Guidance updated on taxpayer obligations during transfer pricing exam
“Administrative Principles 2020” (AP 2020), released by Germany’s Federal Ministry of Finance (BMF) on 3 December 2020 (and subsequently published in the official gazette), set out a taxpayer’s obligations during the course of a transfer pricing examination, in particular with respect to the attribution of income between internationally associated enterprises, the estimation of the tax base and sanctions for failure to comply. AP 2020 updates certain aspects of an AP dating from 2005, focusing on various aspects of a taxpayer’s duty to cooperate with the German tax authorities, the burden of proving that transfer prices are on arm’s length terms and the powers of the tax authorities to make estimated assessments under sections 90 and 162 of the Federal Fiscal Code (AO). The AF should be welcomed by taxpayers as it clarifies certain issues that are not addressed in legislation.
The most important aspects of AP 2020 are as follows:
Duty to cooperate
AP 2020 emphasises that the taxpayer’s duty to cooperate with the tax authorities and the tax authorities’ duty to carry out an official investigation coexist and that the taxpayer’s duty is limited by the “proportionality principle.” Under German law, the arm’s length nature of transfer prices must be supported by documentation that typically is requested by the domestic tax authorities as part of routine tax audits. The taxpayer must ensure that evidence is accessible and be able to produce sufficient evidence necessary for the German tax authorities to determine whether the transaction(s) at issue are in compliance with the arm’s length principle. The duty to cooperate is enhanced in cross-border transactions, because the German tax authorities do not have the same access to information as they would in a purely domestic case. According to the BMF, relevant evidence in cross-border cases can include electronic communications (e.g., emails or messaging services) that contain business and commercial content with a tax reference. The taxpayer also must ensure it can subsequently access evidence located abroad to submit to the German tax authorities, if so requested.
With respect to the documentation that should be submitted in cross-border cases, AP 2020 refers to what a “prudent manager” would do in the circumstances and sets out the following examples of relevant documentation:
- Sales prices in transactions between a related company and unrelated third parties where the resale price method is used;
- The basis for calculating expenses of a foreign service company when applying the cost-plus method;
- Evidence of contributions made by companies participating in a cost contribution arrangement;
- Income generated by a licensee from intangibles where such assets are transferred in return for revenue-based royalties; or
- Information on the total profit or loss and the allocation formula when applying the transaction-based profit-split method.
If the taxpayer either does not submit documentation or submits inadequate documentation within the meaning of section 162(3) AO following a request by a tax auditor, a rebuttable presumption arises that the taxpayer underreported its income from related party transactions. This presumption reverses the burden of proof and the taxpayer then must demonstrate that the transfer prices are on arm’s length terms. In such a case, the German tax authorities may estimate taxable income and impose penalties under section 162 AO. The transfer prices used by the German taxpayer can be adjusted based on an estimation applying the upper or lower range, depending on what is most disadvantageous for the entity.
Special documentation requirements
Section 90 AO sets out the transfer pricing documentation requirements. The documentation should enable an expert third party to determine within a reasonable time the actual facts asserted by the taxpayer and whether and the extent to which the taxpayer has complied with the arm’s length principle. AP 2020 contains examples of information that can be included in documentation with regard to activities, functions exercised, assets used and risks assumed. Business relationships with related parties should be presented in a transaction overview showing the type and volume (amounts) of transactions.
AP 2020 does not specify any particular point in time that will be decisive for carrying out an arm’s length test using comparative data (price setting vs. outcome testing approach). The economic and factual circumstances that exist at the time a business relationship is established are decisive for purposes of the documentation. Therefore, a taxpayer should document when a transaction is concluded and how the transfer price was determined. The appropriateness of the business relationships should be reviewed (with the time the contract was concluded being decisive), although external arm‘s length data can be used if it relates to the time of the relevant agreement.
The taxpayer must be able to justify the transfer pricing method selected, but the German tax authorities have the power to use a different method if that method proves to be the most appropriate. The application of an alternative transfer pricing method by the authorities could lead to an adjustment “if the results of that method are more feasible.” The taxpayer is supposed to provide the information requested by the tax authorities to apply the method they consider more appropriate. Except in cases where the method applied by the taxpayer is patently incorrect, it is questionable whether such request for information would be in accordance with the proportionality principle.
In the case of a hypothetical arm‘s length comparison, the taxpayer is expected to conduct “sensitivity analyses” that show how the determined value of the object changes depending on alternative assumptions and parameters.
Estimation of the tax base and penalties
The taxpayer’s duty to cooperate with the German tax authorities is breached if the taxpayer fails to disclose information that is within its possession or area of knowledge and/or if the taxpayer fails to comply with transfer pricing documentation requirements. AP 2020 addresses the burden of establishing the facts, as well as the admissibility and use of estimated assessments where there has been a violation of the duty to cooperate. The AP clarifies that estimates of taxable income by the tax authorities must be reasonable, within the bounds of a range and not be arbitrary or punitive in nature. As mentioned above, if a taxpayer fails to comply with the documentation requirements under section 90(3) AO, the burden of proof shifts to the taxpayer to demonstrate that there has not been any reduction in its income.
In the case of gross violations, the tax authorities generally are required to determine the taxable base based on facts that are the least favourable—but still possible—for the taxpayer. According to the BMF, the tax authorities do not have to meet any heightened requirements when making an estimate of transfer prices. They may therefore use methods and data whose evidentiary value would not be sufficient for them to make an income adjustment in other circumstances; for example, the authorities may have recourse to tax authorities’ reference rates or industry averages. The BMF points out that the tax authorities’ ability to make an estimated assessment is not affected by whether or not the authorities previously made use of international legal and administrative assistance.
AP 2020 emphasises that, in terms of determining whether data is “usable,” the quality rather than the quantity of the data is decisive, although the German tax authorities can estimate taxable income even if the data is usable. However, if the transfer prices applied by the taxpayer are unlikely to be in line with the arm’s length principle, the tax authorities can make an adjustment if the price determined by the authorities is at least more likely. According to the AP 2020, this could be the case if, for example, the tax authorities apply a different transfer pricing method than the taxpayer and choose a database study as the estimation method. It does seem questionable whether the tax authorities have the power to estimate income where the taxpayer submits usable records.