642(Vol.12,no.13) In Practice Practical Guidance on Germany's New Documentation Rules By HEINz-KLAUS KROPPEN AND STEPHAN RASCH court stated that under German law no written docu mentation requirements existed for German taxpayers he tax authorities felt that this decision put them at a t major disadvantage and made the auditing of transfer ierman officials h ible. 5 Therefore, they initiated a had prevente ment the arm's-leng two parts: the first, en- transactions nance Ministry authority Set forth in eig s, to apply numerous pract issue docu dress. The tation must ctive retro- documentation o tion. The taxpay- es. This article will de- percent t and analyze what they adjustment Further, ambiguous la data sets must b authorities The new docu ach taxpayer cre- tion of the ta sion of the G ransactions be- for those transac German St yers could orices anc o Pricing Rep 4C S3/01, Der B onale port167,72 1863ff 00, Der Be p.360 Kroppen, H Tax Notes Klaus, Ra Wirtschaft Wasserme Harald and Fach 3 D tus, Inte Wolt Die S Heinz-Kic tional tax p che's Dusseldorf. Steph European Transfer ing Report seldorf. cing Report 1080, 11-12-03 Copyright 2003 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs. Inc. TMTR ISSN 1063-2069
IN PRACTICE (vo.12,No.13) 643 proof actually has shifted to the taxpayer. However, tax authorities and in the business community. Larger the explanatory notes to the decree law state that the companies and some tax officials favor accepting profit new rules do not shift the burden of proof to the tax- based approaches and the use of databanks because, in payer. Instead the notes say the taxpayer may show- their view, it is in many cases the only realistic way to bR gh its documentation-that it has made a good. provide data at all. On the other hand, other tax offi. cree law also clarifies that the documentation tally against the use of profit-based approaches and requirements are not only applicable for the exchange plying the results of databank searches of goods and services, but also for pool contracts and the secondment of employees. 9 This controversy is implicitly reflected in the decree law and its explanatory note so the situation remains Three Types of Data clear.It seems that, contrary to the past, the german ax authorities have become more open to profit-based The decree law explicitly mentions three kinds of approaches. This can be concluded from the fact that data as part of the documentation, namely data Section 1, paragraph 3 of the Rvo states as examples for the data that the taxpayer shall obtain"net profits a from transactions between two unrelated parties and profit allocation (external comparison); from transactions between taxpayer and unrelated The decree law also requires the taxpayer to obtain parties(internal comparison), and data from freely available sources. Such sources nor 1 regarding sales,profit, cost planning, budgets, and mally could only be understood to be publicly available projections. The explanatory notes to the decree law state that he decree law provide that the requirements for docu budgets,projections, and other internal data are not mentation cannot be fulfilled by an overall, rough profit sufficient to prove the arms-length nature of the pric- comparison. In the authors view this statement has to ing, but might become relevant if arms-length data is not available or is of insufficient quality lot take into account the different functions and differ- ent product groups of a company, but solely compares the decree law is whether all three data types must be operating, profits of companies which are not really included in the documentation package or whether it is comparable sufficient to show the arms-length nature with only one If, however, a state-of-the-art transactional net mar data type. The wording of the decree law could be read gin method (TNMM) analysis is prepared, such analy in a way that all three data types do need to be included sis can be used for documentation purposes. The au in the documentation. The explanatory notes to the de- thors'opinion is supported by a recent publication of a cree law, however, states that the arm s length docu- member of the tax authorities who was deeply involved mentation can be prepared based on an external or in- in the creation of the decree law. He has expressed his ternal arms-length comparison so that the use of such riew that profit-oriented methods will lead te data is alternative basis and not cumulative able documentation and will therefore exclude In addition, some tax officials already have ex- alties possible under the law if the criteria for pressed a view that taxpayers will not be required often bility have been observed and the necessar to provide projections, budgets, and other calculation ments have been performed. 3 data if the arm's-length data that is provided is already conclusive on its own. 1o Data from Related Parties Accepting Profit-Based Methods Section l, paragraph 3 of the Rvo explicitly de a second major discussion item in the mands that the taxpayer uses comparable data that it or y related party has at their disposal. This provision is was the acceptability of profit-based approaches and in the reaction of the tax authorities and the legislature to tax authorities were rather famous for their rejection of a Supreme Tax Court holding that data from foreign profit-based methods. This may be changing, ho related parties need not be obtained. Th he question is ever. Various opinions have been noted both with the herefore how far the legal obligation of a German tax payer goes with respect to related-party data, and what sanctions might result from a breach of this obligation s See also Wassermeyer, Franz, Der Betrieb, 2003, pp.1535 Earlier Supreme Court decisions before the Oct. 17 f; Rasch, Stephan, and Roeder, Achim, 11 Transfer Pricing Re- 2001, ruling had interpreted the obligations of the tax- ee the discussion under Cost Allocation Agreement payer to cooperate with the authorities rather exten- Schreiber, Rolf, Stewerberatung, 2003, pp 474, 4 sively and had required the taxpayer to obtain data i See Kroppen, Heinz-Klaus, and Rase from foreign-related pa any Modifies Legislation, Uncertain Future Stills Lies essary for the taxpayer to include in its contractual re Ahead,"11 Transfer Pricing Report 885, 2/19/03; Kroppen, lationships with a foreign-related party a clause that e press release of the Federal Ministry of Finance 13 Schreiber. Rolf erating,2003,pp.474,485 ated July 13, 1995. Deutsches Steuerrecht 1995, p. 150 14 Federal Tax Cou also Kroppen, Heinz-Klaus and Eigelshoven, Axel, in: IBFD ision dated 16.4. 75/78 Federal Tax Bulletin 1981 Il, pp. 492; decision dated raster preng, chare 2, rcie e@f, amstrda m a S of une 186: decision ated 1.e rs T-T R Ist 7 ederal 3 Bulie in, BStBl. 1999 Il, pp. 121. TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069 BNA TAX 11-12-0
44(voL.12,No.13) IN PRACTICE certain data would be provided. Thus, one might ex count the functions and risks For rather large corpora ect that the tax authorities will assume a violation of tions with virtually millions of transactions, even these this obligation if the taxpayer has not explicitly laid aggregation rules will more often than not put them in down in its contractual relationships that the foreign re- a position to prepare documentation with a reasonable lated parties must provide the German affiliate with the amount of efforts and costs necessary data. On the other hand, that would also Therefore, rather early on in the legislative process mean that a German taxpayer cannot be required to ob- large companies tried to convince the german authori- tain data from related parties (e.g,a sister company) ties that documentation based on a consistent and rea E: obligation to obtain data from a foreign in a pre was draft of the如少b间会 with which it does not have any contractual relation- onable transfer pricing guideline should be pern ships at all. sible and should alleviate the documentation mean that the a6, paragraph 3 and 4 of the AO, such one or more appropriate methods, could be part of the line based on arm'slength principles, which was using penalties are only applicable if the taxpayer does not documentation. This provision was not very helpful for provide any documentation, the documentation is unus- the companies because it was obvious before that any of a foreign related party, no penalty should apply in\ soem that the wording of the decree B A ities to convince s were held with the tax autho spite of the violation of the requirement to obtain such positive towards transfer pricing guidelines. As a resul le final enacted version reads that if transfer pricing Best Method Rule guidelines determine the setting of prices and are actu U.S. transfer pricing regulations, specifically Regs. single transactions becomes obsolete. This new word- s1482-1(C), contain the best method rule under which ing has to be seen as a major step forward and a help- termining its transfer prices is the best method, taking their documentation with reasonable efforts into account the functions and risks of the involved tax a transfer pricing guideline should meet essential method is appropriate. I It is explicitly stated that the taxpayer is not required transactions. Hence, it should be stated in the guideline to prepare documentation for more than one appropri- that areas of the company that deviate from the guide ate method. Yet, in practice, it is sometimes rather dif- line must become responsible for setting up individual documentation. Practical experience she that the ate for a certain kind of transaction or transaction fow. number of actual deviations will rapidly decrease To Therefore, very often taxpayers who are in jurisdictions other than the United States have determined the ap essary that the guideline be used according to its actual propriate method by excluding other methods, thereby finding the appropriate method by default of other methods. Such procedure should still be permissible Contemporaneous Documentation Transfer Pricing Guidelines have contained provisions on ongoing documentation Section 2, paragraph 3 of the decree law includes the thorities for not following the arm,s-length example be- cause of these ongoing documentation requirements pared for each and every transaction. However, the de Third parties would usually not change the cree law allows for a certain aggregation of transactions structure once it had been agreed upon. It was if these transactions are comparable, taking into ac- gued in Germany that ongoing documentation ments were in violation of civil law rules because such iS For a detailed analysis, cf. Rasch in: Becker Helmut and Kroppen, Heinz. Klaus(Edits ch Interna- 18 See Kroppen, Heinz-Klaus, and, Rasch, Stephan, Interna- gspreise(cologn ) -Schmidt Ver- tonale wirtschaftsbriefe, Fach 3 Deutschland, pp. 195 lag 1997/2001),0 5.26 2 ff. See also: Schreiber, Rolf, anforde- For coverage see Kroppen, Heinz-Klaus, and, Rasch, rungen an die Mitwirkungspfl Stephan, Internationale wirtschaftsbriefe, Fach 3 Deut sbestimmung in Deutschland, Universitat Hamburg, Hefte zur chand, pp 1955 ff. and of a former draft as of March(Inter ternationalen bested Nr. 139, 2002, p. 36; Hangarter, nationales Steuerrecht 2003, pp, 248 ff), Kroppen, Heinz Helmut, Die Dokumentation von grenzuberschreitenden Ver- Klaus, Kroppen, Heinz-Klaus asch, Stephan, wo Tax Daily, 10 March 2003, 2003 WTD 46 Schon(Hrsg ) Gedachtnisschrift fir Klaus, and, Rasch, Stephan, Internationale Wirtschaftsbriefe 97, pp 557, 576: Schreiber, Rolf, In- Fach 3 Deutschland, pp. 1921 ff. ternationales steuerrecht 1994.S. 315. 316 20 See footnote I 6 Schreiber, Rolf, Steuerberatung, 2003, pp 474, 485 2I See also Schreiber, Rolf, Steuerberatung, 2003, pp. 474 7Cf. section 2, paragraph of 2 RVO 111203 Copyright 2003 TAX MANAGEMENT INC, a subsidiary of The Bureau of National Affairs, Inc. TMTR ISSN 1063-2069
IN PRACTICE 12,No.13)645 rules allowed the deviation of already concluded con- sight cannot only be made by the tax authorities to the tracts only under very extraordinary circumstances axpayer's disadvantage. By the same token e tax- In spite of their prior position, the German tax au- payer must be allowed to make price adjustments to re thorities in the decree law now have formulated a ongo- duce the profitability of a German company if such ing documentation requirement for mainly two situa- profitability is substantially above what was anticipated long-term contracts that, if the circumstances change should not only be accepted if results are below what the taxpayer must continue to collect and document in formation in later time periods to allow the tax authori the parties could have expected when the contract was concluded ties to make a determination as if, and from which point in time, third parties would have adjusted the cond A practical problem of the ongoing documentation uirement is of course that the decree law does not tions of the transaction. Ongoing documentation in this fine exactly in which situations such a documentation sense is in particular necessary if losses occur or if price should be prepared. It is only stated that such a docu hanges Although there are still principle objections against mentation is necessary if losses occur which third par such continuous documentation requirements, it should ties would not have been willing to bear. However, this articular point is usually heavily contested in tax au- also be clear that such price adjustments based on hind- dits and the taxpayer is usually arguing that such losses Practical Approach to Documentation Following the decree law's enactment, several large German and European multinationals have decided or are considering to base their documentation on a transfer pricing guideline that would normally include the following part 1. Preamble The importance of a well-written preamble should not be underestimated. In general, users of st ransfer pricing guideline are not members of the tax department, but working in an operative They are often not familiar with the goals of such a guideline and the underlying tax-related th its. The preamble should therefore contain a clear and unambiguous description goals defined for both the domestic and foreign tax areas 2. Transactions This segment should define the most important transaction forms for the distribution and service trans- actions. The transactions can be limited if one restricts the substantial characteristics of a transaction Such an action has the advantage that the overall distribution and service area in the company will be reduced to a manageable number of transaction categories to document. By defining transaction forms 3. Function and Risk Profile A typical function and risk profile for the defined transactions of pared. Because it seems impossible to cover each special case, the should be pre estricted to the unction and risk profile typical for each transaction form. The oper ould then or entate themselves to these profiles In the discussions necessary to tion will have to be overcome since many operative personnel might think that their business is some. thing special Guided discussions will, however, make clear that finally each transaction will fit into one of the established categories after all On the basis of established function and risk profiles respective framework agreements may be devel- oped that present the agreed function and risk profile in the form of a contract It is thus essential to in- rolve the legal department as soon as possible when developing corporate templates 4. Example It is important to provide practical examples fro om within the company to define the various transaction forms so that the user knows which concrete transaction falls into which abstract description of a trans- action form 5. Transfer Pricing Method One transfer pricing method for each of the previously described transaction forms should be deter mined. Naturally the transfer pricing method will often vary for the different transaction forms Many countries, including Germany, require that taxpayers use comparable data for their transfer pi g documentation. Thus, the guideline should include respective comparable data and analyses of the ifferent transaction types regularly created for the domestic area. This benchmark should be evaluated at regular intervals to fulfill the present demands of the local tax authority AX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069 BNA TAX 11-12-03
646Vol.12,No.13) IN PRACTICE are normal and also third parties would have borne document is prepared within six months after the end them. Under the new rules the taxpayer would have to of the business year in which the transaction has oc- ake the difficult judgment at what point third partie curred. Extraordinary transactions also are defined as would no longer accept such losses. 2 The requirement those that involve: also is illogical because a taxpayer would typically ar- gue that in spite of the losses no adjustment is neces- a the transfer of assets in reorganizations sary because third parties would have been willing to major changes in the functions and risks of the bear the same losses. However, then no documentation cree law. On the other hand, if third parties would not pany; and Changes of the business strategy of the com- would be necessary at all under the wording of the de- ■majo have been willing to bear such losses, it is questionable a the conclusion and amendment of important long what the taxpayer would document because an adjust- term contracts that have a substantial impact on the in ment would then become inevitable, 23 come of the German taxpayer. It has to be emphasized that this definition is rather Materially Unusable Documentation broad and would, for example, also include the conclu sion and amendment of long-term distribution con Section 162, paragraph 4 of the AO applies to penal- tracts between a German distribution subsidiary and its ties in the amount of 5 to 10 percent of the transfer pric foreign parent. It would probably also mean that price ing adjustment and a minimum of 5,000 euros, not only changes within this long-term distribution contract if no documentation is prepared at all, but also if mate- would always have to be currently documented rially unusable documentation is submitted. Howe the ao does not define the term"materially unusable.' Originally Section 6 of the draft decree law of June 12 2003 gave certain criteria to determine when documen- A very common problem in past tax audits has been tation was materially unusable. 4 But the section has that taxpayers have prepared documentation in the lan- been deleted from the final decree law so that there is guage of their parent company and the auditor has in- cree law.According to this explanation, documentation paragraph 5 of the RVO. Here it is confirmed that docu shall be materially unusable if it is impossible for a rea sonable auditor within a reasonable time period to au- mentation principally must be prepared in German dit the transfer prices on the basis of the arms-length However, it is also provided that the tax authorities can test, This shall be the case if the documentation is in allow exceptions upon application by the taxpayer. This comprehensible, incomplete, or contradictory, or if the application can already be filed before the documenta taxpayer has not used any transfer pricing methods at n is prepared, but has to be filed without delay after all or has used a clearly inappropriate one e tax authorities have requested the documentation In spite of this explanation in the explanatory notes This provision is at least some progress in the right di rection insofar as a foreign language is not a priori ex- it has to be expected that in the future a lot of contro- cluded. It is therefore advisable for an internationa versy will come up about what is a materially unusable group to prepare regional or global documentation us documentation. There is no penalty as such for incom- nglish because this language gives the taxpayer be accepted in many countries From crossed if the incompleteness of documentation leads to a German perspective, it will normally not make much it becoming materially unusable. In addition, it can be sense to already apply for an exception from the ger- foreseen that some tax auditors will try to declare that man language requirement before documentation is a taxpayer's transfer pricing method is clearly inappro- prepared because at that point in time it will not be priate to bring related-party transactions under the pen- clear which auditors will audit the company and what lty regime. This is particularly dangerous because their language capabilities are going to be there are still many tax auditors who oppose profit based methods and will probably try to reject sucl Therefore, in practice the application will usually be methods as clearly inappropriate e able to apply filed at the moment the documentation has been re quested by the tax authorities. It is then up to the tax authorities to quickly decide about the application so Extraordinary transactions eral 60-day submission period to prepare the transla- tions. If the tax authorities do not quickly decide about documented. In this context Section 3 of the rvo states hat contemporaneous documentation is assumed if the Heinz-Klaus, and. Rasch, St wide Tax Daily, 10 March 2003, 2003 WTD See also Wassermeyer, Franz, Der Betrieb, 2003 Heinz-Klaus, and, Rasch, Stephan, internatio 1535,1537. briefe, Fach 3 Deutschland, pp. 1955 ff Rolf, Steuerberatung, 2003, pp. 474, 486: biege see Rasch, Stephan, in: Becker, Helmut and Kroppen Wirtschaftsbriefe, Fach 3 Deutschland, pp. 1587, 1601: Was- Heinz-Klaus(Edi buch Internationale Verrechnung spreise(Cologne: Dr. Otto-Schmidt Verlag 1997/2001), 05.5 ermeyer, Franz, Die Wirtschaftsprufung 2002, pp. 10. 16 notes I ff: Kroppen, Heinz-Klaus, and, Rasch, Steph See Kroppen, Heinz-Klaus, and, Rasch, Stephan, Interna nationale wirtschaftsbriefe, Fach 3 Deutschland, pp. 1921 ff tonale wirtschaftsbriefe, Fach 3 Deutschland, pp. 1955 Schreiber, Rolf, Steuerberatung, 2003, pp. 474, 486 f 11-1203 Copyright e 2003 TAX MANAGEMENT INC, a subsidiary of The Bureau of National Affairs. Inc. TMTR ISSN 1063-2069