Joint Audits: Cologne Fiscal Court specifies Procedural Requirements

Joint Audits – International audits according to art. 12 EUAHiG [Law on Mutual Administrative Assistance in Fiscal Matters] – Cologne Fiscal Court specifies Procedural Requirements (ruling of 23rd May 2017, reference no. 2 V 2498/16)

I. Facts of the matter regarding the international audit (Joint Audit)

A Dutch parent company maintained subsidiaries in several states, e.g. A-GmbH in Germany and another subsidiary in Hong Kong. The international audit announced by the fiscal office was also intended to include an audit of transfer pricing between the parent company and A-GmbH. This was because A-GmbH procured its goods from its sister company in Hong Kong - however, it did so via the parent company based in the Netherlands.

The audit of the transfer prices primarily dealt with the method of the "profit split" and its preconditions. The audit then found that there were indications for a transfer of profits to Hong Kong. Such a structure is often selected for tax reasons because in Hong Kong income from the purchase and sale of products in third countries is not taxed. In spite of a formal request by the German audit office, A-GmbH refused to provide its transfer price documentation in an arithmetically comprehensible manner.

At the beginning of the audit, the German audit office pointed out that an international audit (joint audit) involving the Dutch parent company might be carried out. In the further course of the audit, A-GmbH was informed that a joint audit had now been ordered together with the Dutch fiscal administration.

A-GmbH objected to the order of a joint audit with a request for the issue of a temporary injunction according to art. 114 FGO [German Code of Procedure for Fiscal Courts]. This request was intended to prevent the German audit office from transmitting information to the Dutch fiscal administration and, moreover, to prevent the conducting of a joint audit. A-GmbH was of the opinion that the forwarding of this information violated tax secrecy and that it was entitled to injunctive relief according to art. 1004 section 1 sentence 1 BGB in conjunction with art. 30 AO.

II. No injunctive relief regarding the exchange of information during an international audit (Joint Audit)

Cologne Fiscal Court decided that A-GmbH was not entitled to injunctive relief from the German audit office regarding the transfer of tax information to the Dutch fiscal administration. In the opinion of Cologne Fiscal Court, such injunctive relief is not based on art. 1004 section 1 sentence 1 BGB in line with art. 30 AO with regard to forwarding of information for the preparation and arrangement of an international audit (Joint Audit). In other words: In the framework of a Joint Audit, A-GmbH has to tolerate forwarding of the information from the German audit office to its Dutch colleagues in accordance with art. 1004 section 2 BGB.

Comment by LHP Attorneys Tax Advisers: In this respect, the ruling by Cologne Fiscal Court is clearly understandable. Provided tax secrecy is preserved and the preconditions for forwarding of information according to art. 117 AO are fulfilled, the taxable entity is not entitled to injunctive relief. However, this changes if the strict preconditions of art. 117 AO are not fulfilled and there are indications that the tax data are not protected or not sufficiently protected abroad.

III. No violation of tax secrecy in the framework of an international audit (Joint Audit) - International exchange of information permissible

According to art. 30 section 4 no. 2 AO, tax secrecy permits the disclosure of the situation of the taxable person in as far as this is legally permissible (legal reservation). These laws also include the legal bases for providing or obtaining information according to the Law on Mutual Judicial Assistance in Tax Matters between Member States of the EU (EUAHiG). In the opinion of Cologne Fiscal Court, the preconditions for a joint audit were fulfilled in accordance with art. 12 EUAHiG. The Cologne Fiscal Court gave the following reasons:

• In accordance with art. 1 section 1 EUAHiG, the law governs the exchange of information in tax matters which is likely to be material between Germany and other member states of the European Union. It has to be applied to all types of taxes charged by a member state or for a member state as regards its territorial or administrative units, including local authorities. Exceptions are specified in section 2.

• Pursuant to art. 12 section 1 EUAHiG, upon the proposal of a fiscal authority, the central liaison office (in the present case: the respondent) can agree with one or several member states to carry out a concurrent audit of one or several persons of joint or supplementary interest within their respective territory. In as far as permissible under art. 4 EUAHiG, the information obtained in this process and the knowledge required for the arrangement of the audit in advance have to be exchanged. According to art. 12 section 2 EUAHiG, the fiscal authority determines which person or persons it recommends for a joint audit. The central liaison office informs the respective member states of this, gives reasons for the selection and specifies the period during which the joint audit is to be carried out.
• According to art. 199 section 1 AO, the actual legal circumstances which are material for the tax obligation and the assessment of the tax shall be checked to the benefit and to the detriment of the taxpayer during the audit. This means that the fiscal authority is responsible for the findings and, concurrently, it also has control of the proceedings. It determines the type and extent of the investigations (Seer in Tipke/Kruse, Art. 199 AO, margin no. 1).

Requests by German fiscal authorities for administrative assistance from foreign authorities are granted at the discretion of the German fiscal administration. In principle, the information requested must be required for the purposes of German taxation. This principle which is universal for administrative assistance is established in art. 111 section 1 AO as well as in art. 6 section 1 sentence 2 EUAHiG - according to which a fiscal authority is authorised to request "official investigations pertinent to the case". It is in line with the case law of the European Court of Justice that a request for information by a member state from another member state based on directive 2011/16 be based on the precondition that the information requested is "likely to be significant" for taxation purposes in the requesting state (ECJ on 15th May 2017, (comment: regarding the document: the correct date is probably 16/05/2017) C-682/15, ECLI EU:C:2017:373). To prepare for a joint audit, this was expressly covered in art. 12 section 1 sentence 2 EUAHiG by referring to art. 4.

With the criteria of "likely significance" the OECD standard (cf. art. 26 OECD-MA) was taken over into EU-AHiG. This is intended to ensure that the exchange of information in tax matters is effected to the biggest possible extent (Schwarz in Schwarz/Pahlke, art. 1 EUAHiG, margin no. 3). At the same time, it is made clear that member states are not permitted to participate in illicit investigations ("fishing expeditions") or to request information which is unlikely to be material regarding the tax matters of a certain taxpayer (cf. reasons given regarding the draft of the law on mutual judicial assistance within the EU by the German federal government of 25th May 2012, printed document of the Bundesrat 302/12, p. 66 f.; Cologne Fiscal Court, ruling of 7th September 2015, 2 V 1375/15, EFG 2015, 1769; ECJ of 15/5/2017, C-682/15, ECLI:EU:C:2017:373). 

The criteria of "likely significance" requires that, at the time of the request and of forwarding of the information, there must be a reasonable chance as seen by the requesting member state that the requested information might be relevant for tax purposes (cf. ECJ of 15/5/2017, C-682/15, ECLI:EU:C:2017:373; Cologne Fiscal Court, ruling of 7th September 2015, 2 V 1375/15, EFG 2015, 1769; Hendricks in Debatin/Wassermeyer, DBA, Art. 26 margin no. 29; Czakert in Schönfeld/Ditz, DBA, art. 26 margin no. 55). The data must be significant for the subsumption under taxation issues of the requesting member states (Hendricks in Debatin/Wassermeyer, DBA, art. 26 margin no. 29). The question of whether the information is actually relevant after its transmission does not matter and does not render the original request inadmissible (Hendricks in Debatin/Wassermeyer, DBA, art. 26 margin no. 29; Czakert in Schönfeld/Ditz, DBA, art. 26 margin no. 55).

Comment by LHP Attorneys Tax Advisers: In this case, the materiality of the information exchanged for tax purposes was ensured without doubt. In practice, the characteristic of taxation materiality is fairly easy to substantiate by the audit department. If the question concerns the distribution of profits and allocation of income under international tax law and the determination of the "correct" transfer price, the materiality of the information can hardly be doubted. This only changes if the audit department is actually focusing on obtaining other information, such as the identity of persons responsible abroad for the purpose of prosecution within the country.

IV. Errors of discretion and procedural errors in the context of the order for an international audit (joint audit)

The questions of the adequacy of transfer prices and the distribution of profits are certainly significant in order to be able to determine the bases of taxation in Germany. As a result, the order for an international audit is not subject to errors of discretion in these cases.

The obligation for a prior hearing regarding the audit does not apply without restriction. According to art. 117 section 4 sentence 3 AO in conjunction with art. 91 AO, the national taxpayer has to be heard before information is transferred to a foreign fiscal authority for the purpose of a simultaneous audit. However, this does not apply if the success of the audit would otherwise be jeopardised (art.12 section 5 EUAHiG).

The office carrying out the audit isresponsible for the hearing (section 3.2 of the leaflet on coordinated field audits together with fiscal administrations of other countries - German Federal Ministry of Finance of 9th January 2017, IV B 6-S 1315/16/10016:002, Federal Tax Gazette I 17, 89 - and section 3.1.1 of the Leaflet on international administrative assistance through the exchange of information in tax matters - German Federal Ministry of Finance of 23rd November 15, IV B 6-S 1320/07/10004:007, Federal Tax Gazette I 15, 928). Usually, this is the tax office in charge of large-scale and group audits.

According to art. 91 AO, the type and manner of the hearing are subject to the specific discretion of the tax office (Rätke in Klein, art 91 AO, marginal no. 1 int. al.) A required hearing not being held leads to a procedural error. However, according to art. 126 section 1 no. 3 and section 2 AO, this procedural error can be remedied up until the conclusion of fiscal court proceedings. In the framework of the European exchange of information, the taxpayer is regularly subject to hearings at the Federal Central Tax Office.

Comment by LHP Attorneys Tax Advisers: In the case decided by Cologne Fiscal Court, the audit by the tax office for large-scale and group audits had informed A-GmbH that there were plans for an international audit involving several European, e.g. the Dutch, fiscal administrations. In an additional letter, it pointed out that there were plans to carry out a simultaneous audit together with the fiscal administration of the Netherlands. The Cologne Fiscal Court did not consider this a violation of the obligation to grant a hearing according to art. 91 AO. To this extent, A-GmbH had sufficient opportunity to submit objections against the planned forwarding of information. As a result, this has to be agreed with.

V. Concurrence of the international audit (Joint Audit)

In several points, the wording of EUAHiG mentions an international audit (joint audit) to be carried out "concurrently". Now, Cologne Fiscal Court has rendered a first ruling on the legal definition of the term "concurrence". According to this, it does not matter that the German audit had been under way for a considerable time. This is because it cannot be concluded from art. 12 EUAHiG that audit procedures to be carried out concurrently also have to begin simultaneously, according to Cologne Local Court.

Comment by LHP Attorneys Tax Advisers: In cases of international audits, the wording of the standard will have to be interpreted with regard to the question of "concurrence". There are many indications supporting the "juxtaposition" of the audit rather than the absolute congruence of the audit activities. However, in the framework of intervention administration the legislator has to consider the principle of certainty whose boundaries are blurred. In the present case, however, Cologne Fiscal Court did not find any violation. It now remains to be seen whether other courts will agree with this.

VI. Subsidiarity of administrative assistance according to EUAHiG in cases of international audits (Joint Audits)

In its ruling, the Cologne Fiscal Court correctly determined that according to art. 6 section 3 EUAHiG requests for administrative assistance for other member states are subsidiary in relation to national investigative powers. This means that a fiscal authority must have used all investigations options granted under the German tax code before a request can be issued - unless the execution of investigations entails disproportionately great difficulties or does not appear promising. The principle of subsidiarity is a universal principle in administrative law and in German tax procedure law, it is also established in art. 93 section 1 sentence 3 AO. In the case in which the Cologne Fiscal Court rendered a ruling, the question of subsidiarity did not have to be addressed any further. The documents of the company in Hong Kong required for auditing the transfer prices could only be obtained from the parent company in Hong Kong since the Hong Kong subsidiary refused to submit these to the German audit office.

Comment by LHP Attorneys Tax Advisers: The two flexibility clauses "disproportionately great difficulties" and "not promising" are very important in the practical execution of international audits. Apart from exceptional cases, it is not very difficult for the audit office to give reasons why the difficulties encountered in the clarification of facts without involving an international audit (joint audit) are disproportionately great or not promising. Since, moreover, the decision regarding the use of international audits are also discretionary decisions (cf. art. 93 section 1 sentence 3 AO), in addition, these can only be reviewed by fiscal courts to a limited degree (art. 102 FGO [German Code of Procedure of Fiscal Courts)] and, as a result, they can only be cancelled in the event of major violations.

VII. Approval requirement for the execution of an international audit (Joint Audit)

It did not come as a surprise that the Cologne Fiscal Court decided that the taxpayer's approval of the execution of an international audit (joint audit) is not required. Such an approval requirement for the initiation and execution of an international audit is not established in the wording of art. 117 section 4 AO or in the provisions of EUAHiG.

Moreover, an approval requirement (wording argument) cannot be derived from the requirement to grant a hearing prior to forward of information according to art. 117 section 4 sentence 2 and 3 AO in conjunction with art. 91 AO. In the opinion of Cologne Fiscal Court, such a requirement cannot be assumed under teleological aspects either. On the contrary, the aim pursued with a concurrent audit, (i.e. ensuring an efficient audit) would be counteracted if the concurrent audit depended on the reporting company's approval.

Comment by LHP Attorneys Tax Advisers: The wording of the argument used by the Cologne Fiscal Court is difficult to clarify. In principle, the relationship between the state and the citizen always hinges on the question of whether the state's intervention is covered by a legal provision and, apart from this, on whether it is proportionate, i.e. pursues a legitimate objective and is appropriate. The code of procedure in tax matters does not provide for the requirement of approval by the taxpayer - at least, in as far as the determination of tax bases is concerned. Since such a requirement of approval is not provided for by law in cases of international audits, the execution of an international audit is not subject to the approval of the party concerned.

VIII. In the case of international audits (Joint Audits) lack of authority for application corresponding to that in mutual agreement procedures

International audits (joint audits) and the mutual agreement procedures standardised in the double taxation procedures are based on different legal bases (the respective double taxation agreement and art. 12 EUAHiG for international audits). Therefore, the right to request the execution of a mutual agreement procedure cannot be transferred to cases in which international audits (joint audits) are carried out. The international audits (joint audit) always precede a possible mutual agreement procedure. 

The tax office for the audit checks whether, e.g., profits were transferred. Usually, the foreign fiscal authority is also interested in such an audit. However, in the opinion of Cologne Local Court, this does not permit the conclusion that, as early as upon the execution of the audit, the aim of the audit cannot be identified as ensuring a legally binding agreement with the foreign fiscal authority regarding the income tax treatment of an issue mutually agreed.

Comment by LHP Attorneys Tax Advisers: However, we have to identify those audit cases in which there are indications that profits were transferred abroad from Germany or vice versa and in which an agreement is to be established between Germany and the respective other country against this background.

As long as the focus is "exclusively" on the clarification of the facts of the matter rather than the prevention of potential double taxation, there is no room for a possible right to submit requests. This is because, at this early stage, the focus is not on a mutual agreement procedure or such a procedure cannot be foreseen at this point.

LHP Luxem Heuel Prowatke Rechtsanwälte Steuerberater PartGmbB offer comprehensive counselling before, during and after joint audits:

Joint audits as a "relatively new" procedural tool require critical assessment and further development. Some open questions regarding procedural law have been resolved provisionally by the decision of Cologne Fiscal Court. However, these and other questions have not yet been resolved by the supreme court. Indeed, the tax offices and their audit offices are increasingly using the option of joint audits. In times of extensive and increasing cross-border trading of goods and services, this is certainly the right approach. The fact that joint audits can resolve disputes about transfer pricing as early as during the audit (thereby saving much time and effort) definitely constitutes a benefit. However, this only applies within narrow boundaries.

The rights of the parties concerned have to be preserved without any restrictions. First and foremost, this includes the principle of proportionality and the preservation of tax confidentiality. Even today, Germany companies rightly complain about a competitive disadvantage if they have to disclose internal calculation bases for their products to foreign tax administrations in the framework of joint audits. For this reason, the consultant in his or her capacity as a lawyer/expert in tax law/tax adviser has to ensure that the rules of reciprocity and the balanced nature of the exchange of information are preserved (art. 117 section 3 AO [German Tax Code]). Information can only be forwarded to foreign fiscal authorities in this case.

Because of the increased duties to cooperate in foreign matters (e.g. according to art. 90 section 3 AO) and the possible sanctions applicable in this context (cancellation of operating expenses art. 160 AO, reassessments art. 162 AO, fines art. 90 section 3 AO, 162 sections 3 and 4 AO), we advise our clients to specifically prepare for a possible audit. Therefore, the tax departments of companies should pay considerable attention to the provision of proof. This is because corresponding inquiries by the audit offices can only be refused if the documents are irrelevant for taxation. However, the question of materiality is not answered by the taxpayer so that, in practice, the audit office has very broad discretionary powers. In view of the fact that these discretionary powers can only be reviewed by the fiscal courts to a limited degree (art. 102 FGO), this shows how important good provisions for proof are.

We carry out the following for our clients at any time - also before the announcement of an audit:

• Screenings (simulated audits) for potential tax and criminal law weaknesses (if the Tax Authority has merely hinted at a company tax audit over the telephone, but no official notice of company tax audit has been received yet, a voluntary self-disclosure can still be submitted until an audit order is received).
• Preparation of strategies of action and defence
• As of the end of the company tax audit, measures to attain legal certainty, e.g. by way of obtaining a so-called confirmation letter or by entering into a factual agreement
• Appeal and fiscal court proceedings, as well as appeal proceedings before the Federal Fiscal Court