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1.1 Present German Transfer Pricing Policy 1.2 Future German Transfer Pricing Policy 1.3 APAs In Germany 1.4 German Transfer Pricing Case Law Formal Requirements Domestic Marketing Subsidiary 1.5 German Administrative Principles: Selected Topics General Characterisation Standard Method Offsets Costs Of Advertising And Market Penetration Costs Of Defending Or Expanding Market Share Inter-Company Loans, Administrative Services, Intangibles, Cost Sharing Procedural Matters
THE GERMAN POSITION
1.1 Present German Transfer Pricing Policy
The German transfer pricing policy is based on the arm's length standard and set forth primarily in a directive issued by the Ministry of Finance on 23 February 1983. The directive has not been changed since its issuance. A complete English translation exists in Bellstedt, International Transactions Tax Act and Administration Principles on Income Allocation, 4th revised edition, Otto Schmidt, Cologne, 1994. As printed in this dual language (German/English) edition, the directive is some 45 pages in length. The present directive applies by its terms only to transfer pricing between related parties and does not address the controversial issue of allocation of income and expense between a permanent establishment and its headquarters or head office.
The legal bases of transfer pricing adjustments is found, for corporations, in the German doctrine of constructive dividends and constructive contributions to capital, and, subsidiary thereto, in sec. 1 AStG (Foreign Transactions Tax Act). In particular the tax effect of an adjustment treated as a constructive dividend can be very different from a simple increase in taxable income (see German News no. 4/95 p. 9 ff. = Art. no. 39 for a basic discussion of constructive dividends).
1.2 Future German Transfer Pricing Policy
The German tax authorities indicated as early as two years ago that they plan to withdraw the current directive and issue revised transfer pricing guidelines. This is currently not anticipated until 1997 at the earliest. While opinions within the Ministry of Finance are thought to differ on certain points, there is at present no indication that major changes in the current Administrative Principles are planned. The German negotiating position in the OECD deliberations likewise gave no indication that the Ministry of Finance regards the current directive as seriously defective in any area.
The revised Administrative Principles are in particular not expected to recognise the controversial profit-oriented OECD income determination methods (transactional net margin method, profit split method). Simultaneously with the release of the first five chapters of the OECD Guidelines, the Ministry of Finance issued a formal press statement declaring that "since the Federal Republic of Germany considers the traditional methods to be adequate, it does not employ profit-oriented methods (in particular TNMM) except for purposes of verification [of another method] or estimation."
In the same press statement, the Ministry of Finance noted that penalties imposed without regard to fault were contrary to the German legal system.
Also underway is a new directive providing guidance on the allocation of income and expenses to permanent establishments. At least two drafts have been produced so far by the Ministry of Finance. Neither has been made public. It is difficult to estimate when the directive may be issued. Since the OECD has also indicated that it will take a position on this issue, it appears likely that Germany will await the OECD's paper before taking action of its own.
1.3 APAs In Germany
Directives issued by the Ministries of Finance of Baden-Wuerttemberg and Bavaria (dated 28 Nov. 1994 and 9 Jan. 1995 respectively) state that the German tax authorities can enter into advance pricing agreements and cooperate in connection with APA proceedings pending before a foreign tax administration. This represents a significant change in the attitude of the German tax authorities in that they previously refused to make transfer pricing the subject of advance rulings. The legal basis for German APAs is found in the existing directives issued by the tax authorities regarding binding private letter rulings in general (for unilateral APAs) and in the mutual agreement clauses of Germany's tax treaties (for bilateral APAs).
The German position on APAs may be summarised as follows:
1. Rulings equivalent to an APA are available. Germany is also willing to join in a foreign APA proceeding.
2. When cooperating in a foreign APA proceeding, Germany will probably either insist that all information supplied to the foreign tax authorities be made available to it as well or else be very cautious in accepting the results of the foreign APA.
3. Because of staff shortages, Germany will only become involved in unilateral or bilateral APA proceedings in exceptional cases. The directives do not indicate what cases will be considered exceptional. The fact that a foreign APA proceeding is pending will, however, apparently not constitute an automatic exception.
4. An APA issued by a foreign taxing authority will not bind Germany.
5. German tax auditors will routinely inquire whether a company under audit has concluded any APA's with other countries and review these so as to make sure that German tax revenue has not been diminished in a manner inconsistent with the arm's length rule as articulated in the German's 1983 Administrative Principles.
German tax officials have made remarks in public to the effect that German disagreement with a foreign APA secured without German participation may cause the German tax authorities to deny support to the taxpayer in any mutual agreement proceeding initiated to avoid double taxation.
Procedurally, authority to issue an APA rests with the local tax office with jurisdiction over the taxpayer, not with a central national office. Local tax offices have instructions to consult with regional and national offices in suitable cases and to by all means ensure that the local audit personnel is involved. Since bilateral APAs have their legal foundation in tax treaty law, they may be initiated by application to the competent authority under the treaty, i.e. the Federal Ministry of Finance.
1.4 German Transfer Pricing Case Law
There is little German transfer pricing case law since most transfer pricing disputes are settled in negotiations with the tax authorities at the time of tax audits. We wish to call attention to two basic concepts developed out of the case law.
A deduction for expense incurred in favour of a related party will only be accepted for tax purposes if, in addition to being in accordance with the arm's length principle, the expense is incurred pursuant to a clear and unequivocal agreement entered into in advance of the transaction in question (cf. Admin. Principles par. 1.4.1). Written form is highly advisable for such agreements, as otherwise there may be evidentiary difficulties. An agreement entered into may also be disregarded if performance of the agreement is not in accordance with the terms thereof. Lastly, it follows from the requirement that the agreement be entered into in advance that no retroactive effect will be recognised for tax purposes.
Domestic Marketing Subsidiary
What may be called the leading German case on transfer pricing (BFH BStBl II 1993, 457 - 17/02/1993) was decided over three years ago by Germany's highest tax court. The case dealt with the failure of a domestic marketing subsidiary to earn a profit, in part because it had assumed advertising costs in connection with introduction of the parent company's products on the German market. The court held that a reasonable businessman would only agree to market the products of another if a conservative marketing analysis conducted in advance indicated that he would earn a reasonable overall profit within a foreseeable period, taking account of the anticipated market development. Applying this arm's length standard to a domestic marketing subsidiary, the court in effect held that the subsidiary must prepare an advance market analysis and long-term budget and sales planning based on sound business administration principles which indicated that the subsidiary would enter the profit zone after a start-up loss phase which should generally not exceed three years. The court did not say how soon a marketing subsidiary should turn an overall profit, but a window of 5 - 7 years is thought to be reasonable, depending on specific circumstances. The court also did not say how to determine what profit was reasonable. Absent unforeseen events resulting in considerable non-budgeted cost, the subsidiary was, however, expected to perform as budgeted.
The decision compels taxpayers to confront the transfer pricing issue at the outset of their marketing activities. Specifically:
- Advance market analysis and budget planning must be prepared;
- This planning must indicate a limited start-up loss phase and forecast a reasonable overall profit within the foreseeable future;
- Advertising and market introduction expense must be assumed by the parent to the extent necessary to show an acceptable result in the long-range budget planning.
It remains possible to show that unforeseen circumstances prevented the subsidiary from earning the expected profit. Furthermore, the decision has to be applied on a product or product line basis. Obviously, when a marketing subsidiary adds a new product line after commencing some years before with an initial product, the budget planning and start-up loss phase for the new product line can cause the company to remain in the loss zone overall, even though the original forecast, based on the initial product only, had indicated an earlier end to start-up losses.
1.5 German Administrative Principles: Selected Topics
The current German Administrative Principles are general in nature and recognise the need for intelligent application in light of the circumstances of a particular case (par. 1.1.4). They stand firmly on the basis of the arm's length principle (par. 2.1.1) and are intended to guide the taxpayer and the tax authorities in applying this principle. They seek to employ a "reasonable businessman" standard, recognising that sound business discretion is implicit therein (par. 2.1.8) and seeking only to prevent relatively clear abuse of such discretion (par. 2.1.9). They establish no order of priority among transfer pricing methods, permit a mixture of methods, and direct the tax authorities to base their examination on the method used by the taxpayer (par. 2.4.1, 2.4.2). The standard of review is whether the taxpayer's transfer price structure is "appropriate" (sachgerecht) and yields results of "reasonable precision" (hinreichende Genauigkeit) (par. 2.4.3). The taxpayer is not entitled to use methods which are in conflict with market conditions or for which he is unable to present "the required documentation" (par. 2.4.4). The concept of "required documentation" is, however, not further defined and hence left to the sound judgement of the taxpayer and the tax auditor. For exceptional cases involving transactions in which independent third parties would not have engaged at all or on a significantly different basis, "a reasonable division" of the income from the transactions is permitted (par. 2.4.6). While giving guidance with respect to certain types of transactions, the Administrative Principles purposefully leave much to the sound judgement of the taxpayer and the tax examiner and overall reflect the unstated conviction that the uniqueness of each transfer pricing situation makes overregulation counterproductive and scientific precision impossible. As remarked above, there is no evidence that the recent OECD debate has prompted the German tax authorities to alter their basic stance.
The Administrative principles define three standard methods which can be combined and refined as individual circumstances indicate:
- Comparable uncontrolled price method
- Resale price method
- Cost-plus method
Offsets are permitted, though only with respect to transactions in some way interconnected and subject to the conditions that the compensating advantage was agreed or incorporated in the disadvantageous transaction from the start and is realised within three years (par. 2.3). The German requirements on offsets are thus fairly strict in international comparison.
Costs Of Advertising And Market Penetration
The Administrative Guidelines are flexible as to the division of these costs depending on the anticipated benefit, but make clear that the domestic marketing subsidiary cannot be saddled with these costs without compensating advantage (par. 3.3, 3.4). Furthermore, the court decision discussed under sec. 1.4 above makes clear that these costs must not interfere with the subsidiary's prospects for an adequate middle-range overall profit.
Costs Of Defending Or Expanding Market Share
The Administrative Guidelines insist, somewhat illogically, that these costs "generally" be borne by the manufacturer. Here again, the German position is restrictive in international comparison.
Inter-Company Loans, Administrative Services, Intangibles, Cost Sharing
The Administrative Principles contain sections on each of these topics. With respect to administrative services, an attempt is made to distinguish services which benefit a group subsidiary, for which a charge may be made, from the general benefits of membership in an international group (Rueckhalt im Konzern), the exercise of the shareholder function, and overseeing/monitoring by the group parent in its own interest, charges for which are not accepted. Cost sharing arrangements (indirect charge methods) are allowed where charging on an individual basis is factually impossible. The only detailed record-keeping provisions in the directive relate to cost sharing arrangements (par. 7.4). An expert opinion by a German auditing company is allowed as an alternative to submission of certain cost-sharing documentation maintained abroad (par. 7.4.1).
Domestic taxpayers are required to cooperate with the tax authorities and submit the documentation which is required under the circumstances to verify the appropriateness of their transfer prices. Concerning information not within the taxpayer's direct control, the Administrative Guidelines state that the taxpayer is responsible for providing such material to the extent he had a reasonable opportunity to secure for himself the necessary rights thereto against third parties. In general, this is interpreted as requiring production of information controlled by foreign related parties (par. 9.1.3, 9.1.4). There are, however, no requirements for production of information in advance of audit. Failure to comply with the duty of cooperation entitles the tax authorities to estimate the tax owing. This is one context in which the transactional net margin method might be used (see sec. 1.2 above).
German courts have held that the tax authorities bear the burden of proof in transfer pricing disputes.
Germany has no penalty provisions specifically directed to transfer pricing controversies. Under general principles, penalties are only imposed for criminal conduct and for certain intentional or reckless tax misdemeanours.
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