Transfer Prices

In its judgement establishing a principle of October 17th, 2001 (reference no. I R 103/00), the Federal Fiscal Court ruled that the increased duties of cooperation in foreign matters which are provided for in art. 90 sub-section 2 of the German Fiscal Code (AO) are not sufficient to impose the obligation on the taxpayer to prove the adequacy of his/her transfer prices within the meaning of the arm’s length principle. 

The legislator responded to this jurisdiction by inserting section 90 sub-section 3 AO for the 2003 assessment period. According to section 90 sub-section 3 AO, the taxpayers have to create records regarding foreign business relationships with related persons within the meaning of section 1 sub-section 2 AStG.  

The legal definition of a related person has been expanded significantly by the legislator over many years. This aimed at forcing the biggest possible number of companies to document the determination of their transfer prices. Today, both affiliated companies and business establishments can be related persons. According to section 1 sub-section 2 AStG (2018), everydirect or indirectshareholding in the foreign legal entity or the foreign business establishment (in this case, typically a 100% “shareholding”) of, at least, 25% has to be qualified as being related (section 1 sub-section 2 number 1 AStG). Further cases concern third-party shareholdings in unrelated companies which are essential for the external third party, i.e. which reach a shareholding of, at least, 25%. If the external third party’s shareholding in the two companies does not reach the essential shareholding level of 25% but the third party still directly or indirectly exercises dominating influenceon them (section 1 sub-section 2 number 2 AStG), these companies are nonetheless treated as related persons and must comply with the provisions regarding the documentation of transfer prices. Finally, the law also defines persons as being related independently of their direct or indirect shareholding in as far as a person can exercise influence outside this business relationship in agreeing the conditions of a business relationship (typically, contracts regarding the exchange of goods or services) on one or both companies - or if one of the companies has its own interest in obtaining the income of the other. 

As a result of this significant expansion of the legal definition of a related person, comprehensive transfer price documentations have to be kept because of factual and/or actual dependencies. If the company and its consultants do not recognise these obligations or if they do not recognise these in due time, they are at risk of considerable fines and even criminal tax proceedings (cf. below, legal consequences in case of violations).

According to section 1 sub-section 4 number 1 letter a) AStG, business relationships are individual or several connected business transactions between a taxpayer and a related person which are part of an activity to which sections 13, 15, 18 or 21 EStG are applicable. In other words, this concerns the exchange of goods and services from agriculture and forestry, from commercial and freelance enterprises as well as leasing and letting. Moreover, according to letter b) of section 1 sub-section 4 number 1 AStG, every commercial transaction between a taxpayer and an affiliated person which is not based on a shareholder agreement is considered a business transaction. 

According to section 1 sub-section 4 number 2 AStG, business relationships also include business transactions between a company of a taxpayer and his/her business establishment located in another country (or fictitious relationships to be assumed under the law of obligations). 

Moreover, the term business relationship is supplemented by a statutory assumption in sentence 2 of section 1 sub-section 4 AStG. The legal assumption presumes that if a business relationship is not based on an agreement under the law of obligations, proper and conscientious business managers who are independent from each other would have made agreements under the law of obligations. However, in individual cases, this legal assumption can be refuted by the taxpayer.

Section 1 sub-section 3 AStG provides for a priorityof the methods to determine arm’s length values or a corridor of arm’s length values to determine the transfer price.

If arm’s length values which can be compared without restrictionscan be determined, the arm’s length values should preferably be established on the basis of the so-called standard methods. According to section 1 sub-section 3 sentence 1 AStG, the comparable uncontrolled price method, the resale price methodas well as the cost-plus method(step 1) are considered standard methods.

Under the comparable uncontrolled price method (CUP) comparable transactions (market prices actually observed) between unrelated third parties are identified and compared with the business transaction in question. This method is applied in particular to homogeneous goods, such as financial products, loans, guarantees, interest or raw materials.

As a rule, the benchmark for the resale price method (RPM) is the gross profit margin which related persons could have achieved if they had carried out comparable functions for third parties. This method is based on the market price of the delivery or service which is resold to an unrelated buyer (third party). A gross margin for the functions and risks taken over which is common on the market is deducted from this resale price. The resale price method is primarily applied in affiliated distributorsthat purchase their goods from affiliated companies.

The legislator provides for the cost-plus method (C+)) as the third standard method. In the case of the cost-plus method, the costs incurred at the level of the supplier or provider of the service plus a mark-up adequate for the functions and risks constitute the transfer price. In most cases, the cost-plus method is the ultima ratioif the comparable uncontrolled price method or the resale price method cannot be used.

According to section 1 sub-section 3 sentence 2 AStG, in the case of arm’s length comparison values with limited comparability, these comparison values have to be used as the basis after an appropriate adjustment of a suitable transfer price method (2nd step). Moreover, the transactional net margin methodor the profit split methodcan be used as suitable transfer price methods. 

Thetransactional net margin method (TNMM) compares net profit margins which are generated from a transaction with a related person with margins from transactions with independent third parties. The net profit margins are determined in proportion to a profit dimension (operating result, crude result or EBIT) or a reference value (so-called profit-level indicator, e.g. sales, full or partial costs, operating costs). In practice, these profit or reference parameters of comparison companies are taken from databases of various providers. In the case of the transactional net margin method, target profits from a business transaction or from commercially closely related business transactions (range consideration) are allocated. In principle, the Administrative guidelines procedures recognise this method; however, they restrict it to companies with routine functions (e. g. contract manufacturers). The TNMM cannot be applied to strategy carriers (companies holding essential tangible and intangible assets, exercising essential functions and taking over fundamental risks).

In the case of the profit split, the net profit from a business transaction or the group of business transactions is split between the companies involved. The consolidated profit is split on the basis of determined key parameters, such as, e.g., the assets used, the payroll or sales. This flat distribution key is only accepted to a restricted degree by the fiscal administration, in principle. The profit split is used, in particular, in the case of transactions between several strategy carriers.

The taxpayer has to apply the hypothetical arm’s length comparison as a third step, i.e. in cases in which directly or indirectly comparable arm’s length comparison values cannot be established (section 1 sub-section 3 sentence 5 AStG). The hypothetical arm’s length comparison tries to simulate what unrelated third parties would have agreed under comparable circumstances in compliance with commercial principles (Bundestag printed document 16/4841, p. 85).

In the law implementing the amendment of the EU administrative assistance guideline and further measures dated December 20th, 2016, the German legislator implemented the results of measure 13 of the BEPS project of OECD/G20 and the EU legislation requirements on country-by-country reporting into domestic law. In this process, the rules adopted by the German legislator are based on the three-stage OECD documentation approach. This three-stage documentation approach includes:

• the master file;
• the country-specific, company-specific documentation (local file);
• the country-specific report in the framework of the disclosure requirements in section 138a AO (country-by-country reporting).

German companies are obliged to create and submit the master file if they:

• generate business income within the meaning of section 15 sub-section 1 sentence 1 number 1 EStG,
• have at least one business relationship within the meaning of section 1 sub-section 4 AStG,
• have generated sales of, at least, EUR 100 millionin the previous financial year.

The content and scope of this master file are governed by a legal ordinance (Profit Allocation Recording Guideline, abbreviated: GaufzV). According to section 5 sub-section 1 GaufzV, the master documentation is designed to give the fiscal administration an overview of the type of worldwide business activity, the company group and the system for transfer pricing used by the company group. 

The master file first has to be created for financial years beginning after December 31st, 2016.

The local file serves as a supplementary country-specific and company-related documentation for German group companies. 

In addition to the description of the business transactions (facts documentation), the documentation also includes information on the time of pricing, the selection of the most suitable transfer price method and on the arm’s length character of the amount of the transfer price (arm’s length documentation). In section 6 GaufzV, the fiscal administration has created simplifications regarding the documentation obligation essentially created in section 90 sub-section 3 AO.  According to section 6 sub-section 1 sentence 1 GaufzV, these simplifications provide forsmaller companiesthat only have business relationships with related companies abroad to a small extent to provide verbal information and present existing documents on time rather than having to prepare and present written documents. In this case, the obligation to record extraordinary transactions ceases to apply according to note 3.4.17 Administrative guidelines procedures. According to section 6 sub-section 2 GaufzV, taxpayers with profits the sum of whose total net remuneration paid and/or received (without sales tax) from the business relationships with related persons within the meaning of section 1 sub-section 1 AStG abroad does not exceed EUR 6 million for deliveries and EUR 600,000 for services in the current financial year are considered small companies. 

The local file first has to be created for financial years beginning after 31st December 2016.

The preconditions for the preparation as well as the scope of country-by-country reporting for multinational companies subject to the reporting requirement are specified in more detail in section 138a AO. 

Country-by-country reporting has to be submitted by group parent companies in Germany whose consolidated sales revenue was EUR 750 millionor higher in the previous financial year. 

The country-specific report is to permit a first assessment of tax transfer price risks and other tax risks regarding a possible transfer and reduction of profits (Bundestag printed document 18/9536, p. 37). Country-by-country reporting comprises 3 tables. The first table shows the distribution of income, taxes and commercial activities according to fiscal sovereignties. Table 2 provides an overview of the group units and the essential business activities carried out by them. Table 3 can be used by the taxpayer to provide further information which he considers as being required as an addition or to ensure comprehension. For example, information on losses carried forward or on the division of the profit tax paid by domestic partnerships with co-entrepreneurs based abroad can be provided here. 

The entire report can be prepared in English and submitted in this language. In the above-mentioned tables which are enclosed with the letter dated July 11th, 2017 as attachments, the Federal Ministry of Finance lists provisions which are made in addition to the provisions in section 138a AO, regarding the information which must be included in the country-by-country report or which additional information (which must be in English) can be provided. 

Country-by-country reporting first has to be created for financial years beginning after December 31st, 2015 (exception for included domestic group companies, “secondary mechanism”).

Even though there is a legal obligation to prepare a transfer price documentation, there is no fundamental obligation to submit it. This means we differentiate between the obligation to prepare and the obligation to submit the transfer price documentation. With regard to the time requirements for the preparation and submission of a transfer price documentation, the provisions made in section 90 sub-section 3 sentence 6ff AO also differentiate between currentandextraordinary business transactions. 

According to section 90 sub-section 3 sentence 6 AO, the transfer price documentation only has to be submitted in the framework of the field audit as a rule. Outside a field audit, the law does not provide for any obligation to submit the transfer price documentation to the tax office in principle. The so-called “target provision” in section 90 sub-section 3 sentence 5 AO establishes a bound discretion for the tax offices under which the submission of the transfer price documentation is not required in the “normal” assessment procedure. Nonetheless, the transfer price documentation has to be submitted in justified exceptions upon request by the tax office. In these cases, the provisions for the submission of records according to section 97 AO apply accordingly. The tax office shall indicate, in particular, to what end it needs the transfer price documentation. 

If the transfer price documentation is requested by the field auditor, it has to be submitted within a submission period of 60 daysfor current business transactions. In the case of the documentation of extraordinary business transactions, a submission period of 30 daysafter the request by the audit department applies. In justified individual cases, this deadline can be extended. 

With the exception of the provisions for unusual business transactions, there are no provisions regarding the time at which the documentation has to be prepared. In principle, normal business transactions can be prepared by the management board until the request. However, in many cases the documentation can only be prepared with considerable work and time effect subsequently - in many cases several years after the business transaction was carried out. Against this background, it is recommended that the transfer price documentation be prepared promptly also with regard to current business transactions. 

In the case of extraordinary business transactions (e.g. shifts of functions, restructuring measures or the conclusion of long-term contracts of particular importance), section 3 sub-section 1 sentence 2 GaufzV requires these to be prepared “in a timely manner”, i.e. within a period of six monthsafter the end of the financial year during which the business transaction took place.

Determining the “right” transfer price is a constant point of contention with field auditors and tax investigators of the competent tax offices. This applies not only in Germany but in almost all industrial countries. For this reason, other countries have begun to conclude agreements between the companies concerned and the international fiscal administration involved “contractually” agreeing on the “right” transfer price many years ago. Germany has taken up this practice so that here, too, the option to conclude so-called “advance pricing agreements” is available, In international tax law, an “advance pricing agreement” (APA) means a temporary agreement between, at least, one taxpayer and several tax administrations (various countries). As a result, the transfer price methodsbetween the affiliated companies or company parts concerned can be defined across borders in advancefor a given period of time. 

An APA can e.g. avoidfuture (commercial) double taxation, give the taxpayers involved planning reliability and legal certaintyand avoid interest and penal surcharges. 

In Germany, the Federal Central Tax Office (BZSt) is in charge of carrying out the APA. As a second step, the competent tax office then issues a binding advance assurance to the German applicant. 

At a European level, the EU Joint Transfer Pricing Forum regularly publishes statistics about the European APA procedure.

Since the introduction of section 89a AO by the Withholding Tax Relief Modernisation Law (AbzStEntModG), there has been an independent national legal basis for the execution of the advance coordination procedure in connection  with the so-called APA. This creates the option of applying for an advance coordination procedure for all border-crossing matters - rather than for border-crossing income allocation only. In addition, the revision provides for a direct connection of APA applications with coordinated bilateral and multilateral field audits (joint audits[E1] ). Section 89a AO first has to be used for applications for the introduction of an advance coordination procedure which were received by BZSt as of 9th June 2021 (the day on which AbzStEntModG was promulgated). Does the Federal Central Tax Office (BZSt) charge a fee for “Advance Pricing Agreements”?

The APA applications are subject to a fee which is determined before the proceedings are opened. As a rule, the Federal Central Tax Office charges a fee of EUR 30,000 for processing an APA application (section 89a sub-section 7 AO) with different rules applying to renewal and amendment applications.

Since the introduction of section 89a AO by the Withholding Tax Relief Modernisation Law (AbzStEntModG), there has been an independent national legal basis for the execution of the advance coordination procedure in connection  with the so-called APA. This creates the option of applying for an advance coordination procedure for all border-crossing matters - rather than for border-crossing income allocation only. In addition, the revision provides for a direct connection of APA applications with coordinated bilateral and multilateral field audits (joint audit). Section 89a AO first has to be used for applications for the introduction of an advance coordination procedure which were received by BZSt as of 9th June 2021 (the day on which AbzStEntModG was promulgated). Does the Federal Central Tax Office (BZSt) charge a fee for “Advance Pricing Agreements”?

The APA applications are subject to a fee which is charged before the procedure is instituted. Usually, the Federal Central Tax Office charges a fee of EUR 20,000 for processing an APA application, with deviating rules for extension and renewal applications, as well as for smaller companies.

Even before the taxpayer files an application for the execution of an Advance Pricing Agreement procedure, he should request a briefing - the so-called “pre-filing” with BZSt. At this meeting, the prospects of success will already be discussed, in addition to the form, content, documents to be provided as well as the schedule. 

After the pre-filing meeting, the application is filed in which in addition to the content of the AOA the other country involved is also specified. Moreover, an advance pricing agreement between several countries can also be applied for. This is done by submitting several applications for the execution of bilateral procedures. The application is concurrently filed domestically (by the affected domestic company) and abroad (by the company concerned abroad). 

The taxpayer cannot take part in the negotiations; however, he is informed of the status by the authorities concerned. 

If an advance pricing agreement has been concluded and signed with the foreign country, BZSt informs the applicant of the result in writing. Furthermore, the taxpayer is asked to agree to the content of the agreement and to confirm a waiver of legal remediestowards the tax office. As soon as the approval and the waiver of legal remedies have been obtained, the tax office grants the applicant the corresponding binding advance assurance, which implements the understanding under international law into domestic tax law. 

In principle, the “advance pricing agreements” are designed for the future with their term beginning as of the beginning of the financial year during which the application is filed. A retrospective application to assessment periods preceding the agreed term of an APA can be applied for - this is called a “roll-back”.

In section 162 sub-section 3 and sub-section 4 AO, the legislator has established various sanctions depending on the type and severity of the violation of the documentation and submission requirement: 

• section 162 sub-section 3 sentence 1 AO: Refutable presumption of the existence of higher income than declared by the taxpayer (reverse onus and appraisal authority),
• section 162 sub-section 3 sentence 2 AO: Authorisation to use the appraisal frameworkto the disadvantage of the taxpayer,
• section 162 sub-section 4 sentence 1 and sentence 2 EStG, Penal surchargeof 5 to 10%of the income correctionof, at least, EUR 5,000,
• section 162 sub-section 4 sentence 3 AO: Default fineof, at least, EUR 100 per day and transactionwith cap of EUR 1 million.

In addition to the sanctions described above, section 379 sub-section 2 number 1c AO in conjunction with section 379 sub-section 5 AO, provides for another administrative offencefor the non-submission of country-by-country reporting (fine of up to EUR 10,000).

In its ruling of May 31st, 2018 (reference number C 382/16) in the case Hornbach Baumarkt AG(advance pricing agreement request of the Rhineland-Palatinate fiscal court of 28/06/2016 – 1 K 1472/13), the ECJ ruled that the income correction according to section 1 AStG (in the version of the Law to Reduce Tax Breaks and Exceptions of 16th May 2003 (German Federal Gazette I 2003, p. 660)) is only compatible with European legislation to a limited degree. 

Hornbach Baumarkt AGasserted a violation of the freedom of establishment since an income correction would not be made in a purely domestic case (lack of remuneration for letters of guarantee and comfort). Moreover, since section 1 AStG does not provide the option of proof to the contrary, this discrimination is also not proportionate.

The Rhineland-Palatinate fiscal court (ruling of June 28th, 2016 – 1 K 1472/13) shared these concerns, suspended the proceedings and submitted this legal question to ECJ. 

In the legal opinion of ECJ, the income correction under section 1 AStG is generally justified. However, the taxpayer must be given an opportunity to prove commercial reasons for the conclusion of the transaction at conditions which do not fulfil arm’s length conditions. According to this, commercial reasons can restrict the application of the arm’s length principle, as had already been shown in the ruling regarding Société de Gestion Industrielle SA (dated 21/01/2010 – C 311/08). This ruling also established that the taxpayer must be given an opportunity to assert commercial reasons for the deviation from the arm’s length principle. 

After this, the Rhineland-Palatinate fiscal court has to resolve whether the fiscal administration has given Hornbach Baumarkt AGthe possibility to present evidence. 

It remains to be seen how the legislator and the fiscal administration will react to this ruling and which burden of proof will have to be fulfilled by the taxpayer in future.