JANUARY/FEBRUARY 2004 the Administrative Principles. Under the Administrative ferent measures. In addition to the arms length standard, Principles 1983, the allocation provisions of German tax the deductibility of a payment is contingent upon its beir law are also applicable in those cases of related interests based on contractual agreements that were entered into in that are not covered by the allocation provisions of Ger- advance, in clear and unambiguous terms. This condition man tax treaties. 4 The Administrative Principles argue is based on jurisprudence developed by the Federal Tax that it would be inconsistent with the meaning and purpose Court in the context of business relationships between of tax treaties if income adjustments required in a particu- individuals belonging to the same family, and was later lar case were prevented by an applicable treaty. However, expanded to cover payments made to controlling share if this view were correct, Art. 9 would have no legal effect holders. It basically turns out to be an anti-avoidance because domestic law would set forth rules on how to allo- measure and is designed to prevent a group of related tax intent of tax treaties tage by using the benefit of hindsight. 8 As a consequence Tax auditors often see a difference between the standard of the courts have adjusted income even if the transactions the prudent business manager and the arm's length princi- have been at arms length ple, especially when a company incurs losses over several As these additional measures are treated as sub-criteria of years.Moreover, there is a difference in the formal the arm's length principle, one must distinguish between requirements of the two standards. As mentioned above it formal and substantive sub-criteria. The formal sub-crite- is necessary under domestic law to have clear and unam- rion requires that contractual agreements be entered into in biguous agreements in advance. This seems not to be in advance in clear and unambiguous terms The substantive line with Art. 9 of the OECD Model Treaty and most of the sub-criteria look to the"seriousness"(Ernstlichkeit)20 of German treaties that follow Art. 9 of the OECD Model the agreement, the actual performance of the agreement Treaty. In contrast to the German interpretation of the and the consideration to determine whether the transaction arms length principle, Art. 9 only requires that the prices is in line with common practice(Ublichkeit). 2I be charged at arm's length, regardless of the formality(or lack thereof) of the agreements 3.3. Applicability of the sub-criteria under Art. 9 of D Model Treaty 3. 2. Arm's length principle under German tax law In the authors'opinion, it is not helpful to make use of 3. 2.1. Prudent business manager standard these sub-criteria because, for example the consideration For almost 30 years the courts have based the decision of of whether a transaction is customary is not a reliable whether payments made between related parties are yardstick in determining the appropriate transfer price. In so-called prudent business manager standard I5 Much dis Therefore, transactions that seem to be unusual because cussion can be found in the tax literature regarding they are not entered into regularly or are performed for the whether this test could be consistent with the internation first time should not a priori be treated as not being in line tion of other countries and in income tax treaties as well with the arm's length principle as in another German allocation provision, namely Sec. 1 Moreover, Art. 9 of the OECD Model Treaty provides that of the Foreign Tax Code. The main argument was that the the arms length principle is subject to conditions"made' prudent business manager standard, which was developed or "imposed"between two associated enterprises. It is 1967, 6 is a one-sided approach, investigating only therefore only decisive whether services are rendered to whether a"prudent and diligent business manager"of the the benefit of the recipient and if so, whether the consider company would have agreed to the transaction. This approach fails to take into account the view of the other 13. Decree of the fed party to the transaction, which is significant because the ry of Finance, 23 February 1983, BMF 5 S1341-4/83, Federal Tax Bulletin 1983 I, at 218. For an English translation negotiation process of a transaction is basically shaped by see Kroppen and Eigelshoven, the Germany chapter in Tax Treatment of Trans- the conflicting interests of both parties to the transaction. 7 yer Pricing (Amsterdam: IBFD Publications BV, loose-leaf), June 2002, at 8.2 The Federal Tax Court recognized this problem and intro- 15. For a detailed analysis, see Kroppen, Roeder and Eigel duced the standard of the so-called doubly prudent busi- Pricing Intermational: A Country-by-Country Guide,ed.Robert Feinschreiber ness manager, which standard looks to both parties to a (2nd ed. )(New York: John Wiley, 2002), Sec. 24 transaction. As a result, it is widely accepted that in gen- 16. Sce the decision of the Federal Tax Court, 16 March 1967. BStBL 1967 IIL. eral the latter standard is in line with the internationa at b sor a detailed analysis, see Kroppen, in Handbuch Internationale Verrech- arms length principle Cologne: Verlag Dr. Otto-Schmidt Der Betrieb 1994 at 1105: Rasch. kon 3.2.2. Additional criteria under the german arm's length 18. See Federal Tax Court, 26 April 1989, BStBI. II 1989, at 673 Although there is a consensus that the doubly prudent 19. See e. g. Federal Tax Court, 12 October 1995, BFH/NV 1996, at 266 business manager test is basically in line with Art. 9 of the 21. See e.g. Federal Tax Court. 13 July 1994, BFH/NV 1995. at 548t622 LO. See e.g. Federal Tax Court, 13 November 1996. BFH/NV 1997, OECD Model Treaty, German case law on the application 22. For a detailed analysis, see Kroppen, in Handbuch Internationale Verrech of the arms length principle provides for a number of dif- gspreise, eds. Becker and K poppen( Cologne: Verlag Dr. Otto-Schmid 2004 international Bureau of Fiscal Documentation