As in the U.K., the United States, Australia, France, and several other countries, Germany has now enacted (for the first time) legislation which requires companies to document their transfer pricing arrangements. Specifically, Section 90(3) of the German General Tax Code ("GTC") sets forth the rule that taxpayers must sufficiently document their business relationships with foreign, affiliated companies.
The German Ministry of Finance has set forth specific documentation requirements, such as the content and scope of these requirements, in the so-called Profit Allocation and Documentation Regulation dated August 15, 2003 (the "PAD-Regulation"). The PAD-Regulation applies to companies whose fiscal year begins after December 31, 2002, but fines and other penalties for breach of the PAD-Regulation can only be imposed for fiscal years beginning after December 31, 2003.
If a company’s fiscal year is not a calendar year, then the company will be subject to the transfer pricing documentation requirements as of the beginning of such fiscal year (beginning in 2003). However, fines and penalties may only be levied as of January 1, 2004. There are specific documentation requirements that apply to long-term contracts entered into prior to December 31, 2002.
As will be discussed, many companies will soon be required to have proper and sufficient transfer pricing documentation in place. The documentation which had been prepared to date will not suffice for future purposes.
B. The Current Situation
In its seminal decision of October 17, 2001, the Supreme Tax Court of Germany (Bundesgerichtshof), in contradiction to the view of the tax authorities, held that a taxpayer is not required to prepare documentation regarding intragroup business transactions, except as may be specifically set forth in Germany’s commercial and tax laws. To date, however, neither Germany’s Commercial Code nor its Tax Code have included any documentation requirements for cross-border intra-group transactions.
Nevertheless, German law requires taxpayers to cooperate with the authorities if a particular transaction should come under scrutiny as part of an offered investigation. If the taxpayer fails to cooperate, the burden of proof imposed on the Finance Ministry is reduced and it is authorized to make certain assumptions, with the proviso that these assumptions must reflect the most likely scenario. Such assumptions often led to the Ministry of Finance "correcting" unreasonable transfer pricing. That, in turn, resulted in constructive dividends. In essence, if the tax authorities concluded that certain prices were unreasonably too high or too low, they were authorized to make certain assumptions which were not necessarily in line with the position taken by the taxpayer.
These rules of practice did not, however, address the issue of what price the tax authorities were permitted to set when correcting a taxpayer’s original pricing. Since taxpayers had not been required to keep any records or documents as to how they had determined if their transfer prices were reasonable, it was left to the tax administration to assume this burden.
This was effectively the backdrop to the enactment of these latest provisions, notably Sections 90(3), 162(3) and (4) GTC, provisions which essentially seek to override the impact of the Supreme Tax Court’s decision.
Section 90(3) GTC sets forth the specific, operative record-keeping obligations imposed on taxpayers conducting intra-group business crossborder. The actual consequences for failing to cooperate sufficiently with the tax authorities are covered in Sections 162(3) and (4) GTC. In short, the latter confer on the tax authorities the right to exercise expanded presumptions (Section 162(3) GTC) and then impose fines of up to EUR 1 million in appropriate cases (Section 162(4) GTC).
C. The New Situation
I. Applicability of the Documentation Obligations
To the extent they conduct business with foreign affiliated entities as described in Section 1(2) of the Foreign Tax Act, taxpayers will be required to maintain sufficient records regarding these business relationships. As a result, all international business dealings among a group of companies will be subject to the new recordkeeping obligations. Interestingly, these provisions will not apply to purely domestic transactions.
Pursuant to the new definition as set forth in Section 1(4) of the Foreign Tax Act, "business relationships" constitute all contractual arrangements (i) that are not based on company law; and (ii) that will lead to income for one of the parties within the meaning of Sections 13, 15 and 18 of the German Income Tax Act.
II. Type, Content and Reach of Documentation Obligations
Section 1 of the PAD-Regulation sets forth the statutory obligation of the taxpayer to prepare documentation regarding the circumstances surrounding a transaction, as well as documentation regarding the reasonableness of the pricing used. Section 1 of the PAD-Regulation continues by requiring taxpayers to present this documentation to the tax authorities if requested. It is important that the taxpayer be able to present evidence that it has undertaken a good-faith effort to observe arm’s-length principles when it made its transfer pricing calculations. Furthermore, Section 1 of the PAD-Regulation extends the record-keeping obligations to business transactions that are not performance-oriented, e.g., allocation and pooling agreements or the secondment of employees to affiliated companies.
In addition, the taxpayer must be able to present — at its own cost — details on market conditions, as well as information regarding competitors, which should also include comparative information. The crux of the obligation is to compile comparative pricing for the sale of goods, the provision of services, financings, and the licensing of intellectual property. Both the financial calculations and the contractual arrangements need to be documented. Companies may also wish to maintain information regarding the relevant business conditions and their profit margins.
Up to now, at least from a bookkeeping perspective, taxpayers were only required to document their business transactions. However, under these new rules, taxpayers will also be required to document why they reached certain transfer pricing decisions. This will essentially require a taxpayer to justify its subjective decisions by external objective information. It is important to note that this information cannot merely be gathered by a member of the company’s tax department; rather, management, the legal department, pertinent operational departments (e.g., marketing, sales and the controller), and perhaps even external consultants will have to become involved. As can well be imagined, most corporate tax departments do not presently have a budget for such additional costs.
III. Extent and Duration of Documentation Obligations
The PAD-Regulation includes not only the above-discussed compilation and presentation requirements, as well as the requirement to collect and maintain comparative information, but taxpayers are also now required to prepare (and possibly present) information on to how they actually determined their prices. Section 4 of the PAD-Regulation sets forth the so-called "mandatory records" which taxpayers must compile. For example, taxpayers are required to list their holdings in other entities, as well as the structure of the organization, the subsidiaries and business dealings with affiliated companies. In addition, the function, risks and transfer pricing analyses must be prepared.
Unless otherwise provided in the law, the documentation for regular intra-group transactions must always be kept current. The records for extraordinary inter-company transactions must be prepared within six months of any agreement to enter into such a transaction. Extraordinary transactions include, in particular, the transfer of property in connection with a reorganization, material changes to corporate functions and risks, intra-group transactions which are a significant change to the corporate strategy for transfer- pricing purposes, and the consummation and amendment of material long-term contracts.
As an alternative to the individual documentation requirement for each intercompany transaction, taxpayers may also prepare so-called transfer pricing codes of conduct that will mandate that reasonable transfer prices (as set forth therein) be binding on an entire group of companies.
If the tax authorities request the documentation, the taxpayer must present it within 60 days of the request being made.
IV. Legal Consequences for the Violation of the Documentation Obligations
The violation of the above obligations will result in a rebuttable constructive dividend being added to the taxpayer’s income and, in accordance with Section 162(3) GTC, will afford the tax authorities greater leeway in making certain assumptions. Furthermore, a breach of these obligations can subject an entity to considerable penalties (Section 163(4) GTC).
If a taxpayer is not able to present sufficient documentation as set forth above, there will be a rebuttable presumption in favor of the tax authorities that the domestic taxable income is higher than declared. The authorities may then exercise their rights of assumption if the taxpayer is unable to rebut the presumption that the transfer pricing was not set in observance of arm’s-length principles.
In addition to a correction to the transfer pricing, Section 162(4) GTC also provides for various fines if the taxpayer is not able to satisfy the documentation obligations. The statute calls for a minimum fine of EUR 5,000 if the required records are either not submitted or are found to be insufficient. Additionally, if the tax authorities correct the transfer pricing pursuant to Section 162(3) GTC, then an additional penalty of 5% - 10% of the increase in income will be levied. The maximum fine is EUR 1 million for an untimely submission of the requisite documentation.
The documentation obligations also apply to permanent establishments as well as to partnerships. But the PAD-Regulation does not apply to SME’s whose income for the intra-group provision of goods does not exceed EUR 5 million or whose other services does not exceed EUR 0,5 million (Section 6 PAD-Regulation).
V. Could these Sanctions Violate European Law?
The documentation requirements, and the sanctions for the breach of same, apply exclusively to cross-border transactions. As a result, one could argue that these new statutory provisions violate Article 43 of the EC Treaty with respect to the "freedom of establishment", as they impose on discriminatory burden. It remains to be seen how Germany will defend its position under European law and justify imposing these documentation requirements, the effected presumptions of the tax authorities’ and the fines to be imposed on purely international transactions.
D. Summary (and a Look into the Future)
It is inevitable that disputes will arise with the tax authorities. As a result, the latter will not only need to concern themselves with the documentation requirements, but also with any resulting price corrections and penalties. The new documentation requirements for any transfer pricing constitute an administrative act that will certainly be subject to objections. Further, taxpayers can — and it is perhaps advisable that they should — file objections against any notifications that state that the tax authorities have made certain assumptions in accordance with Section 162(3) GTC and/or that they impose penalties pursuant to Section 162(4) GTC.
Unfortunately, Germany has once again lost some of its luster as an attractive investment site as a result of ill-timed and burdensome tax requirements. These new documentation requirements will likely generate a concern analyst amongst investors that, in the future, taxpayers will be responsible for doing the tax authorities’ work, and at the taxpayer’s cost! In deed, global multinationals will be required to satisfy "competing" documentation requirements simultaneously in several countries. And it will become more and more likely that various jurisdictions will assume that taxable profits have been transferred to a different jurisdiction, with greater and greater uncertainty and competing demands for tax receipts, and hence more costs to taxpayers to ensure compliance and do battle to avoid double taxation.
The bottom line, however, is that if a company is not able to satisfy the German tax authorities that it has sufficient records to justify its reasonable transfer pricing, it is possible that it will soon face severe penalties.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.