Germany’s increasingly tough TP audit environment presents challenges for taxpayers
Transfer pricing has been an area of high importance for years. We are seeing that multinational companies operating in Germany are being increasingly examined by tax auditors.
The level of transfer pricing expertise of the tax auditors is also increasing. Therefore, the transfer pricing environment in Germany is getting more and more challenging. We expect that with the BEPS initiative the transfer pricing focus in Germany will even get stronger.
Based on our experience the areas that are most scrutinised and challenged by the German tax authorities include in particular:
• Loss making companies or companies earning relatively low margins
If the company incurs losses, especially over some years or reports considerably lower results than its competitors, the tax auditors are likely to assume that the transfer pricing model inappropriately remunerates the taxpayer, considering its functions, assets and risks. Only recently have we seen, on several occasions, the tax authorities questioning the profitability achieved by the German distributors with a focus on certain industries such as pharma. The tax authorities challenged the distribution margins achieved by these entities, in particular, with reference to local marketing intangibles such as customer databases and customer relationships held by these distributors.
• General focus on intellectual property (IP)
The tax authorities pay special attention to payments for such things as technology, patents, know-how and trademarks. They scrutinise both the transfer and licensing of IP between related parties. A commonly challenged area, in this respect, is the lack of charges for a group name (a trademark) that is utilised by the subsidiaries of the German based corporation.
• Questioning transfer pricing documentation
The tax auditors are becoming stricter on the formal transfer pricing documentation requirements. We are observing that the tax auditors are increasingly branding documentation submitted by the taxpayer as insufficient, hence not compliant with the German requirements. If the taxpayer’s transfer pricing documentation is insufficient, the tax authorities are entitled to perform a transfer pricing adjustment to the less favourable end of the range for the taxpayer or even assess penalties. This will most likely increase with country-by-country reporting (CbCR).
• Application of the hypothetical arm’s length principle
Based on the German regulations the hypothetical arm’s-length principle should be used to verify the transfer prices, whenever transfer prices cannot be verified based on the prices agreed in comparable transactions between unrelated parties (neither fully nor partially comparable transactions exist). The concept basically means adopting a fictional situation to answer what the transaction would look like – particularly what price would be agreed – if it was concluded between unrelated parties. To this end, a transfer pricing range has to be determined between the minimum price the seller would be willing to sell goods/services and the maximum price the purchaser could offer, assuming that both parties would act in a prudent and diligent manner. Ultimately, the most likely value should be chosen within the defined range as the arm’s-length price. By default, it is the arithmetic mean of the range, unless another value can be substantiated by the taxpayer. Initially, this principle was applied in relation to business restructurings (transfer of functions/assets/risks between related parties); however, we are seeing the tax authorities applying this principle to the licencing of IP. The tax authorities claim that the arm’s-length royalty fee for licensing a given IP cannot be determined by reference to royalty fees for licencing potentially comparable IP because, according to the tax authorities, each IP is unique, so in fact no comparable IP exists (except for internal CUPs). Questioning benchmarking studies of IP prepared by the taxpayers and applying the hypothetical arm’s-length principle instead, can lead to significant income adjustments.
• Financial transactions
Interest on debt, such as loans and cash pooling, is also under scrutiny by the German tax auditors. We have seen the tax authorities questioning the interest rate agreed in the controlled transaction based on the interest applied by the banks because of insufficient comparability of both transactions. In particular, the tax authorities claim that that the banks are specialised entities, which is not the case in intra-group financing arrangements. Consequently, the tax authorities conclude that in such circumstances (similarly as for IP) the hypothetical arm’s-length principle should be applied.
Given the tough transfer pricing audit environment in Germany, it is pivotal for taxpayers to prepare robust transfer pricing documentation substantiating the arm’s-length character of the transfer prices. The documentation is the first line of the taxpayer’s defence during a tax audit, hence preparing solid documentation may help a taxpayer to save time and money. This is even more important in the changing tax environment which awaits the introduction of CbCR.
