Germany: 221. Transfer Pricing: Documentation Regs. Derailed By FTC Decision?

A slightly condensed version of this article will appear in the July/August edition of International Tax Review.

A decision handed down in early May 2001 by the Federal Tax Court (FTC) indicates that key provisions of Germany's proposed regulations on transfer pricing documentation requirements are devoid of legal foundation and therefore invalid (ruling of 10 May 2001 - I S 3/01 - DStR 2001, 985). Further delay in issuing final documentation regulations may now be expected as the Federal Ministry of Finance strives to assess the impact of the FTC decision on its transfer pricing policies.

Article no. 216 reported on the proposed transfer pricing documentation regulations that the Federal Ministry of Finance first issued in August 2000 and then revised in a confidential March 2001 version, which has still not been made public. The August 2000 version of the proposed regulations is the subject of this author's articles in the January and February 2001 issues of International Tax Review (pp. 38 and 17 respectively).

The new FTC decision is a summary interlocutory ruling on a motion to stay the collection of tax assessments, not a judgement on the merits. Furthermore, the ruling was handed down by the chief justice of the 1st Chamber of the FTC acting alone pursuant to statutory authority to decide requests for interim relief where the full chamber is not able to act with appropriate speed. Summary rulings do not carry the same weight as judgements on the merits, nor do rulings by a single justice have the same value as decisions by a full chamber of justices. This being said, the May 2001 ruling still sends a strong signal to the Federal Ministry of Finance that it needs to rethink its transfer pricing documentation strategy.

The case giving rise to the May 2001 ruling was reported on at the lower court level by the same author in article no. 177. The case poses a variety of interesting transfer pricing issues, including the permissibility of comparable profits methods or transactional net margin methods under German tax law and the admissibility of so-called "secret comparables" as evidence in transfer pricing litigation. As expected, the Federal Tax Court agreed to hear an appeal of this case. As an offshoot from the pending appeal, the taxpayer asked the FTC to block collection of tax based on the original assessment notices after the tax authorities ran out of patience and took steps to collect the tax, or at least to force the taxpayer to post bond for the full amount owing.

German law gives the taxpayer the right to have collection of tax stayed where there is "serious doubt" as to the legality of the assessment in question. The parties appear to have agreed that "serious doubt" was presented by the case in question. The tax authorities argued , however, that the taxpayer had itself caused the doubt by violating its compliance responsibilities under German tax law and was therefore not entitled to profit from its own wrongdoing. The court agreed with the tax authorities in principle, but held that the taxpayer had not breached any duties of cooperation because there was no legal basis for the compliance obligations alleged by the tax authorities. Hence, the FTC granted the requested stay of collection.

The crux of the FTC's May 2001 decision is its holding that the compliance obligations alleged by the tax authorities in fact do not exist. Specifically:

• The recordkeeping requirements applicable to German taxpayers are exhaustively stated by §§ 140 ff. of the Tax Procedure Act and §§ 238 ff. of the Commercial Code. Hence, the taxpayer's failure to produce any documentation in support of the prices paid on purchases from controlled parties breaches no duty of cooperation because the statutory provisions contain no special documentation requirements for transfer prices or constructive dividends.
• Under existing recordkeeping law, taxpayers are required merely to produce upon request whatever books and records actually exist. They are not required to create documentation specifically for transfer pricing purposes.
• The court's holding that taxpayers are not required to create documentation for transfer pricing purposes would appear to apply as well to taxpayer explanations of the method used in arriving at its transfer prices and to profit forecasts as to when taxpayers will turn an overall profit on their dealings with controlled parties.
• The court-developed doctrine of Beweisvorsorge ("ensuring the future availability of evidence") – one of the pillars supporting the proposed transfer pricing documentation regulations – requires only the preservation of existent evidence, not the creation of special documentation for transfer pricing purposes.
• A domestic subsidiary is generally not required to produce documentation showing how its foreign parent company calculated the prices charged to the subsidiary. Subsidiaries have no company law rights to parent company documents. While they can in theory bargain for a contractual right to such documentation, this is not the common practice of parties dealing with each other at arm's length, hence it may not be required of a controlled subsidiary. Access in fact to parent company documents likewise generally does not exist.
• In a passage which on first impression is difficult to understand, the court seems to say that taxpayers at most have an obligation to prepare documentation showing that payments made to related parties are in principle motivated by arm's length considerations, but that taxpayers are not required to assemble more detailed documentation defending the precise amount of such payments. When the court speaks of documents showing that related party dealings are motivated by arm's length considerations, one may conjecture that it is thinking of documents proving that exchanges of goods and services occur pursuant to clear agreements entered into in advance of the transactions to which they relate, hence to documentation of the contractual basis of such exchanges.
• Taxpayer failure to prepare special transfer pricing documentation in advance of a tax audit or upon request in a tax audit does not relieve the tax authorities of their burden of proof on the issue of what transfer prices are in fact appropriate, nor does it facilitate the assessment of tax on an estimated basis. While the court agrees that something akin to a reversal of the burden of proof can occur when the taxpayer breaches compliance obligations, the failure to prepare transfer pricing documentation does not constitute such a violation under the court's reading of current law.

Analysis of the impact that the May 2001 FTC ruling will have on Germany's proposed transfer pricing documentation regulations will be the subject of a later article. One should note, however, that § 147 (1) AO requires taxpayers to retain all documents having tax significance, and that the decision by the Münster Tax Court described in article no. 223 (judgement of 22 August 2000) indicates that the tax courts may be willing to require production for tax audit purposes of any potentially relevant documents that a taxpayer possesses in fact. Furthermore, the new electronic audit provisions will greatly facilitate tax authority access to such documents as a practical matter (see article no. 213 by same author). Moreover, a legislative reaction to the decision here reported on cannot be ruled out.