TRANSFER PRICING

Germany - Country Summary

Outline of the rules on Transfer Pricing in Germany

On April 12, 2005 the German Federal Ministry of Finance (BMF) issued the final "Administrative Principles for the Examination of Income Allocation Between International Related Enterprises With Cross-Border Transactions in Respect of Income Adjustments, Investigation and Compliance Obligation, as well as Mutual Agreement Procedures and EU Arbitration Proceedings (Administrative Principles - Procedures)."

This extensive 76 pages document is the last in a series of changes to the German transfer pricing environment that started in 2003. Section 90 (3) of the German Tax Procedures Act (Abgabenordnung, AO) is now demanding that taxpayers document their transfer pricing transactions in thorough detail. Section 162 (3) and (4) of the Tax Procedures Act imposed sanctions for non-compliance of documentation requirements. Third change was the imposition of the German Documentation Decree Law (GAufzV) which is based on the new section 90 (3) of the Tax Procedures Act. This Documentation Degree Law regulates in more detail the documentation requirements.

While sections 90 (3) and 162 (3) and (4) of the German Tax Procedures Act and the respective Documentation Decree Law (GAufzV) are binding only on the tax authorities, the taxpayers and the tax courts, the new administrative principles are only the tax authorities' interpretations of the new legal requirements and are binding only on the tax authorities. Currently, the transfer pricing documentation obligations apply only to cross-border transactions.

The administrative principles and procedures are divided into seven chapters:

introduction;

the tax authorities' obligations;

taxpayers' obligation to cooperate;

consequences of non-compliance;

performance of adjustments;

competent authority and arbitration procedures;

the replacement of existing rules.

The administrative principles emphasize at the outset that it is the tax authorities' obligation to investigate the facts of a case and to try to discover facts that are beneficial for the taxpayer.

The taxpayer's obligation, which are mainly regulated by the German Tax Procedures Act, are explained in more detail in the third chapter of the administrative principles and procedures. These obligations include extensive cooperation and document preservation obligations for foreign related-party transactions. The taxpayer is committed to take reasonable precautions with related parties to ensure that he can obtain documents and relevant information from related parties. This provision could lead to extensive disputes with the German tax authorities.

The third chapter also specifies the documentation requirements for taxpayers. Under the new documentation provisions, taxpayers are requested to document prices and terms of their business activities with related parties including detailed analysis of the functions performed. Such documentation has to cover the activities conducted, the risks borne, agreements between the related parties as well as legal and economic facts being relevant for their transfer pricing. In particular, the documentation package on transactions related to these agreements (i.e. sales and purchases of goods as well as services, financing, intellectual property etc.) needs to include information such as:

comparable prices

calculation of prices

margins of comparable companies

agreements with economic impact on related transactions

benefit test.

Under the new documentation law, a full-scale transfer pricing study will be required for every relevant transaction or group of similar transactions. The documentation must allow a competent third party to ascertain within an adequate period of time the fact and circumstances the taxpayer has realized in connection with the business to related parties and whether the taxpayer has followed the arm's length principle.

The administrative principles do not contain formal guidelines on how to prepare documentation, other than the provision that documents must prepared in the German language. Nevertheless, the relevant tax authorities may grant an exception to this requirement upon request.

Documentation my be prepared in written or electronic form, and must maintained and stored for 10 years in an appropriate manner. The taxpayer is required to ensure that the documents and data kept by a foreign related party that are relevant for German taxation are preserved and not destroyed before the German time limit for preservation of files has elapsed. The German requirement that documentation must be preserved for 10 years is often longer than time periods in other countries, a fact that could create a substantial burden for an international group of companies to ensure that the 10-years period is observed by related parties in foreign countries.

Generally, transfer pricing documentation must be prepared only at the request of the tax authorities; however, in the case of extraordinary transactions it must be prepared contemporaneously, that is, within six month after the end of the fiscal year in which the extraordinary transaction took place. Extraordinary transactions are defined as major changes in the functional and risk profile of a taxpayer; transactions in the context of a change in business strategy that has a significant impact of transfer prices and the entering into or the changing of long-term agreements that are particularly important. Taxpayers must keep in mind that they must make available the documentation for tax audit upon request within 60 days.

The most important aspect of the Documentation Law and the administrative principles is the documentation of compliance with the arm's length principle. Taxpayers must provide an economic analysis that demonstrates the arm's length character of the transfer pricing. They must show - through documentation - good faith efforts to comply with the arm's length principle.

According to the new documentation requirements, the taxpayer will have to produce sales forecasts and planning data to explain why the prices chosen are reasonable from his perspective. It can be expected that data for a third-party comparisons will have to be produced to the extent possible with "reasonable effort". Consequently, this means that databank screenings will be necessary for margins but normally not for prices.

Under German law, taxpayers are in theory free to choose the transfer pricing method. The new administrative principles do not require explicitly an application of the "best method rule", but prefer the standard methods, i.e. "comparable uncontrolled price method", "resale price method" and "cost plus method". The taxpayer shall - if possible and reasonable - use internal and external comparables, as well as internal budget data. Net margins of comparable companies for different kind of business transactions or aggregated business transactions are acknowledged when using the transactional net margin method (TNMM). However, the administrative principles note that the use of TNMM is permitted only if a company exclusively performs certain clearly defined routine functions without assuming major risks, and does not use any non-routine intangibles in its typical business activities.

Chapter four of the administrative principles defines the legal consequences of a violation of the taxpayer's duties to cooperate, and supplements the existing sanctions and penalties regulations in the Tax Procedures Act. When a taxpayer violates its duty to cooperate, the tax authorities' duties to investigate are reduced accordingly, but are not completely extinguished. If the tax authorities cannot fully investigate the actual and legal circumstances to determine the taxpayer's tax liability, the administrative principles regulate that an estimate is required. Even a marginal violation of the taxpayers' duties may be harmful. For example, if the determination of the transfer prices is based on internal data and the budgeted data was not checked against the actual data at regular intervals, the internal data could be regarded as materially unusable.

In addition to the income adjustments related to the transfer prices, also monetary penalties are applied if any documentation requirement has been violated. A minimum penalty of Euro 5,000 will be levied for not filing or late filing or inadequate filing. This penalty applies regardless of any adjustment to income. Also, a minimum penalty of Euro 100 applies for every day of delaying the documentation package. The penalty is limited at Euro 1,000,000 if documentation package is simply delayed, as long as the tax authorities can make use of it for tax audit purposes.

The penalties in cases of income adjustment range from 5 to 10% of the amount adjusted, not on the additional taxes.

The new administrative principles constitute a comprehensive set of rules for documentation and related issues. It remains to be seen how tax auditors will apply the new rules. Taxpayers are well advised to take the opinion of the tax authorities into account in preparing their documentation, if they want to avoid transfer pricing issues from the beginning.

Prepared by: Bernd Burkhard

	TRANSFER PRICING Germany - Country Summary Outline of the rules on Transfer Pricing in Germany On April 12, 2005 the German Federal Ministry of Finance (BMF) issued the final "Administrative Principles for the Examination of Income Allocation Between International Related Enterprises With Cross-Border Transactions in Respect of Income Adjustments, Investigation and Compliance Obligation, as well as Mutual Agreement Procedures and EU Arbitration Proceedings (Administrative Principles - Procedures)." This extensive 76 pages document is the last in a series of changes to the German transfer pricing environment that started in 2003. Section 90 (3) of the German Tax Procedures Act (Abgabenordnung, AO) is now demanding that taxpayers document their transfer pricing transactions in thorough detail. Section 162 (3) and (4) of the Tax Procedures Act imposed sanctions for non-compliance of documentation requirements. Third change was the imposition of the German Documentation Decree Law (GAufzV) which is based on the new section 90 (3) of the Tax Procedures Act. This Documentation Degree Law regulates in more detail the documentation requirements. While sections 90 (3) and 162 (3) and (4) of the German Tax Procedures Act and the respective Documentation Decree Law (GAufzV) are binding only on the tax authorities, the taxpayers and the tax courts, the new administrative principles are only the tax authorities' interpretations of the new legal requirements and are binding only on the tax authorities. Currently, the transfer pricing documentation obligations apply only to cross-border transactions. The administrative principles and procedures are divided into seven chapters: introduction; the tax authorities' obligations; taxpayers' obligation to cooperate; consequences of non-compliance; performance of adjustments; competent authority and arbitration procedures; the replacement of existing rules. The administrative principles emphasize at the outset that it is the tax authorities' obligation to investigate the facts of a case and to try to discover facts that are beneficial for the taxpayer. The taxpayer's obligation, which are mainly regulated by the German Tax Procedures Act, are explained in more detail in the third chapter of the administrative principles and procedures. These obligations include extensive cooperation and document preservation obligations for foreign related-party transactions. The taxpayer is committed to take reasonable precautions with related parties to ensure that he can obtain documents and relevant information from related parties. This provision could lead to extensive disputes with the German tax authorities. The third chapter also specifies the documentation requirements for taxpayers. Under the new documentation provisions, taxpayers are requested to document prices and terms of their business activities with related parties including detailed analysis of the functions performed. Such documentation has to cover the activities conducted, the risks borne, agreements between the related parties as well as legal and economic facts being relevant for their transfer pricing. In particular, the documentation package on transactions related to these agreements (i.e. sales and purchases of goods as well as services, financing, intellectual property etc.) needs to include information such as: comparable prices calculation of prices margins of comparable companies agreements with economic impact on related transactions benefit test. Under the new documentation law, a full-scale transfer pricing study will be required for every relevant transaction or group of similar transactions. The documentation must allow a competent third party to ascertain within an adequate period of time the fact and circumstances the taxpayer has realized in connection with the business to related parties and whether the taxpayer has followed the arm's length principle. The administrative principles do not contain formal guidelines on how to prepare documentation, other than the provision that documents must prepared in the German language. Nevertheless, the relevant tax authorities may grant an exception to this requirement upon request. Documentation my be prepared in written or electronic form, and must maintained and stored for 10 years in an appropriate manner. The taxpayer is required to ensure that the documents and data kept by a foreign related party that are relevant for German taxation are preserved and not destroyed before the German time limit for preservation of files has elapsed. The German requirement that documentation must be preserved for 10 years is often longer than time periods in other countries, a fact that could create a substantial burden for an international group of companies to ensure that the 10-years period is observed by related parties in foreign countries. Generally, transfer pricing documentation must be prepared only at the request of the tax authorities; however, in the case of extraordinary transactions it must be prepared contemporaneously, that is, within six month after the end of the fiscal year in which the extraordinary transaction took place. Extraordinary transactions are defined as major changes in the functional and risk profile of a taxpayer; transactions in the context of a change in business strategy that has a significant impact of transfer prices and the entering into or the changing of long-term agreements that are particularly important. Taxpayers must keep in mind that they must make available the documentation for tax audit upon request within 60 days. The most important aspect of the Documentation Law and the administrative principles is the documentation of compliance with the arm's length principle. Taxpayers must provide an economic analysis that demonstrates the arm's length character of the transfer pricing. They must show - through documentation - good faith efforts to comply with the arm's length principle. According to the new documentation requirements, the taxpayer will have to produce sales forecasts and planning data to explain why the prices chosen are reasonable from his perspective. It can be expected that data for a third-party comparisons will have to be produced to the extent possible with "reasonable effort". Consequently, this means that databank screenings will be necessary for margins but normally not for prices. Under German law, taxpayers are in theory free to choose the transfer pricing method. The new administrative principles do not require explicitly an application of the "best method rule", but prefer the standard methods, i.e. "comparable uncontrolled price method", "resale price method" and "cost plus method". The taxpayer shall - if possible and reasonable - use internal and external comparables, as well as internal budget data. Net margins of comparable companies for different kind of business transactions or aggregated business transactions are acknowledged when using the transactional net margin method (TNMM). However, the administrative principles note that the use of TNMM is permitted only if a company exclusively performs certain clearly defined routine functions without assuming major risks, and does not use any non-routine intangibles in its typical business activities. Chapter four of the administrative principles defines the legal consequences of a violation of the taxpayer's duties to cooperate, and supplements the existing sanctions and penalties regulations in the Tax Procedures Act. When a taxpayer violates its duty to cooperate, the tax authorities' duties to investigate are reduced accordingly, but are not completely extinguished. If the tax authorities cannot fully investigate the actual and legal circumstances to determine the taxpayer's tax liability, the administrative principles regulate that an estimate is required. Even a marginal violation of the taxpayers' duties may be harmful. For example, if the determination of the transfer prices is based on internal data and the budgeted data was not checked against the actual data at regular intervals, the internal data could be regarded as materially unusable. In addition to the income adjustments related to the transfer prices, also monetary penalties are applied if any documentation requirement has been violated. A minimum penalty of Euro 5,000 will be levied for not filing or late filing or inadequate filing. This penalty applies regardless of any adjustment to income. Also, a minimum penalty of Euro 100 applies for every day of delaying the documentation package. The penalty is limited at Euro 1,000,000 if documentation package is simply delayed, as long as the tax authorities can make use of it for tax audit purposes. The penalties in cases of income adjustment range from 5 to 10% of the amount adjusted, not on the additional taxes. The new administrative principles constitute a comprehensive set of rules for documentation and related issues. It remains to be seen how tax auditors will apply the new rules. Taxpayers are well advised to take the opinion of the tax authorities into account in preparing their documentation, if they want to avoid transfer pricing issues from the beginning. Prepared by: Bernd Burkhard
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