On 10 December 2019, the German Federal Ministry of Finance published a draft bill of the so-called ATAD Implementation Act (“ATAD-UmsG“) by which the second European Anti Tax Avoidance Directive (“ATAD II”) should be implemented into German national law. This draft not only contained amended provisions related to the already existing German CFC rules and to new rules concerning hybrid mismatches but also an amendment of the German transfer pricing rules. However, so far, the ATAD-UmsG has still not been passed by the German parliament even though the European commission has initiated formal infringement proceedings against Germany on 24 January 2020.
In an answer by Germany’s Federal Government to a parliamentary enquiry made by the FDP (German Liberal Party) on 19 March 2020 regarding the new transfer pricing provisions, an interesting aspect was revealed which, at first sight, seems to be new in the German transfer pricing world: a clear refusal of the so-called price-setting approach. However, with reference to the wording in the new section 1 (3) (4) of the German Foreign Tax Act (“FTA”), some advisors (see e.g. EY in the statement on the draft bill of 5 February 2020, p. 12; PwC in a YouTube webcast of 18 December 2019; Deloitte in an article in IStR 2020, p. 162 et seqq.) were of the opinion that this new provision would be the implementation of the (ex ante) price-setting approach (see OECD Transfer Pricing Guidelines 2017, mn. 3.69) into the FTA. This view was based on the wording according to which the circumstances at the time of the agreement on the business transaction must be taken into account when determining transfer prices.
However, experienced transfer pricing experts have considered this wording to be a confirmation of decade long case law in relation to section 8 (3)(2) Corporation Tax Act, namely that the decisive point in time for the examination of the arm’s length principle is basically the time of the conclusion of the contract (see, for example, former presiding judge of the Federal Tax Court Gosch, in Gosch, Corporation Tax Act, 3rd ed., Commentary, Sec. 8, no. 370 with reference to the established case law in this respect, which should also apply to Sec. 1 FTA). The fact that the legislator used the term “determination” of transfer prices in Sec. 1 (3) (1) FTA should not have changed this.
Even a closer look at the explanations of the draft bill gives rise to doubts that the application of the price-setting approach was ever intended by the FTA. In order to determine a taxpayer’s income, the explanations contain a three-step approach according to which the taxpayer may determine transfer prices at liberty in the first step, which in a second step must be reviewed based on the arm’s length principle and, if necessary, adjusted until the tax return is submitted if doubts regarding the arm’s length character still exist. This description is probably more consistent with the so-called (ex post) “outcome-testing approach” (see OECD Transfer Pricing Guidelines 2017, mn. 3.70), which is the only conceivable approach in a taxation system based on the assessment by the tax authorities (see below).
In this context, the authors believe that the discussion in Germany on this topic mixes up certain things anyway: the discussion at OECD level on the two approaches has been driven in particular by countries such as the US or the UK, whose taxation system is based on the so-called “self-assessment system” in which the taxpayer is responsible for the correctness of the tax base when submitting the tax return. For this reason, companies in the US prepare annual database/benchmark studies when filing their tax returns, because already at that point in time they need to be certain that transfer prices or margins are arm’s length. As a consequence, there is also the possibility of penalties, for example pursuant to Sec. 6662 of the Internal Revenue Code, if the taxpayer has abused the trust placed in him by the self-assessment system and has agreed on inappropriate transfer prices. Penalties of this kind do not exist in German tax law, because the tax authorities act as a sort of auditing authority when performing the tax assessment for the taxpayer based on the tax returns taxpayers have submitted.
In other words, the price-setting approach is alien to the German tax system and, therefore, cannot have been introduced by the new Sec. 1 (3)(4) FTA as long as the declaration of intent of the German Federal Government to gradually introduce a self-assessment in the coalition agreement does not go beyond this stage (cf. coalition agreement of CDU, CSU and SPD for the 18th legislative period, 2013, p. 64). In other words, without a self-assessment system in Germany, any discussion about the government’s intentions to introduce the price-setting approach are nil and void.
For some people this seems to be a rather academic discussion; but so far, it has led to a number of problems in practice as it has raised e.g. the following question: What is the arm’s length transfer price when a supply contract is concluded (by submitting the price lists to the distribution company) in the first quarter, if at that time it cannot be foreseen whether these prices will lead to an arm’s length profit of the distribution company at the end of the year? The different views of different countries as to which approach should be applied triggered cases of double taxation which either led to the initiation of mutual agreement procedures (MAP) or made some taxpayers accept the double taxation, despite the fact that the tax auditor and the taxpayer agreed on the fact that the (overall) profit level of the distribution company was arm’s length.
The Federal Government’s clear refusal published within the aforementioned answer proves that the price-setting approach was already alien to the FTA, even though some representatives of the tax administration at times may have voiced a deviating opinion. One might say today that such deviating opinion would not have been based on a sound understanding of the major parameters of the national tax system which up until the very day is not a self-assessment system.
On the contrary, taxpayers are free to decide how to calculate or determine their transfer prices. The arm’s length principle is not primarily a standard of conduct, but is intended to check whether the agreed transfer prices lead to appropriate profits. Whether or not the tax base for the tax period which, in Germany, is the financial year is considered to be arm’s length, is decided when taking into account the entire financial year. If, at the end of such year, there are doubts that the margin earned by an entity or the price agreed in intra-group transactions may not have been arm’s length, adjustments would have to be made. If possible and the books are still open, such adjustments would be booked in the commercial financial statements. If these were closed, adjustments could always be made to the accounts receivable/accounts payable in the balance sheet, or, an explicit transfer pricing adjustment outside of the (tax) balance sheet.
What does this mean for German taxpayers? In our opinion, the interpretation presented in the answer to the parliamentary enquiry has consequences for the past and for the future: On the one hand, this interpretation could certainly be used as an argument in current tax audits if – as our experience shows – there is a risk of possible double taxation due to the strict application of the price-setting approach by the German tax auditors (despite the analysis above). In such cases it would be difficult to maintain a position that it is only the price-setting approach that can be applied in Germany. On the other hand, the interpretation can make it easier for the ongoing determination of prices during the year (e.g. on a quarterly basis), since it could be easier to adjust transfer prices. This can be particularly important considering the current Corona crisis, as transfer prices may have been determined on the basis of entirely different planning data than the current economic forecasts suggest. Nevertheless, options to adjust transfer prices should always be laid down in the respective contract.
Ultimately, the focus of the German tax audit on the price-setting approach can also not be maintained taking into account the actual meaning and purpose of the FTA (ratio legis): If the ultimate purpose of the FTA is to prevent the arbitrary shifting of profit via intra-group business transactions, this purpose is fulfilled if the taxpayer declares – in accordance with its functional and risk profile – an arm’s length profit in its tax return. The tax return, however, is prepared only once a year, after the end of the financial year; (from an income tax perspective) arm’s length transfer prices must have been agreed upon (ex post) at the latest at this point in time for the entire year. Considering this fundamental principle, one can sum up the discussion about the potential impact of section 1 (3)(4) FTA with Shakespeare: Much ado about Nothing!