Transfer pricing in Germany.

In international business, most industrialized countries have adopted tax rules that require related parties to deal at arm's-length when transacting business with one other. Under Germany's rules, if a taxpayer conducts business with related parties, then the tax authority will usually examine whether it fully accounted for the income (i.e., whether the income is correctly allocated between the related parties). Along with Germany, other European countries, Great Britain, Luxembourg and the Netherlands, have strict laws or regulations for correctly allocating income between related parties, based on the Organisation for Economic Co-operation and Development's (OECD's) guidelines.

The German legislation on transfer pricing (TP) establishes the principle of arm's-length pricing for related-party transactions. The TP statutory rules are not found within one integrated section of the legislation, but in several provisions in different acts. The provisions include a definition of related parties and provide that when the assets or income of a German taxpayer are reduced by means of non-arm's-length transactions with related parties, that taxpayer's income may be adjusted accordingly.

Pricing Methods

Transactions between related parties should be evaluated for tax purposes according to whether those involved have acted like third parties independent of each other (i.e., under the arm's-length principle). The difficulty is how to find an appropriate transfer price that meets the arm's-length principle.

The OECD-accepted TP methods have been divided into two groups: the traditional transaction methods (which include comparable uncontrolled price, resale price and cost-plus) and the transactional profit methods (which include profit-split and transactional net-margin); see the exhibit at right.

German fiscal authorities have a clear focus on transaction-based methods; there is no order of priority of the standard methods for the examination of transfer prices. Profit-based methods are not formally accepted by the German tax authority--only profit-split is discussed as a method of last resort.

Written Contracts (Contractual Terms)

From a fiscal viewpoint, for transactions between a dominant shareholder and its subsidiary, a written agreement is almost required for the intercompany transactions to prove compliance with the arm's-length principle. Besides evaluating proper transfer prices and stipulating them in written contracts, another important factor is comparing the significant contractual terms of controlled and uncontrolled transactions, particularly, warranties, payment terms, rebates, discounts, risks and guaranties.

Documentation Requirements

Section 90 of the German Finance Act of 2003 amended the general duty to cooperate and disclose information under the German Tax Code. This provision requires documenting the mane and content of cross-border transactions between related parties, as well as cross-border profit allocations between headquarters and permanent establishments.

These documentation requirements are intended to facilitate the tax authority's understanding of the tax-payer's intercompany transactions and assessment of whether and the extent to which income has been calculated in accordance with the arm's-length principle. To comply with the requirements and avoid income adjustments, double taxation and penalties, the TP documentation must contain at least the following elements:

* Description of the transaction (general information, including owner ship and organizational structure and business relationships with related parties);

* Analysis of value-adding activities (functions and risks, intangible assets involved, market conditions and competitive environment);

* TP analysis (including method and bases of calculation);

* Additional documentation in special circumstances (e.g., an explanation of the reasons for multiple-year losses and a statement of the action(s) taken to end them); and

* Appendices (additional information, such as organizational charts, contractual arrangements and financial statements containing the data used in the analysis).

The German tax authority does not normally perform tax audits specifically for TP issues, but examines TP during normal field audits performed at regular intervals. When doing a field audit, the tax authority normally requests the TP documentation and gives the taxpayer no more than six weeks to provide it.

Legal Consequences of Insufficient Documentation

In recent years, the German tax authority has attempted to introduce additional, partly contemporaneous, documentation rules for the specific purpose of supporting transfer prices. In 2003, new legislation brought Germany up to a procedural level comparable to a growing number of other countries and provided an efficient tool for more structured tax audits by authorities. Failure to comply with the documentation requirements expands tax auditors' authority to estimate appropriate income adjustments. The statute also creates monetary penalties for non-compliance.

Section 162 of the German Tax Code provides the legal consequences of insufficient documentation. It authorizes the tax authority to estimate and increase a German entity's income if it has been reduced by inappropriate means (i.e., non-arm's-length transfer prices). When a taxpayer's income is estimated, the tax authority is obliged to impose penalties of at least 5% of the adjustment, not exceeding 10%. The (minimum) penalty that applies is 5,000. If the taxpayer fails to submit the required documentation six weeks after a request, the tax authority may impose late submission penalties of up to 1 million. The minimum penalty for late submission is 100 per day for each day past the due date.

Conclusion

As a matter of principle, a taxpayer has to prove TP compliance with German tax law. However, it only has to provide the transaction's underlying facts, which include presenting the functions and risks, and a description of how the transfer price was determined. The onus is on the tax authority to prove whether the TP is at arm's length.

Exhibit: OECD-recognized TP methods

* Comparable uncontrolled price method: Compares the price for properly or services transferred in u controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances.

* Cost-plus method: Uses the costs incurred by the supplier of property (or services) in a controlled transaction. An appropriate mark-up is added to the cost, to make an appropriate profit in light of the functions performed (taking into account assets used and risks assumed) and the market conditions. The result of adding the mark-up to the above costs may he regarded as an arm's-length price of the original controlled transaction.

* Resale price method: Is based on the price at which a product that has been purchased from an associate enterprise is resold to an independent enterprise. The resale price is reduced by the resale price margin. The remainder, after subtracting the resale price margin, can be regarded, after adjusting for other costs associated with the purchase of the product (e.g., custom duties), as an arm's-length price of the original transfer of property between the related parties.

* Profit-split method: Identifies the combined profit to be split for the associated enterprises from a controlled transaction (or controlled transactions, when aggregating is appropriate) and then splits those profits between the related parties based on an economically valid basis that approximates the division of profits that would have been anticipated and reflected in an arm's-length agreement.

* Transactional net-margin method: Examines the net profit margin relative to an appropriate base (e.g. costs, sales and assets) that a taxpayer realizes from the controlled transaction (or transactions, when aggregating is appropriate).

FROM KERSTIN JARSCH, GERMAN CPA, SENIOR TAX MANAGER, AND PETER FABRY, TAX LAWYER, BAKER TILLY DEUTSCHLAND, GMBH, MUNICH, GERMANY