent for 1985 to 1987, and 24 percent for 1988 to 1990. The tax auditors did not accept that margin and adjusted it to 28 percent for 1981 to 1985 and 26 percent for 1986 to 1990, based on an analysis of four other apparel distribution companies the auditor found comparable. Transfer Pricing Adjustment In Germany, the most important legal basis for making a transfer pricing adjustment, for prices paid from a subsidiary to its parent company, is section 8, para. 3 of the Corporate Tax Law, which permits a deemed dividend. The Federal Tax Court emphasized that the two major requirements for making an adjustment under that provision are that: • the amount of the charge price was agreed, or paid, because of the shareholder-company relationship; and • the price led to a reduction of taxable income compared to the situation in which an arm’s-length price is paid. Secret Comparables In Germany, taxpayer data and files are protected by the Tax Secrecy Law. The tax authorities are not allowed to disclose taxpayer information. During the audit and the court proceedings in this case, the auditor identified four companies as comparable to the taxpayer using the Markus database. The auditor then used the tax files of the companies to refine his analysis and support his case for an adjustment. He presented the analysis to the Tax Court, without disclosing the names of the companies, or submitting the taxpayer’s files to the Tax Court. The Federal Tax Court had to decide whether the procedure was proper. The court held that if the four companies’ files had been submitted to the Tax Court, the taxpayer would have been entitled to have access to the files, under the fairness principles in the German Constitution. The Federal Tax Court also cited articles 1.12 and 3.30 of the OECD Transfer Pricing Guidelines, even though the legal validity of the guidelines in Germany is unclear, 3 proving that the court is willing to take them into account. Tax Notes International 10 December 2001 • 1111 Special Reports German Federal Tax Court Issues Landmark Transfer Pricing Decision by Dr. Heinz-Klaus Kroppen, Dr. Stephan Rasch, and Dr. Achim Roeder Dr. Heinz-Klaus Kroppen, LL.M., Dr. Stephan Rasch, and Dr. Achim Roeder, M.A. are with Deloitte & Touche in Düsseldorf. Copyright © Deloitte & Touche, 2001 1See decision of Düsseldorf Tax Court at first instance, dated 8 Dec. 1998, 6 K 3661/93, Deutsches Steuerrecht Entscheidungsdienst, hereinafter DStRE 20(1999), pp. 787 ff.; for a detailed analysis of the Düsseldorf Tax Court cf. Kroppen/ Eigelshoven, International Transfer Pricing Journal 2000, pp. 156 ff; see also: Borstell and Prick, International Tax Review 4 (1999), pp. 9 ff.; Kuckhoff/ Schreiber, Internationales Steuerrecht, hereinafter: IStR, 1999, pp. 515 ff.; Kroppen/Eigelshoven, Internationale Wirtschaftsbriefe, hereinafter: IWB, Fach 3 Gruppe 1 Deutschland, pp. 1587 ff. 2Decision of Federal Tax Court of 10 May 2001, I S 3/01, Der Betrieb, hereinafter: DB 2001, pp. 1180 ff. with which the taxpayer applied for a tax suspension. This decision of the Federal Tax Court has also been widely discussed in tax literature, see: Kroppen/Eigelshoven, IWB Fach 3 Deutschland Gruppe 1, pp. 1745 ff.; Becker, IWB Fach 3 Gruppe 1 Deutschland, pp. 1765 ff.; Strunk/Kaminski, IWB Fach 3 Gruppe 1 Deutschland, pp. 1749 ff.). 3Becker, in: Becker/Kroppen (eds.) Handbuch Internationale Verrechnungspreise (Köln: Dr. Otto Schmidt Verlag, 1999), O Vorbemerkungen I, notes 5 ff
Special Reports Ifother taxpayers'files are Court nor the taxpayer can law. However reliable sources in submitted to the Tax Court and the undertake a comparability the tax authorities have indicated taxpayer is entitled to have access analysis. The taxpayer will not be that they will introduce documen auditor could be deemed to have court if the taxpayer does not have tax law. They believe that violated the tax secrecy law access to the data. Therefore, if the because of international competi Therefore, in the case at ba information is not disclosed to the tion for tax revenues the german auditor did not submit the files, nor court and the taxpayer, the ernment cannot protect its tax did the Tax Court request them. principle of fair court proceedings revenue base without documenta The question then arose whether is violated when the court bases its tion requirements comparable to the secret data used by the auditor decision on the comparables or those of other major trading could be used by the Tax court to value. it remains to be seen how ourt answered that question in the tax Court and the federal tax Burden of proof the negative and dismissed the Court will handle that issue once The taxpayers obligations auditors entire analysis the data is reviewed by the Tax regarding pricing of intercompany Court The Federal Tax Court ansactions is limited to proving overruled the Tax Court and the facts; that is, showing the price decided that secret comparables that has been agreed to how the may be used in court. The elated parties reached the he tax authorities would be agreement and which functions allowed to develop their own data nd risks are assumed by each banks, to which neither taxpayers The Federal tax court party. However, according to the nor the courts would have access Federal Tax Court, the taxpayer reiterated its prior does not have to prove that the However, secret comparables prices agreed on are at arms introduced into Tax Court proceed position, from the length. The court states that it ings must fulfill minimum preliminary the tax authorities task to prove standards and the Tax Court may proceedings, that that a price is not at arm s length be required to determine the German tax law does if they want to make an adjust ment Therefore the tax office questions regarding the data and not require the taxpayer must collect the comparable data he analysis made. If the auditor to submit specific and undertake the pricing analysis cannot answer the questions because of tax secrecy, the data's transfer pricing to support an adjustment. evidentiary value may be reduced. documentation According to the Federal Tax The federal tax court did not rule Court, when a taxpayer does not on the value of the data because cooperate in explaining how it the tax court had not used the determined pricing, that only secret comparables- that will results in a presumption that the price-setting was influenced by the now happen when the case is sent back to the Tax Court for further shareholder-company relationship That presumption, however, is only fact gathering and a new decision Documentation Every transfer pricing practi Requirements ioner knows that the key element of any arm s-length analysis is the The Federal Tax Court reiter- comparability of the data. The ated its prior position, from the OECD Guidelines broadly discuss preliminary proceedings, that that issue. Data is useful only if it German tax law does not require can be determined. with some the taxpayer to submit specific 之 O number 1.15 reliability, that it is comparable transfer pricing documentation Hence, in today's transfer pricing submit books, records, and The taxpayer is only required to Number 1.16 ff OECD guidelines. world, the main discussion point between tax auditors and business papers and to answer eCf Decision of Federal Tax Court here isnt a dated 10 May 2001, DB 2001, pp. 1180 ff. taxpayers is the comparability of the data that each side is using to requirement to prepare a transfer Gruppe 1 Deutschland, pp. 17454-Fach3 pricing study If the details of the comparables The federal Tax Courts pp 1765 ff Tax Managen Transfer Pricing Report, Vol 10(2001),no. are not disclosed, neither the Tax findings are correct under existing 13; and number6below 1112·10 December2001 Tax Notes international
If other taxpayers’ files are submitted to the Tax Court and the taxpayer is entitled to have access to the files,the Tax Court and the auditor could be deemed to have violated the tax secrecy law. Therefore, in the case at bar,the auditor did not submit the files, nor did the Tax Court request them. The question then arose whether the secret data used by the auditor could be used by the Tax Court to support an adjustment. The Tax Court answered that question in the negative and dismissed the auditor’s entire analysis. The Federal Tax Court overruled the Tax Court and decided that secret comparables may be used in court. Therefore, the tax authorities would be allowed to develop their own data banks, to which neither taxpayers nor the courts would have access. However, secret comparables introduced into Tax Court proceedings must fulfill minimum standards, and the Tax Court may be required to determine the quality of the data by asking questions regarding the data and the analysis made. If the auditor cannot answer the questions because of tax secrecy, the data’s evidentiary value may be reduced. The Federal Tax Court did not rule on the value of the data because the Tax Court had not used the secret comparables — that will now happen when the case is sent back to the Tax Court for further fact gathering and a new decision. Every transfer pricing practitioner knows that the key element of any arm’s-length analysis is the comparability of the data. 4 The OECD Guidelines broadly discuss that issue. 5 Data is useful only if it can be determined, with some reliability, that it is comparable. Hence, in today’s transfer pricing world, the main discussion point between tax auditors and taxpayers is the comparability of the data that each side is using to support its case. If the details of the comparables are not disclosed, neither the Tax Court nor the taxpayer can undertake a comparability analysis. The taxpayer will not be able to challenge data presented in court if the taxpayer does not have access to the data. Therefore, if the information is not disclosed to the court and the taxpayer, the principle of fair court proceedings is violated when the court bases its decision on the comparables or gives them decisive evidentiary value. It remains to be seen how the Tax Court and the Federal Tax Court will handle that issue once the data is reviewed by the Tax Court. Documentation Requirements The Federal Tax Court reiterated its prior position, from the preliminary proceedings, 6 that German tax law does not require the taxpayer to submit specific transfer pricing documentation. The taxpayer is only required to submit books, records, and business papers and to answer questions. There isn’t a legal requirement to prepare a transfer pricing study. The Federal Tax Court’s findings are correct under existing law. However, reliable sources in the tax authorities have indicated that they will introduce documentation requirements into German tax law. 7 They believe that, because of international competition for tax revenues, the German government cannot protect its tax revenue base without documentation requirements comparable to those of other major trading nations. Burden of Proof The taxpayer’s obligations regarding pricing of intercompany transactions is limited to proving the facts; that is, showing the price that has been agreed to, how the related parties reached the agreement, and which functions and risks are assumed by each party. However, according to the Federal Tax Court, the taxpayer does not have to prove that the prices agreed on are at arm’s length. The court states that it is the tax authorities’ task to prove that a price is not at arm’s length if they want to make an adjustment. Therefore, the tax office must collect the comparable data and undertake the pricing analysis to support an adjustment. According to the Federal Tax Court, when a taxpayer does not cooperate in explaining how it determined pricing, that only results in a presumption that the price-setting was influenced by the shareholder-company relationship. That presumption, however, is only 1112 • 10 December 2001 Tax Notes International Special Reports 4See Becker, in: Becker/Kroppen (eds.) Handbuch Internationale Verrechnungspreise (Köln: Dr. Otto Schmidt Verlag, 1999), O number 1.15, note 1 ff 5Number 1.16 ff OECD guidelines. 6Cf. Decision of Federal Tax Court, dated 10 May 2001, DB 2001, pp. 1180 ff. 7See Kroppen/Eigelshoven, IWB Fach 3 Gruppe 1 Deutschland, pp. 1745 ff.; Becker, IWB Fach 3 Gruppe 1 Deutschland, pp. 1765 ff.; Tax Management Transfer Pricing Report, Vol. 10 (2001), no. 13; and number 6 below. The Federal Tax Court reiterated its prior position, from the preliminary proceedings, that German tax law does not require the taxpayer to submit specific transfer pricing documentation
Special Reports one requirement for a transfer Commission recommends incorporated in the new law and pricing adjustment (see discussion following a common EU approach regulations above) and only gives an initial on documentation requirements indication that the price is not at The purpose of the arm s-length Transfer Pricing Analysis arms length test is to put related parties on the The Tax Court made an adjust Nevertheless, an adjustment is same level playing field as ment by applying the resale price possible only if the agreed price is unrelated parties; unrelated method. It compared the gross outside the range of appropriate parties by the very nature of their margin that the taxpayer prices. The determination must be relationship do not have to prepare generated from the sale of made by the authorities, even in products parent the tax authorities through docu- to the gross margin earned from use a transfer pricing method at mentation rules force related sales of products purchased from all, used an unaccepted method, or taxpayers to spend millions of three unrelated manufacturers used a"wrong"method. The price dollars on documentation, related The purchases constituted used might still be at arm's length taxpayers will be at a disadvan- percent of the taxpayers total by sheer accident, even though the tage compared to independent sales. The Federal Tax Court found taxpayer did not determine it that the third-party purchases based on any economic or scientific were not comparable to the basis purchases made from the parent company because of their low It is not German tax authorities are oncerned about the documenta The court held that on the one tion and burden of proof aspects of It is not surprising that hand, a purchaser of high volumes the Federal tax Court's decision the german tax may be able to negotiate b They are currently discussing changes to the existing tax law. 8 authorities are percent of purchases may onl Although the final outcome of the concerned about the pplement the existing product discussion is uncertain a new law documentation and nge, and the wholesaler, having might cover several issues a special interest in the products burden of proof aspects willing to accept higher prices. 1 The new law will probabl of the Federal tax The findings of the Federal Tax ntroduce documentation require- ments into German Tax Law Courts decision. They Court are probably correct. They whereby taxpayers will be are currently discussing required to show how they set prices and why they believe changes to the existing those prices are at arm s length. If tax law the taxpayer does not prepare the documentation, the burden of proof For an analysis of the first draft might be shifted to the taxpayer if administrative principles see Kroppen/Roeder, Tax Management ere is uncertainty regardin Transfer Pricing Report, Vol 9(2000), no. whether a price is within the arm's-length range sEe Commission Staff Working Paper: It can only be hoped that the tax parties because the related Market. " SEC(2001)1681, dated 23 Oct. authorities will be reasonable taxpayers will have fewer 2001,pp.346f when they draft the new laws. to spend on their LThe EU Commission stressed this They shouldnt enact totally new tional needs, including research aspect, too. See Commission Staff Workin documentation concepts, but should instead require documents and development, and marketing. Market. "SEC(2001)1681. dated 23 Oct. similar to those that are alread Taxpayers will accept new required in other jurisdictions. It is documentation rules, including This argument of the Federal Tax Court is in line with its decision as of 4 try to reinvent the wheel, which studies, only if the new rules result 1981 part Il, pp. 492t ederal Tax Bulletin acceptable for each country to requirements for transfer burdens taxpayers with different in greater certainty for taxpayers n: Becker/Kr requirements that are time n their dealings with the tax eds )Handbuch Internationale authorities. The authorities should Verrechnungspreise(Koln: Dr.Otto Commission recently published a consider safe harbor rules limiting Schmidt verlag, 1999), W 22, Bar mhofi, report on EU company taxation the scope of an audit when the AuBensteuerrecht(Koln: Dr. Otto Schmidt addressing transfer pricing. The documentation satisfies standards Verlag, 1997, 2001), Sec. 1 AStG note 303 Tax Notes international 10 December2001·1113
one requirement for a transfer pricing adjustment (see discussion above) and only gives an initial indication that the price is not at arm’s length. Nevertheless, an adjustment is possible only if the agreed price is outside the range of appropriate prices. The determination must be made by the authorities, even in cases where the taxpayer did not use a transfer pricing method at all, used an unaccepted method, or used a “wrong” method. The price used might still be at arm’s length by sheer accident, even though the taxpayer did not determine it based on any economic or scientific basis. It is not surprising that the German tax authorities are concerned about the documentation and burden of proof aspects of the Federal Tax Court’s decision. They are currently discussing changes to the existing tax law. 8 Although the final outcome of the discussion is uncertain, a new law might cover several issues. The new law will probably introduce documentation requirements into German Tax Law whereby taxpayers will be required to show how they set their prices and why they believe those prices are at arm’s length. If the taxpayer does not prepare the documentation, the burden of proof might be shifted to the taxpayer if there is uncertainty regarding whether a price is within the arm’s-length range. It can only be hoped that the tax authorities will be reasonable when they draft the new laws. They shouldn’t enact totally new documentation concepts, but should instead require documents similar to those that are already required in other jurisdictions. It is unacceptable for each country to try to reinvent the wheel, which burdens taxpayers with different requirements that are timeconsuming and costly. The EU Commission recently published a report on EU company taxation addressing transfer pricing. The Commission recommends following a common EU approach on documentation requirements. 9 The purpose of the arm’s-length test is to put related parties on the same level playing field as unrelated parties; unrelated parties by the very nature of their relationship do not have to prepare transfer pricing documentation. If the tax authorities, through documentation rules, force related taxpayers to spend millions of dollars on documentation, related taxpayers will be at a disadvantage compared to independent parties because the related taxpayers will have fewer resources to spend on their operational needs, including research and development, and marketing. 10 Taxpayers will accept new documentation rules, including requirements for transfer pricing studies, only if the new rules result in greater certainty for taxpayers in their dealings with the tax authorities. The authorities should consider safe harbor rules limiting the scope of an audit when the documentation satisfies standards incorporated in the new law and regulations. Transfer Pricing Analysis The Tax Court made an adjustment by applying the resale price method. It compared the gross margin that the taxpayer generated from the sale of products from its parent company to the gross margin earned from sales of products purchased from three unrelated manufacturers. The purchases constituted 5 percent of the taxpayer’s total sales. The Federal Tax Court found that the third-party purchases were not comparable to the purchases made from the parent company because of their low volume. The court held that on the one hand, a purchaser of high volumes may be able to negotiate better discounts. On the other hand, the 5 percent of purchases may only supplement the existing product range, and the wholesaler, having a special interest in the products, is willing to accept higher prices. 11 The findings of the Federal Tax Court are probably correct. They Tax Notes International 10 December 2001 • 1113 Special Reports 8For an analysis of the first draft administrative principles see Kroppen/Roeder, Tax Management Transfer Pricing Report, Vol. 9 (2000), no. 4 pp. 122. 9See Commission Staff Working Paper: “Company Taxation in the Internal Market,” SEC(2001) 1681, dated 23 Oct. 2001, pp. 346 ff. 10The EU Commission stressed this aspect, too. See Commission Staff Working Paper: “Company Taxation in the Internal Market,” SEC(2001) 1681, dated 23 Oct. 2001, p. 258. 11This argument of the Federal Tax Court is in line with its decision as of 4 April 1980, I R 75/78, Federal Tax Bulletin 1981 part II, pp. 492 ff. 12See Kroppen, in: Becker/Kroppen (eds.) Handbuch Internationale Verrechnungspreise (Köln: Dr. Otto Schmidt Verlag, 1999), W 22; Baumhoff, in: Flick/Wassermeyer/Baumhoff (eds.), Außensteuerrecht (Köln: Dr. Otto Schmidt Verlag, 1997, 2001), Sec. 1 AStG note 303. It is not surprising that the German tax authorities are concerned about the documentation and burden of proof aspects of the Federal Tax Court’s decision. They are currently discussing changes to the existing tax law
Special Reports are supported in the literature, There are cogent argument 1The OeCD member countries should and they are in accordance with supporting the Federal Tax Courts the concept of an arms length the U.S. regulations, the oecd decision. If the taxpayer chooses a ee for example the new transfer tion in the Netherland Guidelines and the german price within the range, the price is which explicitly refers to the OECD administrative principles. 13 an arms-length price that cannot Guidelines, for a detailed analysis see be adjusted. 16 The adjustment of a Kroppen/Rasch, IB Fach 5 Niederlande price, outside the range, to the Gruppe 2, pp 321 ff. Ranges midpoint of the range would Becker. in: Becker/Kro In its analysis of the pricing violate the German legal principle Handbuch Internationale situation, the Tax Court tried to that punishment is only permitted Verrechnungspreise(Koln:Dr.Otto determine the correct transfer under criminal laws. but not tax Schmidt Verlag. 1999). 0 number 1.4 price. The Federal Tax Court Grotherr/Kroppen(eds ) criticized that approach, noting Furthermore constitutional that rarely does a single correct (Herne/Berlin, NWB Verlag, 1997), Art. 9 principles support the court's view transfer price actually exist. a The Tax Law significantly transfer pricing analysis can only interferes with the rights of the Pricing (Amsterdam 1987), note 2.1.5 lead to a range of acceptable prices individual. That interference is based on the available comparable subject to the principle of adequate section 18.113: Sieker. in: Debat and proportional interference, Wassermeyer(eds ) Doppelbesteuerung. under comparable circumstances which means that when the sabkommen (Munchen: Beck Verlag 1999) will not always charge an identical authorities have the choice of rt. 9 Rz. 154: Baumhoff. in: Flick/ price, and based on number 1.45 of different measures, they must the oecd Transfer Pricing choose the measure that least AuBensteuerrecht(Koln: Dr. Otto Schmidt Guidelines, the Federal Tax Court interferes with the individual's Verlag, 1997, 2001), Sec. 1 AStG note 151 ccepted that price ranges can be rights. 17 ationalen, Bilateralen und europaischen used to determine an arm s-length Steuerrecht (Koln: Dr. Otto Schmid ce. The courts ruling Distribution Companies verlag 2001), pp 141 ff, 210, 311 ff.; O.H. with the regulations of other With losses sbesteuerung (Munchen: Beck Verlag countries14 and the comments in In a widely recognized8 1999), pp 868, 870; Portner, IWB Fach 10 the german tax literature. 15 decision, the Federal Tax Court 1993, pp 704 f: Theisen, Der konzern decided in 1993 that german Betriebswirtschaftliche und rechtliche Which Point in the range? distribution companies of foreign Grundlagen der Konzernunternehmung Once a determination is made groups should not incur losses for longer than three years Salzberger, IStR 1999, p. 97; Berger, in: arding the range of acceptable The Federal Tax Court has now im Internationalen Steuerrecht(Koln: prices, a question arises as to confirmed and refined that rule Otto Schmidt Verlag 1994), pp 151 ff. where in the range an adjustment Generally, a distribution company Borstell/Prick, IStR 1999, pp304 f. should be made to. when the taxpayers price is outside the should make an adequate profit within a foreseeable planning Internationalen Konzern(Frankfurt aM ange. The Federal Tax Court held period that should correspond to Kluwer Verlag 1976), pp 144 ff; Ritter, that an adjustment must be made the functions and risks assumed BB1988,pp.1677f to the most advantageous point for The court states that, at a I6 See OECd guidelines number 1.48 the taxpayer, which is either the minimum, the total profit should Kroppen, in: Becker/Kroppen high or low end of the range. The be oriented toward an appropriate court believes that there is no legal return on the invested capital, nungspreise(Koln: Dr. Otto basis for an adjustment to the mid- based on market interest rates Verlag, 1999), O number 7.30 point of the range. German Tax Kroppen/Rasch, IWB Fach 5 plus an appropriate risk mark-up. Niederlande Gruppe 2, pp 321 ff. Law does not provide for estimates to punish the taxpayer The tax authorities consider this Verrechnungspreise(Koln: Dr. Otto Schmidt Verlag. 1999). w note 77. Becker ortion of the decision critical. They IWB Fach 3 Gruppe 1, pp 1339; Baumhoff, are concerned that taxpayers may ose any price outside the 13Cf. Sec. 1.482-1(d)(3 ii) (A)and (C ht(Koln: Dr Otto schmid range without any risk of being umber 1. 19 and 2.13 of the OECD Guide- verlag, 1997, 2001), Sec. 1 AStG note 606. lines. clause 3.1. 1 of the German adminis- worse off following a transfer pricing trative principles of the income allocation 1 Federal Tax Court refIR 3/9 djustment that they would have ed companies, for been if they had tried to determine an English translation of the text see for an English transla poppen/Eigelshoven, Chapter Germany an arms-length price from the Tax Treatment of Transfer Pricing Tax Treatment of G outs et. Amsterdam 1987). ch. 8.2. (Amsterdam 1987). ch. 8.5. 1114·10 December2001 Tax Notes international
are supported in the literature, 12 and they are in accordance with the U.S. regulations, the OECD Guidelines, and the German administrative principles. 13 Ranges In its analysis of the pricing situation, the Tax Court tried to determine the correct transfer price. The Federal Tax Court criticized that approach, noting that rarely does a single correct transfer price actually exist. A transfer pricing analysis can only lead to a range of acceptable prices based on the available comparable data. Even independent parties, under comparable circumstances, will not always charge an identical price, and based on number 1.45 of the OECD Transfer Pricing Guidelines, the Federal Tax Court accepted that price ranges can be used to determine an arm’s-length price. The court’s ruling is in line with the regulations of other countries 14 and the comments in the German tax literature. 15 Which Point in the Range? Once a determination is made regarding the range of acceptable prices, a question arises as to where in the range an adjustment should be made to, when the taxpayer’s price is outside the range. The Federal Tax Court held that an adjustment must be made to the most advantageous point for the taxpayer, which is either the high or low end of the range. The court believes that there is no legal basis for an adjustment to the midpoint of the range. German Tax Law does not provide for estimates to punish the taxpayer. The tax authorities consider this portion of the decision critical. They are concerned that taxpayers may now choose any price outside the range without any risk of being worse off following a transfer pricing adjustment that they would have been if they had tried to determine an arm’s-length price from the outset. There are cogent arguments supporting the Federal Tax Court’s decision. If the taxpayer chooses a price within the range, the price is an arm’s-length price that cannot be adjusted. 16 The adjustment of a price, outside the range, to the midpoint of the range would violate the German legal principle that punishment is only permitted under criminal laws, but not tax laws. Furthermore, constitutional principles support the court’s view. The Tax Law significantly interferes with the rights of the individual. That interference is subject to the principle of adequate and proportional interference, which means that when the authorities have the choice of different measures, they must choose the measure that least interferes with the individual’s rights. 17 Distribution Companies With Losses In a widely recognized 18 decision, the Federal Tax Court 19 decided in 1993 that German distribution companies of foreign groups should not incur start-up losses for longer than three years. The Federal Tax Court has now confirmed and refined that rule. Generally, a distribution company should make an adequate profit within a foreseeable planning period that should correspond to the functions and risks assumed. The court states that, at a minimum, the total profit should be oriented toward an appropriate return on the invested capital, based on market interest rates, plus an appropriate risk mark-up. 1114 • 10 December 2001 Tax Notes International Special Reports 14The OECD member countries should accept the concept of an arm’s length range. See for example the new transfer pricing legislation in the Netherlands, which explicitly refers to the OECD Guidelines, for a detailed analysis see Kroppen/Rasch, IWB Fach 5 Niederlande Gruppe 2, pp. 321 ff. 15Becker, in: Becker/Kroppen (eds.) Handbuch Internationale Verrechnungspreise (Köln: Dr. Otto Schmidt Verlag, 1999), O number 1.45, note, 2 ff.; Becker, in: Becker/Höppner/ Grotherr/Kroppen (eds.), Doppelbesteuerungsabkommen (Herne/Berlin, NWB Verlag, 1997), Art. 9 note 167; Kroppen/Eigelshoven, Chapter Germany, in: Tax Treatment of Transfer Pricing (Amsterdam 1987), note 2.1.5; Schaumburg, Internationales Steuerrecht (Köln: Dr. Otto Schmidt Verlag, 1998), section 18.113; Sieker, in: Debatin/ Wassermeyer (eds.), Doppelbesteuerungsabkommen (München: Beck Verlag 1999), Art. 9 Rz. 154; Baumhoff, in: Flick/ Wassermeyer/Baumhoff (eds.), Außensteuerrecht (Köln: Dr. Otto Schmidt Verlag, 1997, 2001), Sec. 1 AStG note 151 ff.; Rasch, Konzernverrechnungspreise im nationalen, Bilateralen und Europäischen Steuerrecht, (Köln: Dr. Otto Schmidt Verlag 2001), pp. 141 ff., 210, 311 ff.; O.H. Jacobs, Internationale Unternehmensbesteuerung (München: Beck Verlag 1999), pp. 868, 870; Portner, IWB Fach 10, International, Gr. 2, pp. 863 ff.; Werra, DB 1993, pp. 704 f.; Theisen, Der Konzern. Betriebswirtschaftliche und rechtliche Grundlagen der Konzernunternehmung (Stuttgart: Poeschel 1991), pp. 315 ff.; Salzberger, IStR 1999, p. 97; Berger, in: Haarmann (ed.), Grenzen der Gestaltung im Internationalen Steuerrecht (Köln: Dr. Otto Schmidt Verlag 1994), pp. 151 ff.; Borstell/Prick, IStR 1999, pp. 304 ff.; Kumpf, Steuerliche Verrechnungspreise im Internationalen Konzern (Frankfurt a.M: Kluwer Verlag 1976), pp. 144 ff.; Ritter, BB 1988, pp. 1677 ff. 16See OECD guidelines number 1.48. 17See Kroppen, in: Becker/Kroppen (eds.) Handbuch Internationale Verrechnungspreise (Köln: Dr. Otto Schmidt Verlag, 1999), O number 7.30, note 7 ff.; Kroppen/Rasch, IWB Fach 5 Niederlande Gruppe 2, pp. 321 ff. 18See Kroppen, in: Becker/Kroppen (eds.) Handbuch Internationale Verrechnungspreise (Köln: Dr. Otto Schmidt Verlag, 1999), W note 77, Becker, IWB Fach 3 Gruppe 1, pp. 1339; Baumhoff, in: Flick/Wassermeyer/Baumhoff (eds.), Außensteuerrecht (Köln: Dr. Otto Schmidt Verlag, 1997, 2001), Sec. 1 AStG note 606. 19Federal Tax Court ref. I R 3/92, Federal Tax Bulletin 1993 part II, pp. 457; for an English translation of the text see Kroppen/Eigelshoven, Chapter Germany, in: Tax Treatment of Transfer Pricing (Amsterdam 1987), ch. 8.5. 13Cf. Sec. 1.482-1(d)(3)(ii)(A) and (C), number 1.19 and 2.13 of the OECD Guidelines, clause 3.1.1. of the German administrative principles of the income allocation of internationally related companies, for an English translation of the text see Kroppen/Eigelshoven, Chapter Germany, in: Tax Treatment of Transfer Pricing (Amsterdam 1987), ch. 8.2
epo The court further ruled that has turned that understanding different price. It's unsustainable when a distribution company has upside down. The court stated that that, under identical circumstances substantial losses for three years, even if the taxpayer's determina nd with the same pricing, an there is a presumption that the tion of the transfer prices was djustment would be possible just transfer prices are not at arms based on a standard method and because the results are different length. However, the taxpayer may the prices fall within a range of rebut that presumption by proving arms-length prices, the transfer Conclusion that the agreed transfer prices are prices may still have to be adjusted The Federal Tax Court has at arms length. For example, the if they do not lead to acceptable issued an important decision that taxpayer may be able to show will affect how transfer prices are mismanagement or that third party distributors also incurred The court's ruling permits the set in Germany. It will result in egislative measures because the long-lasting losses because of application of a profit-based difficult market conditions. If the determine a price. In fact, it uses a the impact of certain aspects of the taxpayer can rebut the presump- tion, losses will be accepted for a profit-based approach to supercede court's decision esults obtained by using a period longer than the three years. standard method and Because the Federal Tax Court es within has sent the case back to the Tax In defending audits, taxpayers the range Court. it remains to be seen how already try to analyze the reasons for their losses that are indepen A literal reading of the court's that court deals with some of the holding would allow an adjustment open issues. The most interesting dent from the transfer prices they. when a foreign manufacturer aspect will be the evidentiary used. The court has now recognized supplies products to several value the court gives to secret that practice as a valid audit unrelated and related distributors comparables. If the case is then in germany, under comparable appealed again, the Federal Tax The court also stated that if the circumstances for the same price if Court might get another opportu taxpayer is unsuccessful in proving the related distribution company nity to include this issue in its that the loss resulted from other makes losses. The court's position ruling reasons, the tax authorities cannot is unsupportable. If the situations be prevented from adjusting the are comparable, there is a strong prices, even in the first loss year, to presumption that the losses were achieve a total profit at the end of not caused by the pricing, but by the acceptable loss period. The other circumstances. Independent first year adjustment may not parties made profits with the same Min. See press release of the German nce dated 13 July 1995 d in IStR 1995, pp 384 result in a profit in the first year. price when the related party made punge istR 1995, pp 505 f and Tax losses at the same time Standard versus Profit Methods However the tax authorities 9(2001),no.18,pp.641f may still want to make an 2See number 3.54 OECD guidelines. The german tax authorities djustment under the facts. An Against this view Kroppen, in have always expressed strong adjustment is only acceptable if Becker/Kroppen(eds ) Handbuch reservations regarding profit they prove that the circumstances Dr. Otto Schmidt Verlag, 1999), w91 ff. based methods. Under the oeCd in both cases are not comparable guidelines, qualified profit-based An unrelated party under the Handbuch internationale methods are methods of last same circumstances as the related verrechnungspreise(Koln:Dr.Otto resort 21 The Federal Tax Court party would have negotiated a Schmidt verlag. 1999). W77 Tax Notes international 10 December2001·1115
The court further ruled that when a distribution company has substantial losses for three years, there is a presumption that the transfer prices are not at arm’s length. However, the taxpayer may rebut that presumption by proving that the agreed transfer prices are at arm’s length. For example, the taxpayer may be able to show mismanagement or that thirdparty distributors also incurred long-lasting losses because of difficult market conditions. If the taxpayer can rebut the presumption, losses will be accepted for a period longer than the three years. In defending audits, taxpayers already try to analyze the reasons for their losses that are independent from the transfer prices they used. The court has now recognized that practice as a valid audit defense. The court also stated that if the taxpayer is unsuccessful in proving that the loss resulted from other reasons, the tax authorities cannot be prevented from adjusting the prices, even in the first loss year, to achieve a total profit at the end of the acceptable loss period. The first year adjustment may not result in a profit in the first year. Standard Versus Profit Methods The German tax authorities have always expressed strong reservations regarding profitbased methods. 20 Under the OECD guidelines, qualified profit-based methods are methods of last resort. 21 The Federal Tax Court has turned that understanding upside down. The court stated that even if the taxpayer’s determination of the transfer prices was based on a standard method and the prices fall within a range of arm’s-length prices, the transfer prices may still have to be adjusted if they do not lead to acceptable profits. 22 The court’s ruling permits the application of a profit-based analysis or profit-based method to determine a price. In fact, it uses a profit-based approach to supercede results obtained by using a standard method and prices within the range. A literal reading of the court’s holding would allow an adjustment when a foreign manufacturer supplies products to several unrelated and related distributors in Germany, under comparable circumstances for the same price, if the related distribution company makes losses. The court’s position is unsupportable. If the situations are comparable, there is a strong presumption that the losses were not caused by the pricing, but by other circumstances. Independent parties made profits with the same price when the related party made losses at the same time. 23 However, the tax authorities may still want to make an adjustment under the facts. An adjustment is only acceptable if they prove that the circumstances in both cases are not comparable. An unrelated party under the same circumstances as the related party would have negotiated a different price. It’s unsustainable that, under identical circumstances and with the same pricing, an adjustment would be possible just because the results are different. Conclusion The Federal Tax Court has issued an important decision that will affect how transfer prices are set in Germany. It will result in legislative measures because the tax authorities will seek to limit the impact of certain aspects of the court’s decision. Because the Federal Tax Court has sent the case back to the Tax Court, it remains to be seen how that court deals with some of the open issues. The most interesting aspect will be the evidentiary value the court gives to secret comparables. If the case is then appealed again, the Federal Tax Court might get another opportunity to include this issue in its ruling. ✦ Tax Notes International 10 December 2001 • 1115 Special Reports 20See press release of the German Ministry of Finance dated 13 July 1995, published in IStR 1995, pp. 384; cf. also Runge, IStR 1995, pp. 505 ff. and Tax Management Transfer Pricing Report, Vol. 9 (2001), no. 18, pp. 641 ff. 21See number 3.54 OECD guidelines. 22Against this view Kroppen, in: Becker/Kroppen (eds.) Handbuch Internationale Verrechnungspreise (Köln: Dr. Otto Schmidt Verlag, 1999), W 91 ff. 23Kroppen, in: Becker/Kroppen (eds.) Handbuch Internationale Verrechnungspreise (Köln: Dr. Otto Schmidt Verlag, 1999), W 77
