: Transfer Pricing in Germany Dr. Heinz-Klaus Kroppen, LLM Axel Eigeshoven .r. Achim Roeder,ma Extract from: Feinschreiber, Robert: Transfer Pricing International: A-Country-by-Country Guide, New York 2000 CHAPTER 24 Germany Heinz-Klaus Kroppen Axel Eigelshoven Achim Roeder 24.1 Introduction (a) U.S.Impact (b)German Tax Audits ()Arbitration and Tax Changes 24.2 Provisions for the Determination of Transfer Prices (a)Administrative Principles for Transfer Prices (b)Hidden Profit Distributions (c) Hidden Capital Contribution (d) Section 1 of the Foreign Tax Code (e) Article 9 of the Tax Treaties 24.3 Relevant Principles to Derive the Arm's Length Price (a) Comparability Analysis (b) Contractual Relationship as a Starting Point (c)Range of Prices (d) Aggregation of Transactions and Multiple-Year Analysis 24.4 Acceptable Methods in Germany (a)Standard Methods ndaro (b) Transactional Net Margin Method/Comparable Profit Method (c)Profit Split Method (d)Choice of Methods 24.5 Practical Areas of the Application of Transfer Pricing Rules () Distribution Companies (b) Contract Manufacturing (c) Provision of Services 24-1
Germany (d) Transfer and Use of Intangibles (e) Cost Sharing Agreements 24.6 Documentation (a) Prior Approaches (b) Standard Questionnaire (c) Audit Respons 24.7 Unilateral Rulings and Advance Pricing agreements (a) Basic Issues (b) Advance Pricing Agreement Administration 24.1 INTRODUCTION Transfer pricing is now becoming one of the main tax issues, if not the predom- inant tax issue of multinational enterprises operating in Germany. This develop ment is being driven by the german tax authorities who are focusing on transfer prices in almost every tax audit of a multinational enterprise. The tax auditors of- ten believe that profits are shifted artificially abroad due to the high tax rates in Ger- many, but the development of transfer pricing in Germany must also be seen in ar international context (a) U.S. Impact The increasing attention German tax auditors have given to transfer pricing started after the release of the final U.S. Regulations in 1994. After the release of the U.S. Regulations, many European countries adopted a similar regulatory framework and increased pressure on multinational companies by introducing doc umentation requirements, penalties and by shifting the burden of proof to the tax payer. In Europe, Germany is one of the last major Organization for Economic Co- operation and Development(OECD)members that has not changed its transfer pricing regime in the last two or three years Thus, from a regulatory point of view, Germany fell behind countries like the United Kingdom, France, Belgium, and Denmark. The German Ministry of Finance has finally started its review of the 1983 administrative principles" in earnest after some standstill due to the withdrawal of experienced staff in the wake of German reunification. Meanwhile, the Ministry has issued a new version of the regulations covering cost sharing agreements. It is widely believed that a complete overhaul of the regulations by the German Ministry of Finance will follow in due course Some parts of this article are extracted from Kroppen/Eigelshoven, in I BFD, Tax. Treatment of Transfer Pric- ing, Germany 'Decree of the Federal Ministry of Finance dated February 23, 1983, BStB1 I 1983, p: 218, see Kroppen/Eigelshoven, in: IBFD: Tax Treatment of Transfer Pricing, Germany, pp 102 ff. for an English translation. SCf. Transfer Pricing Report, March 13, 1996, p. 732 Decree of the Federal Ministry of Finance, December 30, 1999 Cf. Transfer Pricing Report, November 27, 1997, p 465
24.2 Provisions for the determination of Transfer prices 24-3 (b German Tax Audit Issues At the same time, the German tax authorities'audit staff is increasingly becom- ing more aware and sophisticated as relates to transfer pricing matters. For exam- ple, in the mid 1990s, the German tax authorities started to improve the audit staff's transfer pricing training. Some senior tax inspectors recently announced that audits will focus on transfer pricing in the future Another recent development is the increasing aggressiveness of the tax audit staff, who are less prepared to negotiate audit results and increasingly are willing to test their position in the tax courts instead. The aim of this strategy is to use court rulings to establish a dense regulatory framework and precedent for their audit work. The auditors are encouraged by tax court decisions that in the past have re- sulted in sweeping judgments against taxpayers; for example, the Federal Tax Court ruled that distribution companies should in general not incur losses longer (c) Arbitration and Tax Changes a The taxpayer is well advised to find a solution through competent authorities and itration procedures instead of the court proceedings. Especially in Europe, arbitration procedure has proven to be a very powerful tool to avoid double taxa tion. Even the existence of the arbitration procedure is often very fruitful to achiev ng a solution at the audit level. It is not likely that the pressure on the taxpayer will decrease after the govern- ments tax reform plans will be implemented in 2001. However, the new legisla- tion will reduce the incentive for the taxpayer to shift profits abroad. According to the German government, it plans to reduce the effective tax rates from 56 percent in 1998 to about 39 percent beginning in 2001. The reduction in taxes will be fi nanced through a broader tax base. This regulatory framework will probably be ac- companied by increased audit activity. Thus, transfer pricing will remain a main concern of the taxpayer. 24.2 PROVISIONS FOR THE DETERMINATION OF TRANSFER PRICES (a) Administrative Principles for Transfer Prices The German Tax Administration issued guidelines in 1983 desig narize the principles governing the allocation of income between internationally related taxpayers under the provisions contained in Germany's domestic and treaty law. The administrative principles were intended to outline the view of the Kuckhoff/Schreiber, Verrechnung spreise in der Betriebspriifung, Munich: Beck, 1997, P. 8 See Federal Tax Court, February 17, 1993, BStBl. 1993, p. 457 ates are based on nondistributed profits, including municipal trade tax and solidarity surcharge, see press of the Federal Ministry of Finance, December 21, 1999
German tax authorities and to provide tax auditors with guidance on the exami- nation of cross-border transactions. Compared to the 1994 U.S. Regulations and the 1995 OECD Guidelines, the German administrative principles are less com- prehensive, but these principles still provide the taxpayer with helpful guidance Though taxpayers follow the administrative principles in order to receive legal ertainty, they are binding on neither the taxpayer nor on the tax courts, but only on the tax administration Hidden Profit Distributions The most frequently used provision to adjust income in Germany is section, 8 paragraph 3, sentence 2, of the Corporation Tax Code. This provision determines that"hidden profit distributions(verdeckte Gewinnausschuittung) should not de- crease the income of a corporation. "Thus, section 8 of the Corporation Tax Code distinguishes between payments made based on contractual agreements and those based on the shareholder relationship. However, section 8 of the Corporation Tax Code does not provide for a definition or a further explanation. Instead, the tax courts have defined what is deemed to be a dividend by this provision. G Prudent Business Manager Standard. From an intemational tax per- spective, it would have been obvious to use the arm,'s length standard to evaluate whether the company would have agreed to the same conditions if it had dealt with unrelated parties. However, section 8 of the Corporation Tax Code historically fo- cused on domestic aspects. The courts developed the so-called prudent business manager standard, which is derived from German commercial law. Under this standard, an income adjustment is justified if a prudent business manager--in deal ing with a nonaffiliated person-would not have agreed to the conditions of the In the past, practitioners discussed whether the prudent business manager stan- dard is different from the arm's length principle. Practitioners argued that the pru- dent business manager standard is a one-sided approach, in that it focuses only on the question of whether the business manager of the corporation would have agreed to the conditions of the transaction. The question of whether the other party to the transaction would have adhered to such conditions was not considered Gii) Arms Length Criteria Distinguished. The prudent manager standard is very different from the arm's length principle, which ideally looks at both sides of a contract This difference in approach became obvious when the federal tax court ruled that a prudent business manager would not accept losses for more than 9See, for example, Federal Tax Court, February 2, 1989, BStB 1. II 1989, p 522; Federal Tax Court,December 1995,BStB1.m1996,p. iOSee, for example, Federal Tax Court, February 11, 1987, BStBl I 1987, p. 461; Lower Tax Court of Hessen October 17, 1988, EFG 1989, P. 200
24.2 Provisions for the determination of Transfer Prices 24-5 three years. The taxpayer provided evidence that a third party bought the same products for the same price, but the court did not analyze this transaction, arguing that it would have been irrelevant for the intercompany transaction in the light of the loss situation However, recent court rulings indicate that the federal tax court now seems to have changed its view. In these more recent rulings, the tax court elaborated the prudent business manager concept in such a way that the conditions of a transac tion would have to be agreed upon by two prudent business managers with oppos- ing interest. 2 This is now called the theory of the doubled prudent business man- nger, meaning that there are two business managers facing each other in a transaction (ii Eliminating the Distinction. Based on this most recent tax court rul- ng, it now appears that the substance of section 8 of the Corporation Tax Code is identical to the intermational standard. however, there is still a decisive difference in formality standards. In addition to the arms length test, the deductibility of a payment requires that it is based on contractual agreements that were entered into in advance, in clear and unambiguous terms. This condition is based on jurispru- dence developed by the Federal Tax Court in the context of business relationships between individuals belonging to the same family. This relationship standard was later expanded to cover payments made to controlling shareholders The relationship standard basically amounts to an antiavoidance measure. As such, it is designed to prevent a group of related taxpayers from rearranging their have adjusted the income even if the transactions have been at arm's lengtourts tax situations to their advantage using the benefit of hindsight. Thus, the (e) Hidden Capital Contribution The rules governing hidden capital contributions are found in section 4, para- graph 1, of the Income Tax Code in conjunction with section 8, paragraph 1, of the Corporation Tax Code. A hidden capital contribution(verdeckte Einlage)can be as- sumed if a shareholder or a related party of the shareholder makes a contribution to the corporation without proper consideration and the reason for this contribution can be found only in the shareholder relationship Like the principles that apply to hidden profit distributions, the rules governing hidden capital contributions were developed by jurisprudence ISee Federal Tax Court, February 17, 1993 Federal Tax Court, May 17, 1995, BStB1. II 1996, P. 204; Federal Tax Court, December 6, 1995, BStBl.II 1996,p.383 poppen, in: Becker/Kroppen(eds ) Handbuch In rechnungspreise, Cologne: Schmidt, 1999,n. w97: Baumhoff, in: FS Flick, pp 633 ff. Wassermeyer, DB 1994, pp. 110 ff.; Becker, DB 1996, 14See Federal Tax Court, April 26, 1989, BStB1. I 1989, p 673 See, for example, Federal Tax Court, October 12, 1995, BFH/NV 1996, p. 266