Transfer Pricing in Germany: Translation of important law and regulations 9783504381226

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Kratzer/Blesgen Transfer Pricing in Germany

Transfer Pricing in Germany Translation of important law and regulations von

Carsten Kratzer Steuerberater Düsseldorf

Martin Blesgen Steuerberater Düsseldorf

2012

Bibliografische Information der Deutschen Nationalbibliothek Die Deutsche Nationalbibliothek verz:eiclmet diese Publikation in der Deutschen Nationalbibliografie; detaillierte bibliografische Daten sind im Internet über http://dnb.d-nb.de abrufbar.

Verlag Dr. Otto Schmidt KG Gustav-Heinemann-Ufer 58, 50968 Köln Tel. 02 21/9 37 38-01, Fax 02 21/9 37 38-943 info®otto-schmidt.de www.otto-schmidt.de ISBN 978-3-504-26014-9 ©2012 by Verlag Dr. Otto Schmidt KG, Köln

Das Werk einschließlich aller seiner Teile ist urheberrechtlich geschützt. Jede Verwertung, die nicht ausdrücklich vom Urheberrechtsgesetz zugelassen ist, bedarf der vorherigen Zustimmung des Verlages. Das gilt insbesondere für Vervielfältigungen, Bearbeitungen, Ühersetzungen, Mikroverfilmungen und die Einspei.chenmg und Verarbeitung in elektronischen Systemen. Das verwendete Papier ist aus chlorfrei gebleichten Rohstoffen hergestellt, holz- und säurefrei, alterungsbeständig und umweltfreundlich. Einbandgestaltung: Jan P. Lichtenford, Mettmann Satz: WMTP, Birkenau Druck und Verarbeitung: Kösel, Krugzell Printed in Germany

Preface Multinational enterprises with worldwide business units have become a symbol of the advancing globalization. According to estimates, the major part of all worldwide trade relations is realized among affiliated companies. The economic significance of transfer prices increases equally, also since their design substantially influences the tax assessment bases of affiliated companies and offers opportunities of optimizing tax rates. However, such pricing also gives rise to extensive tax risks, especially as the tax authorities of the affected states intend to secure or even maximize their tax revenues. Unless the prices determined by the enterprise comply with the requirements of the respective state or their appropriateness is sufficiently documented from the viewpoint of the competent national tax authority, double taxation and penalties are often imminent. In order to reduce these uncertainties, preferably the relevant national provisions of the states involved ought to be taken into account besides the international provisions like the OECD Transfer Pricing Guidelines. It is obvious that the practicability of the respective national standards will increase where they are communicated in a language that is rather commonly spoken. Compared internationally, Germany relies on relatively extensive and specific transfer pricing provisions. As the German provisions are almost exclusively published in the official language German, the authors have often experienced the urgent need for an English edition of the German laws and provisions during their long-standing international consultancy. In light of this, they have decided to contribute to the simplification of the daily work in the field of international tax consultancy. In this regard, it is the authors’ opinion that taxpayers or consultants often benefit considerably more from a complete translation of the respective regulations than from the usual translation of individual technical terms using search engines and translation programs. This has originated in the present edition for transfer prices including an English translation of material German tax laws (excerpts), statutory ordinances, and administrative guidelines in their entirety that are consistent in their terminology and as close as possible to the original text. Provisions that have been published until March 31, 2011 have been taken into account.

V

Preface

We would like to express our gratitude to Ms. Sabine Otto who materially contributed to the book by providing the authors with excellent draft versions of individual texts being a basis for the final version. Furthermore, we thank the transfer pricing experts of RölfsPartner for their helpful advices. Düsseldorf, October 2011

VI

Carsten Kratzer

Martin Blesgen

Vorwort Multinational agierende Unternehmen mit weltweiten Geschäftseinheiten sind ein Symbol der fortschreitenden Globalisierung geworden. Inzwischen wickelt sich den Schätzungen nach der überwiegende Teil der weltweiten Handelsbeziehungen zwischen verbundenen Unternehmen ab. Im gleichen Umfang wächst die wirtschaftliche Bedeutung der Verrechnungspreise, auch weil ihre Gestaltung erheblich die steuerlichen Bemessungsgrundlagen verbundener Unternehmen beeinflusst und Chancen zur Optimierung der Steuerquote bietet. Diese Preisgestaltung birgt jedoch auch beträchtliche steuerliche Risiken in sich, zumal die Finanzbehörden der betroffenen Staaten auf die Sicherung oder auch Maximierung ihrer Steuereinnahmen bedacht sind. Sollten die vom Unternehmen bestimmten Preise den Anforderungen des jeweiligen Staates nicht genügen oder ihre Angemessenheit aus Sicht der zuständigen nationalen Finanzbehörde nicht hinreichend dokumentiert sein, drohen häufig Mehrfachbesteuerung und Strafzuschläge. Zwecks Reduzierung dieser Unsicherheiten sollten vorzugsweise neben den internationalen Vorschriften wie den OECD-Verrechnungspreisleitlinien auch die einschlägigen nationalen Regelungen der beteiligten Staaten berücksichtigt werden. Es ist naheliegend, dass die Praktikabilität der jeweiligen nationalen Normen weiter steigt, wenn sie in einer möglichst weit verbreiteten Sprache kommuniziert werden. Im Bereich der Verrechnungspreise ist Deutschland im internationalen Vergleich ein Land mit verhältnismäßig umfangreichen und spezifischen Vorschriften. Da die deutschen Regelungen fast ausschließlich in der Amtssprache Deutsch veröffentlicht werden, haben die Autoren in ihrer langjährigen internationalen Beratungspraxis oft den dringenden Bedarf an einer englischsprachigen Ausgabe der deutschen Gesetze und Regelungen erlebt und vor diesem Hintergrund beschlossen, einen Beitrag zur Vereinfachung der praktischen Tätigkeit auf dem Gebiet der internationalen Steuerberatung zu leisten. Eine vollständige Übersetzung der jeweiligen Regelungen stellt hierbei nach Auffassung der Autoren für den Steuerpflichtigen oder den Berater einen erheblich höheren Nutzen dar als das in der Praxis gebräuchliche Übersetzen von einzelnen Fachbegriffen via Suchmaschinen und Übersetzungsprogrammen. So entstand das vorliegende Werk für Verrechnungspreise, das maßgebliche deutsche Steuergesetze im Auszug, Rechtsverordnungen sowie Verwaltungsanweisungen vollständig, in der Terminologie konsistent und möglichst eng am Originaltext in der englischen Sprache darlegt. Bis zum 31. März 2011 veröffentlichte Regelungen konnten ihre Berücksichtigung finden.

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Vorwort

Herzlicher Dank gebührt Frau Sabine Otto, welche mit ihren Übersetzungsarbeiten einen wesentlichen Beitrag zu diesem Buch geleistet hat; ihre herausragenden Entwürfe einzelner Texte dienten der endgültigen Version als Grundlage. Wir danken ebenso den Verrechnungspreisexperten von RölfsPartner für die wertvollen Hinweise. Düsseldorf, Oktober 2011

VIII

Carsten Kratzer

Martin Blesgen

Table of Contents Seite

Preface. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Vorwort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

A. Introduction to German Transfer Pricing Regulations

V VII

1

B. Tax Law I. General Fiscal Code - Extract . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3

II. Foreign Tax Act - Extract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

10

C. Statutory Ordinances I. Documentation of Income Attribution (2003) . . . . . . . . . . . . . . . .

13

Statutory Ordinance on the Nature, Content and Scope of Documentation Requirements in Terms of § 90 (3) General Fiscal Code

II. Relocation of Functions (2008) . . . . . . . . . . . . . . . . . . . . . . . . . . .

20

Statutory Ordinance on the Application of the Arm’s Length Principle according to § 1 (1) Foreign Tax Act in Cases of Cross-Border Relocations of Functions

D. Administrative Guidelines I. Income Allocation (1983) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

27

Guidelines for the Examination of the Income Allocation Between Internationally Affiliated Enterprises

II. Permanent Establishments (1999) . . . . . . . . . . . . . . . . . . . . . . . . .

52

Guidelines for the Examination of the Allocation of Income for Permanent Establishments of Internationally Operating Enterprises

III. Cost Sharing Agreements (1999) . . . . . . . . . . . . . . . . . . . . . . . . . . 129 Guidelines for the Examination of the Income Allocation by Cost Sharing Agreements Between Internationally Affiliated Enterprises

IV. Personnel Secondment (2001) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140 Guidelines for the Examination of the Income Allocation between Internationally Affiliated Enterprises in Cases of Personnel Secondment

V. Dotation Capital of Credit Institutions (2004) . . . . . . . . . . . . . . . . 151 Guidelines for the Determination of Dotation Capital of Permanent Establishments of International Credit Institutions

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Table of Contents

VI. Procedures (2005). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162 Guidelines for the Examination of Income Attribution between Affiliated Parties with Cross-Border Business Transactions Regarding Investigation and Cooperation Duties, Adjustments as well as Mutual Agreement and EU-Arbitration Procedures

VII. Business Relationship (2005) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232 Business Relationship with Foreign Countries within the Meaning of § 1 (1) and (4) Foreign Tax Act; Decision of the Federal Fiscal Court of April 28, 2004, I R 5, 6/02

VIII. Mutual Agreement and Arbitration Procedures (2006). . . . . . . . . . . 234 Bulletin Regarding the International Mutual Agreement and Arbitration Procedures for Taxes on Income and Capital

IX. Advance Pricing Agreements (2006) . . . . . . . . . . . . . . . . . . . . . . . 263 Bulletin Regarding Bilateral or Multilateral Advance Mutual Agreement Procedures Based on Double Taxation Agreements with the Purpose of Issuing Binding Advance Pricing Approvals on Transfer Prices among Internationally Affiliated Companies

X. Business Relationship (2010) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291 Interpretation of the Term “Business Relationship” as Set Forth in § 1 Foreign Tax Act for Assessment Periods Prior to 2003 (Prior to the Revised Version of § 1 (4) Foreign Tax Act in the Version of Article 11 Number 1 Tax Benefit Reduction Act of May 16, 2003)

XI. Relocation of Functions (2010) . . . . . . . . . . . . . . . . . . . . . . . . . . . 293 Guidelines for the Examination of Income Allocation between Affiliated Persons in Cases of Cross-Border Relocations of Functions

XII. Intercompany Loans (2011). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366 Application of § 1 Foreign Tax Act to Cases of Write-Down to Going Concern Value and Other Depreciations on Loans to Affiliated Foreign Companies

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379

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A. Introduction to German Transfer Pricing Regulations German tax law refers to different sources of law with different legal quality. Tax law as a general-abstract regulation with external impact (e.g. the General Fiscal Code and the Foreign Tax Act) is issued by the legislature, i.e. the German Bundestag (parliament) through a formal legislative procedure. They are universally binding legal norms governing tax law which in general define the basic tax elements. They usually require the consent of the Federal Council, i.e. the Bundesrat (representation of the federal states) and in the last instance must be signed by the Federal President. Tax law is frequently supplemented by statutory ordinances, so-called implementing regulations. Statutory ordinances represent material law that determines the specific arrangement of the acts. Unlike formal acts, statutory ordinances are not achieved through a formal legislative procedure but are issued by the executive (German federal government or Federal Ministry of Finance). The effectiveness of a statutory ordinance presumes that an authorization by law exists and that the ordinance identifies this so-called enabling legislation. A statutory ordinance imposes rights and obligations on anyone who fulfills the respective facts. Being a directive of higher ranking tax authorities to subordinate tax authorities, administrative guidelines reflect the interpretation of the legal provisions by the tax administration. Thus, the taxpayer regularly also refers to such administrative guidelines. Nevertheless, only the tax administration and not the courts are bound by those administrative guidelines. The most important administrative guidelines constitute the Circulars of the Federal Ministry of Finance. In conjunction with the Bulletins as discussed in this book, these are guidelines issued by the Federal Ministry of Finance that provide for the interpretation of thematically restricted, current legal and procedural matters. On behalf of the judiciary, the Federal Fiscal Court represents the highest court for tax and customs matters in Germany and serves as an appellate court. In general, judgments of the Federal Fiscal Court only bind the parties to the proceeding, but in practice their principles are frequently transferred to comparable cases as well as adapted by the financial administration.

1

B. Tax Law I. General Fiscal Code – Extract General Fiscal Code as of October 1, 2002 (Federal Law Gazette 2002 I p. 3866 and Federal Law Gazette 2003 I p. 61) – Extract Last amended: April 28, 2011

§ 2 Precedence of public international law (1) Treaties with other countries within the meaning of art. 59 (2) sent. 1 of the Federal Constitution take precedence over the tax laws to the extent that they have become directly applicable domestic law. (2) 1The Federal Ministry of Finance is authorized to issue with the consent of the Federal Council statutory ordinances for the implementation of consultation agreements in order to assure the uniformity of taxation and to avoid double taxation or double non-taxation. 2Consultation agreements pursuant to sent. 1 are amicable agreements between the competent authorities of the contracting states designed to govern details of the implementation of such agreement, especially to eliminate difficulties and doubt that arise from interpretation or application of the respective agreement.

§ 11 Registered office The registered seat of a corporation, association of persons, or conglomeration of assets is at the place which is determined by law, articles of association, by-laws, acts of trust foundation, or similar provisions.

§ 12 Permanent establishment 1A

permanent establishment is any fixed place of business or facility serving the business of an enterprise. 2In particular, the following shall be considered as permanent establishments: 1. The place of management; 2. Branches; 3. Offices; 4. Factories or workshops; 5. Warehouses; 6. Premises for purchases or sales; 3

B. Tax Law

7. Mines, quarries, or other fixed, geographically moving or floating facilities for the extraction of natural resources; 8. Building sites or constructions or installation projects which may also be geographically moving or floating if a) the individual building site or construction or installation project or b) one of several simultaneous building sites or constructions or installation projects or c) several consecutive building sites or constructions or installation projects carried out without any interruption last longer than six months.

§ 13 Permanent representative 1A

permanent representative is any person who sustainably conducts the business of an enterprise and, in doing so, is subject to its instructions. 2A permanent representative is especially a person who on an ongoing basis and on behalf of an enterprise 1. concludes contracts or acts as broker or takes orders or 2. maintains an inventory of goods or merchandise and arranges for deliveries from it.

§ 15 Relatives (1) Relatives are: 1. the engaged person 2. the spouse, 3. relatives by blood or by law in a direct descend, 4. brothers or sisters, 5. children of brothers or sisters, 6. spouses of brothers or sisters and brothers or sisters of spouses, 7. brothers or sisters of parents, 8. persons that are related to one another as they live in one household like parents and child based on a long-term foster relationship (foster parents and foster children).

4

I. General Fiscal Code – Extract

(2) The persons specified in sec. (1) are also related to one another if 1. the marriage causing the relationship in the cases of numbers 2, 3, and 6 no longer exists; 2. the relation by blood or by law in the cases of numbers 3 to 7 has expired upon the adoption as child; 3. the common household in the case of number 8 no longer exists provided that the persons continue to be related like parents and child.

§ 39 Attribution (1) Assets are to be attributed to the owner. (2) Deviating from the provisions of clause 1, the following provisions are applicable: 1. 1If another person than the owner actually controls an asset in such manner that he may usually bar the owner from operating the good during the ordinary period of its useful life, the asset shall be attributed to such person. 2 The assets shall be allocated to the trustor in cases of fiduciary relationships, in cases of transferred ownership to the party providing security, and in cases of proprietary possessions to the proprietary possessor. 2. Assets to which various persons are entitled as joint owners shall be attributed to the parties pro rata to the extent that a separate attribution is required for tax purposes.

§ 42 Abuse of tax planning schemes (1) 1The tax law may not be evaded by abusing legal possibilities in tax planning. 2Where the element of a provision in a single tax law is fulfilled that shall prevent tax avoidance, the legal consequences shall be governed by this provision. 3Elsewise, in cases of an abuse within the meaning of clause (2) a tax liability arises as it would under a legal structure that is appropriate to the regarded business transaction. (2) 1An abuse exists where, compared to an appropriate legal arrangement, an inappropriate structure is chosen that results in a legally not intended tax benefit for the taxpayer or a third person. 2This is not applicable in cases where the taxpayer provides evidence of factors other than for tax purposes for the chosen strategy that is relevant considering the overall facts and circumstances.

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B. Tax Law

§ 88 Principle of judicial investigation (1) 1The tax administration investigates the facts ex officio. 2It defines the nature and scope of the investigations; it is not bound by the submission of motions to admit evidence of the parties to the proceeding. 3The scope of these obligations shall be determined by the circumstances of the individual case. (2) The tax administration is obliged to consider all circumstances significant for the individual case, including those favorable to the parties. (3) 1In order to assure a uniform and legitimate assessment and imposition of taxes the Federal Ministry of Finance can define the requirements regarding the nature and scope of the investigations using automatic facilities by means of statutory ordinances and upon the approval of the Federal Council. 2The approval of the Federal Council is not required to the extent that consumption taxes except for the beer tax are concerned.

§ 90 Cooperation duties of the parties (1) 1The parties are obliged to cooperate in the determination of the facts. 2They especially comply with their cooperation duty by completely and truthfully disclosing the facts relevant for taxation and by declaring evidence known to them. 3The scope of these requirements is based on the circumstances of the individual case. (2) 1If facts referring to transactions taking place outside of the territory of applicability of this law have to be determined and assessed for tax purposes, the participants are obliged to clarify these facts and to obtain the necessary evidence. 2They are required to exploit all legal and factual options available to them. 3If objective indications are recognized for the assumption that the taxpayer maintains business relations with financial institutions in a country or a territory with which no treaty exists that provides for the exchange of information pursuant to art. 26 of the OECD Model Tax Convention on Income and Capital as amended in 2005, or the country or the territory does not furnish information to a comparable extent or is not willing to issue such information, upon request of the tax authorities the taxpayer is obliged to affirm in lieu of an oath the accuracy and completeness of his documents and to authorize the tax authorities to assert on his behalf claims to obtain information against the credit institutions named by the tax authorities both inside and outside of court; pursuant to § 328 the affidavit may not be enforced. 4A party may not claim its inability to clarify facts or to obtain evidence if, according to the circumstances of the case it could have structured its relations as to obtain these or as to be granted the means to be provided with these. (3) 1In cases where facts regard transactions with an international dimension, the taxpayer is obliged to prepare documentation on the nature and the content of his business relations with affiliated persons within the 6

I. General Fiscal Code – Extract

meaning of § 1 (2) Foreign Tax Act. 2The documentation requirement also include the economic and legal bases for the agreement with affiliated parties on prices and other terms and conditions that are in line with the arm’s length principle. 3Documentation for extraordinary business transactions shall be prepared contemporarily. 4The documentation requirements are accordingly applicable to taxpayers who allocate profits between their domestic enterprise and its foreign permanent establishment or are required to determine the profit of the domestic permanent establishment of its foreign enterprise for domestic tax purposes. 5In order to ensure a uniform application of law, the Federal Ministry of Finance is authorized to determine with the consent of the Federal Council the nature, content, and scope of documentation to be prepared by means of a statutory ordinance. 6As a rule, the tax authorities shall request the submission of documentation only for tax audit purposes. 7The submission is governed by § 97 provided that clause 2 of this provision shall not apply. 8Upon request, it shall be submitted within 60 days. 9To the extent that documentation shall be submitted for extraordinary business transactions, the deadline shall be 30 days. 10The deadline for the submission may be extended in substantiated individual cases.

§ 162 Estimation of assessment bases (1) 1To the extent the tax authorities are unable to determine or calculate the assessment bases, they have to estimate these. 2In this context all circumstances that are relevant for the estimation must be considered. (2) 1An estimation shall especially be carried out in case where the taxpayer is unable to sufficiently disclose information regarding his statements or refuses to furnish further information or an affirmation in lieu of an oath or breaches his cooperation requirement pursuant to § 90 (2). 2The same applies in cases where the taxpayer cannot submit books that he is required to keep under the tax laws, if the bookkeeping or the documentation cannot be used for taxation with reference to § 158, or if there is actual indication for the incorrectness or incompleteness of the information furnished by the taxpayer regarding his taxable income or increases in business assets and if the taxpayer fails to give his consent pursuant to § 97 (7) sent. 1 no. 5. 3If the taxpayer has breached his cooperation requirements pursuant to § 90 (2) sent. 3, it is refutably assumed that taxable income exists in states or territories within the meaning of § 90 (2) sent. 3 or that such exceeds the declared income. (3) 1In case a taxpayer breaches his cooperation requirements pursuant to § 90 (3) by not submitting documentation or by submitting documentation that is substantially unusable or if it is determined that the taxpayer has not prepared documentation within the meaning of § 90 (3) sent. 3 contemporarily, it is disputably assumed that his income subject to domestic taxation, the calculation of which is based on the documentation as set forth in § 90 (3), exceeds the income declared by him. 2If the tax 7

B. Tax Law

authorities are required to carry out an estimation and in such cases the income may only be determined within a certain range, especially only based on price ranges, this range may be exploited to the disadvantage of the taxpayer. 3Sent. 2 shall be applied accordingly if, despite the submission of usable documentation by the taxpayer, there is indication that under the consideration of the arm’s length principle the income may exceed the income that was declared based on the documentation, and respective doubt may not be clarified because a foreign affiliated person has not fulfilled his cooperation requirements pursuant to § 90 (2) or has not fulfilled his duties to disclose information pursuant to § 93 (1). (4) 1In case a taxpayer does not submit documentation within the meaning of § 90 (3) or the documentation is substantially unusable, a surcharge in the amount of 5,000 Euros shall be assessed. 2The surcharge shall amount to at least 5 % and the most to 10 % of the additional income that arises from an adjustment after having applied clause 3 if pursuant to it the surcharge amounts to more than 5,000 Euros. 3For the belated submission of usable documentation the surcharge shall amount up to 1,000,000 Euros, yet at least 100 Euros for each full day by which the deadline has been exceeded. 4To the extent that the tax authorities are granted discretion with regard to the amount of the surcharge, especially the benefit of the taxpayer and in cases of belated submission the time by which the deadline has been exceeded must be considered besides the purpose of the surcharge to advise the taxpayer to prepare and to submit the documentation within the meaning of § 90 (3) in time. 5It shall be refrained from imposing a surcharge if the failure to fulfill the requirements pursuant to § 90 (3) are deemed to be justifiable or constitutes only minor fault. 6The fault of a legal representative or an assistant is deemed equal the personal fault of the taxpayer. 7As a rule, the surcharge shall be assessed after the tax audit has been concluded. (5) 1In the cases as set forth in § 155 (2), the assessment bases that are to be determined for a basic assessment notice may be estimated.

§ 175a Implementation of mutual agreements 1A

tax assessment notice shall be issued, annulled, or amended to the extent it is required for the implementation of a mutual agreement or an arbitration verdict pursuant to a treaty within the meaning of § 2. 2In this respect, the assessment period shall not end prior to the expiration of one year after the mutual agreement or arbitration verdict has come into effect.

§ 178a Expenses for special demands to the tax authorities (1) 1The Federal Central Tax Office imposes a fee for processing an application regarding the implementation of a mutual agreement (advance pricing agreement) procedure pursuant to an agreement within the meaning 8

I. General Fiscal Code – Extract

of § 2 regarding the mutual taxation of business transactions not yet implemented between a taxpayer and affiliated persons within the meaning of § 1 Foreign Tax Act, or with regard to a future mutual profit allocation between a domestic enterprise and its foreign permanent establishment, or with regard to future mutual profit determination of a domestic permanent establishment of a foreign enterprise that shall be assessed by the Federal Central Tax Office prior to opening the advance pricing agreement procedure. 2The opening of such procedure shall commence upon sending the first written correspondence to the other country. 3If the application aims at concluding advance pricing agreements with several countries, a fee shall be imposed and paid for every procedure. 4The advance pricing agreement procedure shall not commence until the fee assessment has become incontestable and the fee has been paid; in case an application for a fee reduction is filed according to clause 4, the decision on it shall also have become incontestable. (2) 1The fee amounts to 20,000 Euros (basic fee) for each application within the meaning of clause 1; the application of a responsible enterprise of a tax group within the meaning of § 14 (1) Corporate Tax Act that includes respective transactions of its subsidiaries belonging to the tax group shall be deemed to be one application. 2In case the applicant files an application to extend the period of validity of an already concluded advance pricing agreement, the fee amounts to 15,000 Euros (extension fee). 3An applicant that amends his application prior to the decision on the original application or that files for an amendment of the advance pricing agreement during the period of validity of the advance pricing agreement shall be imposed with an additional fine amounting to 10,000 Euros for each amendment application (amendment fee); this shall not apply to amendments initiated by the Federal Central Tax Office or the other country. (3) To the extent that the total value of business transactions included in the advance pricing agreement will probably not exceed the amounts set forth in § 6 (2) sent. 1 Ordinance on the Documentation of Income Attribution of November 13, 2003 (Federal Law Gazette I p. 2296), the basic fee shall amount to 10,000 Euros, the extension fee to 7,500 Euros and the amendment fee to 5,000 Euros. (4) 1Upon request, the Federal Central Tax Office may reduce the fee pursuant to clause 2 or 3 if its payment causes an unreasonable hardship for the taxpayer and the Federal Central Tax Office determines that the tax authorities have a special interest in conducting the advance pricing agreement procedure. 2The application shall be filed prior to opening the advance pricing agreement procedure; it is illegitimate to file a subsequent application. (5) In case the application is withdrawn or rejected or in case the advance pricing agreement procedure fails, the incontestable fee shall not be reimbursed.

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B. Tax Law

II. Foreign Tax Act – Extract Law on the Taxation of Foreign Relations (Foreign Tax Act) as of September 8, 1972 (Federal Law Gazette 1972 I p. 1713) – Extract Last amended: December 8, 2010

Part One. International interrelations § 1 Adjustment of income (1) 1In case the income of a taxpayer derived from a business relationship to foreign territory with an affiliated person is reduced by the fact that he based his determination of income on other conditions, especially prices (transfer prices), than those that unrelated third parties would have agreed on under the same or similar circumstances (arm’s length principle), regardless of other provisions the assessment of his income shall comply with the income that unrelated parties would have generated based on their agreed terms and conditions. 2With regard to the application of the arm’s length principle it shall be assumed that unrelated third parties know of all essential circumstances of the business relationship and that they act in accordance with the principles of sound and prudent business managers. 3If the application of the arm’s length principle results in additional adjustments to those of other provisions, the additional adjustments shall be carried out besides the legal consequences of the other provisions. (2) A person is affiliated with the taxpayer, if 1. the person has a direct or indirect share in the taxpayer amounting to at least one quarter (substantial participation) or may directly or indirectly exercise over the taxpayer a controlling influence or vice versa the taxpayer holds a substantial participation in the person or may exercise a direct or indirect controlling influence over this person; or 2. a third person has a substantial participation in both the person and the taxpayer or may exercise on both a direct or indirect controlling influence; or 3. the person or the taxpayer is able to exercise an influence extraneous to the business relationship over the taxpayer or the person when concluding the terms and conditions of a business relationship or if one of them has an own interest regarding the income generation of the other person. (3) 1For a business relationship within the meaning of clause 1 sent. 1, the transfer price shall primarily be determined applying the comparable uncontrolled price method, the resale price method or the cost plus method in cases where unrestrictedly comparable arm’s length data may be determined under these methods after having made appropriate adjustments 10

II. Foreign Tax Act – Extract

with regard to the functions performed, the assets employed, and the assumed opportunities and risks (functional analysis); several of such values constitute a range. 2If such arm’s length data cannot be determined, the application of a suitable transfer pricing method shall be based on restrictedly comparable data that was derived from making appropriate adjustments. 3If several restrictedly comparable arm’s length values are determinable for the cases described in sent. 2, the resulting range shall be narrowed. 4The median shall prevail if the value that the taxpayer applies in determining his income lies outside this range for the cases covered by sent. 1 or if the value lies outside of the narrowed range for the cases covered by sent. 2. 5If no restrictedly comparable data can be determined, the taxpayer is obliged to perform a hypothetical arm’s length test in order to determine his income under consideration of clause 1 sent. 2. 6For this purpose, he is obliged to determine the minimum price of the supplier and the maximum price of the recipient (range of mutual consent) based on a functional analysis and internal planning data; the range of mutual consent is determined by the respective profit expectations (profit potentials). 7The income determination shall be based on the price within the range of mutual consent that, with utmost probability, complies best with the arm’s length principle; unless another value is credibly shown, the mean value of the range of mutual consent shall be taken as basis. 8In case the range of mutual consent determined by the taxpayer is incorrect and thus another agreement range has to be assumed, it may be refrained from an income adjustment if the value applied by the taxpayer lies within the other range of mutual consent. 9Where a function is transferred including the corresponding opportunities and risks and including the assets and other advantages transferred or otherwise provided (relocation of function) and sent. 5 shall apply to the transferred function as at least restrictedly comparable arm’s length data is not available for the transfer package as a whole, the taxpayer shall determine the range of mutual consent based on the transfer package under consideration of functions and risk adequate capitalization interest rates. 10After having made appropriate adjustments, the determination of individual transfer prices for all assets and services affected shall be accepted for cases covered by sent. 9 if the taxpayer shows credibly that no essential intangible assets and advantages were subject to the relocation of function or that the sum of the applied individual transfer prices measured by the evaluation of the transfer package as a whole complies with the arm’s length principle; in case the taxpayer shows credibly that at least one essential intangible asset was subject to the function transferred and if he specifies it exactly, the individual transfer prices shall be acknowledged for the elements of the transfer package. 11If in the cases covered by sent. 5 and 9 essential intangible assets and benefits are part of a business relationship and the subsequent actual profit development deviates substantially from the profit development on which the determination of the transfer prices was based on, it shall disputably be assumed that uncertainties regarding the price agreement existed at the time of the conclusion of the agreement and unrelated

11

B. Tax Law

third parties would have agreed on an appropriate adjustment clause. 12If it was not agreed on such a clause and a substantial deviation as defined in sent. 11 occurs within the first ten years after the conclusion of the agreement, the taxation in the business year following the year in which the deviation occurred shall be based on a non-recurring adjustment amount on the original transfer price for purposes of an adjustment pursuant to clause 1 sent. 1. 13In order to ensure a uniform application of the law and congruence with the international principles of income allocation, the Federal Ministry of Finance shall be authorized, subject to the consent of the Federal Council, to determine details regarding the application of the arm’s length principle within the meaning of clause 1 and sent. 1 to 12 by means of statutory ordinances. (4) 1If, in the cases set forth in § 162 (2) General Fiscal Code, an estimation shall be performed regarding the income as quoted in clause 1, in the absence of other appropriate indicators an average return on sales or an average interest yield on the capital employed within the company shall be applied under consideration of the functions performed, assets employed, and risks assumed. 2Estimations pursuant to § 162 (3) General Fiscal Code shall remain unaffected. (5) A business relationship as defined in clauses 1 and 2 is any incomebased relationship under the law of obligation that does not constitute an agreement based on the articles of association and is part of an activity to which §§ 13, 15, 18, or § 21 Income Tax Act apply either for the taxpayer or the affiliated person or in the case of a foreign affiliated person would be applied if the activity was performed in the domestic territory.

12

C. Statutory Ordinances I. Documentation of Income Attribution (2003) Statutory Ordinance on the Nature, Content and Scope of Documentation Requirements in Terms of § 90 (3) General Fiscal Code (Ordinance on the Documentation of Income Attribution) as of November 13, 2003 (Federal Law Gazette I p. 2296) Last amended: August 14, 2007

Based on § 90 (3) sent. 5 General Fiscal Code of March 16, 1976 (Federal Law Gazette I p. 613) which was added by Article 9 No. 3 of the law of May 16, 2003 (Federal Law Gazette I p. 660), the Federal Ministry of Finance enacts as follows:

§ 1 Principles of the documentation requirement (1) 1Documentation to be prepared pursuant to § 90 (3) General Fiscal Code shall reveal those facts the taxpayer has implemented within the scope of his business relations within the meaning of § 1 (4) Foreign Tax Act with affiliated persons within the meaning of § 1 (2) Foreign Tax Act and whether and to what extent these business relations are based on circumstances, including prices, from which it can be derived that he met the arm’s length standard (arm’s length principle) (documentation). 2The documentation must demonstrate the serious effort of the taxpayer to organize his business relations with affiliated persons under consideration of the arm’s length principle. 3The documentation requirement also applies to business relations that do not consider any compensation in exchange of goods and services, like personnel secondment agreements and pooling agreements (e.g. cost sharing agreement). 4Documentation that is substantially useless (§ 162 (3) and (4) General Fiscal Code) shall be treated as if it had not been prepared. (2) To the extent that pursuant to clause (1) in connection with § 90 (3) sent. 1 General Fiscal Code it has to be documented what facts had been realized, it is required to prepare documentation about the nature, the scope, and the implementation as well as about the economic and legal conditions of the business relations. (3) 1To the extent that pursuant to clause (1) in connection with § 90 (3) sent. 2 General Fiscal Code it has to be documented whether and to what extent the taxpayer has complied with the arm’s length principle within the meaning of clause (1) as regards his business relations, the market and competitive conditions relevant for the activities of the taxpayer and the agreed terms have to be documented. 2In accordance with his selected method, the taxpayer is obliged to refer to comparable data for his documentation to the extent such data had been available at the time the busi13

C. Statutory Ordinances

ness relationship was concluded either to himself or to the affiliated person or to the extent that the taxpayer is able to obtain it with reasonable effort from freely accessible sources. 3Information to be used and, where required, to be procured for the preparation of the documentation especially includes data from comparable business transactions between unrelated third parties and that from comparable business transactions which the taxpayer or an affiliated person concluded with an unrelated person, e.g. prices and business terms and conditions, cost allocations, profit mark-ups, gross margins, net margins, profit splits. 4In addition, documentation has to be prepared about intercompany data that permits a plausibility cross-check of the transfer prices on that the taxpayer agreed, e.g. planning forecasts and data on sales projections, profit planning, and cost planning.

§ 2 Nature, content, and scope of the documentation (1) 1Documentation may be prepared in written or electronic form. 2It must be kept and retained in proper order. 3The documentation shall enable an expert third person to determine within a reasonable time period which facts the taxpayer has realized with regard to his business relations with affiliated persons and whether and to what extent he has complied with the arm’s length principle. (2) 1Nature, content, and scope of the documentation to be prepared are determined by the circumstances of the individual case, especially by the transfer pricing method applied by the taxpayer. 2The taxpayer has to document why he considers the applied method as suitable with respect to the nature of his business transactions and the other circumstances. 3He is not obliged to prepare documentation for more than one suitable method. (3) 1As a rule, documentation is to be prepared referring to each individual business transaction. 2Business transactions that are economically comparable in terms of functions and risks may be aggregated to groups for documentation purposes if the aggregation follows pre-determined and plausible rules and if the business transactions are identical or equivalent or the aggregation is customary for business transactions between unrelated third parties. 3An aggregation is also permitted for causally linked business transactions or for partial performances under a package deal in cases where the examination of the appropriateness does not emphasize the assessment of the individual business transaction as much as that of the package deal. 4In case documentation is prepared for groups of business transactions, the rules regarding their performance and the criteria regarding the aggregation must be outlined. 5If a group of affiliated enterprises applies intercompany transfer pricing guidelines that comply with the arm’s length principle and specify one or more suitable methods for the different enterprises, the guidelines may be used to form part of the documentation. 6To the extent that such guidelines govern the pricing 14

I. Documentation of Income Attribution (2003)

and actually are adhered to, it may be refrained from preparing documentation for the individual transactions. (4) 1If the circumstances material for the appropriateness of negotiated prices change for long-term relationships, the taxpayer is obliged to gather information and to document it even after the transaction has been concluded that enables the tax authorities to examine whether and at what point in time unrelated third parties would have agreed to amend the business terms and conditions. 2This is especially applicable where tax losses that an unrelated third party would not have accepted become evident in a business division or if price adjustments are carried out to the detriment of the taxpayer. (5) 1As a rule, documentation has to be prepared in the German language. 2Upon application of the taxpayer, the tax authorities may accept exceptions hereof. 3The application may be filed prior to preparing the documentation, yet at the latest must be filed without delay after the tax authorities requested the submission of the documentation. 4Necessary translations of agreements and similar documents within the meaning of §§ 4 and 5 are part of the documentation. 5§ 87 (2) General Fiscal Code remains unaffected. (6) 1Documentation shall in principle only be requested for purposes of carrying out a tax audit. 2The request shall identify the business fields and business relations of the taxpayer that shall be the subject of the audit. 3The request shall also specify the nature and the scope of the required documentation. 4The request may be sent in conjunction with the order of the audit and may be issued, supplemented, or amended at any time.

§ 3 Contemporaneous documentation of extraordinary business transactions (1) 1Documentation of extraordinary business transactions within the meaning of § 90 (3) sent. 3 General Fiscal Code shall be considered as prepared contemporaneously if it was compiled in a timely manner with the business transaction. 2It is considered as contemporaneously prepared if it is created within six months after the business year in which the business transaction occurred has expired. (2) Extraordinary business transactions especially include: the conclusion and the amendment of long-term agreements significantly affecting the amount of the taxpayer’s income from his business relations, transfers of assets within the scope of restructuring measures, the transfer and provision of assets and benefits in connection with essential changes of functions and risks of the enterprise, business transactions in connection with a significant change in the business strategy that affects transfer pricing, and the conclusion of cost sharing agreements.

15

C. Statutory Ordinances

§ 4 Generally required documentation In accordance with §§ 1 to 3, the taxpayer is obliged to prepare the following documentation to the extent it is material for the examination of business relations within the meaning of § 90 (3) General Fiscal Code: 1. General information on shareholding relationships, business operations, and organizational structure: a) Illustration of shareholding relationships between the taxpayer and affiliated persons within the meaning of § 1 (2) no. 1 and 2 Foreign Tax Act with which he has business relations directly or via intermediary persons as of the beginning of the tax audit period and their changes until its end, b) Illustration of other circumstances that might constitute an “affiliation” within the meaning of § 1 (2) No. 3 Foreign Tax Act, c) Illustration of the organizational and operative group structure and their changes, including permanent establishments and participations in business partnerships, d) Description of the taxpayer’s fields of activity, e. g. services, manufacturing or distribution of assets, research & development; 2. Business relations with affiliated persons: a) Illustration of the business relations with affiliated persons, summary of nature and scope of these business relations (e. g. purchase of goods, service, loan relationships and other provision for use, cost allocations) and summary of the contracts underlying these business relations and their changes, b) Compilation (list) of essential intangible assets that the taxpayer owns and that he uses or grants for use within the scope of his business relation with affiliated persons; 3. Functional and risk analysis: a) Information on the respective functions performed and risks borne by the taxpayer and his affiliated persons within the scope of their business relations and their changes, on the essential assets employed, on the contractually agreed terms and conditions, on business strategies selected and on important market and competitive conditions, b) Description of the value-added chain and description of the taxpayer’s contribution to the added value compared to that of affiliated persons whom he has business relations with;

16

I. Documentation of Income Attribution (2003)

4. Transfer pricing analysis: a) Description of the transfer pricing method applied, b) Justification of the suitability of the method applied, c) Documents about the calculations while applying the selected transfer pricing method, d) Editing of prices or financial data of unrelated enterprises on which the comparison was based and documents on adjustment calculations carried out.

§ 5 Required documentation for special circumstances 1To

the extent that the kinds of special circumstances specified in sent. 2 are relevant to the agreed business relations of the taxpayer or he refers to special circumstances to demonstrate that his contracted business relations are at arm’s length, the taxpayer is obliged to provide documentation about these circumstances as required by §§ 1 to 3. 2Depending on the circumstances in the individual case, the following documentation may be required: 1. Information on changes in business strategies (e.g. market share strategies, selection of distribution channels, management strategies) and on other special circumstances like measures regarding the set-off of benefits to the extent that they may influence the determination of the transfer pricing by the taxpayer; 2. In cases of allocations the contracts, where applicable including appendices, attachments and additional agreements, documentation on the application of the allocation key and the anticipated benefit for all participants, and at least documents on the nature and scope of invoice examination, on adjustments made to changed circumstances, on the right of access to the documents of the supplying enterprise, and on the assignment of the rights of use; 3. Information on advance pricing agreements or transfer pricing arrangements of foreign tax administrations toward or with the taxpayer and on applied for or contracted mutual agreement and arbitration procedures of other states that affect the business relations of the taxpayer with affiliated parties; 4. Documentation on price adjustments carried out by the taxpayer, even if these result from transfer pricing adjustments or advance rulings of foreign tax authorities issued to affiliated persons of the taxpayer; 5. Documentation of the causes of losses and of measures the taxpayer or affiliated persons took to overcome the loss situation in cases where

17

C. Statutory Ordinances

the taxpayer has shown tax losses in more than three consecutive business years from business relations with affiliated parties; 6. In cases of changes of functions and risks as specified in § 3 (2), documentation on research projects and current research activities that might be connected to a change of a function and took place or were completed within the three years prior to implementing the functional change; the documentation must at least include data about the exact object of the research activities and all related attributable costs. This is only applicable to the extent a taxpayer regularly pursues research and development and prepares documents for internal reasons from which the aforementioned documentation may be derived.

§ 6 Application provisions for smaller enterprises and taxpayers generating other income than business income (1) For taxpayers who generate other income than business income from commercial relations with affiliated persons and smaller enterprises the documentation requirements as specified in § 90 (3) sent. 1 to 4 General Fiscal Code as well as those specified in this ordinance shall be regarded as fulfilled by furnishing information that meets the requirements of § 1 (1) sent. 2 and by submitting existing documents upon the request of the tax authorities if they adhere to the deadlines specified in § 90 (3) sent. 8 and 9. (2) 1Smaller enterprises within the meaning of clause (1) are enterprises for which in the current business year neither the sum of 5 million Euros regarding remuneration for the supply of goods or commodities from business relations with affiliated persons as defined in § 1 (2) Foreign Tax Act nor the sum of 500,000 Euros for remuneration of other services than the supply of goods and commodities from business relations with such affiliated persons is exceeded. 2In case the aforementioned amounts are exceeded in a business year, clause (1) shall stop to apply starting with the following business year. 3If an enterprise that is not privileged pursuant to clause (1) falls below the aforementioned amounts in one business year, it shall be treated as an enterprise within the meaning of sent. 1 in the following business year. (3) Interrelated domestic enterprises as defined in §§ 13, 18, and 19 Tax Audit Regulations of March 15, 2000 (Federal Tax Gazette I p. 368) in the respectively applicable version and domestic permanent establishments of affiliated persons shall be aggregated regarding the examination of the cap amounts pursuant to clause (2).

18

I. Documentation of Income Attribution (2003)

§ 7 Analogous application to permanent establishment and business partnerships 1§§

1 to 6 are analogously applicable to taxpayers obliged to attribute for domestic tax purposes their profit between the domestic enterprise and its foreign permanent establishment or to determine the profit of the domestic permanent establishment of their foreign enterprise to the extent that based on the transfer of assets or the rendering of services a tax profit must be declared or to the extent that expenses shall be allocated with a tax effect. 2Sent. 1 shall apply analogously regarding the determination of the profit of business partnerships in which the taxpayer holds a share to the extent that business relations as defined in § 1 Foreign Tax Act shall be examined in this context.

§ 8 Effective date This ordinance shall come into effect as of June 30, 2003.

19

C. Statutory Ordinances

II. Relocation of Functions (2008) Statutory Ordinance on the Application of the Arm’s Length Principle according to § 1 (1) Foreign Tax Act in Cases of Cross-Border Relocations of Functions (Ordinance on the Relocation of Functions) as of August 12, 2008 (Federal Law Gazette 2008 I, p. 1680) Based on § 1 (3) sent. 13 Foreign Tax Act of September 8, 1972 (Federal Law Gazette I p. 1713) which was added by Article 7 of the law of August 14, 2007 (Federal Law Gazette I p. 1912) the Federal Ministry of Finance enacts:

Part 1: General provisions § 1 Definition of terms (1) 1A function is a business activity consisting of an aggregation of similar operational tasks that are performed by certain centers or departments of an enterprise. 2It is an organic part of an enterprise without having to form a separable part of a business operation in a tax meaning. (2) 1Subject to clauses (6) and (7), a relocation of functions within the meaning of § 1 (3) sent. 9 Foreign Tax Act is assumed in case an enterprise (transferring enterprise) either transfers or concedes the right of use of assets and other advantages including the corresponding opportunities and risks to another affiliated enterprise (acquiring enterprise) to enable the acquiring enterprise to perform a function that has thus far been performed by the transferring enterprise and thereby limiting the transferring enterprise in exercising this function. 2A relocation of a function may also take place if the acquiring enterprise performs the function only temporarily. 3Business transactions that are realized within five business years must be aggregated as a single relocation of functions at the time when the requirements of sent. 1 were economically fulfilled by reason of their collective realization. (3) A transfer package within the meaning of § 1 (3) sent. 9 Foreign Tax Act consists of a function including the opportunities and risks connected with this function and the assets and benefits that are either transferred or provided for use along with the function from the transferring enterprise to the acquiring enterprise and the services rendered in this connection. (4) Profit potentials within the meaning of § 1 (3) sent. 6 Foreign Tax Act are the net profits after tax (present value) respectively expected from the transferred function that a sound and prudent business manager within the meaning of § 1 (1) sent. 2 Foreign Tax Act would, from the perspective of the transferring enterprise, not relinquish without a compensation and for which such a business manager would be willing to pay compensation from the perspective of the acquiring enterprise.

20

II. Relocation of Functions (2008)

(5) Intangible assets and benefits are essential in cases of relocations of functions within the meaning of § 1 (3) sent. 10, first alternative, of the Foreign Tax Act if they are required for the transferred function and their transfer price amounts to more than 25 % of the total of all individual prices of all assets and benefits of the transfer package and this being credible under consideration of the impacts from the relocation of functions as shown in the documentation within the meaning of § 3 (2) sent. 2. (6) 1A relocation of functions within the meaning of clause (2) does not take place where there is no restriction in the exercise of the respective function by the enterprise named first in clause (2) sent. 1 within five years after the function had been acquired by the affiliated enterprise even though the other prerequisites of clause (2) sent. 1 are met (duplication of function). 2If such a restriction occurs within this time period, the entire transaction constitutes a single relocation of functions at the time when the restriction first occurs unless the taxpayer shows credibly that this restriction is not directly economically connected with the duplication of the function. (7) 1Likewise, a relocation of functions within the meaning of clause (2) does not take place if merely assets are sold or provided for use or merely services are rendered, unless these business transactions are part of a relocation of functions. 2The same is applicable if personnel is seconded within the group without transferring a function or if this transaction would not be viewed as a disposal or acquisition of a function between unrelated third parties.

§ 2 Application of the transfer package provisions (1) 1In cases of transfers of functions where the price for the transfer package as a whole may be determined based on unrestrictedly or restrictedly comparable values, the application of § 1 (3) sent. 1 to 4 of Foreign Tax Act shall take precedence. 2Elsewise, the price for the transfer package shall be determined by performing the hypothetical arm’s length test pursuant to § 1 (3) sent. 5 and 6 Foreign Tax Act. 3§ 1 (3) sent. 10, first alternative, of the Foreign Tax Act remains unaffected. (2) 1If the acquiring enterprise performs the transferred function exclusively for the transferring enterprise and if the compensation that shall be awarded for performing the function and for supplying the respective goods or services is determined using the cost plus method, it must be assumed that the transferred transfer package does not include any essential intangible assets and benefits and thus, § 1 (3) sent. 10, first alternative, of the Foreign Tax Act is applicable. 2In case an acquiring enterprise within the meaning of sent. 1 supplies goods or services previously supplied exclusively to the transferring enterprise independently – either completely or partially – to other enterprises at prices that exceed the compensation determined under the cost plus method or that must be set higher in ac21

C. Statutory Ordinances

cordance with the arm’s length principle, at the time the first supply to other enterprises took place a compensation according to § 3 must be charged for the assets and benefits which were previously provided free of charge by the transferring enterprise for the supply of the goods or services; the respective assets and benefits are considered as one transfer package to the extent that the other prerequisites are fulfilled for this purpose. (3) 1Where pursuant to § 1 (3) sent. 10, second alternative, of the Foreign Tax Act a transfer pricing determination that is based on the sum of the transfer prices for the individual assets and benefits shall be acceptable for a relocation of a function, the range of mutual consent and the value for the transfer package as a whole must be determined pursuant to § 1 (3) sent. 7 and 9 Foreign Tax Act. 2The sum of the individual transfer prices for the assets and benefits that must all be included may only be applied if it is within the range of mutual consent and the taxpayer shows credibly that it complies with the arm’s length principle.

Part 2: Value of the transfer package and assignment of transfer prices for its elements § 3 Value of the transfer package (1) If the value for a transfer package allocable to the transferring enterprise must be determined as a whole for cases noted in § 2 (1) sent. 2, then, in compliance with the arm’s length principle within the meaning of § 1 (1) Foreign Tax Act, this value shall, from the perspective of the enterprises involved, be commensurate with the profit that is expected from exercising the function at the time of the transfer and that is allocable to the function (profit potentials). (2) 1The respective profit potentials must be determined in consideration of all circumstances of the individual case based on a functional analysis prior to and after the relocation of functions considering actually existing possibilities for action and including the locational advantages or disadvantages and synergy effects. 2Starting point for the calculation are the documents based on which the enterprise decided to carry out a relocation of functions. 3The calculation of the respective profit potentials and the range of mutual consent (§ 7) shall be based on the profit expectations of the concerned enterprises that comply with the standard set forth in § 1 (1) sent. 2 Foreign Tax Act, appropriate capitalization interest rate (§ 5), and a capitalization period that relies on the circumstances under which the function is exercised (§ 6).

§ 4 Elements of the transfer package (1) In case different agreements are concluded for individual elements of the transfer package or in case such agreements are assumed to exist in ac22

II. Relocation of Functions (2008)

cordance with the arm’s length principle, transfer prices must be assigned for all elements of the transfer package that altogether equal the value determined pursuant to § 3 (1) for the transfer package as a whole. (2) Where there is doubt whether a transfer or provision of use shall be presumed for the transfer package or its individual elements, a provision of use is assumed upon the application of the taxpayer. (3) If it is subsequently discovered that a relocation of functions took place for cases covered by § 1 (6), the transfer prices for the business transactions that resulted in the relocation of functions must be assigned pursuant to the arm’s length principle in such manner that, in conjunction with the originally determined transfer prices, they equal the value determined pursuant to § 3 (1) for the transfer package as a whole.

§ 5 Capitalization interest rate 1The

starting point for the determination of the respectively appropriate capitalization interest rate is, under consideration of the tax burden, the interest for a risk-free investment on which a functions and risks adequate premium must be added. 2The duration of the comparable risk-free investment depends on the time period during which the transferred function will presumably be exercised. 3The premium must be assessed in such manner that it considers the respective risk assessment customary both in the acquiring and the transferring enterprise in comparable circumstances.

§ 6 Capitalization period If it cannot be credibly substantiated that a limited capitalization period is indicated by the circumstances of exercising the function and such reasons are not otherwise evident, an unlimited capitalization period shall be taken as basis.

§ 7 Determination of the range of mutual consent (1) 1To a transferring enterprise that expects profits from the function, the lower limit of the negotiating range (minimum price within the range of mutual consent) within the meaning of § 1 (3) sent. 6 Foreign Tax Act shall result from the compensation for the loss or the reduction of the profit potential plus the closing costs that may accrue. 2Actually existing possibilities for action that the transferring enterprise would have if it were unrelated to the acquiring enterprise must be considered without questioning the discretion regarding entrepreneurial decisions of the transferring enterprise.

23

C. Statutory Ordinances

(2) In cases where, for legal, actual, or economic reasons, the transferring enterprise is unable to exercise the function with its own funds, the minimum price equals the liquidation value. (3) 1In case an enterprise relocates a function from which it expects permanent losses, the negotiation range for the transferring enterprise is limited by the expected losses or the closing costs that might possibly accrue; the lower absolute amount is relevant. 2In order to limit losses, it may in such cases comply with the behavior of a sound and prudent business manager to negotiate a compensation for the relocation of functions that covers the arising closing costs only partially or to make a compensatory payment to the acquiring enterprise for assuming the source of loss. (4) 1The profit potential of the acquiring enterprise from the function transferred is in principle the upper limit of the negotiating range (maximum price within the range of mutual consent). 2Actually existing possibilities for action that the acquiring enterprise would have if it were unrelated to the transferring enterprise must be considered without questioning the discretion regarding entrepreneurial decisions of the acquiring enterprise. (5) Also in the cases covered by clauses (2) and (3) where the minimum price of the transferring enterprise amounts to zero or is below, it must be examined in accordance with the arm’s length principle whether an unrelated third person would, pursuant to § 1 (3) sent. 9 in connection with § 1 (3) sent. 7 Foreign Tax Act, be willing to pay a price for acquiring the function.

§ 8 Claims for damages, reimbursement and compensation 1Legal

or contractual claims for damages, reimbursement and compensation as well as claims to which unrelated third parties would be entitled had they excluded their possibilities for action contractually or factually may be taken as basis for the taxation of the relocation of a function if the taxpayer shows credibly that such third parties would have proceeded in comparable manner under similar circumstances. 2Furthermore, the taxpayer needs to show credibly that no essential intangible assets and benefits were either transferred or provided for use unless the transfer or provision mandatorily results from claims within the meaning of sent. 1.

Part 3: Details of retrospective adjustments § 9 Adjustment clause of the taxpayer An adjustment clause of the taxpayer that eliminates retrospective adjustments within the meaning of § 1 (3) sent. 11 and 12 Foreign Tax Act also exists if, with regard to essential intangible assets and benefits, license agreements are concluded under which either the license to be paid de-

24

II. Relocation of Functions (2008)

pends on the turnover or profit of the licensee or consider turnover and profit as regards the amount of the royalty rate.

§ 10 Significant deviation 1A

significant deviation in the cases set forth in § 1 (2) sent. 12 Foreign Tax Act exists if the appropriate transfer price based on the actual profit development falls outside the original range of mutual consent. 2The new range of mutual consent is restricted by the original minimum price and the newly identified maximum price of the acquiring enterprise. 3A significant deviation also exists if the newly identified maximum price is below the original minimum price of the transferring enterprise.

§ 11 Appropriate adjustment An adjustment within the meaning of § 1 (3) sent. 12 Foreign Tax Act is appropriate if, in the cases covered by § 10 sent. 1, it equals the difference between the original and the newly identified transfer price or if, in the cases set forth in § 10 sent. 3, it equals the difference between the original transfer price and the mean value in the scale between the new maximum price of the acquiring enterprise and the original minimum price of the transferring enterprise.

Part 4: Final provisions § 12 Application provision This ordinance shall be applied for assessment periods as of 2008 for the first time.

§ 13 Coming into effect This ordinance becomes effective on January 1, 2008.

25

D. Administrative Guidelines I. Income Allocation (1983) Administrative Circular on the Guidelines for the Examination of the Income Allocation Between Internationally Affiliated Enterprises (Administrative Guidelines – Income Allocation) Published on February 23, 1983 (IV C 5 – S – 1341 – 4/83, Federal Tax Gazette 1983 I p. 218); last amended on April 12, 2005

With regard to the results of the discussion with the highest tax authorities of the Federal States, the following rules are applicable regarding the principles according to which the international income allocation shall be examined applying the arm’s length standard under the provisions of domestic law and double taxation agreements: Content 1. Statutory bases for income allocation . . . . . . . . . . . . . . . . . . . . 1.1 Allocation regulations of domestic tax law . . . . . . . . . . . . 1.2 Allocation stipulations of double taxation agreements . . . . 1.3 Requirements for income allocation to affiliates . . . . . . . . 1.3.1 Hidden profit distribution and hidden capital contribution. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.3.2 Income adjustments under § 1 Foreign Tax Act . . . . . 1.4 Legal form of business relations between affiliated companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.5 Business relations to affiliated persons in low tax areas . . . . 2. General principles for the allocation of income . . . . . . . . . . . . . 2.1 The arm’s length test as criterion for income allocation . . . 2.2 Standard methods for the examination of transfer prices . . . 2.3 Set-off of benefits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.4 Application of the methods . . . . . . . . . . . . . . . . . . . . . . . 3. Supply of goods and services . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1 Delivery of goods and commodities. . . . . . . . . . . . . . . . . . 3.1.1 Principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1.2 Determining factors . . . . . . . . . . . . . . . . . . . . . . . . 3.1.3 Examples for the application of the standard methods 3.2 Commercial services . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.1 Principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.2 Special cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.3 Comparable uncontrolled price method, resale price method, and cost plus method . . . . . . . . . . . . . . . . .

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28 28 29 30

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30 31

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D. Administrative Guidelines

3.3 3.4 3.5

Advertising costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Market penetration costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . Start-up costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4. Interest and similar remuneration . . . . . . 4.1 General . . . . . . . . . . . . . . . . . . . . 4.2 Relevant interest rates . . . . . . . . . . 4.3 Particular cases . . . . . . . . . . . . . . . 4.4 Guarantees and similar obligations .

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43 43 44 45 46

5. Transfer of rights to use patents, know-how and other intangible assets; contract research . . . . . . . . . . . . . . 5.1 General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.2 Deriving arm’s length prices . . . . . . . . . . . . . . . 5.3 Contract research . . . . . . . . . . . . . . . . . . . . . .

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47 47 47 48

6. Administrative services within the group. . . . 6.1 General . . . . . . . . . . . . . . . . . . . . . . . 6.2 Requirements for intercompany charges 6.3 Examples . . . . . . . . . . . . . . . . . . . . . . 6.4 Deriving arm’s length prices . . . . . . . . .

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48 48 48 49 50

7. Income allocation by cost sharing agreements . . . . . . . . . . . . . . . . .

50

8. Implementation of adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . .

50

9. Procedure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

50

10. Miscellaneous . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.1. Repeal of other administrative provisions . . . . . . . . . . . . . . . . 10.2. Transitional provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

51 51 51

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42 42 43

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1. Statutory bases for income allocation 1.1 Allocation regulations of domestic tax law 1.1.1 In case a taxpayer has business relations with affiliated parties (see sec. 1.3), it must be examined whether his income has been completely reported, i.e. whether it has been correctly allocated (income allocation) towards a foreign country according to the arm’s length principle (see sec. 2.1). This is to be determined in accordance with the provisions (allocation regulations) concerning (a) hidden profit distribution (§ 8 (3) Corporate Income Tax Act) (sec. 1.3.1.1), (b) hidden capital contribution (sec. 1.3.1.2), and (c) the adjustment of income for business relations with foreign countries (§ 1 Foreign Tax Act) (sec. 1.3.2).

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I. Income Allocation (1983)

1.1.2 The general provisions on the allocation of assets and income as well as on the determination of the tax assessment basis (e.g. §§ 39 to 42 General Fiscal Code) take precedence over the allocation regulations. 1.1.3 Regarding their legal requirements, the allocation regulations shall be applied independently and concurrently. In case the requirements of a hidden profit distribution or constructive capital contribution and those of § 1 Foreign Tax Act are simultaneously fulfilled, the resulting adjustment amount must be treated according to the income tax principles on the hidden profit distribution or hidden capital contribution. 1.1.4 This circular includes general principles regarding the examination of the international income allocation. All circumstances of the individual case must be considered in its application; these include e.g. special circumstances resulting from market or supply structures, from the corporate structure, and from federal measures as well as existing customs of the trade. The general principles regarding tax audits (e.g. on the clarification and examination of the facts also in favor of the taxpayer) as well as regulations on the economization remain unaffected. 1.1.5 Where necessary, the highest tax authorities of the Federation and the Federal States will release instructions to (a) take into account the result of international understandings on the arm’s length principle in certain fields, or (b) to preserve the principle of reciprocity in order to protect enterprises that have their seat in the Federal Republic of Germany. 1.2 Allocation stipulations of double taxation agreements 1.2.1 Double taxation treaties contain provisions on income allocation following the arm’s length principle (see in particular Art. 9 (1) OECD Model Tax Convention). They do not establish a direct liability for taxation (ruling of the Federal Fiscal Court of March 12, 1980; Federal Tax Gazette II p. 531). Nevertheless, they allow for an internationally uniform application of the arm’s length principle. The allocation regulations of national German tax law (especially § 1 Foreign Tax Act) remain also applicable in cases of conflicts of interests not named in the allocation regulations of double taxation treaties. Double taxation treaties are not designed to prohibit an income adjustment that is objectively required in certain cases. 1.2.2 The allocation regulations of double taxation treaties enable the German and foreign tax authorities to allocate income based on the common legal basis of the agreement. According to German interpretation of the agreement, mutual agreement and consultation procedures may be initiated. See decision of the Federal Fiscal Court of May 26, 1982 – Federal Tax Gazette II p. 583 for aspects to be considered regarding the protection of the taxpayer in this connection. 29

D. Administrative Guidelines

1.2.3 Based on a mutual agreement or consultation procedure (a) taxed income in the Federal Republic of Germany may be reduced in order to accomplish a corresponding income attribution in both countries; (b) it may be determined that the corresponding allocation shall be carried out regardless of the administrative finality of a German tax assessment notice if double taxation cannot be avoided using other means (see Art. 25 OECD Model Tax Convention in connection with § 2 General Fiscal Code and decision of the Federal Fiscal Court of February 1, 1967 – Federal Tax Gazette III p. 495). In this regard, the German tax authorities will consider the principle of reciprocity. 1.2.4 In order to accomplish a joint allocation of income, the German tax authorities may also initiate mutual agreement procedures if no double taxation treaty exists, the double taxation treaty does not include an allocation regulation, or an existing allocation regulation does not regulate the respective income allocation. 1.2.5 The taxpayer shall be given the timely opportunity to notify the other parties affected about the intended adjustment so that they may discuss with their competent tax authorities possible consequences regarding their taxation that may result from the intended adjustment. The tax authorities will issue certifications required abroad. 1.2.6 In case foreign tax authorities inform the foreign affiliated party about an intended adjustment, upon its request the domestic affiliated party shall be granted the opportunity to discuss with the domestic tax authorities prior to the initiation of a mutual agreement procedure consequences resulting from the intended adjustment regarding its taxation. If the statement of the tax authorities requires a tax audit, it may be scheduled early, where possible. The enterprise has to submit documents necessary for the assessment, especially including the measures intended by the foreign tax authorities. 1.3 Requirements for income allocation to affiliates 1.3.1 Hidden profit distribution and hidden capital contribution 1.3.1.1 A hidden profit distribution is made when a corporation transfers to a shareholder or to a party affiliated to the shareholder a pecuniary advantage outside the ordinary profit distribution under corporate law and when this transfer is caused by the shareholder relationship. As a rule, the percentage of the share is irrelevant. See sec. 31 Corporate Tax Regulations for further details. 30

I. Income Allocation (1983)

1.3.1.2 A constructive capital contribution is made when a qualifying pecuniary advantage is transferred to a corporation by a shareholder or by a person affiliated to the shareholder and the transfer is caused by the shareholder relationship. See sec. 36a Corporate Income Tax Regulations for further details. In case a pecuniary advantage cannot to be treated as a hidden capital contribution e.g. because it does not qualify, adjustments pursuant to § 1 Foreign Tax Act may have to be carried out, if need be. 1.3.2 Income adjustments under § 1 Foreign Tax Act 1.3.2.1 An adjustment may be made in all cases where income is reduced if a business relationship to a foreign country exists and those involved are affiliated – through substantial participation (sec. 1.3.2.2), – through controlling influence (sec. 1.3.2.4), – through special means of influence (sec. 1.3.2.6) or – through identity of interests (sec. 1.3.2.7). Business relations that business partnerships, associations, and similar entities have as such with affiliated corporations may also have to be evaluated under § 1 Foreign Tax Act. 1.3.2.2 An affiliation created through a substantial participation may exist not only by a participation in corporations but also by participating in business partnerships and in a sole proprietorship. It may also be constituted by a silent participation or an equity contribution under a loan agreement. 1.3.2.3 In order to calculate the percentage of an indirect participation of a person in a company, the participation that an intermediary company holds must be considered to the extent of the direct or indirect participation of that person in the intermediary company in relation to the sum of the participants in this intermediary company. 1.3.2.4 An affiliation created by a controlling influence may be based on a legal or factual basis or the combination of both. A controlling influence of others may also be exerted on individuals. The affiliation is already constituted by the mere possibility to exert an controlling influence. 1.3.2.5 The affiliation created by a controlling influence may especially be based on (1) rights similar to participations; (2) company agreements within the meaning of §§ 291 and 292 Stock Corporation Act, corporate integration within the meaning of § 319 Stock Corporation Act, the centralization of several companies under a sin31

D. Administrative Guidelines

gle management within the meaning of § 18 Stock Corporation Act, reciprocal shareholdings within the meaning of § 19 Stock Corporation Act; (3) the indirect or direct participation of the same persons in the management or the control of two companies or (4) the subordination of two companies to the controlling influence of a third company. 1.3.2.6 An affiliation created through special means of influence presumes that the influence of the person or taxpayer extends to the business relation in question. An affiliation is already constituted by the mere possibility to exercise such an influence. It is sufficient to have the possibility to exercise influence on others like through affiliated companies (§ 1 (2) no. 1 and 2 Foreign Tax Act). 1.3.2.7 An affiliation created through identity of interest exists e.g. if the own business or personal interest of the person or taxpayer himself is relevant to the income that is subject to adjustment. 1.4 Legal form of business relations between affiliated companies 1.4.1 In case a company claims expenses for the benefit of an affiliated party as business expenses, it must be examined whether these expenses have a business purpose or are legally caused by the shareholder relationship. As a rule, the deduction of business expenses made in the relation to the controlling partner may only be accepted if the expenses are based on precise and unambiguous agreements made in advance (decision of the Federal Fiscal Court of November 3, 1976 – Federal Tax Gazette 1977 II p. 172; for exceptions see decision of the Federal Fiscal Court of July 21, 1882, Federal Tax Gazette II p. 761). The same is applicable to relations with affiliated companies. The same formal requirements applicable to business transactions between third parties shall be applied to normal deliveries and transactions. In all other cases it is sufficient that the expenses are based on legal title as customary among third parties. 1.4.2 In case a company has waived remuneration for business relations with an affiliated party which it would have claimed according to the arm’s length principle, the absence of respective agreements does not prevent an adjustment. 1.4.3 If missing precise and unambiguous agreements lead to an adjustment in one country and a deduction in the other country is not possible due to absent agreements, sec. 1.2.3 is applicable regarding the resulting double taxation. 32

I. Income Allocation (1983)

1.4.4 Refer to sec. 9 with respect to evidence. 1.5 Business relations to affiliated persons in low tax areas 1.5.1 The relevant provisions (e.g. §§ 39 to 42 General Fiscal Code) as well as the respective administrative principles are applicable to the examination of the income allocation with respect to affiliated parties in low tax areas. The special circumstances that have to be considered for the evaluation (see e.g. sec. 2.1.3 sent. 4, sec. 2.1.8 sent. 8) must be clarified by the taxpayer as required by §§ 16 Foreign Tax Act, 90 General Fiscal Code. Sec. 2.4.3 and 2.4.6 are in principle not applicable to such cases. 1.5.2 The allocation regulations are also applicable to business relations with interposed companies within the meaning of § 5 and with intermediate companies within the meaning of §§ 7 to 14 Foreign Tax Act; where applicable, a corresponding adjustment shall be carried out for the determination of the amount of additional income that is allocated to the intermediate company (§ 10 (3) Foreign Tax Act).

2. General principles for the allocation of income 2.1 The arm’s length test as criterion for income allocation 2.1.1 For tax purposes, business relations between affiliated parties must be evaluated according to whether those involved acted like unaffiliated third parties (arm’s length test). In this regard, the relations of free competition form the standard. The underlying principle is the normal degree of commercial prudence exercised by a reasonable and prudent business manager that he applies in dealing with third parties (see e.g. decisions of the Federal Fiscal Court of March 16, 1967 – Federal Tax Gazette III p. 626 and of May 10, 1967 – Federal Tax Gazette III p. 498). 2.1.2 The income allocation is generally to be based on each specific business transaction with the affiliated party. The actual facts and circumstances are decisive in accordance with their economic substance (see decisions of the Federal Fiscal Court of July 30, 1965 – Federal Tax Gazette III p. 613, of February 26, 1970 – Federal Tax Gazette II pg 419 and of January 15, 1974 – Federal Tax Gazette II p. 606; see also sec. 3.1.3 example no. 3). 2.1.3 The functions of the individual affiliated companies must be regarded for the income allocation. Of special importance are – structure, organization, division of functions, and risk allocation within groups as well as allocation of assets; – which companies fulfill the individual functions (production, assembly, research and development, administrative services, marketing, services); and 33

D. Administrative Guidelines

– the capacity with which the companies perform these functions (e.g. as fully fledged distributor, agent, or party on an equal basis or agent of a pool). In this context, the economic substance of the actual activity is decisive (see sec. 2.1.2). Service remuneration for companies without functions is not allowed; in cases where companies perform merely simple functions, only the actually rendered economic services may be taken into consideration, i.e. as a rule by means of a cost-oriented remuneration (see sec. 2.2.4). 2.1.4 For the allocation it is decisive how third parties would have set remuneration for supplies or services of the same kind (hereinafter: “arm’s length price”) or which income or expenses would have accrued to or been incurred by the taxpayer if third parties had been conducting business. In this case it is assumed that the individual supplies and services in the ordinary course of business between independent parties are generally the object of separate business relations, i.e. of separate agreements and invoices. However, package deals among affiliated parties are subject to an audit as such; if in this context a single transfer price is charged for several supplies or services then there is no objection to this if the overall remuneration can be split to specific partial performances or third parties also agree to such aggregate prices. Sec. 2.3 (set-off of benefits) is applicable to cases where several business agreements exist. 2.1.5 In order to determine arm’s length prices, it shall be relied on data based on which the prices between independent third parties are determined. The prices of the market in which unaffiliated parties would negotiate their business conditions are decisive. 2.1.6 Accordingly, the following standards may be considered in determining arm’s length prices: (a) stock market prices, common trade prices that are determined in the relevant market (market price) as well as other market information; (b) prices which the taxpayer, the affiliated party or third parties have actually agreed for respective supplies or services in the relevant market; (c) profit mark-ups, calculation methods or other business aspects influencing the pricing in the free market (business data). 2.1.7 Where required, this data has to be adequately corrected adjusting it to the divergent conditions of the respective business which are important for the determination of the arm’s length price (example: market prices for goods of standard quality are customary recalculated to qualities for which no special market price exists using a customary commercial standards; market prices based on cif must be recalculated accordingly for fob transactions). Customary volume discounts have to be considered. 2.1.8 A sound business manager will derive the transfer price with all necessary care (see sec. 2.1.1) from available or accessible data (see decision 34

I. Income Allocation (1983)

of the Federal Fiscal Court of January 10, 1973 – Federal Tax Gazette p. 322). Herewith, he has leeway making his assessment and business decisions resulting from his involvement in the general trade and the market situation. On the other hand, the management of the taxable enterprise has to safeguard its own interests towards affiliated parties and the whole group the same way it would towards third parties. Using such leeway presupposes that the total framework complies either with the normal practice of the business, the industry, or general commercial dealings. 2.1.9 The following examples illustrate the application of the principles: Example 1 In order to determine the arm’s length price, there is often only one range of prices available in the market within which its independent market participants negotiate the price for individual business transactions from case to case. Without any economically substantial reason, two affiliated companies set the prices schematically at the upper or lower limit of the range whereby the profit of the disadvantaged company is continuously reduced. A sound business manager of the disadvantaged company would not accept such pricing but would intend to accomplish a balanced pricing in the interest of his company. Therefore, the income of the disadvantaged company must be adjusted. Example 2 A distribution company in a low tax country is engaged in the export of goods of a German company. Leeway regarding the deliveries of goods to this company is always used in such manner that the distribution company earns an unreasonably high profit which does not comply with its function. A sound business manager of the disadvantaged German company would not accept such a situation. The income has to be adjusted.

2.2 Standard methods for the examination of transfer prices 2.2.1 The standard methods described below give the most important guidelines for the transfer pricing examination (see sec. 2.4.1). 2.2.2 Comparable uncontrolled price method The price which affiliated parties have agreed is compared with prices that third parties would have agreed in the market for their transactions. This may be done (see sec. 2.1.6 above) by (a) an external price comparison (comparison with market prices determined according to price quotations, customary commercial prices or agreements concluded between independent third parties); (b) internal price comparison (comparison with market derived prices that the taxpayer or an affiliated party agreed with an unaffiliated party). Preferably, the compared transactions should be as similar to each other as possible (direct price comparison). It may be relied on inhomogeneous transactions if the influence of the divergent factors can be eliminated and, according to sec. 2.1.7, the price agreed upon for these transactions 35

D. Administrative Guidelines

can be recalculated to a price for the compared transaction (indirect price comparison; example: recalculation of cif-prices to fob-prices). 2.2.3 Resale price method This method begins with the price at which a good purchased from an affiliated party is sold to an independent purchaser. Then the resale price is calculated back to the price that shall be applied for the transaction between the affiliated parties. Accordingly, the resale price is reduced by customary market discounts that reflect the function and the risk of the reseller. In case the reseller has processed or otherwise modified the good, this must be considered by appropriate reductions. If a good passes through a whole chain of affiliated parties, it may be possible to recalculate the price (derived from the market) of the last delivery to an unaffiliated party across the entire chain back to its starting point. The same is applicable to services. 2.2.4 Cost plus method With regard to deliveries or services among affiliated parties, this method begins with the costs of the manufacturer or service provider. These costs are calculated according to calculation methods on which the manufacturing or supplying party also bases his pricing towards third parties or – if there are no supplies or services to third parties – that comply with business management principles. Profit mark-ups customary for the company or the industry will be added then. Where goods or services are transferred through a chain of affiliates, this method shall be applied to each individual member consecutively, whereas the actual functions (sec. 2.1.3) of the individual affiliated companies have to be regarded. 2.3 Set-off of benefits 2.3.1 An adjustment between profitable and unprofitable transactions of a taxpayer with an affiliated party is only permitted in case third parties would have made such an adjustment for their business transactions. Accordingly, the benefits must be set off against the disadvantages if the taxpayer has accepted disadvantageous conditions in transactions with the affiliated party with regard to benefits granted to him in return by the affiliated party in connection with the transaction concerned. 2.3.2 The set-off of benefits under sec. 2.3.1 requires that – the transactions have such coherence to assume that the taxpayer would also have concluded the transactions with the same person under arm’s length conditions;

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I. Income Allocation (1983)

– the benefits and disadvantages of the individual transactions can be quantified with the care of a reasonable and prudent business manager; and – the set-off of benefits had been agreed or had been part of the commercial motivation for the unprofitable transaction (decision of the Federal Fiscal Court of June 8, 1977, Federal Tax Gazette II p. 704). 2.3.3 In case the disadvantageous conditions were not set off in the business year in which they took effect, a set-off is only permitted if it is determined until the end of the same business year at the latest when and against which benefits the disadvantages will be set off. The disadvantages are to be offset within the following three business years. The setoff is also achieved where the advantage has been capitalized. 2.4 Application of the methods 2.4.1 There exists no priority among the standard methods for the examination of transfer prices that applies to all cases. The examination is based on the transfer pricing determination the company carried out itself. In verifying the appropriateness of that determination as regards method and its application, it is assumed that a sound business manager (a) would refer to the method closest to the circumstances under which arm’s length prices are formed in commercially comparable markets; (b) will in case of doubt refer to the method for which most reliable price relevant data is available from actual transactions of the participating affiliated companies with third parties. In this context, the circumstances of the individual case shall be determined. 2.4.2 The market circumstances will often make it necessary to rely on several methods to determine the transfer prices. It is thus not objected if standard methods are specified, mixed, or supplemented by other elements to meet the market conditions. Several standard methods may be used when analyzing transfer prices. 2.4.3 Affiliated companies often determine their transfer prices based on costs, calculation or other computation figures, or centrally collected data. The examination of income allocation may rely on such calculation systems if they lead with appropriate accuracy to the same results as business transactions would between unaffiliated third parties. This presupposes that (a) the calculation systems are sufficiently differentiated and, with regard to system and application, are in detail easily and completely verifiable;

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(b) the calculation systems guarantee that a domestically generated income is taken into account completely and accurately; and (c) the companies check the standards and data contained in the computation systems in appropriate time intervals and adjust them to changed circumstances. The calculation systems must be reviewed regarding their consistency and proper application to the individual transactions. In this context, sec. 2.3 must be regarded. 2.4.4 In applying these principles, (a) the starting point is the actual functions of the affiliated companies within the group; (b) a company cannot refer to a standard method deviating from the market conditions and those of the company; (c) a company may only refer to a specific method in case it submits the documents required; (d) a company shall not depart arbitrarily from an appropriate method of determining its transfer prices and from appropriate calculation systems. 2.4.5 When applying the aforementioned principles, the tax audit may rely on the operating results that the taxpayer, his affiliated parties, or third parties generated under comparable business conditions from comparable transactions with unaffiliated parties in order to determine special audit fields, to cross-check transfer prices, or to find other indication for the income allocation. For these purposes it may be referred to the total profits of connected business divisions and their allocation to the individual business divisions of the affiliated group. The results within the meaning of sentences 1 and 2 above may be taken alone as basis for the income allocation in case the application of the standards methods should not lead to appropriate results due to special circumstances (e.g. when goods or a group of goods can, to a great extent, only be acquired or manufactured, processed, and distributed within vertically organized groups of companies) as well as in cases quoted in sec. 2.4.6 and for estimations (e.g. according to § 1 (3) Foreign Tax Act). 2.4.6 In special cases it may not be possible to compare the actual circumstances with similar situations between unaffiliated parties, above all where, applying the criteria of sec. 2.1.1, business relations of the same kind would not have been concluded between unaffiliated parties or would only have come about with an essentially different commercial context. In such cases the income allocation has to be based on an appropriate allocation of the income from the business relations, such as sound business managers would have agreed. 38

I. Income Allocation (1983)

3. Supply of goods and services 3.1 Delivery of goods and commodities 3.1.1 Principle In case a company supplies goods or commodities to an affiliated company, the arm’s length price is the price that unaffiliated parties would have had agreed for – similar goods or commodities – in comparable quantities – to the same market – at a comparable trade level and – at comparable conditions for delivery and payment under the conditions of commercially comparable markets. See sec. 2.4.1 regarding the application of the standard methods. 3.1.2 Determining factors 3.1.2.1 The examination of the transfer prices has to consider all circumstances of the individual case. It must especially be based on the (1) special nature, features, and quality as well as innovative factor of the goods and commodities supplied; (2) conditions of the market in which the goods or commodities are used, consumed, treated, processed, or sold to unaffiliated parties; (3) the functions that the involved companies actually perform and the market levels on which they actually operate (see sec. 2.13); (4) terms of delivery, especially regarding liabilities, payment terms, rebates, discounts, bearing of risks, warranty, etc.; (5) advantages and risks in connection with long-term supply relationships; (6) special competitive situations (see e.g. sec. 3.1.2.4 sent. 2). The conditions at the time of the conclusion of the contract are relevant; yet it must be examined for long-term contracts whether unaffiliated third parties would take such risks into account by concluding respective agreements (e.g. price adjustment clauses). 3.1.2.2 In case special financing services (e.g. payment terms not customary to trade, customer financing), part supplies of materials by the customer, or auxiliary services are agreed in connection with the supply of goods 39

D. Administrative Guidelines

or commodities, this has to be reflected in the arm’s length price. If separate contracts are concluded regarding these services, a set-off of profit is permitted as cited in sec. 2.3. 3.1.2.3 In case goods or commodities were manufactured using an intangible asset (e.g. industrial property right, design patent right, copyright, an unprotected invention or any other achievement that constitutes a technological improvement, plant variety right, commercial or business secret or any other similar rights or values), their purchase and subsequent use or consumption by the purchaser does in general not entail any use of the intangible asset; in such cases the purchaser does not owe any royalties. If manufacturer and purchaser nevertheless agree on a license fee, this shall in principle not be accepted tax-wise. This is not applicable though, in case the purchaser otherwise exploits an additional intangible asset (e.g. a patent within the meaning of sec. 5.1.1 sent. 2) by using the goods or commodities, utilizes the goods or commodities for a procedure protected under patent law, or produces from them another legally protected asset. In such cases it is also not permissible that the consideration for the use of the intangible assets is included in the price of the goods or commodities; a set-off of benefits and disadvantages for these assets and the charges for their subsequent use must be acknowledged. 3.1.2.4 When the standard methods are applied, data and prices that are influenced by exceptional competitive circumstances shall be left out of account and can therefore not be transferred to the business relation in question. This is e.g. applicable to prices (1) determined in closed special markets in which prices are formed deviating from the market in which goods are sold or bought; (2) for which special reductions are granted in connection with the market launch of goods; (3) set up either by avoiding or, in some other way, by not bearing any reference to valid patent protection; (4) influenced by governmental price controls or comparable measures. It shall be relied on these prices to the extent that they can be adjusted according to sec. 2.1.7. 3.1.2.5 The arm’s length price relevant for the income allocation may differ from the custom value and/or other assessment bases for the import on which customs clearance or the assessment of the turnover upon import is based within the meaning of § 11 Value Added Tax Law (see decision of the Federal Fiscal Court of February 1, 1967 – Federal Tax Gazette III p. 495).

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I. Income Allocation (1983)

3.1.3 Examples for the application of the standard methods Example 1: A group company supplies finished goods to an affiliated sales company acting as a distributor. Neither a market price nor a price that is derived from a market may be identified for the international supply of these goods from producer to wholesalers. Furthermore, the affiliated distribution company is solely responsible for selling these goods in the respective sales market. In this case, the resale price method will generally need to be applied if, in arm’s length sales, all parties consider a certain functional discount to exclusive agents for their pricing expectations. Sales companies are companies selling goods without essentially treating or processing these. Example 2: A group company supplies semi-finished goods to an affiliated manufacturing company at a more advanced stage in the chain of production. There is no market for such products. In this case the cost plus method will generally be applied, if unaffiliated parties would base their price expectations on the costs of the good plus a respective mark-up under similar conditions. Example 3: A company transfers specific parts of its production to a foreign subsidiary. Production and distribution by the foreign subsidiary are carried out closely in connection with the domestic company’s operation. The products will be purchased by the parent company under a long-term arrangement. With its limited scope of production, the subsidiary would not survive in the long run as an independent enterprise. Unaffiliated parties would have carried out the production on a toll manufacturing basis (see also sec. 2.1.2). Accordingly, the transfer price may be determined using the cost plus method.

3.2 Commercial services 3.2.1 Principle If a company renders commercial services to an affiliated company, sec. 3.1.2 and 3.1.3 shall apply accordingly. The provisions regarding the market level are only applicable to the extent that it is customary in the market to make differences between various groups of customers. 3.2.2 Special cases Sec. 5 shall be applied for services in the field of research and development and sec. 6 for administrative services. 3.2.3 Comparable uncontrolled price method, resale price method, and cost plus method 3.2.3.1 With regard to commercial services, standard industry prices can usually only be determined for standardized services or for special fields (e.g.: transport and insurance) due to the variety of the services. In this connection the pricing modes established in special fields of the service sector have to be observed.

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3.2.3.2 If comparable prices are not available, the cost plus method is usually applied (reason: services are in principle not resold, precluding the resale price method). 3.2.3.3 In case services are connected to supplies of goods, they cannot be charged separately if, among unaffiliated parties, they are usually compensated with the commodity price (e.g. warranty, maintenance, or ex gratia services customary in the industry). Otherwise, Sec. 3.1.2.2 is applicable accordingly. 3.3 Advertising costs 3.3.1 The advertising costs must be borne by the affiliated company whose functions are promoted by the advertisement measure. If a company assumes advertising tasks for an affiliated company, the services rendered herewith may (a) be allocated as commercial services (sec. 3.2) to the extent that their nature and scope comply with the services of independent advertising companies (e.g. independent implementation of an entire advertisement campaign including the production of advertising materials, samples, etc.); (b) in all other cases be allocated according to the principles regarding administrative services (sec. 6). 3.3.2 The aforementioned principles are also applicable to affiliated manufacturing and distribution companies. To the extent that advertising measures is related to the functions of both companies, it must be examined whether the advertising expenditures have been appropriately allocated between these companies. Benefits from bearing the costs for advertising measures may be set off with price agreements for the purchase of goods or vice versa. With regard to the set-off, sec. 1.4 is applicable. 3.3.3 There shall be no objections if affiliated enterprises regulate the allocation in the group with special allocation contracts based on a medium or long-term advertising concept. Such arrangements must be examined according to sec. 2.4.3 and, where applicable, to sec. 7. 3.4 Market penetration costs 3.4.1 Usually, when launching new products higher costs or profit shortfalls incur for manufacturing companies and their distribution companies during the introductory period. Among unaffiliated parties they are in principle borne by the distribution company only if an appropriate business profit remains from the business relation.

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I. Income Allocation (1983)

3.4.2 Unaffiliated parties would also allocate such costs or profit shortfalls in such manner that (a) the distribution company bears these costs or profit shortfalls to a large extent and in return is granted such delivery prices with which it is able to make up the shortfall in its profits within a foreseeable period after the introductory period, or (b) the manufacturer bears these costs or profit shortfalls to a large extent and is able to make up the shortfall in its profits within a foreseeable period after the introductory period inter alia with higher delivery prices. The envisaged compensation between the manufacturing and the distribution company shall generally be calculated in advance based on projected profitability and be subject to contractual agreement. Provided that these conditions are met, such allocation may serve as basis for the income allocation between affiliates. 3.4.3 Costs and profit shortfalls resulting from aggressive prices or similar means that a distribution company uses to considerably increase or defend its market share shall always be borne by the manufacturer. 3.5 Start-up costs For newly established companies or companies which are either enlarged or essentially reorganized, start-up costs are accepted in expectation of profits being realized in later business years. Such costs are in principle to be borne by the newly founded, enlarged, or reorganized company. For costs and profit shortfalls which accrue during the start-up phase due to the introduction of products, sec. 3.4 is applicable.

4. Interest and similar remuneration 4.1 General With regard to financing services among affiliated parties, it must first be examined whether a loan was provided in earnest or whether there was a hidden profit distribution and/or a hidden capital contribution (hidden capital). Interest charges for tax purposes may only be considered if a loan was seriously granted. A hidden profit distribution and/or hidden capital contribution (hidden capital) is assumed if a repayment of the loan could not seriously be expected from the start (decision of the Federal Fiscal Court of September 16, 1958 – Federal Tax Gazette III p. 451). A hidden contribution to nominal capital is further assumed if in individual cases for legal or economic reasons this kind of injecting capital constitutes the only possible means or if the contractual arrangements under the law of obligations is proven 43

D. Administrative Guidelines

to be so unusual that it must be seen as an abuse of legal structuring possibilities within the meaning of § 42 General Fiscal Code. 4.2 Relevant interest rates 4.2.1 In case a person grants credits (e.g. loans, mortgages, commercial credits, current account credits) to an affiliated party, the arm’s length price is the interest rate at which unaffiliated parties would have granted the loan in the money or capital market under comparable circumstances (see decision of the Federal Fiscal Court of November 25, 1965 – Federal Tax Gazette 1965 III p. 176). The examination shall consider the interest rates at which banks would grant loans to unaffiliated parties under comparable circumstances (interest rate on debits). 4.2.2 All circumstances of the individual case must be regarded when examining the interest rates. In particular, the examination is to be based on: (1) loan amount and duration; (2) nature and purpose of the credit; (3) securities and creditworthiness of the borrower (considering special conditions that unaffiliated parties would also grant to the borrower with regard to his association to the group); (4) the currency involved, exchange rate risks, and exchange rate opportunities (see sec. 4.2.3) and any costs of hedging against exchange risks; (5) refinancing costs for pass-through credits (for further details see sec. 4.3.3); (6) other circumstances relating to the granting of the credit, especially the situation on the capital markets (see especially sec. 4.2.4). The circumstances of the individual case may make it necessary to rely on other interest rates as those set forth in sec. 4.2.1 if third parties would also rely on them. If an examination leads to a range of interest rates, it must be adhered to sec. 2.1.8 and 2.4.6. 4.2.3 In case the credit was made in a foreign currency, the interest rates in the currency area of that foreign currency must be considered when applying sec. 4.2.1 and 4.2.2 provided that unaffiliated parties would also have agreed on the credit in this currency under comparable circumstances. Furthermore, measures that unaffiliated parties would have taken to spread the exchange rate risk must be considered (e.g. by means of indexing clauses or forward exchange transactions at the borrower’s expense). 4.2.4 If the taxpayer could either have borrowed or granted the credit in the currency set forth in the credit agreement in a money or capital market 44

I. Income Allocation (1983)

other than that in the currency area of the currency applied at an interest rate more advantageous to him, these interest rates must also be regarded. 4.2.5 The circumstances at the time the credit was granted are decisive. It must be examined though, whether with regard to medium or longterm credits fluctuations in the interest rate level have been taken into account in the manner customary among unaffiliated parties (e.g. by stipulating termination or interest rate adjustment clauses). 4.2.6 The examination may refrain from necessary objections if a non-interest-bearing or a low-interest loan is granted instead of a required equity contribution due to mandatory legal provisions in the country of domicile of the affiliated party or due to similar reasons which lie outside the loan arrangement. If this provision is applied, the sheer fact that the loan does not bear any interest or only low interest does not justify the loan being written down to going-concern value. 4.3 Particular cases 4.3.1 In the case of trade receivables it must be examined whether – charging interest is normal commercial practice, – the business partners would calculate interest in the opposite direction for comparable transactions. Sec. 4.2 remains unaffected for all other cases. 4.3.2 Loans may possibly be given bearing no interest or only at a reduced interest rate for business reasons outside the credit-relationship. This may e.g. be the case if (a) the parent company grants a non-interest-bearing commercial credit to an affiliated distribution company in order to promote the sales of its products; (b) the affiliated sales company is economically incapable of providing, from its own funds, a deposit required by the authorities to obtain import licenses for products of the parent company and thus receives a non-interest-bearing loan from the parent company for this reason. The examination must consider that there is adequate compensation under sec. 2.3 in the relationship that forms the basis of the interest arrangement. 4.3.3 If a domestic company interposes a foreign affiliated party with respect to the borrowing of capital in a foreign market, the following is applicable: If the affiliated party acts (a) as agent or commission agent, the borrowing of capital in the foreign market must be allocated directly to the domestic company. The af45

D. Administrative Guidelines

filiated party is only entitled to receiving an appropriate commission from the domestic company for its services rendered. It shall especially be assumed that the affiliated party acts as agent in case it borrows for the domestic company capital in its own name in capital markets with favorable interest rates; (b) as lender, the interest to be paid by the domestic company to the affiliated party must be assessed according to sec. 4.2.1 and 4.2.2; (c) as booking center or has merely lent its name, it did not render a service to be remunerated. Booking fees may also not be acknowledged as the loan constitutes a business transaction to be booked by the domestic company. 4.3.4 In case a foreign company interposes a domestic affiliated party in a credit transaction or in exploiting special domestic investments, sec. 4.3.3 is applicable correspondingly. 4.4 Guarantees and similar obligations 4.4.1 If a person gives a guarantee on behalf of an affiliated person, the resulting legal consequences (e.g. future guarantee payments) may only reduce the income of this person for tax purposes if he would have given such guarantee with the care of a sound business manager also on behalf of an unaffiliated party (decision of the Federal Fiscal Court of March 19, 1975 – Federal Tax Gazette II p. 614); this presumes that guarantee was given for economic reasons that lie beyond the shareholder relationship. 4.4.2 If the prerequisites of sec. 4.4.1 are met, a commission must be estimated for giving the guarantee provided that unaffiliated parties would have agreed on such a guarantee (see decision of the Federal Fiscal Court of May 19, 1982 – Federal Tax Gazette II p. 631). This is e.g. (1) the case, if the debtor benefits from the guarantee especially by saving own financing costs or if access to a certain capital market is given. Thus, a provision for a guarantee must e.g. be determined in case the guarantee is assumed for a financing company that raises bonds in foreign capital markets with which it plans to finance investments of the group; (2) not the case, if the guarantor would have given the guarantee without charge to an unaffiliated party in his own operational interest. Such operational interest of the guarantor may in certain cases exist if a guarantee is given for the benefit of a distribution company. 4.4.3 The aforementioned principles are applicable accordingly to other obligations (e.g. letter of comfort) provided that such can be characterized as a guarantee.

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I. Income Allocation (1983)

5. Transfer of rights to use patents, know-how and other intangible assets; contract research 5.1 General 5.1.1 In case an affiliated company is granted the right to use an intangible asset (see sec. 3.1.2.3), the arm’s length price shall be estimated for it. This is also applicable if the acquiring company does not use the intangible asset, however, achieves or probably will achieve an economic benefit from it (e.g. protection effect of reserve and blocking patents). See sec. 6.3.2 regarding the right to use the group’s name. 5.1.2 A remuneration for use of intangible assets cannot be recognized for tax purposes if the provision of use is connected with supplies of goods or services for which between unaffiliated parties the use of intangible assets is covered by the price of the goods or services; a set-off of benefits and disadvantages shall be recognized though, if goods and services on the one hand and the right to use such legally protected property rights on the other hand are invoiced separately. 5.1.3 If the person to whom the right to use intangible property is transferred to provides the transferor thereof with an achievement that is not legally protected and that constitutes a technological improvement or a similar benefit (know-how) that he developed by using the intangible property, this must be considered when examining the remuneration. In case such person provides know-how independently of such use, it must be charged between the parties as between unaffiliated persons. 5.2 Deriving arm’s length prices 5.2.1 The transfer price is to be based on the individual intangible assets actually provided for use. The intangible assets used by a licensee can in principle only be aggregated if they form a unit technically and economically. 5.2.2 The arm’s length prices for the provision of intangible assets are in principle to be arrived at by applying a user fee determined on an appropriate assessment basis (e.g. turnover, quantity, lump-sum payments). To the extent feasible, the Federal Office for Finance may determine for tax audit purposes customary standard royalty ranges for the provision of intangible assets. For their application it has to be considered that unaffiliated parties would negotiate the conditions regarding the transfer of intangible assets using a differentiated approach. 5.2.3 If the appropriateness of the negotiated license fee cannot be assessed sufficiently using the comparable uncontrolled price method, it must be assumed for audit purposes that the sound business manager of a licensee would only pay a license fee up to an amount that leaves the company with an appropriate operating profit from the licensed product. 47

D. Administrative Guidelines

In principle, the sound business manager will make this decision based on an analysis of the expenses and income expected from the transfer of the intangible assets. See sec. 9 with regard to evidence. 5.2.4 In exceptional cases, the cost plus method may be considered for separate invoicing. The costs may be used as estimation indication for the verification of license fees. 5.3 Contract research In case a company conducts research and development (contract research) on behalf of another company, the commissioning company and not the researching company rather benefits from the results. In such cases, the cost plus method is regularly to be applied in order to determine the appropriateness of the remuneration for the services provided.

6. Administrative services within the group 6.1 General In a group of companies, the parent company, subordinated companies, or similar organizations regularly assume either centrally or regionally for the entire group administrative tasks, management, control, consultancy, or similar functions. Remuneration for these activities cannot be charged under any circumstances to the extent that they are based on the shareholder relationship or other circumstances constituting the affiliation (see sec. 1.3.2.4 to 1.3.2.7). Only to the extent that such institutions additionally render services to their affiliated companies, an allocation according to the following principles may be considered. 6.2 Requirements for intercompany charges 6.2.1 Separate intercompany charges are possible if remuneration would have been paid for services outside the shareholder relationship between unaffiliated parties (see sec. 6.1). The intercompany charge must be contracted in advance by the paying company and proof must be provided by it. This is not permissible in case expenses and/or services of these organizations are charged differently to the receiving companies, e.g. in the form of charges for the intra-group trade and services transactions at arm’s length prices which already include these expenses and services, respectively. 6.2.2 Unaffiliated parties would only agree on remuneration for such services if they – can be clearly distinguished and quantified and – are rendered in the interest of the receiving person (i.e. a benefit is expected and own costs are saved).

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I. Income Allocation (1983)

Services cannot be charged if a subsidiary accepts those only out of consideration for the situation of the parent company yet would not have used these if it were an independent company having regard only to its own situation. 6.2.3 The services must actually be rendered. The mere offer within the group is insufficient as unaffiliated parties generally would only remunerate services actually rendered. It cannot be objected though, if services that fluctuate with regard to their volume are remunerated with an average compensation that complies with the services actually rendered within a period covering several years. 6.3 Examples 6.3.1 According to these principles, remuneration may be charged e.g. for – assuming bookkeeping works and similar services, e.g. specific consultancy services regarding the own economic and legal issues of an affiliated company; – temporary provision of personnel including that of the management level of an affiliated company; – training and further education of, and providing social security to, personnel working with the affiliated company in its interest; – services of the parent company for purposes of procuring goods and of arranging services that are directly obtained and/or received by the respective subsidiary; – the supply of services on call as customary in the market to the extent that it is proven that the subsidiary required these and that it indeed demanded services to an appropriate extent. 6.3.2 In contrast, a parent company may not charge a remuneration e.g. for – so-called group support including the right to use the group’s name as well as the benefits resulting only from the legal, financial, and organizational affiliation in the group; – the activity of its executive board and supervisory board as such and for its shareholders’ meetings; – the legal organization of the group as a whole and for the coordination of production and investments within the whole group; – activities resulting from its shareholder position including the general organization and the control and revision which serves the group headquarters;

49

D. Administrative Guidelines

– the protection and administration of the shareholdings; – the group management and such management tasks of subordinated companies that the group management has itself taken over in order to prepare, implement, and control its own management measures better. The management includes planning, entrepreneurial decisions and coordination. 6.4 Deriving arm’s length prices 6.4.1 It may be relied on arm’s length prices for administrative services to the extent that services rendered between unaffiliated parties are comparable according to nature and scope with the intra-group administrative services. In this context it must be considered that the parties involved have a long-term relationship. If market prices cannot be determined, as a rule the arm’s length price is to be determined according to the cost plus method. Furthermore, it must be regarded that the service recipient’s sound business manager would generally not pay a remuneration exceeding the expenses that would arise if his company had carried out the administrative tasks in question itself or if it had outsourced the respective assignments to local unaffiliated parties. 6.4.2 In order to determine the remuneration under the cost plus method, (1) the individual services rendered and (2) the costs to be allocated to the individual services must be considered separately. The taxpayer has to provide evidence by submitting documents (§ 90 (2) General Fiscal Code).

7. Income allocation by cost sharing agreements (Sec. 7 repealed; see circular of the Federal Ministry of Finance of December 30, 1999; Federal Tax Gazette 1999 I p. 1122. See page 129 ff.).

8. Implementation of adjustments (Sec. 8 repealed; see circular of the Federal Ministry of Finance April 12, 2005; Federal Tax Gazette 2005 I p. 570. See page 162 ff.).

9. Procedure (Sec. 9 repealed; see circular of the Federal Ministry of Finance of April 12, 2005, Federal Tax Gazette I p. 570. See page 162 ff.).

50

I. Income Allocation (1983)

10. Miscellaneous 10.1 Repeal of other administrative provisions Sec. 1 of the Introductory Circular of July 11, 1974 (Federal Tax Gazette 1974 I p. 442) on the Foreign Tax Act is no longer applicable to cases of income allocation within the meaning of this circular. 10.2 Transitional provisions In case companies restructure their relationship with regard to this circular (e.g. by concluding or amending cost sharing agreements) the examination of the time preceding such restructuring under the arm’s length principle will remain unaffected. The restructuring itself shall not give grounds for drawing legal consequences for the past that would be to the disadvantage of the company. It may be assumed that restructurings carried out within three years after the publication of this circular were performed with regard to this circular.

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D. Administrative Guidelines

II. Permanent Establishments (1999) Administrative Circular on the Guidelines for the Examination of the Allocation of Income for Permanent Establishments of Internationally Operating Enterprises (Administrative Guidelines – Permanent Establishments) Published on December 24, 1999 (IV B 4 – S – 1300 – 111/99, Federal Tax Gazette 1999 I p. 1076); last amended on April 16, 2010

With regard to the results of the discussion with the highest tax authorities of the Federal States, the following rules are applicable regarding the principles according to which business property and income of an enterprise has to be allocated between its head office in one state and its permanent establishment(s) in another state or other states pursuant to domestic law and double taxation agreements: Content 1. Legal basis regarding the taxation of commercial permanent establishments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1 Domestic tax law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1.1 Permanent establishment . . . . . . . . . . . . . . . . . . . . . . . 1.1.1.1 Fixed place of business . . . . . . . . . . . . . . . . . . . 1.1.1.2 Building sites or constructions or installation projects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1.2 Permanent representative . . . . . . . . . . . . . . . . . . . . . . . 1.1.3 Taxation in cases of a domestic permanent establishment 1.1.3.1 Relevant provisions . . . . . . . . . . . . . . . . . . . . . 1.1.3.2 Documentation and cooperation duties . . . . . . . 1.1.4 Taxation in cases of a permanent establishment or a permanent representative abroad . . . . . . . . . . . . . . . . . . 1.1.4.1 Relevant provisions . . . . . . . . . . . . . . . . . . . . . 1.1.4.2 Documentation and cooperation duties . . . . . . . 1.1.5 Commercial business partnership . . . . . . . . . . . . . . . . . 1.1.5.1 Participation in a business partnership . . . . . . . . 1.1.5.2 Classification of a foreign enterprise. . . . . . . . . . 1.1.5.3 Documentation and cooperation duties . . . . . . . 1.1.5.4 Profit share of a taxpayer subject to unlimited taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1.5.5 Profit share of a taxpayer subject to limited taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1.6 Domestic income from business without a permanent establishment or a permanent representative in the domestic territory. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

52

. . . .

. . . .

56 56 57 57

. . . . .

. . . . .

57 58 58 58 59

. . . . . . .

. . . . . . .

60 60 60 61 61 61 61

..

61

..

62

..

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II. Permanent Establishments (1999)

1.2 Double taxation agreements . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2.1 Permanent establishment . . . . . . . . . . . . . . . . . . . . . . . 1.2.1.1 Fixed place of business . . . . . . . . . . . . . . . . . . . 1.2.1.2 Building sites or constructions or installation projects . . . . . . . . . . . . . . . . . . . . . 1.2.2 Dependent agent, independent agent . . . . . . . . . . . . . . . 1.2.3 Participation in a business partnership (special remunerations) . . . . . . . . . . . . . . . . . . . . . . . . . 1.2.4 Legal consequences of a double taxation agreement . . . . . 1.2.5 Protection of the taxpayer . . . . . . . . . . . . . . . . . . . . . . . 1.2.6 Reversion clauses in double taxation agreements . . . . . . 2. Attribution of business property and income. . . . . . . . . . . . . . . . . . 2.1 General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2 Principles of allocation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3 Profit attribution methods . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.1 Direct method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.2 Indirect method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.4 Allocation of assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5 Share of the permanent establishment in the equity of the entire group (dotation) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5.1 Dotation capital of permanent establishments . . . . . . . . 2.5.2 Change in ownership within business partnerships . . . . . 2.6 Transfer of assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.6.1 Transfer to a foreign permanent establishment of the domestic head office . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.6.2 Transfer/repatriation of assets to the domestic territory . . 2.6.3 Transfers between domestic permanent establishment and foreign head office or its foreign permanent establishment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.6.4 Transfers to a foreign business partnership . . . . . . . . . . . 2.7 Attribution of expenses and income . . . . . . . . . . . . . . . . . . . . 2.8 Currency conversion of the result of the permanent establishment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.8.1 Currency conversion for profit determination by business property comparison under § 4 (1) in Connection with § 5 Income Tax Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.8.2 Conversion for profit determination by revenue surplus method pursuant to § 4 (3) Income Tax Act . . . . . . . . . . . 2.8.2.1 Business revenues. . . . . . . . . . . . . . . . . . . . . . . 2.8.2.2 Business expenses. . . . . . . . . . . . . . . . . . . . . . . 2.8.2.3 Time of valuation . . . . . . . . . . . . . . . . . . . . . . .

.. .. ..

62 62 63

.. ..

64 64

. . . . . . . . . . .

. . . . . . . . . . .

65 66 67 67 68 68 68 69 70 71 71

. . . .

. . . .

72 72 73 73

.. ..

73 74

.. .. ..

75 75 75

..

76

..

77

. . . .

79 79 79 79

. . . .

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2.8.3 Conversion in special cases . . . . . . . . . . . . . . . . . . . . . . 2.8.3.1 Transfer of assets from the foreign to a domestic permanent establishment . . . . . . . . . . . . . . . . . 2.8.3.2 Claims by and liabilities to partners . . . . . . . . . . 2.9 Creation and dissolution of the permanent establishment. . . . . 2.9.1 Organization expenses and preceding expenses . . . . . . . . 2.9.2 Dissolution of the permanent establishment . . . . . . . . . 2.10 Contribution of a permanent establishment into a corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3. Individual issues regarding the allocation of business property and income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1 Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1.1 General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1.2 Services as main activity of the permanent establishment 3.1.3 Toll manufacturing by permanent establishments . . . . . . 3.1.4 Management of permanent establishments by the head office . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2 Advertising and market development . . . . . . . . . . . . . . . . . . . 3.2.1 Expenses for advertising . . . . . . . . . . . . . . . . . . . . . . . . 3.2.2 Expenses for market development . . . . . . . . . . . . . . . . . 3.3 Interest and similar compensations . . . . . . . . . . . . . . . . . . . . . 3.4 Management expenses, general administrative expenses, and similar expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.1 Attribution of expenses to the permanent establishment . 3.4.2 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4. Permanent establishments in special cases . . . . . . . . . . . . . . . . . . . 4.0 General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.1 Permanent establishment of banks . . . . . . . . . . . . . . . . . . . . . 4.1.1 Domestic permanent establishment. . . . . . . . . . . . . . . . 4.1.2 Attribution of accounts receivables and margin shares. . . 4.1.3 Dotation capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.1.4 Interest charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2 Permanent establishments of insurance companies . . . . . . . . . 4.2.1 Domestic permanent establishment. . . . . . . . . . . . . . . . 4.2.2 Domestic permanent establishments that are subject to insurance supervision by the Federal Insurance Supervisory Authority . . . . . . . . . . . . . . . . . . . . . . . . . 4.2.3 Domestic permanent establishments that are not subject to insurance supervision by the Federal Insurance Supervisory Authority . . . . . . . . . . . . . . . . . . 4.2.4 Foreign permanent establishments of domestic insurance companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

54

..

79

. . . . .

. . . . .

79 79 80 80 81

..

81

. . . . .

. . . . .

81 81 81 81 82

. . . . .

. . . . .

82 82 82 83 83

. . . . . . . . . . . .

. . . . . . . . . . . .

84 84 84 84 84 85 85 85 86 88 89 89

..

90

..

91

..

92

II. Permanent Establishments (1999)

4.3 Building sites or constructions or installation projects . . . . . . . . 4.3.1 General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3.2 Building and installation supervision as building site or construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3.3 Delegation to subcontractors . . . . . . . . . . . . . . . . . . . . . . 4.3.4 Building and construction and installation projects by a consortium or a joint venture . . . . . . . . . . . . . . . . . . . . . 4.3.5 Evaluation of building sites or constructions. . . . . . . . . . . 4.3.6 Allocation of profit and loss between head office and permanent establishment . . . . . . . . . . . . . . . . . . . . . . . . 4.3.7 Supply of materials for construction or installation works by the permanent establishment . . . . . . . . . . . . . . 4.3.8 Allocation of construction material and installation parts to the permanent establishment . . . . . . . . . . . . . . . 4.3.9 Allocation of financing costs and income . . . . . . . . . . . . . 4.4 Control and coordination offices . . . . . . . . . . . . . . . . . . . . . . . . 4.4.1 General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.4.2 Qualification of the control and coordination offices as permanent establishment . . . . . . . . . . . . . . . . . . . . . . 4.4.3 Attribution of shares and assets as well as income flowing therefrom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.4.4 Profit of the permanent establishment . . . . . . . . . . . . . . . 4.4.5 Assets and liabilities of the permanent establishment . . . . 4.5 Permanent establishments when operating sea-going vessels and inland-navigation vessels . . . . . . . . . . . . . . . . . . . . . . . . . . 4.5.1 General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.5.2 Special provisions for foreign income from operating merchant vessels in international traffic. . . . . . . . . . . . . . 4.5.3 Special provisions for shipping enterprises in double taxation agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.6 Prospecting and extracting natural resources in international waters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.6.1 Domestic territory with respect to tax . . . . . . . . . . . . . . . 4.6.2 Permanent establishment . . . . . . . . . . . . . . . . . . . . . . . . 4.7 Permanent establishments while exploring . . . . . . . . . . . . . . . . 4.7.1 Taxation in the exploration phase . . . . . . . . . . . . . . . . . . 4.7.1.1 Permanent establishment under national law . . . . 4.7.1.2 Permanent establishment under double taxation agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.7.2 Taxation at the time of transition to the development and production phase . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.7.3 Special provisions for the treatment of the permanent establishment result . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.8 Transport facilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. .

92 92

. .

93 94

. .

94 95

.

96

.

97

. . . .

97 97 98 98

.

99

. 99 . 100 . 100 . 100 . 100 . 101 . 101 . . . . . .

102 102 103 103 104 104

. 104 . 104 . 105 . 105

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5. Procedure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.1 Cooperation and documentation duties . . . . . . . . . . . . . . . . . . . 5.1.1 Cooperation under § 90 (2) General Fiscal Code. . . . . . . . . 5.1.2 Cooperation duties of divisions of an enterprise . . . . . . . . 5.1.3 Collection of evidence in advance . . . . . . . . . . . . . . . . . . 5.1.4 Increased cooperation duty . . . . . . . . . . . . . . . . . . . . . . . 5.2 Scope of the cooperation duty . . . . . . . . . . . . . . . . . . . . . . . . . . 5.3 Legal consequences from insufficient cooperation . . . . . . . . . . . 6. Miscellaneous . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.1 Self-employed persons within the meaning of art. 14 OECD-Model Tax Convention . . . . . . . . . . . . . . . . . . . . 6.2 First-time application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.3 Repeal of other administrative regulations. . . . . . . . . . . . . . . . . Appendix I: Basic elements (character of the permanent establishment) . Appendix II: Building sites or constructions or installation projects . . . . Appendix III: Permanent Representative . . . . . . . . . . . . . . . . . . . . . . . Appendix IV: Facilities not constituting permanent establishments . . . . Table 1: Legal forms of international enterprises (except Eastern Europe). Table 2: Legal forms of Eastern European enterprises . . . . . . . . . . . . . . .

. . . . . . . . .

106 106 106 106 107 107 107 107 108

. . . . . . . . .

108 108 108 109 112 116 120 123 127

1. Legal basis regarding the taxation of commercial permanent establishments 1.1 Domestic tax law When examining and applying national regulations to the taxation of permanent establishment of commercial enterprises, it must first be determined whether the double taxation agreements restrict the right of taxation of the Federal Republic of Germany as, pursuant to art. 59 German Constitution, double taxation agreements are declared legally binding in Germany by the respective approving law and precede, as set forth in § 2 General Fiscal Code, national taxation law being a more explicit regulation. Accordingly, the scope, definition of terms, and the assignment of international taxation rights laid down in the respective double taxation agreement must be regarded. This is not applicable to the income of taxpayers subject to limited taxation who are liable to withholding tax on income from capital or withholding tax under § 50a (4) Income Tax Act (cf. § 50d (1) sent. 1 Income Tax Act). From a domestic perspective especially the following legal bases are important for the taxation of permanent establishments of commercial enterprises: Business income that is subject to limited taxation is generated where a permanent establishment is maintained in the domestic territory (§ 12 General Fiscal Code) or a permanent representative (§ 13 General Fiscal 56

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Code) has been appointed for the commercial business (§ 49 (1) no. 2 (a) Income Tax Act). Refer to sec. 4.6.1 regarding the term “domestic territory”. Under unlimited taxation, foreign business income is generated e.g. when it is earned by a permanent establishment situated in a foreign country (§ 12 General Fiscal Code) or by a permanent representative (§ 13 General Fiscal Code) active in a foreign country (§ 34d no. 2 Income Tax Act). However, as mentioned above, the definition of the terms permanent establishment and permanent representative must be taken from the respective double taxation agreement regarding the application of that double taxation agreement (§ 2 General Fiscal Code); see also sec. 1.2.1. 1.1.1 Permanent establishment 1.1.1.1 Fixed place of business Within the meaning of § 12 sent. 1 General Fiscal Code, a permanent establishment is defined as any fixed place of business or property that serves the business of an enterprise. It must be a geographically fixed place and the entrepreneur must conduct his own business activities there (decision of the Federal Fiscal Court of February 10, 1988, Federal Tax Gazette II p. 653). A fixed connection with the surface or its visibility is not required, though (decision of the Federal Fiscal Court of October 30, 1996, Federal Tax Gazette 1997 II p. 12). The entrepreneur must have certain, not just temporary power of disposition over this establishment (decision of the Federal Fiscal Court of October 11, 1989, Federal Tax Gazette 1990 II p. 166 and decision of the Federal Fiscal Court of February 3, 1993, Federal Tax Gazette II p. 462). A fixed place of business is established to have a certain degree of permanence. A fixed place of business is always permanent when it exists for more than six months (decision of the Federal Fiscal Court of May 19, 1993, Federal Tax Gazette II p. 655). The listing in § 12 sent. 2 General Fiscal Code is not exhaustive. While § 12 sent. 1 General Fiscal Code requires a fixed establishment or a facility as basic features, the conditions set forth in § 12 sent. 2 no. 1-8 General Fiscal Code do not necessarily require this (decision of the Federal Fiscal Court of July 28, 1993, Federal Tax Gazette 1994 II p. 148). The term branch within the meaning of § 12 sent. 2 no. 2 General Fiscal Code is determined according to commercial law (§ 13d Commercial Code). 1.1.1.2 Building sites or constructions or installation projects Building sites or constructions or installation projects only constitute a permanent establishment if the duration of these projects exceeds six months (§ 12 sent. 2 no. 8 General Fiscal Code). In cases where a double taxation agreement exists between the state in which the building sites or constructions or installation projects are carried out and the state in which the executing enterprise has its seat, it must be considered that the term permanent establishment may be applied differently than laid down

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in § 12 sent. 2 no. 8 General Fiscal Code; as a rule a duration of more than six months is required. See sec. 4.3, Appendix II for further details. 1.1.2 Permanent representative A permanent representative within the meaning of § 13 General Fiscal Code has to manage the business of an entrepreneur sustainably and is subject to his instructions; he does not have to be an employee of the enterprise but only has to become active on behalf of the enterprise. In case the permanent representative is a commission agent or a broker maintaining business relations for the foreign enterprise within the course of his ordinary business activity and the taxation of the foreign enterprise is not regulated by a double taxation agreement, the income of the foreign enterprise shall not be taxed to that extent. This also applies if the permanent representative is a sales agent (§ 84 Commercial Code) who has neither a general power of attorney to negotiate and conclude contracts on behalf of the foreign enterprise nor has a warehouse from which he regularly carries out orders for the enterprise (see Regulation 222 (1) sent. 2 and 3 Income Tax Regulations). See sec. 22 (5) and (6) Trade Tax Regulations 1998 regarding whether trade tax liability is caused by the permanent representative. In case the domestic business of a taxpayer subject to limited taxation is leased as a whole, the lessor only generates domestic business income if he has appointed a permanent representative in the domestic territory and during that time neither declared the termination of his business nor conducted the sale of the business (decision of the Federal Fiscal Court of April 12, 1978, Federal Tax Gazette II p. 494). 1.1.3 Taxation in cases of a domestic permanent establishment 1.1.3.1 Relevant provisions In cases where a taxpayer subject to limited taxation either maintains a domestic permanent establishment or is represented by a permanent representative there, especially the following provisions are applicable for tax purposes: (a) Regarding income tax/corporate income tax: § 1 (4) in connection with § 49 Income Tax Act; § 2 no. 1 Corporate Income Tax Act (limited tax liability); § 15 Income Tax Act (business income); § 49 (1) no. 2 (a) and § 50 (1) Income Tax Act (demarcation provisions); § 50 (3) Income Tax Act, § 23 (2), (3) Corporate Income Tax Act (tax rate); §§ 4 to 7k Income Tax Act, § 8 (1) Corporate Income Tax Act (determination of profit); § 50 (5) sent. 3 Income Tax Act, § 50 (1) no. 2 Corporate Income Tax Act (no compensation effect of withholding taxes); § 36 58

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(2) sent. 2 no. 3 Income Tax Act, § 50 (5) sent. 3 Income Tax Act, § 49 (1) Corporate Income Tax Act (crediting of German corporate income tax); § 50 (6) Income Tax Act, § 26 (6) Corporate Income Tax Act (crediting of foreign income tax). (b) Regarding trade tax: § 2 (1) Trade Tax Act; § 9 no. 3 sent. 1 Trade Tax Act. 1.1.3.2 Documentation and cooperation duties According to § 138 (1) General Fiscal Code, the municipality must be notified within one month about the foundation, relocation, or termination of a permanent establishment. The start of business operations results in commercial bookkeeping duties (§ 238 et seq. Commercial Code, § 140 General Fiscal Code) if the respective permanent establishment is a branch either registered or obliged to register according to § 13d Commercial Code. In case permanent establishments do not constitute branches under commercial law, according to § 141 General Fiscal Code the bookkeeping duty begins only after the request of the tax office. The request may either result from a tax or assessment notice or from a special administrative act; it shall be announced to the taxpayer at least one month prior to the start of the business year beginning with which it shall be complied with the bookkeeping obligation (Application Decree to the General Fiscal Code no. 4 on § 140 General Fiscal Code). Furthermore, documentation duties result from § 143, § 144 General Fiscal Code and § 22 Value Added Tax Act). If foreign taxpayers participate in a domestic permanent establishment in the form of a civil-law business partnership (joint venture, consortium), bookkeeping duties under commercial and tax law (§§ 2, 238 et seq. Commercial Code, § 140 General Fiscal Code) may exist even though such civil-law business partnerships are exempted from the uniform and separate assessment procedure pursuant to § 180 (4) General Fiscal Code. Books must be retained in the domestic territory (§ 146 (2) General Fiscal Code). Under § 148 General Fiscal Code, reliefs may be granted. See §§ 97, 200 General Fiscal Code with respect to the requirements when submitting books, documentation, certificates, and other business documents. Increased clarification and cooperation duties regarding transactions toward foreign jurisdictions (§ 90 (2) General Fiscal Code) and the disclosure and cooperation requirement regarding business relations with low-tax regions (§ 16 Foreign Tax Act) also apply to taxpayers subject to limited taxation. See sec. 5 for further details.

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1.1.4 Taxation in cases of a permanent establishment or a permanent representative abroad 1.1.4.1 Relevant provisions In particular the following provisions are applicable to the taxation in cases where a taxpayer who is subject to unlimited taxation either maintains a permanent establishment abroad or is represented there by a permanent representative: (a) Regarding income tax/corporate income tax: §§ 34d Income Tax Act, § 8 (1) Corporate Income Tax Act (definition of foreign income, here § 34d no. 2 (a) Income Tax Act, that is important for qualifying foreign taxes, §§ 34c Income Tax Act, § 26 (7) Corporate Income Tax Act (indirect and fictitious crediting of taxes)); (b) Regarding trade tax: § 9 no. 3 sent. 1 Trade Tax Act (non-consideration of trade income of foreign permanent establishments). In case the taxpayer derives losses from a foreign permanent establishment, the restrictions regarding the set-off of losses and loss deduction of § 2a (1) and (2) Income Tax Act must be considered. See Circular of the Federal Ministry of Finance of April 10, 1984 (Federal Tax Gazette I p. 252), the so-called decree on flat-rate taxation, regarding the flat-rate taxation of income from a permanent establishment situated abroad. 1.1.4.2 Documentation and cooperation duties The general bookkeeping, documentation, declaration, and retention duties pursuant to Commercial Code and General Fiscal Code are applicable. The formation and the acquisition of enterprises and permanent establishments must be announced to the tax office at the latest at the time an income or corporate income tax return or a declaration regarding the separate determination of profits has to be submitted after the reportable event took place (§ 138 (2) General Fiscal Code). If the taxpayer fails to comply with his notification requirements or the information is incomplete or belatedly submitted, the taxpayer may be punished with an administrative offence under the prerequisites set forth in § 379 General Fiscal Code. The retention duty under commercial and tax law always includes the entire enterprise with its foreign permanent establishments. The duty must in general be fulfilled in the domestic territory regardless of whether the income of the foreign permanent establishment pursuant to a double taxation agreement is exempt from taxation and from any bookkeeping and

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documentation duties in the country where the permanent establishment is situated. In case the permanent establishment is required to keep books and records pursuant to the laws of the country where the permanent establishment is situated and these duties are complied with, it is sufficient to include the result of this bookkeeping into the bookkeeping of the domestic enterprise (§ 146 (2) to (4) General Fiscal Code). Adjustments to German tax regulations must be carried out and indicated. A proper currency conversion must be regarded (sec. 2.8). If the books are not kept separately for the permanent establishment, its business transactions must be recorded individually in the domestic territory and must be indicated (§ 145 (2) in connection with § 146 (2) General Fiscal Code). See §§ 97, 200 General Fiscal Code regarding the duties for submitting books, records, and other business documents; increased cooperation duties apply to issues with foreign jurisdictions (§ 90 (2) General Fiscal Code) and the disclosure and cooperation duties apply to business relations with low-tax regions (§ 16 Foreign Tax Act). 1.1.5 Commercial business partnership 1.1.5.1 Participation in a business partnership (Sec. 1.1.5.1 repealed; see circular of the Federal Ministry of Finance of April 16, 2010; Federal Tax Gazette 2010 I, p. 354) 1.1.5.2 Classification of a foreign enterprise (Sec. 1.1.5.1 repealed; see circular of the Federal Ministry of Finance of April 16, 2010; Federal Tax Gazette 2010 I, p. 354) 1.1.5.3 Documentation and cooperation duties The partner is in principle obliged to submit bookkeeping, the annual financial statements, and to the extent required, further business documents and to furnish necessary information (§§ 90 (2), (97), (200) General Fiscal Code). The limits of this obligation are determined by the principles of reasonableness and proportionality. 1.1.5.4 Profit share of a taxpayer subject to unlimited taxation When a taxpayer who is subject to unlimited taxation holds shares in a foreign business partnership that neither maintains a domestic permanent establishment nor has appointed a permanent representative in the domestic territory, the profit of this business partnership shall be determined pursuant to § 4 (1) or (3) Income Tax Act in order to determine the 61

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profit share of the taxpayer subject to unlimited taxation (decision of the Federal Fiscal Court of September 13, 1989, Federal Tax Gazette 1990 II, p. 57). When determining profits pursuant to § 4 (1) Income Tax Act, under consideration of the generally accepted accounting principles all business transactions must be observed even if these are shown in foreign currency. The books of the business partnership that are kept pursuant to foreign law forms the basis from which profit within the meaning of §§ 4 (1), 15 (1) no. 2 Income Tax Act will be derived by means of adjustments to the German tax law regulations. In case the foreign business partnership maintains a permanent establishment in the domestic territory, the relevant profit is that determined under § 4 (1), § 5 Income Tax Act. 1.1.5.5 Profit share of a taxpayer subject to limited taxation Pursuant to § 49 (1) no. 2 (a), § 15 (1) sent. 1 no. 2 Income Tax Act, the profit share of a domestic business partnership is determined based on the tax balance sheet of the enterprise and potential supplementary tax balance sheets and special purpose balance sheets of the partner. The same applies correspondingly to a foreign business partnership with a domestic permanent establishment. The share of a taxpayer subject to limited taxation in the profit/loss of a foreign permanent establishment of a domestic business partnership is not taxable as it cannot be allocated to the domestic permanent establishment (Federal Tax Court of February 24, 1988, Federal Tax Gazette II p. 663). 1.1.6 Domestic income from business without a permanent establishment or a permanent representative in the domestic territory Even though a foreign enterprise does not have a permanent establishment or a permanent representative in the domestic territory, it may achieve income that is subject to limited taxation within the meaning of § 49 (1) Income Tax Act. Depending on the facts of the respective case, it may constitute income from trade or business (§ 49 (1) no. 2 (b) to (f) Income Tax Act) or other income within the meaning of § 49 (1) Income Tax Act. 1.2 Double taxation agreements 1.2.1 Permanent establishment The term permanent establishment is linked in double taxation agreements in order to allocate the taxation rights of treaty states and to allocate hereby corporate profits and corporate assets (art. 7, 22 (2) OECD Model Tax Convention on Income and on Capital 1992, OECD-Model Tax Convention 92), to allocate dividends, interest, and royalties to a perma62

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nent establishment (art. 10 (4), 11 (4), 12 (4) OECD-Model Tax Convention 92), to assign the taxation right for the sale of permanent establishment assets (art. 13 (2) OECD-Model Tax Convention 92) and for other income (art. 21 (2) OECD-Model Tax Convention 92). 1.2.1.1 Fixed place of business Art. 5 (1), (2) OECD-Model Tax Convention 92 and most double taxation agreements define the term permanent establishment as a fixed place of business through which the business of an enterprise is wholly or partly carried out. See sec. 1.1.1.1 regarding the term fixed place of business. Under treaty law, a place of management permanent establishment always assumes a fixed place of business (cf. sec. 12 of the Commentary on art. 5 (2) OECD-Model Tax Convention 92). Whereas art. 5 (1) OECD-Model Tax Convention 92 specifies that the business of the enterprise must be carried out from a fixed place of business, § 12 General Fiscal Code assumes a permanent establishment when the fixed place of business (or facility) serves the business of the enterprise. As regards content though, the treaty-law term permanent establishment complies with the term as defined under § 12 General Fiscal Code. Nevertheless, it is regularly defined much narrower with respect to the activities performed. The fixed place of business has to be set up to serve the enterprise with certain continuity (see sec. 1.1.1.1) i.e. longer than six months, yet regardless of the deadline set for building sites or constructions or installation projects in the individual double taxation agreements. Pursuant to art. 5 (4) OECD-Model Tax Convention 92, places of business with a supportive or preparatory nature like warehouses and procurement and information centers are not considered as permanent establishments due to their mere auxiliary character (cf. appendix, IV). Preparatory activities are such that are performed prior to the main activity (decision of the Federal Fiscal Court of January 23, 1985, Federal Tax Gazette II p. 47). Auxiliary activities accompany the main activities and follow these chronologically. By their nature, they are different from the main activity. The main activity of an enterprise results from its assignment. An activity is part of the main activity if it comprises an essential and relevant part of the activity of the whole enterprise like the research of a pharmaceutical enterprise. In case an enterprise is leased to another enterprise, the lease alone does not constitute a permanent establishment for the lessor (sec. 11 OECDCommentary on Article 5 OECD-Model Tax Convention 92; decision of the Federal Fiscal Court of July 28, 1982, Federal Tax Gazette 1983 II p. 77). To the extent that immovable property is leased, it shall be proceeded pursuant to art. 6 OECD-Model Tax Convention 92 and in all other cases pursuant to art. 21 OECD-Model Tax Convention 92. 63

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The mere fact that a person resident abroad leases or rents essential domestic business fundamentals to a domestic corporation it controls (cross-border operational split) does not constitute a permanent establishment (sec. 8 OECD-Commentary on art. 5 OECD-Model Tax Convention 92). The holding enterprise may only maintain a permanent establishment by means of a permanent representative or a fixed place of business, e.g. at the place of the operating enterprise. In case no permanent establishment exists within the meaning of a double taxation agreement, art. 6 OECD-Model Tax Convention 92 and not art. 7 OECD-Model Tax Convention 92 applies to the extent that immovable property is leased. Due to the necessary isolated approach set forth in § 49 (2) Income Tax Act, leasing income of the foreign holding enterprise shall be treated as domestic income from leases and rentals within the meaning of § 49 (1) no. 6 Income Tax Act. 1.2.1.2 Building sites or constructions or installation projects Under art. 5 (3) OECD-Model Tax Convention 92, building sites or constructions or installation projects only constitute a permanent establishment if their duration exceeds a specific period, cf. Appendix II. A building site or construction begins at the time when the enterprise begins its work including all preparatory works in the state in which the building is to be erected, thus e.g. starting with the establishment of a construction planning office (cf. sec. 19 OECD-Commentary on art. 5 OECD-Model Tax Convention 92). Building sites or constructions or installation projects that do not fulfill this prerequisite do not constitute permanent establishments by themselves even if they have a fixed place of business (e.g. a construction container as office) that is connected to the construction and installation work (cf. sec. 16, 17 OECD-Commentary on art. 5 OECD-Model Tax Convention 92). A permanent establishment within the meaning of art. 5 (1), (2) OECD-Model Tax Convention exists to the extent that the activity performed at the fixed place of business is not just of a supportive and preparatory nature and it exists within the time period provided by art. 5 (3) OECD-Model Tax Convention. In case the management of several short-term building sites or constructions or installation projects is carried out in a fixed place of business, the question whether a permanent establishment exists is determined pursuant to art. 5 (1) OECD-Model Tax Convention 92. See sec. 4.3 for further details. 1.2.2 Dependent agent, independent agent Pursuant to art. 5 (5) OECD-Model Tax Convention 92, an agent must be a dependent agent of the enterprise and, more restrictive than § 13 Gener64

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al Fiscal Code, must habitually exercise his authority and not just carry out activities of a supportive nature within the meaning of art. 5 (4) OECD-Model Tax Convention 92 (cf. Appendix III). The dependency does not require a personal dependent relationship (e.g. employment). If the agent does not bear the economic risk of his activity, it indicates his economic dependency. Authority to contract exists in case the enterprise may be legally or economically bound by the representative; an indirect agency is possible. It can be assumed that the enterprise is economically bound in case a person is authorized to negotiate all details of a contract that are binding for the enterprise. The double taxation agreements negotiated by the Federal Republic of Germany generally adopt the provisions of the OECD-Model Tax Convention 92 regarding the term dependent agent. However, several double taxation agreements differ from the OECD-Model Tax Convention 92 or they contain special provisions (e.g. for insurance companies), see Appendix III. Pursuant to art. 5 (6) OECD-Model Tax Convention 92, any broker, commission agent or any other agent of independent status may constitute an agency permanent establishment in case they act outside their ordinary course of business. Pursuant to the prevailing opinion, an independent agent acts outside his ordinary course of business if his activity lies outside his occupational image and industry (decision of the Federal Fiscal Court of September 14, 1994, Federal Tax Gazette 1995 II p. 238). A subsidiary may in principle not be seen as an agent constituting a permanent establishment. It only constitutes a dependent agent of the parent enterprise if an agent character results from circumstances outside the control relationship (art. 5 (7) OECD-Model Tax Convention 92) and is not based on its ordinary business activity. An agency permanent establishment is subordinate to art. 5 (1), (2) OECD-Model Tax Convention. Provided that the activity of the agent is carried out independently from and outside the fixed place of business, two permanent establishments exist. Foreign corporations may constitute a permanent establishment (or the head office) to the extent that persons authorized for the representation carry out the management activity or conduct day-to-day business in a domestic apartment or a construction container (see decision of the Federal Fiscal Court of December 16, 1998, Federal Tax Gazette 1999 II p. 437). 1.2.3 Participation in a business partnership (special remunerations) Even though the double taxation agreement does not provide for an explicit provision, special remunerations of a domestic partner of a foreign business partnership and such of a foreign partner of a domestic business partnership must be treated as business profits within the meaning of the double taxation agreements (see art. 7 OECD-Model Tax Convention 92). In the first case they are not exempt from the German assessment basis 65

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pursuant to the article on methods of the applicable double taxation agreement if the other state qualifies these differently than the German tax law, e.g. as interest or royalties and based on such qualification the foreign state feels required to exempt the special remunerations from taxation or to tax these only at a certain tax rate that does not exceed a certain percentage of the income (see also Federal Fiscal Court of February 27, 1991, Federal Tax Gazette II p. 444, decision of the Federal Fiscal Court of July 14, 1993, Federal Tax Gazette 1994 II p. 91). As regards the option in art. 10 to 13 and art. 21 OECD-Model Tax Convention-92 to refer back to art. 7 OECD-Model Tax Convention 92 it has to be taken into account whether the assets on which dividends, interest, or royalties are based are indeed associated with the permanent establishment of the business partnership and therefore, with the permanent establishment of its partner(s) (decision of the Federal Fiscal Court of February 26, 1992, Federal Tax Gazette II p. 937; decision of the Federal Fiscal Court of May 31, 1995, Federal Fax Gazette II p. 683; decision of the Federal Fiscal Court of August 30, 1995, Federal Tax Gazette 1996 II p. 563; decision of the Federal Fiscal Court of December 17, 1997, Federal Tax Gazette 1998 II p. 296). 1.2.4 Legal consequences of a double taxation agreement Double taxation agreements stipulate that (a) the income and property of the permanent establishment may be taxed to the extent provided by the double taxation agreement in the state where the permanent establishment is situated; (b) the income and property allocated for taxation in the state where the permanent establishment is situated shall be tax-relieved in the state of residence; in case the Federal Republic of Germany is the state of residence, the income and property are generally exempt from domestic taxation bases (exemption). The clause as to progression (§ 32b (1) no. 3 Income Tax Act) must be observed. The activity clauses included in certain double taxation agreements must be considered. To the extent that the permanent establishment does not carry out active business within the meaning of the respective double taxation agreement, the income will be taxed domestically while crediting/deducting foreign tax (§ 34c (6) in connection with (1) and (2) Income Tax Act, § 26 (6) Corporate Income Tax Act). Furthermore, the following is to be observed: – Dividends, interest, and royalties only constitute part of the business profit if – the participation for which the distribution is carried out, or – the accounts receivables for which interest is paid, – the right or the asset for which royalties are paid for 66

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are actually associated with the permanent establishment (decision of the Federal Fiscal Court of August 30, 1995, Federal Tax Gazette 1996 II p. 563); – If income with investment character within the meaning of § 10 (6) sent. 2 Foreign Tax Act is derived which is subject to foreign low tax, pursuant to § 20 (2) Foreign Tax Act, and deviating from the provisions of the respective double taxation agreement, double taxation shall be avoided not by means of exemption but by crediting the foreign tax that is allocated to this income; – The restrictions of the set-off of losses and loss deduction pursuant to § 2a (1) and (2) Income Tax Act; these provisions affect the income that is tax exempt under the double taxation agreement while applying the clause as to progression; – The loss deduction pursuant to § 2a (3) in connection with (2) Income Tax Act (up to and including the assessment period 1998) regarding business losses of the permanent establishment that are tax exempt under the double taxation agreement and subsequent taxation of later profits pursuant to § 2a (3) sent. 3, (4) Income Tax Act (up to and including the assessment period 2008). 1.2.5 Protection of the taxpayer The double taxation agreements enable the German and foreign tax authority to initiate consultation procedures in order to allocate profits (property) and in individual cases mutual agreement procedures upon the application of the taxpayer (see Bulletin on International Mutual Agreement Procedures and Arbitration Procedures Regarding Tax Issues of July 1, 1997, Federal Tax Gazette I p. 717). 1.2.6 Reversion clauses in double taxation agreements Some double taxation agreements contain so-called reversion clauses according to which the taxation right for profit or income from the other state is returned to the state of domicile or residence in case the profit or income is indeed not taxed in this country. Such reversion clauses are currently included in art. 24 (3) double taxation agreement Denmark 1995, art. 23 (3) double taxation agreement Canada 1981, art. 23 (3) double taxation agreement New Zealand 1978, art. 23 (3) double taxation agreement Norway 1991, art. 23 (1) final sentence double taxation agreement Sweden 1992, art. 23 (2) final sentence double taxation agreement USA 1989, and no. 16d of the final protocol to the double taxation agreement Italy 1989. They are to be interpreted as subject-to-tax clauses (see decision of the Federal Fiscal Court of June 11, 1996, Federal Tax Gazette II 1997 p. 117; remained unsettled in the decision of the Federal Fiscal Court of August 27, 1997, Federal Tax Gazette II 1998 p. 58). A number of double taxation 67

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agreements also include subject-to-tax clauses applicable only to individual (treaty law) types of income (e.g. art. 15 (4) double taxation agreement Switzerland for parts of employment activities). In case the profit or income that is part of a type of income under the double taxation agreement is subject to foreign tax, it is irrelevant for the exemption from German taxation to what extent it is subject to foreign taxation or whether all parts of the income lead to an actual tax liability under the foreign tax assessment procedure (Federal Tax Court of August 27, 1997, l.c.). Foreign taxation is also assumed if foreign taxes are eliminated only due to tax-free allowances, a set-off of losses or a loss deduction or if the foreign taxation regards the respective income as negative income. If such clauses exist, the taxpayer is required within his increased cooperation duty pursuant to § 90 (2) General Fiscal Code to bring forth evidence, at the latest during the assessment procedure, to prove that the income was subject to taxation abroad. In case no evidence is produced, such income must in principle be included in the domestic taxation (decision of the Federal Fiscal Court of June 11, 1996, Federal Tax Gazette II 1997 p. 117). If proof of the taxation is submitted at a later time, the income assessment notice has to be amended pursuant to § 175 (1) sent. 1 no. 2 General Fiscal Code (Federal Fiscal Code of June 11, 1996, l.c.).

2. Attribution of business property and income 2.1 General The profit of the domestic or foreign permanent establishment has to be determined by applying the principles of German tax law. In order to apply the following principles for the attribution of income and capital between the domestic/foreign head office (permanent establishment where the top management of the enterprise resides) and the domestic/foreign permanent establishment, all circumstances of the individual case must be observed; these include special circumstances that are e.g. based on the structure of the markets and the enterprise or existing commercial practices. The remarks regarding the allocation of income are correspondingly applicable to the allocation of capital. 2.2 Principles of allocation Double taxation agreements regularly include special provisions for the allocation of income that is taxed in the state of the permanent establishment and to be relieved in the state of residence. Accordingly, the attributable profit to the permanent establishment “is such that it might be expected to make if it were a distinct and separate enterprise engaged in the 68

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same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment” (see art. 7 (2) OECD-Model Tax Convention 92, dealing at arm’s length principle). The purpose of the allocation is to assign to the permanent establishment the part of the profit of the entire enterprise that it generated in accordance with the arm’s length principle. For this purpose, the assets must be allocated to the permanent establishment observing the principle of economic connection and the business income/loss in connection with the assets must be allocated according to the principle of inducement. As head office and its permanent establishment form a legal and factual entity, agreements made under the law of obligations like loan, rental, and license agreements between head office and permanent establishment are legally not possible (sec. 16 et seq. of the Commentary on art. 7 OECD-Model Tax Convention 92, decision of the Federal Fiscal Court of July 27, 1965, Federal Tax Gazette 1966 III p. 24, decision of the Federal Fiscal Court of July 20, 1988, Federal Tax Gazette 1989 II p. 140). However, the allocation between head office and its permanent establishment must be performed in accordance with the arm’s length principle if the allocation refers to services that are the subject of the ordinary business activity of the rendering enterprise unit and if the allocation based on the division of functions between head office and its permanent establishment results in a proper income allocation. As regards transactions within the meaning of § 4 (1) sent. 3 Income Tax Act and § 12 (1) Corporate Income Tax Act, the common value pursuant to § 6 (1) no. 4 sent. 1 2nd Clause Income Tax Act is applied that, as a rule, complies with the arm’s length price (see decisions of the Federal Fiscal Court of October 18, 1967, Federal Tax Gazette 1968 II p. 105 and of November 27, 1974, Federal Tax Gazette 1975 II p. 306 in which the Federal Fiscal Court assumes the common value for the assessment of hidden profit distributions, as well as decision of the Federal Fiscal Court of October 17, 2001, Federal Tax Gazette 2004 II p. 171 in which the Federal Fiscal Court applies the arm’s length price for the assessment of hidden profit distributions; see also Circular of the Federal Ministry of Finance of April 12, 2005 – IV B 4 – S-1341 – 1/05 –, Federal Tax Gazette I p. 570, sec. 5.3.1). The comments given above also apply to cases where no double taxation agreement exists with the state in which the foreign permanent establishment or the foreign head office is located. 2.3 Profit attribution methods The permanent establishment is only part of the entire enterprise. Accordingly, only part of the corporate profit may be attributed to it. The necessary attribution of the total profits between head office and permanent establishment is carried out either by the direct or indirect profit attribu69

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tion method (see art. 7 (4) OECD-Model Tax Convention 92 and its commentary). Art. 7 OECD-Model Tax Convention 92 and German tax law give priority to the direct profit determination (decision of the Federal Fiscal Court of March 28, 1985, Federal Tax Gazette II p. 405, decision of the Federal Fiscal Court of June 25, 1986, Federal Tax Gazette II p. 785, and decision of the Federal Fiscal Court of July 29, 1992, Federal Tax Gazette 1993 II p. 63). Thus, it constitutes the normal or standard method. A random change of method is not permitted (see art. 7 (6) OECD-Model Tax Convention 92). 2.3.1 Direct method The direct method requires that the profit of the permanent establishment is determined separately based on bookkeeping and German profit determination regulations (see sec. 1.1.3 and 1.1.4). The direct method is especially applied in cases where head office and permanent establishment exercise different functions. In each case, the actual circumstances are decisive. Especially the following must be considered: – Structure, organization, and division of functions within the enterprise as well as the use of assets; – The individual functions of the permanent establishment, e.g. manufacture, installation work, research and development, administrative services, sales, other services; and – In what capacity the permanent establishment would have exercised this function if it were independent, e.g. as fully fledged distributor, agent. Adjustments have to be made if auxiliary functions are assumed. Operating revenues or operating expenses that cannot be allocated explicitly to head office or permanent establishment have to be attributed properly by means of estimation. When allocating expenses, the aspects that are decisive for the assumption of a set-off of benefits in the relations between affiliated persons may also be taken into account (see also sec. 2.3 of the Administrative Circular on the Guidelines for the Examination of the Income Allocation Between Internationally Affiliated Enterprises (Administrative Guidelines – Income Allocation), Circular of the Federal Ministry of Finance of February 23, 1983, Federal Tax Gazette I p. 218).

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2.3.2 Indirect method In order to apply the indirect method, the total profit of the enterprise is allocated between head office and permanent establishment based on an appropriate key. Where function and inner structure is equal, sales in the trade or service sector, premiums received in the insurance sector, the share in the total working capital in the banking sector, and wage and/or material costs in the production sector may serve as a key. If the total profit is influenced by extraordinary expenses or income or by other operating expenses or income that does not affect all parts of the business, such expenses or income must be added to or deducted from the total profit prior to the application of the key and must be considered at the permanent establishments they relate to after the application of the key. 2.4 Allocation of assets Assets can only be attributed either to the head office or the permanent establishment. Positive and negative assets serving to fulfill the function of the permanent establishment must be allocated to the permanent establishment (decision of the Federal Fiscal Court of July 29, 1992, Federal Tax Gazette 1993 II p. 63). This relates especially to assets that are designed for the exclusive application and use by the permanent establishment. In addition, assets from which income is generated to which the activity of the permanent establishment predominantly contributed must be allocated to the permanent establishment. The actual circumstances are always material, especially the structure, organization, and the tasks of the permanent establishment within the enterprise. If the assets fulfill the function they were assigned within the entire group both as part of the business property of the head office as well as that of the permanent establishment, it materially depends on the manifest intent of the management to which business property they will be allocated (decision of the Federal Fiscal Court of April 1, 1987, Federal Tax Gazette II p. 550); to enter them in the accounts can only be an indication and not a prerequisite for the allocation (decision of the Federal Fiscal Court of July 29, 1992, Federal Tax Gazette 1993 II p. 63). The central function of the head office must be observed in the allocation. Therefore, the following is in general allocated to the head office: (a) the holding of the financial funds that serve the entire group; and (b) participations, if they do not serve an activity performed by the permanent establishment (decision of the Federal Fiscal Court of August 30, 1995, Federal Tax Gazette 1996 II p. 563) 71

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The financial funds generated by a permanent establishment are in principle part of its business property to the extent they are necessary to secure the business activities of the permanent establishment or shall provide for the financing of already decided investments or such that are planned within a foreseeable future. Additional funds exceeding this have to be allocated to the head office. It may be refrained from allocating assets to the utilizing permanent establishment if (a) the assets are only temporarily transferred to the permanent establishment and if between unaffiliated third parties the transfer would have been carried out based on tenancy, tenure, or similar legal relations or (b) these assets are such that are utilized by several permanent establishments at the same time or in succession. 2.5 Share of the permanent establishment in the equity of the entire group (dotation) 2.5.1 Dotation capital of permanent establishments In order to fulfill its function, a permanent establishment must have the necessary dotation capital available which complies with the arm’s length principle. This also applies in case the permanent establishment generates losses and this results in an essential reduction of the dotation capital. In case the dotation capital does not comply with these requirements, the profit and the property of the permanent establishment have to be determined as if it had been provided with sufficient dotation capital. Hence, it follows that borrowed capital of a permanent establishment has to be treated as equity up to the amount of a dotation capital appropriate for tax purposes. If, pursuant to this, only part of the borrowed capital is treated as dotation capital and the borrowed capital consists of liabilities with varying interest rates, the chronological order in which the liabilities incurred shall be decisive for the rededication as borrowed capital. An exception may only be considered if the other parts of the business are also insufficiently endowed with capital. When deciding to what extent the internal capital funding of the permanent establishment consists of equity or of borrowed capital forwarded by the head office, the managerial decision of the head office has special importance (decision of the Federal Fiscal Court of June 25, 1986, Federal Tax Gazette II p. 785). This decision is not decisive if it contradicts commercial and economic requirements (see decision of the Federal Fiscal Court of April 1, 1987, Federal Tax Gazette II p. 550) and thus violates arm’s length standards. As a rule, the external arm’s length test under the direct method shall be applied for the determination of sufficient dotation capital of the perma72

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nent establishment (decision of the Federal Fiscal Court of July 27, 1965, Federal Tax Gazette 1966 III p. 24 and of June 25, 1986, Federal Tax Gazette II p. 785). This means that the arm’s length test shall take independent enterprises into account that have comparable market opportunities and/or are subject to comparable market risks. Where appropriate, adjustment calculations have to be made due to company-specific differences. If the external arm’s length test cannot be carried out for want of comparable companies, there are no objections to allocate equity of the entire group to head office and permanent establishment according to the functions performed by means of estimation (internal arm’s length comparison). When head office and permanent establishment perform the same functions, the equity ratio of the head office may be a suitable indicator for the equity capitalization of the permanent establishment (capital mirror). In case the function of the permanent establishment with its capital requirements exceeds the function of the head office in connection with its capital requirements or vice versa, the equity of the entire enterprise is to be allocated appropriately. Accordingly, the management is limited in its discretion. An endowment of the foreign permanent establishment exceeding the economic requirements shall not be accepted. See sec. 4.1.3, 4.2.2, 4.2.3, and 4.2.4 regarding the dotation capital concerning the permanent establishments of banks and insurance companies. 2.5.2 Change in ownership within business partnerships When shares in German business partnerships are acquired by taxpayers subject to limited taxation, the equity capitalization cannot be reduced randomly after the acquisition to the detriment of the permanent establishment of the taxpayer subject to limited taxation as the previous endowment by the former partners has to be taken into account as economically necessary standard of comparison. 2.6 Transfer of assets 2.6.1 Transfer to a foreign permanent establishment of the domestic head office When transferring assets of the domestic head office to its foreign permanent establishment, hidden reserves are in principle recognized at the arm’s length price1 at the time of the transfer, i.e. at the price on which independent third parties would have agreed under same or similar circumstances. 1 See sec. 2.2 according to which the arm’s length price regularly equals the actual value.

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In particular, the following applies to such cases: a) Fixed assets For fixed assets, the profit (loss) is recorded as the difference between the arm’s length price1 of the asset and the value the asset has at the time of its transfer pursuant to § 6 Income Tax Act (book value). The price and value at the time of their transfer are decisive. A decrease in value that occurred at the time of the transfer and which may be permanent must be considered. It is referred to the possibility to form an adjusting item under § 4g Income Tax Act. b) Current assets For current assets, the profit (loss) shall also be recorded as the difference between the arm’s length price2 of the asset and the value the asset has at the time of its transfer pursuant to § 6 Income Tax Act (book value). A decrease in value that occurred at the time of the transfer and which may be permanent must be observed. c) Intangible assets Letters a) and b) apply accordingly for intangible assets that were self-created. A transfer of such an asset occurs to the extent it is designed for the use or exploitation by the permanent establishment. To such assets also belong manufacturing and production know-how applied in the transfer of products or product lines to the foreign permanent establishment. d) Transfer of assets from a permanent establishment entitled to tax credit (double taxation agreement or non-double taxation agreement) to a permanent establishment subject to tax exemption (double taxation agreement) The aforementioned principles also apply to cases where assets are transferred from a permanent establishment the results of which are subject to domestic taxation to a permanent establishment the results of which are exempt under a double taxation agreement. 2.6.2 Transfer/repatriation of assets to the domestic territory When transferring an asset acquired or manufactured by a permanent establishment in a double taxation agreement country to the domestic head office, the actual value shall be applied if the double taxation agreement requires the application of the tax exemption method (§ 4 (1) sent. 7 and § 6 (1) no. 5a Income Tax Act). This does not apply to the transfer or repatriation of an asset to the head office from a permanent establishment which is either maintained in a 1 See sec. 2.2 according to which the arm’s length price regularly equals the actual value. 2 See sec. 2.2 according to which the arm’s length price regularly equals the actual value.

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non-double taxation agreement country or for which the tax credit method under a double taxation agreement applies. § 4g (3) Income Tax Act applies in cases where assets are repatriated from a permanent establishment located in a European Union member state to the domestic territory. 2.6.3 Transfers between domestic permanent establishment and foreign head office or its foreign permanent establishment Assets that are transferred from the domestic permanent establishment to the foreign head office or its foreign permanent establishment under limited tax liability are excluded from German tax jurisdiction. Therefore, hidden reserves are to be taxed at the time of the transfer; the transfer value equals the arm’s length price at the time of the transfer. If assets are transferred from the foreign head office or its foreign permanent establishment to the domestic permanent establishment, they are capitalized at the arm’s length price at the time of the transfer. 2.6.4 Transfers to a foreign business partnership When transferring an asset from domestic business property to a foreign permanent establishment (including the special business property), the arm’s length price applies. Deferred taxation cannot be considered. 2.7 Attribution of expenses and income Expenses of the head office for the permanent establishment that cannot be directly allocated (e.g. financing, management, and general administration costs like inter alia costs of the bodies of an enterprise, costs of the shareholders’ meeting, coordination, and control) may, where applicable, be attributed pro rata to the permanent establishment to the extent those are not already included in amounts otherwise attributed. It is irrelevant whether the expenses have accrued in the domestic territory or abroad; the direct or indirect business inducement is decisive (decision of Federal Fiscal Court of July 20, 1988, Federal Tax Gazette 1989 II p. 140). In order to attribute expenses of the entire group, facts obtained from operational cost accounting must be taken into account. Cost accounting of the head office and the permanent establishment should be carried out under the same or similar criteria. Documents to be provided by the taxpayer regarding the allocation of his expenses should a) be differentiated and easily to be verified, b) include the complete result of the permanent establishment, and 75

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c) be verified regarding their specifications and data within appropriate time periods and should have been adjusted to changed circumstances. Such cost accounting must be checked regarding its plausibility and appropriate application to the individual business transactions. Expenses or income may also be attributed in lump sums or in a pool of costs if a) such attribution serves an attribution that is functionally appropriate and in compliance with the aforementioned principles and leads, with an appropriate accuracy, to the results that an individual allocation of income or expenses would have shown or b) an individual attribution is impossible or unreasonably difficult. Corrections to the results often originate from the transfer of fixed and current assets. Corrections to expenses may be necessary a) where operating losses booked in the profit and loss statement of a domestic business unit in fact refer to the foreign permanent establishment, b) for appropriate parts of the administrative costs of the domestic head office (overhead charges), c) for parts of the advertising expenses if the advertisement was centrally performed by the head office and the foreign permanent establishment was not or not sufficiently charged under the internal cost equalization, d) for the expenses of a central research and development department that are attributed pro rata to the foreign permanent establishment unless sufficient cost sharing has already been carried out with an internal set-off, whereby the statements regarding the administrative services within the group must be considered, e) for interest portions for credits to the extent they may be attributed to the foreign permanent establishment. The same applies to a domestic permanent establishment of a foreign head office. 2.8 Currency conversion of the result of the permanent establishment The result of the permanent establishment calculated in foreign currency using the business property comparison or the revenue surplus method must be converted into German Marks or Euro.

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2.8.1 Currency conversion for profit determination by business property comparison under § 4 (1) in Connection with § 5 Income Tax Act As the tax profit under § 4 (1) in connection with § 5 Income Tax Act (for special cases see sec. 1.1.5.4) is derived from the commercial balance sheet, the conversion of foreign currency positions cannot oppose domestic generally accepted accounting principles under commercial law and other tax provisions. This generally assumes that each individual business transaction will be converted at the relevant rate of the day (officially set exchange rate, e.g. published in the Federal Gazette) (so-called time-reference method; decision of the Federal Fiscal Court of September 13, 1989, Federal Tax Gazette 1990 II p. 57, decision of the Federal Fiscal Court of August 9, 1989, Federal Tax Gazette 1990 II p. 175). It is not objected if the reference date method is used for the conversion of business transactions if the fluctuations in the exchange rate between the reference dates were insignificant, e.g. conversion using the monthly official VAT exchange rate or the annual average exchange rate derived from the official monthly VAT exchange rate (decision of the Federal Fiscal Court of September 13, 1989, l.c. and of August 9, 1989, l.c.). Under these conditions and under consideration of the special situations below it cannot be objected to a conversion of the profit of the permanent establishment using the exchange rate that is applied for the balance sheet day and valuation day. A departure from the once chosen method can only be allowed in substantiated exceptional cases. If the conversion results in exchange profits or currency losses, such are economically connected to the foreign income and must therefore be allocated to it (decision of the Federal Fiscal Court of February 16, 1996, Federal Tax Gazette II p. 588 and of February 16, 1996 Federal Tax Gazette 1997 II p. 128). The determination of the tax result of the permanent establishment is carried out as follows: a) Fixed and current assets Conversions are carried out for acquisitions at the offered rate at the time of the addition, for manufactured assets progressively pursuant to the progress in manufacture. The values determined in this manner are the acquisition or manufacturing costs of these assets. A loss following the conversion of the book value at different reference days does by itself not justify a write down to going concern value as the apparent loss of value is regularly offset against a corresponding increased going concern value. For accounts receivables, money and other similar items it must be examined whether a diminution in value that may be permanent has occurred.

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b) Liabilities and provisions Liabilities have to be assessed with the higher offered rate in cases where an increase in the exchange rate is presumably permanent. Provisions are to be converted at the respective drawing rate. c) Advance payments and deferred items Advance payments received and passive deferred items have to be converted at the buying rate the day payment is received, advance payments made and active deferred items have to be converted the day payment was made. d) Dotation capital Currency fluctuations of the dotation capital of a foreign permanent establishment do not affect the profit of the domestic head office of this permanent establishment. Losses and profits from currency fluctuations of the dotation capital of the permanent establishment are caused by the existence of the permanent establishment and must therefore be allocated to it (decision of the Federal Fiscal Court of February 16, 1996, Federal Tax Gazette II p. 588 and of February 16, 1996, Federal Tax Gazette 1997 II p. 128). They will not be realized until the dissolution of the permanent establishment. Thus, the currency fluctuations have, to the extent that the method of tax exemption is applied to the income of the permanent establishment, only an effect on the progression clause pursuant to § 32b (1) no. 2 Income Tax Act and potentially under the application of § 2a (3) Income Tax Act (up to and including assessment period 1998). e) Conversion differences To the extent an enterprise makes use of the simplifications of the method of time reference, deviations originate between the business property comparison and the result revealed by the profit and loss statements (decision of the Federal Fiscal Court of February 16, 1996, Federal Tax Gazette 1997 II p. 128). Such conversion differences have to be set off against the equity of the permanent establishment affecting the current result. f) Hedging transactions Changes in value that are caused by the exchange rate in transactions concluded congruent as to their amount and maturity must be offset; no loss arises in this respect in case the exchange rate risk of several underlying transactions concluded in a foreign currency has been eliminated by concluding an offsetting forward foreign exchange transaction (hedging transaction) (Tax Court Hessen of November 24, 1982, Decisions of Tax Courts Magazine (EFG) 1983 p. 337, Tax Court Cologne of November 19, 1990, Decisions of Tax Courts Magazine (EFG) 1991 p. 452).

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2.8.2 Conversion for profit determination by revenue surplus method pursuant to § 4 (3) Income Tax Act 2.8.2.1 Business revenues Amounts received must be converted upon their receipt. In case the taxpayer keeps the foreign currency, the conversion will be carried out on the day of the inflow at the buying rate. The mid-market rate approach cannot be considered. 2.8.2.2 Business expenses Business expenses that incur in a foreign currency must be converted at the offered rate on the day of payment. As regards fixed assets, the offered rate at the time of acquisition or production shall be material. Subsequent fluctuations in the exchange rate do not affect the acquisition or production costs and accordingly also not the amortization amounts. 2.8.2.3 Time of valuation The conversion is carried out at the time of the inflow and outflow. It is not opposed though, if the conversion is based on the monthly official VAT exchange rate or the annual average exchange rate derived from the official monthly VAT exchange rate in cases where the fluctuations in the exchange rate are minimal. 2.8.3 Conversion in special cases 2.8.3.1 Transfer of assets from the foreign to a domestic permanent establishment Transfers must be based on the offered rate at the time of the transfer for conversion purposes. 2.8.3.2 Claims by and liabilities to partners Unrealized changes in value caused by the exchange rate regarding claims held by a domestic partner against a foreign business partnership cannot be shown as profit-reducing in the tax balance sheet of the business of the domestic partner, because due to § 15 (1) sent. 1 no. 2 Income Tax Act the claims from loans cannot be shown in the tax balance sheet of the partner but present special business property of the business partnership (co-entrepreneurship) receiving the loan and the loan receivables represent equity in the consolidated balance sheet of this co-entrepreneurship. Not until the realization (e.g. termination of the partner position) will a change in the exchange rate only have an impact on the tax dividend of the partner

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in the special balance sheet, cf. sec. 2.8.1 (d) (decision of the Federal Fiscal Court of July 12, 1990, Federal Tax Gazette 1991 II p. 64; decision of the Federal Fiscal Court of May 19, 1993, Federal Tax Gazette II p. 714). § 15 (1) sent. 1 no. 2 Income Tax Act and case law regarding the tax treatment of special business property apply in principle also to cross-border participations (decision of the Federal Fiscal Court of May 19, 1993, Federal Tax Gazette II p. 714). If fluctuations in the exchange rate arise between the capitalization of an interest receivable and the payment of the interest, these profits are liable to income tax (decision of the Federal Fiscal Court of May 31, 1995, Federal Tax Gazette II p. 683). 2.9 Creation and dissolution of the permanent establishment 2.9.1 Organization expenses and preceding expenses Organization expenses and expenses in connection with a permanent establishment prior to its creation have to reduce the result of the permanent establishment as they are causally connected to it. The expenses incurred lead to negative permanent establishment income. If a double taxation agreement exists, it constitutes negative income within the meaning of art. 7 OECD-Model Tax Convention 1992 in the state in which the permanent establishment is to be established. In case this double taxation agreement provides for the exemption of the permanent establishment income from national taxation, in order to take the losses into account it must be proceeded upon application according to § 2a (3) Income Tax Act (up to and including the assessment period 1998) if additional prerequisites are met. Where § 2a (3) Income Tax Act cannot be applied, § 32b Income Tax Act must be observed (decision of the Federal Fiscal Court of May 25, 1970, Federal Tax Gazette II p. 660; decision of the Federal Fiscal Court of October 17, 1990, Federal Tax Gazette 1991 II p. 136). § 2a (1) and (2) Income Tax Act does not preclude this procedure in case e.g. no permanent establishment within the meaning of § 12 General Fiscal Code exists. The aforementioned explanations also apply if the formation of the permanent establishment fails as the expenses are directly economically connected with the income that was to be generated by the permanent establishment to be formed (decision of the Federal Fiscal Court of April 28, 1983, Federal Tax Gazette II p. 566). Expenses for the acquisition of contracts that result in the formation of a permanent establishment only upon success are always to be borne by the head office.

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2.9.2 Dissolution of the permanent establishment The dissolution of a permanent establishment becomes effective if neither a fixed place of business, facility, nor building site any longer exist. A temporary interruption of the business is not considered a shutdown or dissolution, though. Holding a permanent establishment in longterm abeyance equals dissolution. 2.10 Contribution of a permanent establishment into a corporation The contribution of a permanent establishment into a corporation in exchange for shares in the receiving corporation constitutes an exchangelike transaction. For tax purposes, it is treated in principle as a disposition. Pursuant to art. 13 (2) OECD-Model Tax Convention 92, tax jurisdiction for the resulting profit (loss) is allocated to the state in which the permanent establishment has its registered seat.

3. Individual issues regarding the allocation of business property and income 3.1 Services 3.1.1 General The term “services” used here refers in principle only to commercial services. It generally includes all economic activities that consist of personal services and do not comprise the production of goods. Especially the entire sector of transportation, communications, construction management, maintenance, and certain other works qualify as commercial services. Furthermore, the activities of sales agents, brokers, carriers, warehouse keepers, freight carriers, insurance agents, trustees, and any additional participation in commercial activities can be classified as commercial services. The services have to be distinguished from asset management. 3.1.2 Services as main activity of the permanent establishment Services (except for services within the meaning of sec. 3.4) have to be valued at the arm’s length price of the country of that part of the enterprise rendering the service if the rendering of the services constitutes the main activity of the permanent establishment. Where no arm’s length price can be determined, it cannot be objected to determining the profit of the permanent establishment under the cost plus method considering a profit ranging from 5 % to 10 %. This also applies if the expenses can be allocated to other parts of the enterprise using cost allocation. To the extent that services constitute auxiliary activities, a profit mark-up cannot be considered.

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3.1.3 Toll manufacturing by permanent establishments If the production of a foreign permanent establishment may economically be considered as toll manufacturing for the domestic head office, the permanent establishment is only entitled to the profit that an unaffiliated toll manufacturer would have generated in the respective country. This is also applicable to services rendered by a domestic permanent establishment for the foreign head office. 3.1.4 Management of permanent establishments by the head office If the activity of the head office is limited to the business management of permanent establishments, an appropriate share of the total profit must be allocated to the head office (decision of the Federal Fiscal Court of July 28, 1993, Federal Tax Gazette 1994 II p. 148). In individual cases appropriate determinations have to be made regarding the allocation key. If such cases result in double taxation, e.g. the country in which the managing permanent establishment has its seat allocates to the head office a certain percentage of the profit of the whole group for the management, while the country in which the permanent establishment is located does not do so, the state in which the head office has its seat should initiate itself the adjustments during the assessment of tax that are necessary to avoid double taxation (cf. sec. 23 of the OECD- Commentary on art. 7 OECD-Model Tax Convention 92). 3.2 Advertising and market development 3.2.1 Expenses for advertising The expenses for an advertising measure must be borne by the part of the enterprise (head office or permanent establishment) that performs the tasks that are advertised by this measure. To the extent that parts of the enterprise with production and distribution activities perform advertisement measures for other parts of the enterprise, the expenses for advertising must be allocated appropriately between the parts of the enterprise without using a profit mark-up. It is not objected if the allocation within the enterprise is regulated by internal cost sharing agreements based on a medium-term or long-term advertising concept. Where the advertising performances are rendered by one part of the enterprise to another part of the enterprise, the activities carried out may be offset as services (sec. 3.1.1) to the extent that these advertising services constitute the main activity of that part of the enterprise.

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3.2.2 Expenses for market development During the launch period, parts of the enterprise with manufacturing and distribution functions often incur considerable expenses or profit shortfalls for the launch of products. Among unaffiliated parties, such are in principle borne by the part of the enterprise with the distribution function only to the extent that it receives an appropriate operating profit from the distribution of business. Such expenses or profit shortfalls are also allocated between unaffiliated parties in such manner that a) the distributor bears these expenses or profit shortfalls to a larger extent and in return is granted delivery prices with which he may offset his loss of profits at the latest after three years within a foreseeable period of time (decision of the Federal Fiscal Court of February 17, 1993, Federal Tax Gazette 1993 II p. 457), or b) the manufacturer bears these expenses or profit shortfalls to a larger extent and may offset his loss of profit at the latest after three years within a foreseeable period of time (decision of the Federal Fiscal Court of February 17, 1993, l.c.) with higher delivery prices, if need be. The adjustment to be made between the manufacturing and distribution enterprise must be derived in advance from profitability projections and documented in writing. Under these prerequisites, such an allocation may be the basis for business transactions between parts of the enterprise. Expenses and profit shortfalls resulting from “cutthroat prices” or similar means with which the part of the enterprise with distribution functions seeks to expand or significantly defend its market share are in principle to be borne by the part of the enterprise with manufacturing functions. 3.3 Interest and similar compensations Interest payments of the enterprise must be allocated to the permanent establishment to the extent they are related to loans that the enterprise demonstrably borrowed for purposes of the permanent establishment (direct allocation; reference to sec. 2.5.1). To the extent that interest payments of the enterprise cannot be attributed directly to the head office and the permanent establishment, they must be allocated at the ratio applied to the allocation of business property of the whole group between head office and permanent establishment. If the loan was taken up by the permanent establishment in order to provide the head office with funds, the interest payment must be attributed to the head office as the underlying loan serves the head office.

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In case the permanent establishment uses own financial funds of the enterprise, it cannot be charged with notional interest (decision of the Federal Fiscal Court of July 27, 1965, Federal Tax Gazette 1966 III p. 24). 3.4 Management expenses, general administrative expenses, and similar expenses 3.4.1 Attribution of expenses to the permanent establishment Management and general administrative expenses of the head office (see decision of the Federal Fiscal Court of July 20, 1988, Federal Tax Gazette 1989 II p. 140) must be attributed to the permanent establishment to the extent 1. the expenses are caused by a service of the head office to the permanent establishment; or 2. the expenses are based on a service by a third party to the head office from which the permanent establishment also benefits. Expenses which accrue from the enterprise as a whole (e.g. expenses for the legal organization of the enterprise) have to be allocated appropriately. Average expenses may be allocated to services that fluctuate. 3.4.2 Examples Such expenses may be for instance: – the rendering of services for bookkeeping, legal advice, and revision and auditing, – control, coordination, and similar services by the head office if these activities are performed toward the permanent establishment, – temporary secondment of personnel including that at the management level of the head office, and – training and skill enhancement and social security for personnel working at the head office in the interest of the permanent establishment.

4. Permanent establishments in special cases 4.0 General The general comments given in sec. 1 to 3 also apply in their full extent to the permanent establishments referred to in the following sections, unless other provisions are made. In this regard, particularly the general principles regarding the profit determination apply.

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4.1 Permanent establishment of banks 4.1.1 Domestic permanent establishment Pursuant to § 53 (1) German Banking Act, branches of enterprises with their registered seat in another country that conduct banking business within the meaning of § 1 (1) German Banking Act are considered as credit institutions. Domestic branches of foreign credit institutions shall in addition be regarded as branches within the meaning of § 13 Commercial Code and therefore, as permanent establishments within the meaning of § 12 sent. 2 no. 2 General Fiscal Code. Bookkeeping and accounting duty The bookkeeping and accounting duty is derived from §§ 238 and 340 Commercial Code. In addition to the provisions of the Commercial Code, special accounting principles apply to permanent establishments of banks (§ 53 (2) no. 2 to 4 German Banking Act). As of January 1, 1993, § 53 German Banking Act no longer applies under certain circumstances to permanent establishments of banks of enterprises with their registered seat in another member state of the EU (§ 53b German Banking Act). The special provisions of the German Banking Act regarding foreign enterprises with their registered seat in another member state of the EU may be applied by statutory ordinances to enterprises with their registered seat outside the EU (§ 53c German Banking Act). 4.1.2 Attribution of accounts receivables and margin shares For the attribution of accounts receivables and shares in margins from the origination of loans it is material tax-wise which bank office involved (head office, permanent establishment) has primarily performed the essential main activities to accomplish the business. Part of the main activities are acquisition, the rating of the borrower and the credit risk, bearing of the credit risk, refinancing, the decision about the loan granting, the conclusion of the contract, and credit management, monitoring, and processing. In case the permanent establishment takes the aforementioned material measures regarding the granting of the loan, the accounts receivables are regularly to be allocated to its business property. Potential expenses for value adjustments have to be borne by the permanent establishment, unless another bank office assumed the credit risk prior to the granting of the loan by means of internal agreement and against arm’s length remuneration. In case the head office or another permanent establishment par85

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ticipated in the granting of the loan, the margin may be allocated according to the individual contributions or be remunerated with the customary reimbursement of costs. A subsequent modification of the allocation is usually not possible unless substantial economical reasons like changes in essential functional contributions are material for the modification. These do not exist if the modification was performed for tax purposes only (sec. 15.2 of the OECDCommentary on art. 7 OECD-Model Tax Convention 92). The transfer of accounts receivables must be carried out at market prices. Main and auxiliary functions (management, booking, dunning, current risk control etc.) must also be transferred. 4.1.3 Dotation capital1 Domestic permanent establishments of foreign lending institutions must possess dotation capital that meets the nature of their business. Domestic permanent establishments of EU credit institutions It is not objected if the domestic permanent establishment of a credit institution with its registered seat in a member state of the European Union applies dotation capital that is not less than the dotation capital derived from the following table. Balance Sheet Total

Dotation Capital

0-100 million DM

2 million DM

from 100 million to 500 million DM

2.0 % of the balance sheet total

from 500 million to 1 billion DM

10 million DM

from 1 billion To 2 billion DM

1 % of the balance sheet total

from 2 billion To 5 billion DM

1 % of 2 billion DM plus 0.5 % on the increased amount

as of 5 billion DM

1 % of 2 billion DM plus 0.5 % of 3 billion DM and plus 0.25 % on the amount exceeding 5 billion DM

In order to determine the balance sheet total, the annual financial statements of the preceding business year are used. For the avoidance of random values, the average balance sheet total of the last 12 BISTA reports (BISTA = balance sheet statistical reports to the Federal Banking Supervisory Authority) of the preceding business year must be calculated. If it exceeds the closing balance sheet value by more than 20 %, the average bal-

1 For fiscal years from January 1, 2005, sec. 4.1.3 is superseded by the circular of the Federal Ministry of Finance of September 29, 2004. See page 151 ff.

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ance sheet total of the preceding business year is material for the assessment of the dotation capital. Current fluctuations within the business year are neglected. In case the business activities were initiated during the assessment period, a dotation capital of at least 2 million DM must be applied. Where the dotation capital derived from the table above is below the data determined, a respective interest portion for the borrowed capital cannot be deducted as business expense. To that extent no liability can be stated. This provision shall apply for the first time – to business years that end after December 31, 1995, – to assessment dates as of January 1, 1996. To the extent a higher dotation capital than required under (1) and (2) above was applied to business years or assessment dates preceding those mentioned, it cannot be reduced retrospectively. This rule expires after 31 December 2000. Permanent establishments of foreign credit institutions that are equivalent to those of EU banks 1. Pursuant to the statutory ordinance of the Federal Ministry of Finance of April 21, 1994 (Federal Law Gazette I p. 887), branches of credit institutions with their registered seat in the USA are in principle equivalent to permanent establishments of EU credit institutions. To such enterprises apply the aforementioned provisions for domestic permanent establishments of EU credit institutions with the following provisos: (a) A minimum capital of 5 million ECU must be applied. On January 1, 1999, the amount is converted to Euro at a ratio of 1:1. (b) This provision applies to dates as of May 4, 1995. 2. Regarding the permanent establishments of credit institutions in Japan, this provision is effective with the proviso that it is applied to periods as of December 21, 1995. Permanent establishments of foreign credit institutions that are not equivalent to those of EU banks Permanent establishments of foreign credit institutions that are not equivalent to EU banks must use a dotation capital that is at least required under the regulatory law of the German Banking Act.

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Foreign permanent establishment of banks (a) Endowment An endowment of the foreign permanent establishment exceeding the economic requirements cannot be accepted. The assessment of the appropriateness has to be performed based on the arm’s length test (see sec. 2.5.1). The endowment does insofar not contradict the commercial and economic requirements to the extent that the dotation capital is in accordance with the standards of the equity base of the regulatory law of the country where the permanent establishment is situated or with the standards required by § 10 German Banking Act. Furthermore, it is not objected if equity of the entire group that exceeds the equity under regulatory law is allocated at reasonable discretion based on prudent commercial assessment to the permanent establishment at the most at the ratio equaling the share of this permanent establishment in the equity of the entire group necessary under regulatory law and the permanent establishment may factually dispose of it. (b) Refinancing With the capital transfer, equity of the credit institution that was until then available in the domestic territory is transferred to the foreign branch. In case the credit institution has verifiably borrowed funds in direct connection with it or if it is inevitably concluded from other circumstances that borrowed funds were used, these funds and the connected refinancing expenses cannot be considered in the domestic territory because they must be allocated to foreign income. 4.1.4 Interest charges Funds made available by the head office or other permanent establishments must be accepted as loans bearing interest to the extent they exceed the dotation capital, as money has to be seen as goods for credit institutions (see decision of the Federal Fiscal Court of July 27, 1965, Federal Tax Gazette 1966 III p. 24 and sec. 18.3 and sec. 19 and 20 of the OECDCommentary on art. 7 OECD-Model Tax Convention 92). The same applies to the transfer of funds from the permanent establishment to the head office or sister branches. When money and capital is taken up by a domestic permanent establishment, the same interest rates that third parties would have agreed on in the respective currency under similar circumstances are assumed. If borrowings from the head office or another foreign branch are, unlike similar domestic borrowings, exempt from minimum reserve requirements, the domestic branch is entitled to that benefit for tax purposes. It cannot be passed on to the head office or the other foreign permanent establishment (e.g. by means of an increased borrowing rate). 88

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Interest from loans provided by a domestic permanent establishment to its head office must in general be assessed according to the conditions in the domestic market. In case of a higher foreign interest rate, the higher foreign interest must be applied and the interest benefit must be allocated between head office and permanent establishment. 4.2 Permanent establishments of insurance companies Domestic branches of foreign insurance companies within the meaning of the Insurance Supervision Act are branches within the meaning of § 13d Commercial Code. 4.2.1 Domestic permanent establishment Pursuant to insurance law, the following provisions apply to insurance companies with their registered office abroad that conduct insurance business: Insurance companies with their registered office outside the member states of the European Union or the European Economic Area that want to conduct direct insurance business in the domestic territory through intermediaries require the permission of the German insurance supervisory authority (§ 105 Insurance Supervision Act) and must establish a branch according to § 106 Insurance Supervision Act. Insurance companies with their registered office in a member state of the European Union or the European Economic Area may, however, conduct pursuant to §§ 110a, 110d Insurance Supervision Act direct insurance business in the domestic territory through a branch or an intermediary. Permission by the German insurance supervisory authority is not required anymore. The business activities are financially supervised by the regulatory authority of the home member state (§ 110a (3) Insurance Supervision Act). In case no branch exists under insurance law, a permanent establishment is constituted by a dependent representative pursuant to sec. 1.2.2 if he has the authority in the domestic territory to conclude contracts (authority to contract) on behalf of the foreign insurance company and exercises this authority regularly. Similarly, a broker (commission agent) or other independent representative with the authority to contract constitutes a permanent establishment if he acts outside his ordinary course of business. Foreign reinsurance companies conducting their reinsurance business in the domestic territory through a branch or intermediary do not require permission in this context. Pursuant to § 1 (2) Insurance Supervision Act, they only have limited accounting and reporting duties. See sec. 1.2.2 regarding the existence of a permanent establishment. 89

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4.2.2 Domestic permanent establishments that are subject to insurance supervision by the Federal Insurance Supervisory Authority Bookkeeping and accounting duties Domestic permanent establishment of foreign insurance companies that are subject to the domestic commercial and insurance supervision law are required to keep accounts. The bookkeeping duties that are required for domestic permanent establishments of foreign insurance companies under the Commercial Code and the Insurance Supervision Act also apply to tax law pursuant to § 140 General Fiscal Code. Profit determination The balance sheet result of the domestic permanent establishment derived from commercial and tax law is material for the profit determination. In addition, it must be complied with the special provisions for insurance companies under §§ 20 and 21 Corporate Income Tax Act. In order to determine the balance sheet result, all expenses allocable to domestic operations must be deducted including a share in the general expenses of the entire enterprise (expenses of central administration) to the extent that this share has not yet reduced the balance sheet profit. See sec. 2.2 and 2.3 regarding the allocation. If expenses for the insurance business have to be assessed for the determination of tax deductible actuarial provisions or for the calculation of additions or withdrawals, these expenses must include a proportionate share of the general expenses. Where the reinsurances of the permanent establishment business are concluded by the foreign headquarters, the shares of the reinsurer and the amounts allocable to the domestic insurance business must be regarded in all relevant positions of the balance sheet and of the profit and loss statement. The stated amounts must be substantiated by suitable documents (reinsurance contracts, reinsurance clearances). Pursuant to sec. 2.2, reinsurance contracts between head office and permanent establishment cannot be accepted for tax purposes due to their character as internal transactions. Attribution of assets Investments must be attributed to the domestic permanent establishment at least in the amount of 1. the actuarial provisions (including premium surpluses) and deposit liabilities because the activities of the domestic business have contributed to the generation of income resulting therefrom, plus

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2. the minimum equity in the amount of a solvency margin (§§ 53c, 106b (2) Insurance Supervision Act as well as Capital Resources Ordinance) in relation to the scope of the insurance business of the permanent establishment or, in case it is higher, the minimum amount of the guarantee fund within the meaning of §§ 2 and 5 Capital Resources Ordinance. The amount of the solvency margin results from the documents that must be submitted to the Federal Insurance Supervisory Authority. Elsewise, it must be determined separately under analogous application of the Capital Resources Ordinance and the respective circulars published by the Federal Insurance Supervisory Authority. In case the minimum amount calculated from the attribution of assets (arithmetic means at the start and the end of the business year) exceeds the arithmetic means of the investments shown in the balance sheet at the start and the end of the business year, the difference must be allocated to the domestic permanent establishment. In addition, income from investments in the amount of the average profitability of the total capital in relation to the difference must be allocated to the profit of the domestic permanent establishment. Dotation capital The equity in the amount of the minimum equity capitalization necessary under supervisory law must be allocated to the permanent establishment (decision of the Federal Fiscal Court of September 18, 1996, International Tax Law (IStR) 1997 p. 145). 4.2.3 Domestic permanent establishments that are not subject to insurance supervision by the Federal Insurance Supervisory Authority Bookkeeping duties The duty to keep books results from §§ 238 (1) and 242 Commercial Code. Profit determination The balance sheet items calculated by the branch in accordance with the additional provisions for insurance companies of §§ 341b to 34h Commercial Code shall be accepted for tax purposes under consideration of §§ 20 and 21 Corporate Income Tax Act.

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Attribution of assets Sec. 4.2.2 applies correspondingly; with regard to minimum equity finance, the provisions under regulatory law of the country in which the registered seat of the head office is located have to be taken into account. Dotation capital The factually available equity of the entire enterprise must be allocated appropriately between head office and its permanent establishments pursuant to the arm’s length principle (decision of the Federal Fiscal Court of September 18, 1996, International Tax Law Magazine (IStR) 1997 p. 145). This means that equity in the amount which is at least required for the business of the permanent establishments shall be allocated to the domestic permanent establishment pursuant to the law of supervision in the state in which the head office has its registered office. 4.2.4 Foreign permanent establishments of domestic insurance companies Profit determination The statements given in sec. 4.2.2 apply correspondingly. Dotation capital The endowment of the foreign permanent establishment shall be accepted if it is required pursuant to the provisions of the regulatory or tax law applicable in the respective state provided that equity required for exercising its function within the entire enterprise (sec. 2.5.1) is not extracted from the domestic head office. 4.3 Building sites or constructions or installation projects 4.3.1 General Building sites or constructions are defined as the erection of a building, facility, or parts of it (decision of the Federal Fiscal Court of September 22, 1977, Federal Tax Gazette 1978 II p. 140; decision of the Federal Fiscal Court of October 21, 1981, Federal Tax Gazette 1982 II p. 241). Installation projects include the final installation or the conversion or installation of pre-fabricated parts to a whole yet not mere repair or maintenance works (decision of the Federal Fiscal Court of May 16, 1990, Federal Tax Gazette II p. 983). The time limit for building and installation sites is determined by the start and the end of the construction and installation works (cf. Appendix II). 92

II. Permanent Establishments (1999)

A building site or construction commences on the date on which the enterprise begins with its works including all preparatory works in the state in which the building is to be erected, e.g. upon the establishment of a construction planning office. Generally, the building site or construction exists until the work has been completed or has finally been discontinued. Provided that only material and equipment are stored at the construction site, the building site or construction no longer exists. An installation project commences with the arrival of the first person who was assigned by the installation enterprise with the installation works to be carried out. In this regard, “installation works” include such works that provide for the direct preparation of the actual installation works. If the installation project is covered by a contract for a work performance and the agreement requires an inspection of the finished work including the participation of the installation enterprise, the installation project ends at the earliest with the inspection (decision of the Federal Fiscal Court of April 21, 1999, Federal Tax Gazette II p. 694). The deadline is not delayed by seasonally caused or other temporary short-term interruptions in the work like bad weather, strikes, and other interruptions due to the course of operations like shortage in material or other constructional reasons. 4.3.2 Building and installation supervision as building site or construction Regularly, the planning and supervisory activities carried out as partial performances are part of building sites or constructions or installation projects that constitute a permanent establishment under § 12 sent. 2 no. 8 General Fiscal Code and art. 5 (3) OECD-Model Tax Convention 92. This is also applicable to cases where a general contractor carries out the manufacturing of a work by only supervising the works with his own personnel and otherwise transferring the manufacturing to subcontractors (sec. 17 OECD-Commentary on art. 5 (3) OECD-Model Tax Convention 92; decision of the Federal Fiscal Court of November 13, 1962, Federal Tax Gazette 1963 III p. 71). If the building and construction or installation works including planning and supervision are completely transferred to a subcontractor or, within a consortium the responsibility for proper completion is mainly supported by another partner, the general contractor with the remaining coordination tasks does not constitute a permanent establishment within the meaning of § 12 sent. 2 no. 8 General Fiscal Code and art. 5 (3) OECD-Model Tax Convention 92. The mere supervision of construction and installation works may in principle only constitute a permanent establishment within the meaning of art. 5 (1) OECDModel Tax Convention 92. See Appendix II regarding double taxation agreements in which isolated supervisory activities explicitly constitute a permanent establishment.

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4.3.3 Delegation to subcontractors In case a general contractor delegates parts of the assignment to subcontractors, the times that subcontractors spend working on the construction or installation site are allocated to the general contractor (decision of the Federal Fiscal Court of November 13, 1962, Federal Tax Gazette 1963 III p. 71). A subcontractor maintains its own permanent establishment if its business activities exceed the time period stipulated by the respective double taxation agreement. 4.3.4 Building and construction and installation projects by a consortium or a joint venture If a building and construction or installation assignment is carried out by a consortium, – be it as an external consortium in which all members deal with the principal as independent partners with a determined scope of work and individually and jointly assume the overall responsibility for both the fulfillment of the assignment and the warranty of functionality (joint and several liability), – be it as an internal consortium represented by only one partner that concludes the agreement with the contractor, both contractual relationships have in common that in the internal relationship the partners are only liable for their own share in the performance. Accordingly, within a consortium the activity of one partner cannot be allocated to the other partner. It must be examined for each individual consortium member whether a construction or an installation project exists within the meaning of art. 5 (3) OECD-Model Tax Convention and thus constitutes a permanent establishment. A joint venture is a civil-law association that is qualified as an enterprise within the meaning of § 15 (1) no. 2 Income Tax Act for tax purposes. The partners are regarded as entrepreneurs regardless of whether a profit determination procedure under § 180 (1) no. 2 (a) General Fiscal Code is carried out for the joint venture (see § 180 (4) General Fiscal Code). In legal relationships with third parties the joint venture in principle assumes joint and several liability to the principal. With regard to the internal relationship, the service obligations are accurately allocated (to that extent it is not different from a consortium) yet the individual responsibility exists only in the internal relationship and not also to the principal. The assignment is uniformly carried out and the total result is divided among the joint venture partners. The activities of joint venture partners are therefore to be seen as a unit in terms of substance and time and the question

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whether a permanent establishment exists can only be assessed uniformly for the joint venture. As the partners and a consortium or a joint venture act under the law of obligations as unaffiliated third parties towards each other, performances of the partners must be treated as third party services towards an external co-ownership. The profit of the partner is thus already realized during the rendering of the service, see also Circular of the Federal Ministry of Finance of January 27, 1998, Federal Tax Gazette I p. 251. 4.3.5 Evaluation of building sites or constructions In contrast to § 12 sent. 12 no. 8 General Fiscal Code, building sites or constructions that are either carried out simultaneously or follow chronologically must be assessed separately under art. 5 (3) OECD-Model Tax Convention 92. Several building sites or constructions may only be viewed as a unit provided that they are economically and geographically related. An economic relation exists for instance if several building sites or constructions are considered as an overall project like the construction of a radio network or the development of a computer network. A geographical unit only exists where the distance of the building site or construction does not exceed the linear distance of 50 km. Example: Based on a uniform agreement, an enterprise shall build a net of hardware stores for a principal in Cologne, Bonn, Düsseldorf, Emmerich, Arnhem (The Netherlands), and Groningen (The Netherlands). An economic relation exists among the individual building sites or constructions. The geographical relation must be determined pursuant to the chronological order in which the permanent establishments were constituted. Permanent establishment situated abroad are neglected. Depending on the time of their formation, either Bonn and Cologne or Cologne and Düsseldorf must be aggregated. It is not permitted to consider one place two times. The construction project in Emmerich constitutes a separate permanent establishment due to the larger distance.

The aforementioned guidelines also apply to cross-border building or construction and installation projects. In particular, it is referred to the following: – Independent building or construction or installation projects cannot be aggregated for the determination of the time duration; – In principle, independent projects are such that are carried out for different principals unless the projects economically form a single unit (see above); 95

D. Administrative Guidelines

– Different projects for the account of a single principal are generally considered as a unit if they are carried out based on a uniform agreement and a geographical relation exists; – In case works are carried out for the account of the same principal based on several agreements, these are aggregated if they are uniformly carried out. Such unit may exist – in terms of time if these different assignments are carried out simultaneously or immediately in succession without interruptions and – in terms of geography if the works constitute only part of a larger entirety including projects carried out at different places within a geographically related area; – The requirements of art. 5 (3) and 5 (5) OECD-Model Tax Convention must be examined individually. If the requirements for a permanent establishment caused by a dependent agent in accordance with art. 5 (5) OECD-Model Tax Convention 92 are met, the enterprise is treated as though it had a permanent establishment even in case the building and construction or installation project itself does not fulfill the prerequisites of a permanent establishment. Geographically moving building sites or constructions (e.g. works on a rail or road network) or floating building sites or constructions are in principle regarded as an economic and geographic unit (sec. 20 of the Commentary on art. 5 OECD-Model Tax Convention 92) regardless of the 50 km limit. 4.3.6 Allocation of profit and loss between head office and permanent establishment Pursuant to the general principles on the tax profit determination, the profit of building and construction or permanent establishment resulting from installation works is in principle not realized until the inspection of the construction project. The profit or loss (= contractual result) for construction or installation works must be allocated between head office and permanent establishment in such manner that the permanent establishment receives what an unaffiliated third entrepreneur would have received for carrying out the construction or installation works under same or similar conditions. The fiction that the head office constitutes the general contractor and the permanent establishment constitutes the subcontractor provides for a useful approach to the arm’s length test. For complex contractual relationships, an allocation of the contractual result in accordance with the division of activities, functions, and risks between head office and permanent establishment resulting from installation works may be appropriate if third parties would also have shared the risks and opportunities arising from the assignment.

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4.3.7 Supply of materials for construction or installation works by the permanent establishment The final price as agreed with the contractor regularly includes the profit mark-up on the supply of materials like construction material or machines and the profit mark-up on the construction or installation works. The profit from the supply of materials must be allocated to the head office. Furthermore, the final price includes also additional services that have been rendered by a highly qualified staff of the head office, e.g. order procurement (acquisition), planning and development, “know-how”, selection of subcontractors and contractual arrangements with them, their monitoring, and to that extent the bearing of risks in relationship with third parties. Accordingly, the profit attributable to these services must be allocated to the head office under consideration of the fact that the expenses for unsuccessful acquisition must be covered by this profit. As compensation for its construction or installation works, the permanent establishment shall regularly be remunerated with an appropriate share in the profit under the cost plus method without considering the costs for subcontractor services. To the extent that the permanent establishment procures itself on-site with the necessary material or subcontracting services necessary for the construction or installation, it is eligible to a pro-rata profit from the supply of material or subcontractor service in accordance with the scope of its commercial and technical services (decision of the Federal Fiscal Court of November 13, 1990, Federal Tax Gazette 1991 II p. 94). The aforementioned comments also apply correspondingly to the points of supervision of building sites provided that they are regarded as permanent establishments. 4.3.8 Allocation of construction material and installation parts to the permanent establishment Construction material and installation parts stored at the permanent establishment for processing and the rights arising from the already processed material or assembled parts by the permanent establishment are property of the head office and not of the permanent establishment. This is inapplicable to the extent that the permanent establishment itself has procured the construction material or other material. 4.3.9 Allocation of financing costs and income In case an enterprise finances for the principal the contract value, the financing income minus potential refinancing costs must in principle be allocated to the head office as it renders the respective services and bears the risks. A potential service contribution by the permanent establish-

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ment regarding the handling of the financing must be considered proportionally in its profit. So-called “construction interest” (which means such refinancing expenses which incurred by the contractor regardless of the financing business) must be allocated to the permanent establishment pursuant to its share in the construction and installation service. In cases of mixed calculations (financing income that is too high and a reduced contract value at the same time or vice versa), respective profit corrections must be carried out under the cost plus method at the level of the construction or permanent establishment resulting from installation works up to the amount of an appropriate compensation. If the contractor invests advance payments made by the principal and earns interest hereby, the income must be allocated to the head office and the permanent establishment according to the share in the construction or installation works. 4.4 Control and coordination offices 4.4.1 General Occasionally, group managements (parent enterprises) establish offices in another state that supervise subsidiaries and permanent establishments of the respective group in the other state or other states and/or coordinate their activities while the essential functions of a managing holding (decision of the Federal Fiscal Court of December 17, 1969, Federal Tax Gazette 1970 II p. 257) are carried out by another group entity. Such offices may e.g. – supervise and coordinate the accounting and reporting of the subsidiaries and permanent establishments and consolidate their annual financial statements; – coordinate programs, procurement, production plans, work methods, marketing and/or research; – adjust the directives of the group management to local circumstances, implement them in these conditions and monitor their compliance, or prepare questions of regionally restricted importance for the decision by the group management; – as regards decisions of subsidiaries, carry out reservations of approval by the group management that are determined either in the by-laws or in general group directives, and represent it in shareholders’ meetings or supervisory bodies or delegate persons to such panels; – render other administrative services. The office is usually organized as a facility of the group management. The aforementioned tasks may also be carried out for the group management 98

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by domestic group entities or by domestic permanent establishments of foreign group entities. Carrying out these tasks may constitute the sole business objective. 4.4.2 Qualification of the control and coordination offices as permanent establishment The control and coordination offices as establishments of the group management constitute in principle permanent establishments within the meaning of § 12 General Fiscal Code. Furthermore, they are fixed places of business according to the definition of the term permanent establishment set out in double taxation agreements (art. 5 OECD-Model Tax Convention 92). In individual cases they may, however, carry out tasks that do not constitute a permanent establishment under the applicable double taxation agreement (art. 5 (4) OECD-Model Tax Convention 92). This may especially be the case if they – provide only for the gathering of information for the group management; – carry out only preparatory or auxiliary tasks for the group management; such tasks especially exist to the extent that the office merely transmits and prepares instructions from the group management or supports these by evaluation within its area of responsibility. The control and coordination offices do not constitute permanent establishments for subsidiaries they support or coordinate unless they fulfill special criteria like that of a place of management or a permanent representative. Where a control or coordination office is annexed to another permanent establishment of the group management, it is not regarded as its unit if it is organizationally separated and easily distinguishable. 4.4.3 Attribution of shares and assets as well as income flowing therefrom The fact that control and coordination offices become active within the meaning of sec. 4.4.1 does not result in shares held in subsidiaries, loans, patents, or other similar assets of the group management and income flowing therefrom actually belong to the permanent establishment maintained in the respective state. Due to the uniform application of double taxation agreements it is presumed that these assets and/or income are allocated to the group management; to the extent this is not the case, the issue must be settled in a mutual agreement procedure pursuant to the respective double taxation agreement (art. 25 OECD-Model Tax Convention 92) or where required, in an arbitration procedure.

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4.4.4 Profit of the permanent establishment1 The permanent establishment is entitled to an appropriate profit. When allocating its profit, cost-oriented remuneration must generally be considered. Accordingly, it is not objected if the profit of the permanent establishment is determined using the cost plus method considering an arm’s length profit mark-up. 4.4.5 Assets and liabilities of the permanent establishment All assets that serve the permanent establishment must be allocated to it. Regarding shares in subsidiaries and other assets set out in sec. 4.4.3, the provisions stated therein apply. 4.5 Permanent establishments when operating sea-going vessels and inland-navigation vessels 4.5.1 General The navigating ship, be it a sea-going vessel or an inland-navigation vessel, does itself not constitute a permanent establishment for the shipping enterprise (decision of the Federal Fiscal Court of February 13, 1974, Federal Tax Gazette II p. 361, decision of the Federal Fiscal Court of October 9, 1974, Federal Tax Gazette 1975 II p. 203). For inland-navigation vessels it is assumed that the entry of the ship in the maritime register in the town from where the shipping business is actually operated constitutes a permanent establishment of the shipping enterprise there. This assumption may be refuted if it is proven that the shipping business is operated from a different place and that a respective place of business is located there. The center of business management may be located on the premises of a foreign manager or a correspondent proprietor of a ship. The actual circumstances are decisive (decision of the Federal Fiscal Court of July 3, 1997, Federal Tax Gazette 1998 II p. 86). The same principles apply to sea-going vessels. This does not preclude shipping enterprises from operating permanent establishments in other countries by means of places of business that serve the business of the enterprise. Income from shipping operations may only be allocated to such permanent establishments if and to the extent they carry out shipping operations themselves and not only auxiliary activities that are not directly connected with the operation of sea-going vessels (e.g. activities of line agents of the enterprise; cf. in this regard and, with regard to profit allocation the decision of the Federal Fiscal Court of June 28, 1972, Federal Tax Gazette II p. 785).

1 Sec. 4.4.4 revised by the circular of the Federal Ministry of Finance of November 20, 2000, Federal Tax Gazette I p. 1, 509.

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4.5.2 Special provisions for foreign income from operating merchant vessels in international traffic Instead of tax relief under § 34c (1) Income Tax Act or the deduction of foreign tax under § 34c (2) and (3) Income Tax Act, the income tax arising from income from the operation of merchant vessels in international traffic may be assessed for taxpayers subject to unlimited taxation upon application according to the reduced tax rate until the assessment period 1998 (§ 34c (4) Income Tax Act). Pursuant to § 5a Income Tax Act which has been effective from 1999, an enterprise with its place of management in Germany may apply for its profit to be determined based on the tonnage managed in the enterprise, instead of under § 4 (1) or § 5 Income Tax Act, to the extent that the profit is to be attributed to the operation of merchant vessels in international traffic, if the ship management of these merchant vessels is carried out in the domestic territory. § 34c (1) to (3) Income Tax Act is not applicable. § 34c (4) Income Tax Act and § 5a Income Tax Act also apply in case a double taxation agreement applies. Up to and including the assessment period 1992, income from merchant vessels operated in international traffic is trade tax-privileged (cf. § 11 (3) no. 2 Trade Tax Act, sec. 71 Trade Tax Regulations 1990, § 13 (3) Trade Tax Act, sec. 84a Trade Tax Regulations 1998, § 36 (6a) Trade Tax Act). For assessment periods 1997 and 1998, the privileges under § 9 no. 3 Trade Tax Act must be considered. As of assessment period 1999, the profit determined under § 5a Income Tax Act is considered as trade earnings. See Circular of the Federal Ministry of Finance of June 24, 1999, Federal Tax Gazette I p. 669 for individual questions regarding the profit determination under § 5a Income Tax Act. 4.5.3 Special provisions for shipping enterprises in double taxation agreements In treaty law, the permanent establishment principle is superseded by the navigation principle for enterprises of the sea-going and inland-navigation industry. Pursuant to art. 8 (1) OECD-Model Tax Convention 92, the profit of an enterprise operating sea-going vessels in international traffic may only be taxed in the contracting state in which the place of effective management is situated. Under art. 3 (1) (d) OECD-Model Tax Convention 92, “international traffic” is defined as “any transport by a ship… operated by an enterprise that has its place of effective management in a Contracting State, except when the ship… is operated solely between places in the other Contracting State”. In case the place of effective management of a shipping enterprise is aboard a ship, which is in particular applicable to smaller coastal shipping enterprises, art. 8 (3) OECD-Model Tax Convention 92 deems the place of effective management to be situated in the 101

D. Administrative Guidelines

home harbor of the ship. If no such port exists, the place of effective management is alternatively deemed to be in the contracting state of which operator of the ship is resident. Pursuant to art. 8 OECD-Model Tax Convention 92, the profit from the operation of ships includes such profits that are directly connected with the transport service like advertisement activities, sale of shipping tickets for other enterprises, land transfer from port to a warehouse, and the occasional renting of containers even if these are used for inland-navigation transport. It also includes the renting of a completely furnished ship. However, dredging works and towing services are only included in shipping profits if it was explicitly contracted. To the extent that the enterprises carry out other main activities besides their transport tasks, the permanent establishment principle applies if it is trade or business income, and not the special provisions for shipping income. 4.6 Prospecting and extracting natural resources in international waters 4.6.1 Domestic territory with respect to tax According to international law, territorial waters belong to the domestic territory and therefore, regularly also to the geographic area of a state (see part II sec. I and II United Nations Convention on the Law of the Sea of December 10, 1982, Federal Law Gazette 1994 II p. 1,798 et seq.). Enterprises prospecting and extracting natural resources on the continental shelf outside the twelve mile zone (territorial waters) stay in international waters. International waters are not part of the sovereign territory of a state and thus constitutionally do not belong to its domestic territory. According to international law, the continental shelf itself does not belong to the domestic territory, either. Under art. 2 Geneva Convention of April 29, 1958, coastal states are, however, granted a limited sovereignty to explore and to exploit natural resources. The Federal Republic of Germany has made use of this right by proclamation dated January 20, 1964, Federal Law Gazette II p. 104, I p. 497 (Law on Temporary Regulation of the Rights on the Continental Shelf) that was amended by the law of September 2, 1974, Federal Law Gazette I p. 2,149. Pursuant to § 1 (1) sent. 2 Income Tax Act and § 1 (3) Corporate Tax Act, the continental shelf itself belongs therefore to the domestic territory for tax purposes to the extent in this region natural resources of the ocean bed and the subsoil of the ocean are explored and exploited. The same is applicable for the interpretation of the term domestic territory in double taxation agreements. All states are entitled to install submarine cables and pipelines on the continental shelf and in the exclusive economic zone and to that extent the continental shelf itself is not part of the domestic territory for tax purposes (art. 58 (1) and 79 United Nations Convention on the Law of the Sea). Artificial islands, facilities, structures, and similar installations within the ex102

II. Permanent Establishments (1999)

clusive economic zone are part of the domestic territory for tax purposes though, to the extent natural resources of the ocean bed and the subsoil of the ocean are explored and exploited (art. 60 United Nations Convention on the Law of the Sea). 4.6.2 Permanent establishment In case the exploration activity is performed off shore aboard ships e.g. by means of seismic measurement in order to explore natural resources of the subsoil of the ocean, the ship is not the permanent establishment of the research enterprise but the permanent establishment is constituted upon the initiation of the measurement activity. If a measurement or research vessel sailing under the flag of the Federal Republic of Germany does not stay in territorial waters of another state, the trade activities of the research enterprise are carried out in the domestic territory (decision of the Federal Fiscal Court of February 13, 1974, Federal Tax Gazette II p. 361). In case the measurement or research vessel sails under the flag of another state and does not navigate over the continental shelf to which the Federal Republic of Germany is entitled, it constitutes a foreign permanent establishment. 4.7 Permanent establishments while exploring The business of exploring and exploiting natural resources consists of three essential phases: In phase one (project monitoring or acquisition), countries are analyzed regarding their geological, economic, and political fundamentals. In case of a positive result, this phase ends with the conclusion of the exploration and/or production agreement. In phase two (exploration), extensive geological analyses are initially performed, especially seismic measurements, and if the results are positive, it then leads to exploration drillings. If the drillings make discoveries, it is additionally examined whether the resources found can be profitably exploited and transported. The exploration phase ends upon the determination of the economic success. Phase three (development and production) consists of the setup of extraction, processing, and transport facilities and the start of the extraction/exploitation business. The search for and extraction of natural resources will be carried out by enterprises (mining companies, oil/natural gas company) themselves, by mergers of such enterprises or on behalf of these enterprises by companies specialized in these activities. The question whether exploration works outside the Federal Republic of Germany constitute a permanent establishment abroad for the executing enterprise must be answered equally in all cases under application of German law. When applying a double taxation agreement, it must be differentiated between the case groups. Further103

D. Administrative Guidelines

more, differences arise for the determination of the result of the permanent establishment. 4.7.1 Taxation in the exploration phase 4.7.1.1 Permanent establishment under national law Within the meaning of § 12 sent. 2 no. 8 General Fiscal Code, the exploration activity shall be considered as a permanent establishment if – the individual exploration; or – one of several explorations conducted at the same time; or – several consecutive explorations carried out without interruption last longer than six months (no. 3 of the implementation decree on § 12 General Fiscal Code and sec. 22 (3) sent. 20 Trade Tax Regulations 1998). 4.7.1.2 Permanent establishment under double taxation agreements If an enterprise (mining company, oil/natural gas company) itself carries out the exploration activity in a double taxation agreement state, this regularly does not constitute a permanent establishment for the enterprise in the respective state even if the activity in this state is carried out in connection with a fixed place of business. As a rule, the exploration activity is in principle an activity of “preparatory character” that, under art. 5 (4) OECD-Model Tax Convention 92, does not constitute a permanent establishment even if a fixed place of business exists (exception: double taxation agreement Austria 1954/92). The management of operations (operatorship) for a consortium which assumed the exploration for the participation enterprises (mining company, oil/natural gas company) constitutes a permanent establishment under the general provisions. The function of the permanent establishment is limited to the rendering of services to the consortium members, though; the exploration right remains with the head office. The exploration is not an activity of preparatory character if it is carried out for third parties. 4.7.2 Taxation at the time of transition to the development and production phase Upon the determination of the economic success, the enterprise (mining company, oil/natural gas company) constitutes a permanent establishment in the other double taxation agreement state also pursuant to double taxation agreement principles. Intangible assets (mining right; right to extract oil/gas) that until then had been allocated to the domestic head of104

II. Permanent Establishments (1999)

fice are considered as having been transferred to the foreign permanent establishment as they are designated for the exclusive use and exploitation in the permanent establishment. The general principles on the transfer of assets apply (sec. 2.6.1). The arm’s length price for self-created intangible assets includes all expenses incurred until the beginning of the development and production phase by the domestic head office regarding the concession area in the respective foreign state. To the extent that the foreign state attributes in its taxation to the transferred right a value exceeding that of the aforementioned expenses, this value shall be material. This applies correspondingly to cross-border explorations. 4.7.3 Special provisions for the treatment of the permanent establishment result The exploration of the enterprise (mining company, oil/natural gas company) aims at acquiring exploration and/or exploitation rights (concessions). Provided that the enterprise itself carries out the exploration, the expenses cannot be capitalized pursuant to § 5 (2) Income Tax Act. They are immediately deductible business expenses. In case the exploration constitutes a foreign permanent establishment for the mining company, the expenses must be allocated to the permanent establishment. No exploration expenses are allocated to the (service) permanent establishment of the operator which is constituted by assuming the management of operations for a consortium (sec. 4.7.2). These expenses are allocated to the activity of the domestic head office. No profit mark-up shall be charged between the foreign (service) permanent establishment and the domestic head office with regard to the expenses of the permanent establishment (e.g. wage costs). 4.8 Transport facilities Pursuant to § 12 General Fiscal Code, tracks, underground facilities of mining companies, and supply networks constitute permanent establishments of the enterprise maintaining them (cf. decision of the Federal Fiscal Court of October 30, 1996, Federal Tax Gazette 1997 II p. 12, regarding a pipeline as permanent establishment). Such facilities are “fixed” places of business if there is a fixed connection to the ground or the place of business or the facility is located at a certain place for a certain time period. Local fixation may result from a mechanical connection to the ground or from mere localization at the same place. The term permanent establishment in double taxation agreements is usually in particular linked with the fixed place of business and in this respect it is identical with the respective term applied in § 12 sent. 1 General Fiscal Code. In individual cases, exceptions from the double taxation agreement in question must be examined.

105

D. Administrative Guidelines

Transport services (e.g. passing of liquid or gaseous substances through pipes) are in principle not auxiliary services within the meaning of art. 5 (4) OECD-Model Tax Convention 92 (decision of the Federal Fiscal Court of October 30, 1996, l.c.). Sections of a conveyor pipeline are in principle to be allocated to the owner of the entire conveyor pipeline and the transported goods. Sections of a conveyor pipeline that do not constitute permanent establishments under the exceptions in a double taxation agreement must be allocated to the next supply station in the same area that qualifies as a permanent establishment. This applies correspondingly to railway tracks. The activity of persons in or at the place of business (conveyor pipeline) is not required in every case; instead, it is sufficient that the enterprise becomes active with regard to the place of business (conveyor pipeline), especially in cases of fully automated facilities (decision of the Federal Fiscal Court of October 30, 1996, l.c.). Where conveyor pipelines that are only used to transport solid, liquid, or gaseous substances or electric energy qualify as permanent establishments, the arm’s length share in the result shall be determined considering the transport quantity. The same applies to railway tracks. Where supplies of e.g. water or electric energy are made from the conveyor pipelines in the respective area, the corresponding output quantity is a suitable allocation standard.

5. Procedure 5.1 Cooperation and documentation duties 5.1.1 Cooperation under § 90 (2) General Fiscal Code As regards the determination of the correct income allocation, the parties concerned shall cooperate in accordance with to general provisions (especially § 90 (2) General Fiscal Code). Hereby, they also have to a) clarify themselves facts in foreign jurisdictions, and b) obtain evidence which is located abroad. They are obliged to exploit all legal and factual options available to them. 5.1.2 Cooperation duties of divisions of an enterprise To the extent his national tax liability is questioned, the entrepreneur as such is obliged to cooperate. This cooperation duty is not restricted to dependent divisions, such as permanent establishments. The investigation and documentation duty especially extents to issues and evidence relevant for domestic tax purposes which is recorded and documented in the books and documents of foreign divisions of the enterprise. 106

II. Permanent Establishments (1999)

5.1.3 Collection of evidence in advance Pursuant to § 90 (2) sent. 3 General Fiscal Code a party to the proceeding may not claim its inability to clarify the facts or to obtain evidence if, according to the circumstances of the case, he could have structured his relations in such manner as to provide for these or as to be granted the means to be provided with these (collection of evidence in advance; decision of the Federal Fiscal Court of April 16, 1980, Federal Tax Gazette 1981 II p. 492). In relationships between head office and permanent establishment, this especially applies to the investigation and evidence necessary for the income allocation. Accordingly, a taxpayer shall not claim that his foreign permanent establishment or foreign head office has been unable to provide him with the necessary evidence or documents. 5.1.4 Increased cooperation duty In case it has to be relied on circumstances of the other division regarding the income allocation, under § 90 (2) General Fiscal Code the increased cooperation duty also extends to these circumstances. If need be, the taxpayer has to collect evidence in advance as set out in sec. 5.1.3. 5.2 Scope of the cooperation duty The cooperation duty extends to all circumstances that are relevant for the establishment and assessment of the attribution of income and property. This especially includes all data necessary for the examination of the attribution that is available or might be available given the required collection of evidence in advance, e.g. internal cost accounting, documents on the attribution of assets and on the determination of the value for deliveries of goods and services between head office and permanent establishment, documents and information of the entire group. As regards foreign permanent establishments of taxpayers subject to unlimited taxation, as a measure of control of a consistent allocation of the result and property in the home country and abroad, the tax returns and tax assessment notices filed in the state of the permanent establishment must usually be presented. 5.3 Legal consequences from insufficient cooperation In case a taxpayer breaches his duties pursuant to § 90 (2) General Fiscal Code and the facts cannot be clarified otherwise, the tax office may assume circumstances to the detriment of the taxpayer when assessing the tax base (§ 162 General Fiscal Code) that, under consideration of the taxpayer’s greater proximity to the proof and his responsibility to clarify the facts, have a certain degree of probability (decision of the Federal Fiscal Court of February 15, 1989, Federal Tax Gazette II p. 462).

107

D. Administrative Guidelines

6. Miscellaneous 6.1 Self-employed persons within the meaning of art. 14 OECD-Model Tax Convention The same principles that apply to the income from permanent establishments of commercial enterprises are also effective for self-employed persons who are resident in one state and have a fixed place available to them in another state. The provisions of art. 7 OECD-Model Tax Convention 92 as well as the Commentary on it may serve as guidelines for the interpretation and application of art. 14 OECD-Model Tax Convention 92. Accordingly, e.g. the principles of art. 7 OECD-Model Tax Convention 92 on the profit allocation between headquarters and permanent establishment may also be applied to the income allocation between the state of residence of a self-employed person and the state in which the work is performed by means of a fixed place. Likewise, when determining the income to be allocated to the fixed place the expenses incurred for the fixed place including management and general costs are deductible in the same manner as such expenses incurred for a permanent establishment. Art. 7 OECD-Model Tax Convention 92 and the respective Commentary may be of use in any other context to interpret art. 14 OECD-Model Tax Convention 92, e.g. regarding the question whether remuneration for software should be qualified as income within the meaning of art. 7 or 14 OECDModel Tax Convention or as license fees within the meaning of art. 12 OECD-Model Tax Convention 92 (see sec. 12 et seq. OECD- Commentary on art. 12 (2) OECD-Model Tax Convention 92). 6.2 First-time application The principles in the present case apply as of the assessment period 2000. Until then, it is not objected if it is proceeded in accordance with previous practice. 6.3 Repeal of other administrative regulations As of the assessment period 2000, the Circular of the Federal Ministry of Finance on the transfer of assets to a foreign permanent establishment whose income is exempt due to a double taxation agreement, and their retransfer to the domestic territory of February 12, 1990 (Federal Tax Gazette I p. 72) as well as the Circular on the transfer of assets from a domestic permanent establishment to the foreign head office of June 3, 1992 (IV B 2-S 2135-4/92; DB 1992 p. 1655) no longer apply. The same applies to the Circular of the Federal Ministry of Finance of May 31, 1979 (Federal Tax Gazette I p. 306) on the corporate income tax treatment of insurance companies subject to limited taxation, the Circular of August 24, 1984 (Federal Tax Gazette I p. 458) on the treatment of control and coordination offices of foreign groups in the Federal Republic of Germany, and the Circular of November 29, 1996 (Federal Tax Gazette 1997 I p. 136) regarding the dotation capital of domestic permanent establishment of foreign credit institutions. 108

II. Permanent Establishments (1999)

Appendix: Overviews on double taxation agreements (see Federal Tax Gazette 1999 I p. 122 regarding the effective date of application of the double taxation agreements) Appendix I: Basic elements (character of the permanent establishment) No. Double taxation agreement state

Permanent establishments are: fixed places of business through which the business of an enterprise is wholly or partly carried out

Especially: Place of Waremanagehouse ment, branch, office, factory, workshop (retail store or any other sales locations)

Permanent display of goods for sale

Premises for purchases or sales, inventory and other places of business that have the character of a fixed place of business

Mine, quarry, or other place of exploitation of natural resources

1

Egypt (UAR)

x

x

2

Argentina

x

x

3

Australia

x

x

x

x

4

Bangladesh

x

x

x

x

5

Belgium

x

x

x

6

Bolivia

x1

x

x

7

Brazil

x

x

x

8

Bulgaria

x

x

x

9

China (People’s Republic without Hong Kong)

x

x

x

Denmark

x

x

x

11

Ecuador

x2

x

x

12

Ivory Coast

x

x

x

13

Estonia

x

x

x

14

Finland

x

x

x

15

France

x

x

x

16

Greece

x

x

x

17

Great Britain

x

x

x

18

India

x

x

19

Indonesia

x

x

x

20

Iran

x

x

x

21

Ireland

x

x

x

22

Iceland

x

x

x

10

x x

x

x

x

109

D. Administrative Guidelines No. Double taxation agreement state

Permanent establishments are: fixed places of business through which the business of an enterprise is wholly or partly carried out

Especially: WarePlace of managehouse ment, branch, office, factory, workshop (retail store or any other sales locations)

Permanent display of goods for sale

Premises for purchases or sales, inventory and other places of business that have the character of a fixed place of business

Mine, quarry, or other place of exploitation of natural resources

23

Israel

x

x

24

Italy

x2

x

25

Jamaica

x

x

x

26

Japan

x

x

x

27

Yugoslavia3

x

x

x

28

Canada

x

x

x

29

Kazakhstan

x

x

x

30

Kenya

x

x

x

31

Korea (Rep.)

x

x

x

32

Kuwait

x

x

x

33

Latvia

x

x

x

34

Liberia

x

x

x

35

Lithuania

x

x

x

36

Luxembourg

x

x

x

37

Malaysia

x

x

x

38

Malta

x

x

x

39

Morocco

x

x

x

40

Mauritius

x

x

x

41

Mexico

x

x

x

42

Mongolia

x

x

x

43

Namibia

x

x

x

44

New Zealand

x

x

x

45

The Netherlands

x

x

x

46

Norway

x

47

Austria

x4

x

x

48

Pakistan

x

x

x

49

Philippines

x

x

110

x x

x x

x x x

II. Permanent Establishments (1999) No. Double taxation agreement state

Permanent establishments are: fixed places of business through which the business of an enterprise is wholly or partly carried out

Especially: WarePlace of managehouse ment, branch, office, factory, workshop (retail store or any other sales locations)

Permanent display of goods for sale

Premises for purchases or sales, inventory and other places of business that have the character of a fixed place of business

Mine, quarry, or other place of exploitation of natural resources

50

Poland

x

x

x

51

Portugal

x

x

x

52

Romania

x

x

x

53

Russian Federation

x

x

x

54

Zambia

x

x

x

55

Sweden

x

x

x

56

Switzerland

x

x

x

57

Zimbabwe

x

x

58

Singapore

x

x

59

Spain

x

x

x

60

Sri Lanka

x

x

x

61

South Africa

x

x

x

62

Thailand

x

x

x

63

Trinidad and Tobago

x

x

64

Czechoslovakia5

x

x

x

65

Turkey

x2

x

x

66

Tunisia

x

x

x

67

USSR (except nos. 53 and 68)

x6

68

Ukraine

x

x

x

69

Hungary

x

x

x

70

Uruguay

x1

x

x

71

USA

x7

x

x

72

Venezuela

x

x

x

73

United Arab Emirates

x

x

x

x x

x

x

x

111

D. Administrative Guidelines No. Double taxation agreement state

Permanent establishments are: fixed places of business through which the business of an enterprise is wholly or partly carried out

Especially: WarePlace of managehouse ment, branch, office, factory, workshop (retail store or any other sales locations)

Permanent display of goods for sale

Premises for purchases or sales, inventory and other places of business that have the character of a fixed place of business

Mine, quarry, or other place of exploitation of natural resources

74

Vietnam

x

x

x

75

Cyprus

x

x

x

1 Especially notes that the place of business must provide for the generation of income. 2 “fixed place of business in which the activity … must be carried out”. 3 Until further notice, the double taxation agreement with Yugoslavia of March 26, 1987 remains in effect for the Republic of Bosnia and Herzegovina, the Republic of Croatia, the Republic of Slovenia, the Republic of Macedonia, and the Federal Republic of Yugoslavia. 4 “fixed place of business of a commercial enterprise in which the activity … is carried out”. 5 Until further notice, the double taxation agreement with the Czechoslovak Socialist Republic of December 19, 1980 remains in effect for the Czech Republic and Slovakia. 6 “any fixed place through which a person resident in one of the contracting states carries out his business activity in the other contracting state either completely or partially”; the business activity includes the business and independently employed activity. 7 Special provision for concerts, theater, and other artistic events.

Appendix II: Building sites or constructions or installation projects Building sites or constructions or installation projects are considered as permanent establishments No. Double taxation agreement state

if their duration exceeds:

3 months

6 months

183 days

9 months

12 months

1

Egypt (UAR)

x

2

Argentina

x

3

Australia

x

4

Bangladesh

x

5

Belgium

6

Bolivia

7

Brazil

x

8

Bulgaria

x

112

Building and installation supervision as permanent establishment x

x

x x

II. Permanent Establishments (1999)

Building sites or constructions or installation projects are considered as permanent establishments No. Double taxation agreement state

if their duration exceeds:

3 months

6 months

183 days

9 months

12 months

9

China (People’s Republic without Hong Kong)

x

10

Denmark

x

11

Ecuador

x

12

Ivory Coast

13

Estonia

14

Finland

x

15

France

x

16

Greece

x

17

Great Britain

x

18

India

x

19

Indonesia

x

20

Iran

x

21

Ireland

x

22

Iceland

x

23

Israel

x

24

Italy

25

Jamaica

26

Japan

x

27

Yugoslavia1

x

28

Canada

x

Building and installation supervision as permanent establishment x

x x

x

1 Until further notice, the double taxation agreement with Yugoslavia of March 26, 1987 remains in effect for the Republic of Bosnia and Herzegovina, the Republic of Croatia, the Republic of Slovenia, the Republic of Macedonia, and the Federal Republic of Yugoslavia.

113

D. Administrative Guidelines

Building sites or constructions or installation projects are considered as permanent establishments No. Double taxation agreement state

if their duration exceeds:

3 months

6 months

183 days

9 months

12 months

Building and installation supervision as permanent establishment

29

Kazakhstan

30

Kenya

x

x

31

Korea (Rep.)

x

x

32

Kuwait

x

33

Latvia

x

34

Liberia

35

Lithuania

36

Luxembourg

x

37

Malaysia

x

38

Malta

39

Morocco

x

40

Mauritius

x

41

Mexico

x

42

Mongolia

x

43

Namibia

x

44

New Zealand

x

45

The Netherlands

x

46

Norway

x

47

Austria

x

48

Pakistan

x

49

The Philippines

x

50

Poland

51

Portugal

52

Romania

x

53

Russian Federation

x

114

x

x x

x

x

x

x

x x

x

II. Permanent Establishments (1999)

Building sites or constructions or installation projects are considered as permanent establishments No. Double taxation agreement state

if their duration exceeds:

3 months

6 months

183 days

9 months

12 months

x

Building and installation supervision as permanent establishment

54

Zambia

x

55

Sweden

x

56

Switzerland

x

57

Zimbabwe

x

58

Singapore

x

59

Spain

60

Sri Lanka

61

South Africa

62

Thailand

63

Trinidad and Tobago

64

Czechoslovakia1

65

Turkey

x

x

66

Tunisia

x

x

67

USSR (except nos. 53 and 68)

x

68

Ukraine

x

69

Hungary

x

70

Uruguay

x

71

USA

x

72

Venezuela

x

73

United Arab Emirates

74

Vietnam

x

75

Cyprus

x

x x x x

x

x x x

x

x

1 Until further notice, the double taxation agreement with the Czechoslovak Socialist Republic of December 19, 1980 remains in effect for the Czech Republic and Slovakia.

115

D. Administrative Guidelines

Appendix III: Permanent Representative Permanent establishments are constituted by (representatives or employees of foreign enterprises except brokers, commission agents, or other independent representatives who act on behalf of the enterprises under the ordinary business activity) No.

Double taxation agreement state

Fixed Persons who have Persons who Special Represenmaintain cases tatives of place of an authorization to stock that insurance business conclude contracts compa- or agency belongs to on behalf of the ennies for the terprise and who the enterprise and purchase exercise this regufrom which of goods larly, unless their activity is limited they reguof agrilarly carry culture or to the purchase of stockgoods or commod- out orders for breeding ities for the enterthe enterprise prise

1

Egypt (UAR)

x

2

Argentina

x

3

Australia

x

4

Bangladesh

x

5

Belgium

x

6

Bolivia

x

7

Brazil

x

8

Bulgaria

x

9

China (People’s Republic without Hong Kong)

x

10

Denmark

x

11

Ecuador

x

12

Ivory Coast

x

13

Estonia

x

14

Finland

x

15

France

x

16

Greece

x

17

Great Britain

x

18

India

x

x

19

Indonesia

x

x

116

Other

x x x x

x x

x

x

x

II. Permanent Establishments (1999)

Permanent establishments are constituted by (representatives or employees of foreign enterprises except brokers, commission agents, or other independent representatives who act on behalf of the enterprises under the ordinary business activity)

Other

Persons who have Persons who Special RepresenFixed maintain cases tatives of place of an authorization to insurance business conclude contracts stock that on behalf of the encompa- or agency belongs to for the terprise and who the enternies purchase prise and exercise this regularly, unless their of goods from which of agrithey reguactivity is limited to the purchase of larly carry culture or stockgoods or commod- out orders for the enterbreeding ities for the enterprise prise

No.

Double taxation agreement state

20

Iran

x

21

Ireland

x

22

Iceland

x

23

Israel

x

24

Italy

x

25

Jamaica

x

26

Japan

x

27

Yugoslavia1

x

28

Canada

x

29

Kazakhstan

x

30

Kenya

x

x

31

Korea (Rep.)

x

x

32

Kuwait

x

33

Latvia

x

34

Liberia

x

35

Lithuania

x

36

Luxembourg

x

37

Malaysia

x

38

Malta

x

x

x

1 Until further notice, the double taxation agreement with Yugoslavia of March 26, 1987 remains in effect for the Republic of Bosnia and Herzegovina, the Republic of Croatia, the Republic of Slovenia, the Republic of Macedonia, and the Federal Republic of Yugoslavia.

117

D. Administrative Guidelines

Other

Permanent establishments are constituted by (representatives or employees of foreign enterprises except brokers, commission agents, or other independent representatives who act on behalf of the enterprises under the ordinary business activity)

Persons who have Persons who Special RepresenFixed maintain cases tatives of place of an authorization to insurance business conclude contracts stock that on behalf of the encompa- or agency belongs to for the terprise and who the enternies purchase prise and exercise this regularly, unless their of goods from which of agrithey reguactivity is limited to the purchase of larly carry culture or stockgoods or commod- out orders for the enterbreeding ities for the enterprise prise

No.

Double taxation agreement state

39

Morocco

x

40

Mauritius

x

41

Mexico

x

42

Mongolia

x

43

Namibia

x

44

New Zealand

x

45

The Netherlands

x

46

Norway

x

47

Austria

x

x

48

Pakistan

x

x

49

The Philippines

x

x

50

Poland

x

51

Portugal

x

52

Romania

x

53

Russian Federation

x

54

Zambia

x

55

Sweden

x

56

Switzerland

x

57

Zimbabwe

x

58

Singapore

x

118

x x

x

x

II. Permanent Establishments (1999)

Other

Permanent establishments are constituted by (representatives or employees of foreign enterprises except brokers, commission agents, or other independent representatives who act on behalf of the enterprises under the ordinary business activity)

Persons who have Persons who Special RepresenFixed maintain cases tatives of place of an authorization to insurance business conclude contracts stock that on behalf of the encompa- or agency belongs to for the terprise and who the enternies purchase prise and exercise this regularly, unless their of goods from which of agrithey reguactivity is limited to the purchase of larly carry culture or stockgoods or commod- out orders for the enterbreeding ities for the enterprise prise

No.

Double taxation agreement state

59

Spain

x

60

Sri Lanka

x

61

South Africa

x

62

Thailand

x

x

63

Trinidad and Tobago

x

x

64

Czechoslovakia1

x

65

Turkey

x

66

Tunisia

x

67

USSR (except nos. 53 and 68)

x

68

Ukraine

x

69

Hungary

x

70

Uruguay

x

71

USA

x

72

Venezuela

x

73

United Arab Emirates

x

74

Vietnam

x

75

Cyprus

x

x

x

x x

x

1 Until further notice, the double taxation agreement with the Czechoslovak Socialist Republic of December 19, 1980 remains in effect for the Czech Republic and Slovakia.

119

D. Administrative Guidelines

Appendix IV: Facilities not constituting permanent establishments No.

Double taxation agreement state

Facilities used only for storage, display, or delivery of goods of the enterprise

Stocks of the enterprise that is only

maintained for storage, display, or delivery

maintained for changing or processing purposes by another enterprise

Fixed place of business maintained solely for the purpose of

purchasing goods or commodities or gathering information for the enterprise

Speadvertising, furnishing infor- cial cases mation, performing scientific research, or similar activities of a preparatory or auxiliary nature for the enterprise

1

Egypt (UAR)

x

x

2

Argentina

x

x

3

Australia

x

x

4

Bangladesh

x

5

Belgium

6

Bolivia

7

Brazil

x

x

8

Bulgaria

x

x

9

China (People’s Republic without Hong Kong)

x

x

x

x

x

10

Denmark

x

x

x

x

x

11

Ecuador

x

x

x

x

x

12

Ivory Coast

x

x

x

13

Estonia

x

x

x

x

14

Finland

x

x

x

x

x

15

France

x

x

x

x

x

16

Greece

x

x

x

x

x

17

Great Britain

x

x

x

x

x

18

India

x

x

x

x

x

19

Indonesia

x

x

x

x

x

20

Iran

x

x

x

x

x

21

Ireland

x

x

x

x

x

22

Iceland

x

x

x

x

x

23

Israel

x

x

x

x

x

120

x

x

x

x

x

x

x

x

x

x

x

x

x

x

x

x

x

x

x

x

x

x

x

x

x

x

x

x

x x

II. Permanent Establishments (1999) No.

Double taxation agreement state

Facilities used only for storage, display, or delivery of goods of the enterprise

Stocks of the enterprise that is only

Fixed place of business maintained solely for the purpose of

maintained for storage, display, or delivery

maintained for changing or processing purposes by another enterprise

purchasing goods or commodities or gathering information for the enterprise

Speadvertising, furnishing infor- cial cases mation, performing scientific research, or similar activities of a preparatory or auxiliary nature for the enterprise

24

Italy

x

x

x

x

x

25

Jamaica

x

x

x

x

x

26

Japan

x

x

x

x

x

27

Yugoslavia1

x

x

x

x

x

28

Canada

x

x

x

x

x

29

Kazakhstan

x

x

x

x

x

30

Kenya

x

x

x

x

x

31

Korea (Rep.)

x

x

x

x

x

32

Kuwait

x

x

x

x

33

Latvia

x

x

x

x

x

34

Liberia

x

x

x

x

x

35

Lithuania

x

x

x

x

x

36

Luxembourg

x

x

x

x

x

37

Malaysia

x

x

x

x

x

38

Malta

x

x

x

x

x

39

Morocco

x

x

x

x

x

40

Mauritius

x

x

x

x

x

41

Mexico

x

x

x

x

x

42

Mongolia

x

x

x

x

43

Namibia

x

x

x

x

44

New Zealand

x

x

x

x

x

45

The Netherlands

x

x

x

x

x

x x

1 Until further notice, the double taxation agreement with Yugoslavia of March 26, 1987 remains in effect for the Republic of Bosnia and Herzegovina, the Republic of Croatia, the Republic of Slovenia, the Republic of Macedonia, and the Federal Republic of Yugoslavia.

121

D. Administrative Guidelines No.

Double taxation agreement state

Facilities used only for storage, display, or delivery of goods of the enterprise

Stocks of the enterprise that is only

Fixed place of business maintained solely for the purpose of

maintained for storage, display, or delivery

maintained for changing or processing purposes by another enterprise

purchasing goods or commodities or gathering information for the enterprise

x

x

x

x

Speadvertising, furnishing infor- cial cases mation, performing scientific research, or similar activities of a preparatory or auxiliary nature for the enterprise

46

Norway

x

47

Austria

48

Pakistan

x

x

x

x

49

The Philippines

x

x

x

x

50

Poland

x

x

x

x

x

51

Portugal

x

x

x

x

x

52

Romania

x

x

x

x

53

Russian Federation

x

x

x

x

54

Zambia

x

x

x

x

x

55

Sweden

x

x

x

x

x

56

Switzerland

x

x

x

x

x

57

Zimbabwe

x

x

x

x

58

Singapore

x

x

x

x

x

59

Spain

x

x

x

x

x

60

Sri Lanka

x

x

x

x

x

61

South Africa

x

x

x

x

x

62

Thailand

x

x

x

x

x

63

Trinidad and Tobago

x

x

x

x

x

64

Czechoslovakia1

x

x

x

x

x

65

Turkey

x

x

x

x

66

Tunisia

x

x

x

x

x

x x

x

1 Until further notice, the double taxation agreement with the Czechoslovak Socialist Republic of December 19, 1980 remains in effect for the Czech Republic and Slovakia.

122

II. Permanent Establishments (1999) No.

Double taxation agreement state

Facilities used only for storage, display, or delivery of goods of the enterprise

Stocks of the enterprise that is only

Fixed place of business maintained solely for the purpose of

maintained for storage, display, or delivery

maintained for changing or processing purposes by another enterprise

purchasing goods or commodities or gathering information for the enterprise

Speadvertising, furnishing infor- cial cases mation, performing scientific research, or similar activities of a preparatory or auxiliary nature for the enterprise

67

USSR (except nos. 53 and 68)

x

x

x

x

x

68

Ukraine

x

x

x

x

69

Hungary

x

x

x

x

x

70

Uruguay

x

x

x

x

71

USA

x

x

x

x

x

72

Venezuela

x

x

x

x

73

United Arab Emirates

x

x

x

x

74

Vietnam

x

x

x

x

75

Cyprus

x

x

x

x

x

Table 1: Legal forms of international enterprises (except Eastern Europe) State

Abbreviation

Legal form

Comparable with

Sociedad de responsabilidad limitada Sociedad Anónima Sociedad en comandita por acciones Sociedad en comandita Sociedad colectiva Sociedad cooperativa Sociedad accidentale o en participación

GmbH AG KGaA KG OHG Gen. No comparable German legal form

Pty Ltd

Proprietary limited Company

GmbH

PC Ltd

Public Company limited by shares Limited Partnership Partnership

AG KG OHG

Argentina

Australia

123

D. Administrative Guidelines

State

Abbreviation

Legal form

Comparable with

Belgium

SPRL or BVBA

Société privée a responsabilité limitée Or Besloten vennootschap met beperkte aansprakelijkheid Société d’une personne a responsabilité limitée Société anonyme Or Naamloze Vennootschap Société Coopérative

GmbH

SPRLU S.A. or N.V.

Or Kooperative Vennootschap Société en commandite par actions Societe en commandite simple Or Kommanditaire Vennootschap Société en nom collectif Brazil

Ltda

AG No comparable German legal form KGaA KG OHG

Sociedade por Quotas de Responsabilidade Limitada Sociedade Anonima Sociedade Anomina de Capital Aberta

GmbH

Sociedade Anonima de Capital Fechada

geschl. AG

Sociedade em Comandita Sociedade em Nome Colectivo Sociedade em Conta de Participacao

KG OHG stille Gesellschaft

Aps

Anpartsselskab

GmbH

A/S K/S

Aktieslskab Kommanditselskab Kommanditselskab (with AG as limited partner) Interessentskab Andelsselskab

AG KG KGaA

SA Compania aberta Compania fechada

Denmark

Einmann-GmbH

I/S AmbA

AG offene AG

OHG eingetr. Genossenschaft mbH

Finland

OY

Osakeyhtiö Kommandittiyhiö Avoin Ightiö Osuuskunta

AG KG OHG Genossenschaft

France

SARL SA

Société de responsabilité limitée Société anonyme Société en commandite simple Société en commandite par actions Société en nom collectif Groupement d’intérêt économique Société coopérative Société en participation Société civile

GmbH AG KG KGaA OHG ARGE Genossenschaft Stille Gesellschaft GbR

SNC GIE SP SC

124

II. Permanent Establishments (1999)

State

Abbreviation

Legal form

Comparable with

Société crée de fait

No comparable German legal form Einmann-GmbH

EURL

Entreprise unipersonnelle a responsabilité limitée

Greece

EPE AG EE O.E.

Etairia periorismenis evthinis Anonynos Etairia Eterrorrythmos Omorrythmos

GmbH AG KG OHG

Great Britain

Ltd.

Private Company limited by shares

GmbH

Plc

Public Company limited by shares Limited Partnership Partnership (Private) Unlimited company Cooperative society Company limited by guarantee

AG KG OHG KapGes Genossenschaft Gemein. Körperschaft No comparable German legal form

Statutory company Ireland

PrC PLC Ltd.

Private company limited by shares Public company limited by shares Limited Partnership Partnership Cooperative Society Company limited by Guarantees

Unlimited Company

GmbH AG KG OHG Genossenschaft Gemein. Körperschaft No comparable German legal form No comparable German legal form No comparable German legal form Kap.Ges.

Società a responsabilità limitata Società per azioni Società a accomandita Società a accomandita per azioni

GmbH AG KG KGaA

Mitsubishi Kaisha Kabushiki Kaisha Goshi Kaisha Gomai Kaisha

GmbH AG KG OHG

Corporation

AG

Limited Partnership General Partnership

KG OHG

GmbH

Gesellschaft mit beschränkter Haftung

GmbH

AG

Aktiengesellschaft Anstalt Stiftung Treuhandunternehmen

AG jur. Person jur. Person jur. Person

Statutory Company Chartered Company Oversea Company

Italy

S.r.L. S.p.A. S.a. S.u.p.a.

Japan

Canada

Liechtenstein

Ltd. Inc. od. and.

125

D. Administrative Guidelines

State

Abbreviation

Legal form

Comparable with

Luxembourg

S.a.r.l.

Société a responsabilite limitée

GmbH

S.A.

Société anonyme Société en commandite Société en commandite par actions

AG KG KGaA

BV

Besloten Vennootschap met beperkte aansprakelijkheid

GmbH

NV CVoA CV VoF

Naamloze Vennootschap Commanditaire Vennootschap op Andelen Commanditaire Vennootschap Vennootschap onder Firma

AG KGaA KG OHG

GmbH oder Ges. m.b.H. AG KG OHG

Gesellschaft mit beschränkter Haftung

GmbH

Aktiengesellschaft Kommanditgesellschaft Offene Handelsgesellschaft

AG KG OHG

L.da

sociedade por quontas (additional trade GmbH name: sociedade com responsabilidade limitada or limitada -lda) estabelecimento mercantil individual de re- Einzelhandelsunsponsabilidade limitada ternehmen mit beschr. Haftung sociedade anonima (sociedade anonima re- AG sponsabilidade limitada) sociedade em comandita KG sociedade em nome colectivo OHG sociedade civil GbR parcarias maritimas Partenreederei

The Netherlands

Austria

Portugal

EIRL S.A. (SARL)

Sweden

AB

Aktiebolag Handelsbolag Kommanditbolag Enkeltbolag Enskild Firma Kreditavtel med delta gande vid vinst och forlust

AG OHG KG GbR Einzelkaufmann Stille Gesellschaft

Switzerland

GmbH

Gesellschaft mit beschränkter Haftung

GmbH

AG/SA

Aktiengesellschaft Kommanditaktiengesellschaft Kommanditgesellschaft Einfache Gesellschaft Genossenschaft

AG KGaA KG GbR Genossenschaft

Private Company Limited by Shares (possible as Private or Public Company) Company Limited by Guarantee Unlimited Company Limited Partnership Partnership

GmbH

KG

Singapore

126

GmbH KG OHG

II. Permanent Establishments (1999)

State

Abbreviation

Legal form

Comparable with

Spain

SRL

Sociedad de Responsabilidad Limitada (Sociedad Limitada) Sociedad Anonima Sociedad en Comandita Sociedad Regular Colectiva Compania Sociedad commanditaria por acciones

GmbH

Private or Propriety Company (Limited by shares) Public Company (Limited by shares)

GmbH

Company limited by Guarantee Partnership

Mitunternehmerschaft OHG

Anonim Sirket Limited Sirket Kollektiv Sirket Komandit Sirket

AG GmbH OHG KG

Hisseli Komandit Sirket

KGaA

Business Corporation (Public Corporation, Close Corporation) Joint Stock Association (Company)

AG

SA SC SrC South Africa

(Pty) Ltd Ltd or BpK

Turkey

A.S. Kol.SrK. Kom.SrK.

USA

Corp. Inc. Ltd. JSA

Limited Partnership General Partnership Unincorporated Joint Venture Business Trust PTLP

Public Traded Limited

AG KG OHG KGaA

AG

Hybrid: Kap.Ges., Pers.Ges. KG OHG Gelegenh.Ges.: GbR No comparable German legal form KG mit Börsenzulassung (Kap.Ges.)

Table 2: Legal forms of Eastern European enterprises State and legal form

Abbreviation

Comparable legal form

Poland 1. Spólka Akcyjna 2. Spólka z ograniczona odpowiedzialnoscia 3. Spólka komandytowa 4. Spólka prawa cywilnego (Spolka cywilna) 5. Spólka handlowa jawna

S.A. Sp.z.o.o. S.K. S.c.

AG GmbH KG GbR OHG

spol.s.r.o.

GmbH

a.s. ver.obch.spol. or v.o.s. kom.spol. or k.s.

AG OHG

Czech/Slovak Republic 1. Spolecnost s rucen im, omezenim or s rucenim omezenim 2. Akiová spulecnost 3. Verejná obchodni spolecnost 4. Komanditni spolecnost

KG

127

D. Administrative Guidelines

State and legal form Hungary 1. Részvénytársaság 2. Korlátolt felelösségü társaság 3. Közkereseti társaság 4. Betéti társaság 5. Ipari Szövetkezet Bulgaria 1. Zabiratelno drushestwo 2. Komanditno drushestwo 3. Drushestwo s organitschena otgowornost 4. Aktionierno drushestwo 5. Komanditno drushestwo s. akzii

Abbreviation

Comparable legal form

rt kft kkt bt No abbreviation

AG GmbH OHG KG Industriegenossenschaften

KD ocD AD KDA

OHG KG GmbH AG KGaA

Croatia 1. Akzomarskoje Obtschestwo 2. Obtschestwo or Organisazia za Organitschenom otgowomosti

AG GmbH

Slovenia (as of June 10, 1993) 1. Delniska druzba 2. Druz z omejeno odgovornostjo 3. Komanditna druzba 4. Komanditna delniska druzba 5. Tilna druzba 6. Gospordarsko interesno zdruzenje

d.d. d.o.o. k.d. k.d.d. t.d. g.i.z.

7. Druzba z neomenjeno odgovornostjo

d.n.o.

AG GmbH KG KGaA Stille Gesellschaft Complies with French Economic Interest Grouping OHG

Romania 1. societate pe actiuni 2. societate cu raspundere limitada 3. societate in comandita simpla 4. societate in nume colectiv 5. societate in comandita pe actiuni

S.A. S.R.L. S.C.S. S.N.C. S.C.A.

AG GmbH KG OHG KGaA

128

III. Cost Sharing Agreements (1999)

III. Cost Sharing Agreements (1999) Administrative Circular on the Guidelines for the Examination of the Income Allocation by Cost Sharing Agreements Between Internationally Affiliated Enterprises (Administrative Guidelines – Cost Sharing Agreements) Published on December 30, 1999 (IV B 4 – S 1341 – 14/99, Federal Tax Gazette 1999 I p. 1122)

With regard to the results of the discussion with the highest tax authorities of the Federal States, the following is applicable regarding the examination of the income allocation between internationally affiliated enterprises using cost sharing agreements: Content 1. Preface. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1 Definition. . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2 Members of the pool . . . . . . . . . . . . . . . . . . . 1.3 Cost sharing agreement . . . . . . . . . . . . . . . . . 1.4 Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.5 Elimination of double compensation . . . . . . . . 1.6 Capitalization . . . . . . . . . . . . . . . . . . . . . . . . 1.7 Services rendered by non-pool members . . . . . 2. Allocable amount . . . . . . . . . . . . . . . . . . . . . . . . . 2.1 Determination of expenses. . . . . . . . . . . . . . . 2.2 Profit mark-up. . . . . . . . . . . . . . . . . . . . . . . . 3. Cost allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1 Principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2 Allocation key. . . . . . . . . . . . . . . . . . . . . . . . 3.3 Adjustment. . . . . . . . . . . . . . . . . . . . . . . . . . 3.4 Levying of charges . . . . . . . . . . . . . . . . . . . . . 4. Special cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.1 Subsequent entry. . . . . . . . . . . . . . . . . . . . . . 4.2 Premature withdrawal, termination . . . . . . . . 4.3 Rearrangements . . . . . . . . . . . . . . . . . . . . . . 4.4 Withholding tax . . . . . . . . . . . . . . . . . . . . . . 5. Documentation and verification . . . . . . . . . . . . . . 5.1 Documentation . . . . . . . . . . . . . . . . . . . . . . . 5.1.1 Form and substance . . . . . . . . . . . . . . . 5.1.2 Documentation of expenses and services 5.1.3 Documentation of the expected benefit . 5.1.4 Documentation by the service recipient .

. . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . .

130 130 130 131 131 131 131 132 132 132 133 133 133 134 134 134 135 135 135 136 136 136 136 136 137 137 138

129

D. Administrative Guidelines

5.2 Verification . . . . . . . . . . . . . . . . . . . . 6. Deficiencies in the cost sharing agreement . 7. Repeal of administrative provisions . . . . . . 8. Transitory rules . . . . . . . . . . . . . . . . . . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

138 138 139 139

1. Preface These administrative guidelines aim at providing the provisions for the application of the arm’s length principle if internationally affiliated enterprises structure their relationships by cost sharing agreements. The individual settlement of services remains unaffected by this regardless of whether the transfer price is determined pursuant to the direct or indirect method. 1.1 Definition Cost sharing agreements within the meaning of this letter are agreements that are concluded among internationally affiliated enterprises in order to receive or to render services by cooperating in a pool for mutual interest, during a longer time period. The services must be rendered in the interest of the receiving enterprise and in expectation of a benefit, e.g. by saving costs or increasing revenues. The services relate to auxiliary functions of the pool members and are assessed on an aggregated basis or may consist of a range of individual services. Such cost sharing agreements are based on the idea of a cost pool. The costs may affect all service categories, e.g. research and development, acquisition of assets, administrative, or other services. The expenses incurred for pool purposes are – as the case may be, limited to an amount – allocated according to a key based on the benefit received by the pool members. In this context, the enterprises form an undisclosed partnership without constituting a co-entrepreneurship or a permanent establishment. 1.2 Members of the pool Only enterprises with similar interests may be members of a pool qualifying for tax purposes, i.e. the members use the services provided for the pool in a similar economic manner. The services are bundled for purposes of joint acquisition, development or manufacture of goods, services, or rights in order to benefit mutually from the combination of resources or capacities. Accordingly, the group of participants in such cost sharing agreements is restricted to enterprises that themselves benefit from the services they render towards the undisclosed partnership, i.e. the members use their share in the achievements of the joint activity. 130

III. Cost Sharing Agreements (1999)

In a research and development pool for example, holding or patent utilization enterprises have different interests than manufacturing enterprises and therefore cannot be members of a research and development pool. However, this does not prevent them from concluding license agreements with the pool. Contractual partners that render services in the interest of the pool members without using or exploiting the achievements themselves (mere contractors) are not included in the cost sharing agreement (see sec. 1.7). 1.3 Cost sharing agreement Pursuant to commercial practice, a cost sharing agreement must be concluded in advance in writing, must meet minimum requirements, and be supplemented by proper documentation (see sec. 5). The terms and conditions of the cost sharing agreement must be observed. 1.4 Services Services within a pool may be rendered by one, several, or jointly by all pool members except for an acquisition pool (see sec. 1.7). Accordingly, an exchange of service does not take place because the allocated expenses are treated as the own original expenses of the pool members. Enterprises receiving services may be granted a certain title with a specified nature and scope to access services themselves or to place orders to the enterprise rendering services. If different services are supplied, these must be recorded and assessed for each service category, e.g. when a pool member renders services for research and development pools and also supplies different kinds of administrative services. 1.5 Elimination of double compensation In case costs are allocated based on cost sharing agreements, the allocated costs cannot be charged a second time to the service recipient, e.g. by invoicing for deliveries or services. In conducting the cost sharing agreement, there is no additional compensation for making available intangible assets, supplying know-how and services that the pool members may claim under the cost sharing agreement. 1.6 Capitalization Pursuant to § 5 (2) Income Tax Act, the capitalization of intangible assets created within the scope of the cost sharing agreement is left out of consideration. Regarding the capitalization of buy-in payments, see sec. 4.1.

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1.7 Services rendered by non-pool members The pool may also receive services from an affiliated company that is not a member of the pool (acquisition pool) e.g. by way of contract research. The services of this enterprise must be charged to the pool at arm’s length prices (see decision of the Federal Fiscal Court of June 23, 1993 – Federal Tax Gazette 1993 II p. 801). If no appropriate arm’s length prices are available, the services shall usually be invoiced using the cost plus method. The amount quoted to the pool must be attributed to the pool members by way of allocation. Example: The companies A, B, C, situated in different countries, are part of the M-Group and until now have carried out their own research activities. In order to avoid duplicate effects, they establish a research pool in which the research activities are carried out by A only. The expenses of A amount to 126. B carries out coordination activities because the research pool also receives research services from D, a group company. The expenses of company B amount to 6 and of D to 60. The companies A, B, C participate in the result in equal terms. A

B

C

D

Total

126

6

–

60

192

–

–

–

3

3

Total

126

6

–

63

195

Cost allocation

65

65

65

–

195

Reimbursement

61

–

–

63

124

Payment

–

59

65

–

124

Expenses Profit mark-up

2. Allocable amount 2.1 Determination of expenses The allocable amount is based on the direct and indirect expenses that have actually incurred and that are economically related to the services rendered or to be rendered. In principle, the expenses must be determined according to the accounting provisions of the state in which the enterprise rendering the services conducts its business. The non-deductibility of the costs allocated to a domestic service recipient is determined by German tax law; e.g. pursuant to § 160 General Fiscal Code and § 4 (5) Income Tax Act. The expenses must be precisely specified. In case several pool members render the agreed service, the expenses may be determined in accordance with the applicable accounting provisions of one country or the principles applicable for the preparation of a consolidated balance sheet of the enterprises, provided that the tax authorities of the countries in which the services are rendered do not oppose this procedure.

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The expenses must be reduced by earnings (including subsidies and supplementary allowances) that are economically connected to the expenses. The same is applicable to special tax advantages like special allowances for depreciation. If intangible assets that have been created under the cost sharing agreement are licensed by the pool, income from royalties reduces the allocable amount. If particular contributions in kind are rendered by pool members, these are not considered as a transfer of assets but rather as a surrender of use, the value of which must be assessed according to the expenses incurred. The fair market value at the time of the transfer and the remaining useful life applies to tangible assets already depreciated. As regards intangible assets, it is not opposed to estimating the expenses based on an appropriate license fee minus the usual profit portion. In calculating the expenses, an interest on the equity employed in the enterprise as shown in the tax balance sheet may be included at the credit interest rate applicable to the currency of the country in which the economic activity is performed. In case expenses for different services are invoiced under a unitary cost sharing agreement, the expenses to be allocated must be determined separately for each service category (see also sec. 1.4, para. 3). A set-off of benefits is neither permitted between the individual service categories nor other services not subject to the cost sharing arrangement. 2.2 Profit mark-up A profit mark-up on the allocable expenses cannot be accepted for tax purposes with regard to the mutual purpose of the pool and the absence of an entrepreneurial risk for the service-rendering enterprise. Sec. 2.1 para. 4 remains unaffected.

3. Cost allocation 3.1 Principle The allocable expenses are attributed based on the benefit that each pool member expects for himself. The expected benefit is determined according to economic principles and under consideration of all circumstances and developments that are reasonably predictable at the time the agreement is concluded. Accordingly, the basis for the cost allocation and the allocation key itself must be determined. In case different services are subject to a cost sharing agreement, the benefit for each service must be determined separately. A sound and prudent business manager will not participate in the cost sharing if it is obvious from the outset that compared to the cost sharing 133

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agreement he can obtain comparable services more easily and at a reduced rate by means of individually invoiced services. Accordingly, a sound and prudent business manager will not continue a cost sharing agreement in the existing form if it is evident after an appropriate period of time that the allocation is less favorable compared to the expenses for individually received services. Non-quantifiable benefits based on being associated to the group remain unconsidered. The arm’s length principle does not exclude that cost allocation contributions to research and development pools that proved to be unsuccessful may be accepted from a tax point of view. An allocation based on a cost sharing agreement can only be accepted tax wise to the extent it does not permanently exceed the arm’s length price for the services rendered. An allocation based on a percentage of the turnover of the enterprise receiving the services or a similar reference figure cannot be accepted for tax purposes if the percentage is not connected to the expenses. 3.2 Allocation key The key which is most objective in the individual case must be chosen. If several keys prove to be equivalent, it is at the discretion of the business manager which key he selects. The allocation key may be based e.g. on the used, manufactured, sold, or expected units of a product line, cost of materials, machine hours, number of employees, payroll total, value added, capital invested, operating profit, and turnover. Other allocation keys may result from the circumstances in the individual case. Accordingly, combined allocation keys may for instance be derived from weighting different factors. 3.3 Adjustment Unaffiliated parties would examine after an appropriate time period whether the benefit actually gained is consistent with the anticipated benefit. The point in time of the review is determined by the degree of uncertainty connected to the assumptions. Essential changes must be considered by adjusting the cost allocation, i.e. regularly by adjusting the allocation key. A timely review will only lead to adjustments in the future. 3.4 Levying of charges In case prepayments are made or the cost allocation is based on budgeted expenses (projected figures), the final invoicing based on the actual expenses must be made before the balance sheet has been generated for each respective accounting year.

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4. Special cases 4.1 Subsequent entry Enterprises that participate in a cost sharing agreement at a later point in time must make a buy-in payment in case the present pool members surrender tangible and intangible achievements to the new entering party. The buy-in payments shall be determined according to the arm’s length principles. The achievements may e.g. be intangible assets, semi-finished work, or knowledge gained from preceding activities. This means that payments for unsuccessful research activities may also have to be considered. This applies if a sound and prudent business manager would have requested and paid remuneration for the increase in knowledge obtained therewith. In case the entering party has approximately the same level of knowledge as the present pool members, a buy-in payment will generally not be necessary. In all cases of buy-in payments the present pool members transfer part of their respective shares in the achievements obtained from past activities. The acquiring enterprise has to capitalize the buy-in payments. In case the entering enterprise renders benefits in kind in lieu of a buy-in payment or for other reasons, sec. 2.1 para. 3 is applicable accordingly. If the cost sharing agreement refers to administrative services, a buy-in payment will generally not be appropriate. 4.2 Premature withdrawal, termination If pool members withdraw before maturity and may derive additional benefits from the achievements hitherto, e.g. by third-party exploitation or if they additionally burden the remaining pool members, an arm’s length buy-out payment to the remaining pool members may need to be considered. This is always applicable if the withdrawal of a pool member leads to an identifiable and quantifiable decline in the value of the continuing cost sharing agreement because the remaining pool member e.g. transfer or surrender to the withdrawing partner existing rights on intangible assets, semi-finished work or knowledge gained within the scope of the cost sharing agreement. Buy-out payments will usually not be made in case the cost sharing agreement only refers to services the pool members jointly acquire and for which they make continuous payments, unless assets or rights are created by rendering the services. To the extent that, after a pool member has left, the achievements accomplished hitherto will only be to the benefit of the remaining pool members, a compensation payment to the withdrawing member may be justified. This is always applicable if the withdrawing member transfers its proprietary rights resulting from the cost sharing agreement to the remaining pool members. 135

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In case the participants terminate a cost sharing agreement, they are entitled to the individual share in the achievements of the pool that complies with the contributions made to the pool during the contractual period by means of buy-in or compensation payments. 4.3 Rearrangements If the cost sharing agreement is rearranged in such a way that the contractual partners that refrain from a license agreement for their share in the achievements of the cost sharing agreement for the benefit of the future licensor(s), they must receive appropriate compensation for having resigned their share. In case the participants terminate a cost sharing agreement referring to research and development and substitute it by a license agreement without transferring the shares in the achievements of the cost sharing agreement to the licensor, it must be considered that the present pool members may use the know-how gained and the intangible assets created at least for a transitory period. 4.4 Withholding tax The cost allocation is not liable to withholding tax based on § 50a (4) Income Tax Act. Withholding tax imposed on license fees for having granted licenses to third parties to which the pool members as such are entirely entitled can only be claimed proportionally by each individual pool member. To the extent that the pool member that legally owns the rights on the intangible assets claims the total foreign withholding tax in his taxation, compensation must be made to the other pool members. In case a foreign pool member makes available the use of intangible assets to a domestic servicerendering pool member, withholding tax must be imposed on the remuneration to be paid where the prerequisites of § 50a (4) Income Tax Act are fulfilled. The imposition of withholding tax is not affected if the remuneration is offset with the cost contribution.

5. Documentation and verification 5.1 Documentation 5.1.1 Form and substance A cost sharing agreement to be accepted for tax purposes must be in writing; it must meet the following minimum requirements and, where applicable, include appendices, attachments, or additional agreements:

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(1) Names of the pool members and other affiliated beneficiaries; (2) Detailed description of the services that are the subject of the agreement; (3) Determination of the allocatable expenses, the method of cost accounting and potential deviations; (4) Determination of the benefit the respective members anticipate; (5) Determination of the allocation key; (6) Description of how the value of initial and later service contributions is determined and uniformly charged to all pool members; (7) Nature and scope of the invoice checking (e.g. for prepayments; point in time); (8) Stipulations for adjustment to changed circumstances; (9) Contractual period; (10) Regulations regarding the termination of the agreement and, where applicable, the prerequisites and consequences of the entrance of new pool members and the premature withdrawal of present pool members; (11) Agreements relating to the access to documents and records regarding the expenses and the services of the service-rendering enterprise; and (12) Allocation of the rights of use originating from central activities of the pool in case of research and development. 5.1.2 Documentation of expenses and services The services rendered to the pool members and the expenses associated with these must be verifiably documented. This particularly applies to cases where different services are combined in a uniform cost sharing agreement. If indirect expenses are attributed, the basis for the attribution must be documented. Income generated in connection with the cost sharing agreement must be recorded separately. 5.1.3 Documentation of the expected benefit The determination of the expected benefit is particularly of importance. The expected benefit may be documented using problem analysis, project reports, targets, and similar documents. The documents must also reveal to what extent other group members may draw benefits from the cost sharing agreement.

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5.1.4 Documentation by the service recipient The documentation of the service recipient must include: (1) The cost sharing agreement including appendices, attachments and supplements; (2) Unless already included in the agreement or the appendices: documentation to justify the cost allocation paid, especially with regard to the expected services and benefit, the allocation key, and the allocation standard (extent of the benefit compared to that of other service recipients, allocation of expenses that is source-based and use-oriented); (3) Arrangements for prepayments; (4) Annual settlement of the actual expenses: schedule of total expenses according to cost centers and allocation to the pool members; classification of direct and indirect expenses according to cost categories, e.g. personnel costs, travelling expenses, office rent, depreciation, third party licenses, IT costs, warehousing costs; proof of payment; (5) Documentation of services actually received and the benefit gained, e.g. monthly, quarterly or annual statements on single services and projects of the enterprise rendering the services, correspondence, visitor reports, minutes of meetings regarding single projects; research results in report form, schedule of applications for patents, press releases, beginning of the manufacture of new products, improvements or innovations in the fabrication of aged products. 5.2 Verification In principle, the cost sharing agreement can only be used for the income allocation tax wise if the documentation requirements are met. The tax authority may request information, documents, and evidence pursuant to § 90 (2) General Fiscal Code that are necessary in the individual case. Upon request of the tax authority the service recipient is obliged to immediately submit the documents of the service rendering enterprise.

6. Deficiencies in the cost sharing agreement In case the cost sharing agreement contains serious deficiencies that a sound and prudent business manager would not have participated in such an agreement, the deduction of business expenses shall be denied. If a sound and prudent business manager would have only participated by contributing a lower payment, the deduction of business expenses is permitted to that extent only. The deductible amount shall be estimated (§ 162 General Fiscal Code). The tax authority may also estimate the admissible deduction of business expenses in other cases, e.g. if the allocation cannot be verified in default of adequate documentation. It can as138

III. Cost Sharing Agreements (1999)

sume facts and circumstances that are supported by a certain degree of probability.

7. Repeal of administrative provisions Sec. 7 of the Administrative Circular on the Guidelines for the Examination of the Income Allocation Between Internationally Affiliated Enterprises (Administrative Guidelines – Income Allocation) of February 23, 1983 (Federal Tax Gazette I p. 218) is repealed.

8. Transitory rules To the extent that adjustments to existing cost sharing agreements are deemed necessary due to the aforementioned remarks, these must be made by December 31, 2000 at the latest. If such are not made, sec. 6 is applicable.

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IV. Personnel Secondment (2001) Administrative Circular on the Guidelines for the Examination of the Income Allocation between Internationally Affiliated Enterprises in Cases of Personnel Secondment (Administrative Guidelines – Personnel Secondment) Published on November 9, 2001 (IV B 4 – S 1341 – 20/01, Federal Tax Gazette 2001 I p. 796)

With regard to the results of the discussion with representatives of the highest tax authorities of the Federal States, the following rules are applicable to the examination of the income allocation between internationally affiliated enterprises in cases of cross-border personnel secondment within the group of enterprises: Content 1. Starting point and purpose. . . . . . . . . . . . . . . . . . . . . . . . . . 2. Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1 Secondment of personnel . . . . . . . . . . . . . . . . . . . . . . . 2.2 Employer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3 Expenses of a personnel secondment . . . . . . . . . . . . . . . 3. Assessment criteria for the income allocation . . . . . . . . . . . . 3.1 Causation principle and arm’s length test . . . . . . . . . . . 3.1.1 The interest of the assigning enterprise . . . . . . . . 3.1.2 The interest of the receiving enterprise. . . . . . . . . 3.2 Methods for applying the arm’s length test. . . . . . . . . . . 3.2.1 Internal comparison . . . . . . . . . . . . . . . . . . . . . . 3.2.2 External comparison . . . . . . . . . . . . . . . . . . . . . . 3.2.3 Hypothetical arm’s length test. . . . . . . . . . . . . . . 3.3 Indications for the determination of interest . . . . . . . . . 3.4 Special cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.1 Secondment of experts . . . . . . . . . . . . . . . . . . . . 3.4.2 Rotation procedures . . . . . . . . . . . . . . . . . . . . . . 3.4.3 Secondment for training and instruction purposes . 3.5 Uniform allocation scheme . . . . . . . . . . . . . . . . . . . . . 4. Tax treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.1 Incorrect income allocation . . . . . . . . . . . . . . . . . . . . . 4.2 Transfer of know-how . . . . . . . . . . . . . . . . . . . . . . . . . 4.3 Set-off of benefits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.4 Information on taxation of income from employment. . . 5. Procedures, cooperation, and evidence . . . . . . . . . . . . . . . . .

140

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. . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . .

141 141 141 142 142 143 143 144 144 145 145 145 145 145 146 146 146 147 147 148 148 148 148 148 149

IV. Personnel Secondment (2001)

6. Application to the income allocation between permanent establishments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149 7. Directive for application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150

1. Starting point and purpose The extended industrial interdependence and globalization result in an increased secondment of personnel between internationally affiliated enterprises. Secondments enable an enterprise to resolve a shortage of qualified personnel, implement locally standardized corporate policies, enhance the international exchange of experience, and gain working experience abroad. Either the assigning or the receiving enterprise may have an interest in such secondments. In practice, the time period and the purpose of secondments vary considerably. The personnel policy of a multinational enterprise may include that also a parent enterprise has its own operational interest regarding the secondment of personnel to affiliated enterprises. This interest is reflected in several job expectancies and if applicable, in additional reporting duties and is also often demonstrated by complying with the wishes of the employees not to terminate the employment contracts during the secondment but to maintain these, even though these contracts are usually suspended during this time. An employment abroad is regularly connected with financial and personal burdens for the employee. In order to motivate them to work abroad, the employees receive additional payments like a higher basic salary, compensation for additional expenses for the maintenance of two households, reimbursement of moving expenses, and foreign services allowances besides their current remuneration and, if applicable, retirement payments. It is the purpose of this circular to set regulations regarding the application of the arm’s length principle for the examination of domestic enterprises or affiliated enterprises that are active in the domestic market in cases of cross-border secondment of personnel. With the regulations it shall be possible to determine whether and to what extent the assigning and/or the receiving enterprise has its own operational interest in the secondment and thus shall be obliged to bear all or part of the expenses for the seconded employee.

2. Terms 2.1 Secondment of personnel Within the meaning of this circular, a secondment of personnel generally exists in cases where an employee agrees with his current employer (assigning enterprise) to work for an affiliated enterprise (receiving enterprise) for a limited time period and the receiving enterprise either con141

D. Administrative Guidelines

cludes directly an employment agreement with the employee or it may be seen as the economic employer. Accordingly, within the meaning of this circular a secondment of personnel does not exist if an employee works for another affiliated enterprise to fulfill a service obligation or a work performance and his salary is a price component for that service obligation or work performance (e.g. commercial hiring out of employees or machinery construction). In such cases it has to be examined whether the services of the assigning enterprise are remunerated at arm’s length, i.e. regularly including a profit element and whether the activities of the employee constitute a permanent establishment of the assigning enterprise. 2.2 Employer The term employer is defined differently in treaty law, wage tax law, employment law, civil law, and social security law. These differences must be regarded in the application of this decree. For the purposes of this circular the employer is interpreted in terms of employment law and within an economic sense. Accordingly, someone – possibly in addition to the assigning enterprise – who contracts an employment agreement according to labor law with the employee or integrates the employee in his business, who is authorized to give instructions, and economically bears the remuneration for the performed dependent work is to be regarded as employer. The employer may economically bear the remuneration by paying it directly to the employee or by having another enterprise pay the employment remuneration in advance for the employer (decision of the Federal Tax Court of August 21, 1985, Federal Tax Bulletin 1986 II p. 4). The integration in the receiving enterprise is regularly assumed if a secondment exceeds three months. In case the employee works less than three months for the receiving enterprise yet does it repeatedly, the receiving enterprise regularly also becomes the economic employer for this duration. If the receiving enterprise cannot be regarded as an employer, it must be examined whether a service was rendered on behalf of the assigning enterprise. 2.3 Expenses of a personnel secondment All direct and indirect expenses are to be allocated to the employee secondment if they have reduced the results of the receiving and/or the assigning enterprise and are economically connected to the employment activities within the secondment period. This is to be applied regardless of

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whether they are part of the taxable income of the employee. Expenses may include e.g.: – Basic salary; – Current and one-time remunerations of the employee (e.g. severance pay, bonuses); – Premiums, holiday and Christmas bonuses; – Taxes borne; – Payments to the pension provision; – Social security payments in the country of employment and in the home country; – Foreign service allowances; – Remuneration in kind and further incentives (e.g. company car, stock options); – Reimbursement for higher living costs and higher taxes; – Moving and travelling allowances (including allowances to family members); – Compensation for expenses regarding double housekeeping, school tuition, and boarding school expenses. Profit mark-ups on expenses are not permitted for tax purposes as the expenses for secondments within the meaning of this decree constitute original expenses of the respective economic employer.

3. Assessment criteria for the income allocation 3.1 Causation principle and arm’s length test The basis for the correct allocation of income is the question whether taking over the expenses for the respective employee is in accordance with the arm’s length principle. Accordingly, the expenses must be borne by the enterprise in whose interest the secondment has taken place. It must be examined (a) whether the employment is only in the operational interest of the receiving enterprise or whether the employment of the seconded employee is based completely or partially on the interest of the assigning enterprise or a parent enterprise; and

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(b) whether, as regards the amount, a reasonable and prudent business manager of an independent enterprise would have borne expenses in the same amount for a comparable employee. 3.1.1 The interest of the assigning enterprise During the audit of an assigning enterprise it is regularly assumed that the employee becomes active in the interest of and for the account of the receiving enterprise (decision of the Federal Tax Court of February 3, 1993, Federal Tax Bulletin II p. 462). It has to be considered though, that there can also be an interest from the assigning enterprise especially in cases where the respective employee receives remuneration which exceeds the wage level of the country in which the receiving enterprise has its seat. Such interest may be disclosed when the seconded employee assumes planning, coordinating, and control functions for the assigning enterprise that are not remunerated separately, or when the experiences which the employee gained abroad are used after his return within the scope of his continuing employment with the assigning enterprise, or when employees of the parent enterprise are regularly placed in jobs with affiliated enterprises during rotation procedures. The assigning domestic enterprise is obliged to substantiate its economic interest (see sec. 3.3) regarding the secondment if the expenses shall be deducted at its level. 3.1.2 The interest of the receiving enterprise The audit of a domestic enterprise or an affiliated receiving enterprise that is active in the domestic market has to take into consideration that the reasonable and prudent business manager of an independent enterprise would only employ required personnel and would only bear the expenses which accrued to him from a comparable employee under comparable circumstances. This shall be applied to all expenses which reduced the result of the receiving enterprise regardless of whether and to what extent the employee himself has financial benefits from the secondment. If a seconded employee works exclusively for the receiving affiliated enterprise, it does not necessarily mean that the full expenses (see sec. 2.3) will always be treated as deductible expenses of the receiving enterprise. If the seconded employee causes more expenses at the receiving enterprise than local employees with comparable functions and tasks, the receiving enterprise has to prove that the higher share of the total expenses is paid in its interest e.g. because the employee has special knowledge which enables the acquiring enterprise to generate profits exceeding the additional expenses (see also sec. 3.2.3). Unless this proof can be furnished, it is assumed that all additional expenses are caused by the shareholder relationship and must be borne by the assigning enterprise.

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3.2 Methods for applying the arm’s length test The arm’s length test shall primarily be performed according to the comparable uncontrolled price method. In this regard, the appropriate price is determined by internal or external arm’s length tests. If comparable data is unavailable, a hypothetical arm’s length test has to be carried out. 3.2.1 Internal comparison The internal arm’s length test examines at the level of the receiving enterprise which expenses it bears for comparable employees that were not seconded. 3.2.2 External comparison The external arm’s length test examines which expenses independent enterprises operating under the same circumstances in the same country as the receiving enterprises bear for a comparable employee. 3.2.3 Hypothetical arm’s length test With the hypothetical arm’s length test it is determined whether the reasonable and prudent business manager of an independent enterprise would have borne the expenses for the seconded employee at all or to the full extent under the same business conditions or whether he would have asked the assigning enterprise to participate in the costs. It has to be taken into consideration that, e.g. due to its special operational needs, an enterprise may require specially trained employees with particular know-how. In case such employees are unavailable in the local job market, a reasonable and prudent business manager would, however, only bear the additional expenses in connection with the employee secondment if he expected an economically verifiable higher benefit within a reasonable period (e.g. because the special features of products created by the employee or the employee’s achievements enable him to overcompensate the necessary additional costs with higher profits). A period of three years may be considered as reasonable. The arm’s length test has to consider the possibilities that employees may be recruited directly from the assigning country or that local employees may be trained. 3.3 Indications for the determination of interest Assessment criteria for the interest regarding the employee secondment may include:

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– The function performed; – The skills required; – The usual expenses for a comparable employee in the labor market of the employment country; – The connection between the expenses for the seconded employee and his contribution to the economic success of the enterprise; – The place of work; – Which enterprise initiated the secondment; – Whether the activity of the seconded employee is related to an individual project; – Whether the labor market of the receiving enterprise does not provide for employees objectively fulfilling the necessary qualification and such employees cannot be built up with internal training or qualification; – Whether equally qualified employees are available and cause less expenses in the local labor market of the receiving enterprise; – Whether the employee performs coordinating and control functions; – Whether the employee was seconded within a rotation system; – The percental share of seconded employees in the total staff; – The objective requirement of language skills or personal relationships in connection with the function performed. 3.4 Special cases 3.4.1 Secondment of experts In individual cases, especially with regard to project related secondment, the receiving enterprise depends on the expert knowledge of the seconded employee. If a comparable employee cannot be recruited or only with considerable effort, it is assumed that the receiving enterprise will bear all expenses for the employee. 3.4.2 Rotation procedures In case the assigning enterprise regularly fills positions at the receiving enterprise within rotation procedures, it is assumed that the secondment also serves the interests of the assigning enterprise, and therefore, it has to bear the expenses exceeding those for a comparable local employee of

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the acquiring enterprise. This may also be the case for the secondment of experts. A rotation system typically exists if the group management has decided on a staff employment and development concept under which the acquiring enterprise cannot decide freely how to fill job vacancies but is required to place employees of the assigning enterprise in certain positions. Whether such rotation system exists is decided upon the overall assessment of the circumstances. Indications for the existence of such rotation system are inter alia: – The secondments are executed one-way from the parent enterprise to subordinated enterprises but not reciprocal between the affiliated enterprises; – The secondments have a typical duration (three to five years); – Certain executive positions or technical key functions at the receiving enterprise are regularly filled with employees of other group enterprises; – The receiving enterprise does not make serious attempts (e.g. with job advertisements) to fill the positions with employees from the local job market or with its own trained personnel. 3.4.3 Secondment for training and instruction purposes If employees are seconded only for training and instruction purposes, the assigning enterprise has to bear the additional expenses (see sec. 3.1.2). 3.5 Uniform allocation scheme If a tax audit determines that the secondment of numerous employees serves the interests of both the assigning and the receiving enterprise, a functional analysis for the employees seconded may be performed in cooperation with the tax payer assessing an appropriate and uniform allocation scheme applicable to all secondments on the basis of a typical view. Unless the circumstances have changed considerably, in cooperation with the enterprise the tax authorities may take this scheme as tax assessment basis for the auditing period as well as for all business years that have expired until end of the audit. The taxpayer can request the application of this allocation scheme to future business years. The appropriateness of the uniform allocation scheme has to be analyzed regularly and shall immediately be adjusted upon a change of the decisive circumstances. The implementation of a uniform allocation scheme should be coordinated with all foreign tax authorities involved. 147

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4. Tax treatment 4.1 Incorrect income allocation If the expenses of a secondment have not been allocated appropriately to the enterprises involved, i.e. not according to the respective operational interests, the income must be adjusted according to the applicable regulations. 4.2 Transfer of know-how The receiving enterprise regularly acquires the skills and experience of seconded experts through their employment. To the extent that skills and experience are transferred to the receiving enterprise through the activity of the seconded expert (e.g. through a role model function), this is part and purpose of the secondment and is usually not to be remunerated separately. It has to be considered though, that a specific transfer of know-how (plans, samples, procedures, formulas, patents, etc) connected with the granting of the rights to use may also take place which would be remunerated separately between third parties. 4.3 Set-off of benefits If an enterprise claims that the expenses for seconded employees were taken into consideration within the determination of transfer prices e.g. for group internal exchange of goods, it has to be examined whether the necessary requirements are fulfilled for the tax approval of a set-off of benefits. Sec. 2.3 of the Administrative Guidelines – Income Allocation of 1983 has to be regarded. 4.4 Information on taxation of income from employment In case the arm’s length test determines that the expenses for the seconded employee have to be allocated between the assigning and the receiving enterprise, as a rule pursuant to the Double Taxation Agreement (DTA) the country in which the employee is physically present during his employment has the right to tax the entire salary. The right to tax the salary of the employees is determined by the relevant regulations of the corresponding DTA according to art. 15 OECD Model Tax Convention as well as the national provisions. For details, please see the decrees of the Federal Ministry of Finance of October 31, 1983 (Federal Tax Bulletin I p. 470), of January 5, 1994 (Federal Tax Bulletin I p. 11), of July 5, 1995 (Federal Tax Bulletin I p. 373), and of April 20, 2000 (Federal Tax Bulletin I p. 483).

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5. Procedures, cooperation, and evidence With regard to intra-group cross-border secondments, the obligation to furnish information and to provide evidence as laid down in § 90 (2) General Fiscal Code refers to the total expenses (see sec. 2.3) and to the interests according to which the activities of the seconded employee as well as the total expenses are allocated. The interest must be presented by the taxpayer and verified by suitable evidence. This may include for instance: – Secondment contract; – Additional service contract; – Description of the business activity of the receiving enterprise as well as its products and services; – Written correspondence showing the reasons for the secondment; – Job description of the seconded employees; – Precise employment evidence like reports and protocols that the seconded employee prepared for the assigning enterprise; – Job advertisements; – Surveys of comparative wages in the local labor market; – Profit expectations of the receiving enterprise; – Employment contracts with the assigning and the receiving enterprise; – Evidence regarding the amount of wage expenses prior to the secondment; – Benefit test regarding the wage expenses and the contribution of the seconded employee to the result; – Time sheet regarding nature and scope of employment; – Travel expense accounts; – Organizational chart of the employees or similar documents.

6. Application to the income allocation between permanent establishments The aforementioned principles are correspondingly applied when examining the allocation of income between permanent establishments of multinational enterprises.

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7. Directive for application This decree supplements the Administrative Guidelines – Income Allocation of February 23, 1983, Federal Tax Bulletin I p. 218 et seq. and is applicable to all unsettled cases.

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V. Dotation Capital of Credit Institutions (2004) Administrative Circular on the Guidelines for the Determination of Dotation Capital of Permanent Establishments of International Credit Institutions (Administrative Guidelines – Dotation Capital) Published on September 29, 2004 (IV B 4 – S 1300 – 296/04, Federal Tax Gazette 2004 I p. 917)

With regard to the results of the discussion with the highest tax authorities of the Federal States, the following is valid regarding the determination of the dotation capital of permanent establishments of international credit institutions: Content 1. General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2. Dotation capital of domestic permanent establishments of foreign credit institutions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1 Domestic permanent establishments of foreign credit institutions with their registered seat in an EEA state. . . . . . . . . . . . . . . . . . . 2.1.1 Methods for the determination of an appropriate dotation capital and their application . . . . . . . . . . . . . . . . . . . . . . . 2.1.2 Functions and risks-related capital allocation method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1.3 Minimum capital endowment method . . . . . . . . . . . . . . . . 2.1.4 Start of a new business activity . . . . . . . . . . . . . . . . . . . . . 2.1.5 Simplification provision for small permanent establishments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2 Domestic permanent establishments of credit institutions with their registered seat in a non-EEA state that are exempted from the application of certain provisions of the German Banking Law under § 53c no. 2 German Banking Law . . . . . . . . . . . . . . . . 2.3 Domestic permanent establishments of credit institutions with their registered seat in a non-EEA state that are not exempted from applying certain provisions of the German Banking Law under § 53 no. 2 German Banking Law. . . . . . . . . . . 2.4 Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3. Endowment of foreign permanent establishments of domestic credit institutions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1 Endowment in compliance with domestic statutory obligations (minimum capital endowment method) . . . . . . . . . . . . . . . . . . . 3.2 Higher endowment (capital allocation method) . . . . . . . . . . . . . . 3.3 Simplification provision for small permanent establishments . . . . 3.4 Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4. Cooperation duties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

152 152 152 153 153 155 156 157

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157 158 158 159 159 159 160 160

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5. Application provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160 5.1 Coming into effect. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160 5.2 Transitional provision for the time after December 31, 2000 until coming into effect under sec. 5.1 9. . . . . . . . . . . . . . . . 160

1. General It is the purpose of this circular to determine how to precisely allocate an arm’s length dotation capital to permanent establishments of credit institutions within the meaning of § 1 (1) German Banking Law in cases of cross-border activities (see sec. 2.5.1 of the circular of the Federal Ministry of Finance of December 24, 1999, Federal Tax Gazette I p. 1076 “Administrative Guidelines – Permanent Establishments”). A dotation capital calculated at the end of each business year under the following principles shall be acknowledged as meeting the requirements of the arm’s length principle for tax purposes and shall constitute the basis for the income determination of the following business year.

2. Dotation capital of domestic permanent establishments of foreign credit institutions Domestic permanent establishments of foreign credit institutions must dispose of a dotation capital for profit determination purposes taking into account the nature of their business regarding the functions and risks assumed. If such permanent establishment shows a dotation capital that is lower than that derived from the principles set forth below, the dotation capital must be increased (sec. 2.4). Where the credit institution claims that, pursuant to the following principles, it may have apportioned a lower dotation capital to the permanent establishment for tax purposes than it had actually apportioned to it, the endowment may, however, not be amended taking effect for the past as it may be assumed that economic reasons that are thus also substantial under the arm’s length principle had been material for the originally selected endowment. This does not apply to the extent that a respective adjustment of the dotation capital may seem appropriate because of a subsequent modification of the allocation of functions, assets, and risks or the adjustment of other circumstances material for the endowment. 2.1 Domestic permanent establishments of foreign credit institutions with their registered seat in an EEA state Foreign credit institutions with their registered seat in a state of the European Economic Area (EEA) are not required under § 53b German Banking Law to show any equity for their domestic permanent establishments. Nonetheless, an appropriate dotation capital shall be allocated to these permanent establishments for profit determination purposes in order to

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tax them like an independent enterprise pursuant to the arm’s length principle. EEA contractual states are the member states of the EU as well as Iceland, Liechtenstein, and Norway. 2.1.1 Methods for the determination of an appropriate dotation capital and their application The dotation capital of domestic permanent establishments of foreign credit institutions with their registered seat in an EEA state is in principle to be determined under the functions and risks-related capital allocation method (sec. 2.1.2), unless in an individual case as an exception the amount of the appropriate dotation capital may be determined by means of an external arm’s length test based on the data of independent enterprises with comparable market opportunities and risks. Where the credit institution illustrates for a business year that the application of the capital allocation method generates economically inappropriate results, a lower dotation capital may be applied. At the same time, the capital that results from the minimum capital endowment method (cf. sec. 2.1.3) constitutes the minimum level. To the extent no essential change of the facts occurs within the following four business years (e.g. substantial change of the business activity or significant change of the circumstances which resulted in the inapplicability of the capital allocation method), the credit institution may continue with the calculation method to that extent without further evidence. The calculation requires documentation and data that are important to the respective bank supervision purposes. Upon request, under § 90 (3) General Fiscal Code the credit institution is obliged to prepare or to supply such documentation, submit it to the tax authority and, if necessary, to explain it. 2.1.2 Functions and risks-related capital allocation method Under the capital allocation method, pursuant to the arm’s length principle the permanent establishment is allocated the share in the equity for tax purposes of the enterprise as a whole (head office including all permanent establishments) that equals its share in the “rated risk assets1 + 12.5 times the weighting amount of the market risk positions”2 (hereinafter, the product is referred to as “market risk positions”), as calculated under the respectively applicable bank supervision law, in the relation to those of the enterprise as a whole3 (“internal arm’s length test”). When estimat1 See § 4 Principle I on the Equity of the Institutions (Federal Gazette No. 160 of August 25, 2000 p. 17077) in the version of July 20, 2002. 2 See § 5 Principle I, l.c. 3 See § 2 of the explanations on Principle I, l.c., where an arithmetic fraction is presented for determining an “overall ratio” under the bank supervision law including the specified positions.

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ing the market risk positions, the credit institution is at liberty to consider the used third-tier funds in correspondence with the principles of regulatory law. To a large extent the equity for tax purposes complies with the core capital for regulatory purposes. In order to determine the capital share to be allocated to the permanent establishment under this method, it shall be proceeded as follows: a) In a first step it has to be determined which risk assets and market risk positions must be allocated to the permanent establishment at a balance sheet date for tax profit determination purposes in the following business year based on the functions it has assumed. b) In a second step, the risk assets and market risk positions allocated to the permanent establishment, that must be reduced by the “receivables” from the head office (principal place of business) and from the other permanent establishments (branches) of the enterprise as a whole, have to be assessed under the respectively applicable principles of regulatory law. Accordingly, under the application of the aspects of the Principle I and of §§ 10, 10a German Banking Law1 the sum of the weighted risk assets and the market risk positions allocable to the domestic permanent establishment is derived. Only such market risk positions that remain under consideration of hedging transactions may be allocated to the permanent establishment. Where practical difficulties arise from the direct allocation, it shall not be objected to allocating the market risk positions of the enterprise as a whole pursuant to an appropriate key to be justified by the credit institution (e.g. according to the number of the distributors in the respective states). The apportionment must be documented. The key, once selected, cannot be changed at random. As the banking supervision in the state of registered seat of the credit institution (home state) includes the domestic permanent establishment and is regarded as equivalent, a risk assessment under the law applicable in that state shall be permitted. c) If there is clear indication that the sum of the weighted risk assets and market risk positions which must on an average be allocated to the permanent establishment during the business year will exceed the sum of the weighted risk assets and market risk positions at the balance sheet date which was material for the determination of the dotation capital in the business year affected by more than 20 %, the tax authority may increase the sum of the weighted risk assets and market risk positions appropriately if precise calculations made by the credit institution are neither available nor may be prepared subsequently without reasonable

1 Note: Due to the amendments of § 10 German Banking Law by Art. 6 of the Fourth Financial Market Promotion Act of June 21, 2002 (Federal Law Gazette I p. 2010), in the future the equity principle will be governed by a statutory ordinance.

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effort (estimate in accordance with § 162 (1) General Fiscal Code; in principle, the tax authority bears the burden of proof). d) The amount resulting for the permanent establishment must then be put in relation to the sum of the weighted risk assets and market risk positions of the enterprise as a whole at the respective balance sheet date, as established under the regulatory law of the state of residence (home state). e) The part of the equity of the enterprise as a whole that complies with the proportion resulting from letter (d) must be allocated to the permanent establishment as tax dotation capital for the profit determination of the following business year. The equity determined in accordance with the German tax law that is shown at the decisive balance sheet date shall in general apply as the equity of the enterprise as a whole. For simplification purposes it may be based on the deposited capital resulting from the foreign trade balance sheet of the enterprise as a whole plus the provisions and profits carry forward minus the losses carry forward, unless there are significant deviations to the equity under sentence 2 (e.g. pension provisions under foreign commercial law deviating considerably from German tax law). The credit institution is entitled to make adjustment calculations for the purpose of approximating the equity of the enterprise as a whole on which taxation is based (based on foreign commercial law) to the equity under German tax law as far as possible. If the credit institution claims that the dotation capital determined in such manner would not lead to an economically appropriate result in the case of its permanent establishment, it is at liberty to demonstrate which dotation capital is appropriate as regards the functions and risks assumed and assets employed. However, a dotation capital no less than the one that has been determined under the minimum capital endowment method (cf. sec. 2.1.3) must be used as basis for tax profit determination purposes. 2.1.3 Minimum capital endowment method Under the minimum capital endowment method, the permanent establishment is allocated the share in the equity of the enterprise as a whole that equals the amount that an independent credit institution operating under same or similar prerequisites would have to declare as a minimum under regulatory law when it becomes active in the domestic territory. In order to determine the dotation capital allocable as a minimum to the permanent establishment in accordance with regulatory law, it must be proceeded as follows: a) The sum of the weighted risk assets and market risk positions of the permanent establishment (in accordance with the aspects of Principle

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I, §§ 10, 10a German Banking Law1) has to be determined in the same manner as when applying the capital allocation method. An increase of the allocable risk assets and market risk positions in accordance with sec. 2.1.2 (c) is equally feasible as is a reduction of this amount pursuant to sec. 2.1.2 penultimate sentence. The application of the minimum capital endowment method also permits, in accordance with sec. 2.1.2 (b), to carry out the risk assessment under the regulatory law of the residence state (home state). b) The minimum dotation capital is calculated from the following positions: – 8 % of the sum resulting from the weighted risk assets and market risk positions of the permanent establishment in order to ensure the minimum capital endowment in accordance with § 10 German Banking Law. If the credit institution ascertains of which shares the equity of the enterprise as a whole (core capital, supplementary capital and third-tier funds; pursuant to § 10 (2) German Banking Law or foreign regulatory law) is comprised, it may yield a reduction of this percentage. A dotation capital of at least 4 % of the weighted risk assets and market risk positions must be shown. The restrictions under regulatory law regarding the consideration of the supplementary capital and third-tier funds must be observed. – 0.5 % surplus on the sum of the weighted risk assets and market risk positions of the permanent establishment. Commonly, independent credit institutions keep equity which exceeds the minimum capital endowment by at least that amount in order to carry out additional business. Accordingly, the percentage amounts to 8.5 % at most and to at least 4.5 %, depending on the composition of the equity in the enterprise as a whole. The percentage calculated in the individual case, which is applied to the sum of the weighted risk assets and market risk positions of the permanent establishment, results in the minimum dotation capital of the permanent establishment for profit determination purposes. 2.1.4 Start of a new business activity Where the business activity of the permanent establishment is started for the first time during the assessment period, a dotation capital of at least

1 Note: Due to the amendments of § 10 German Banking Law by Art. 6 of the Fourth Financial Market Promotion Act of June 21, 2002 (Federal Law Gazette I p. 2010), in the future the equity principle will be governed by a statutory ordinance.

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5 m. Euros must be applied as is for an independent credit institution in accordance with § 33 (1) no. 1 (d) German Banking Law. 2.1.5 Simplification provision for small permanent establishments In cases where the sum of the assets allocable to the domestic permanent establishments (“total assets”) amounts to no more than 500 m. Euros at the end of the business year, it is unnecessary to determine the dotation capital pursuant to sec. 2.1.2 and 2.1.3, if at least a dotation capital of 3 % of that sum – yet at least 5 m. Euros – is applied. 2.2 Domestic permanent establishments of credit institutions with their registered seat in a non-EEA state that are exempted from the application of certain provisions of the German Banking Law under § 53c no. 2 German Banking Law The principles of sec. 2.1.1 to sec. 2.1.5 apply to domestic permanent establishments of credit institutions with their registered seat in a non-EEA state that are exempted from certain provisions of the German Banking Law under § 53c no. 2 German Banking Law, with the proviso of utilizing at least 5 m. Euros as dotation capital as stipulated under § 33 (1) no. 1 (d) German Banking Law. Currently, permanent establishments of credit institutions with their registered seat in the following states are exempted from applying certain provisions of the German Banking Law: – USA (ordinance of the Federal Ministry of Finance of April 21, 1994, Federal Law Gazette I p. 887), – Japan (ordinance of the Federal Ministry of Finance of December 13, 1995, Federal Law Gazette I p. 1703), – Australia (ordinance of the Federal Ministry of Finance of June 2, 1999, Federal Law Gazette 1999 I p. 1247). 2.3 Domestic permanent establishments of credit institutions with their registered seat in a non-EEA state that are not exempted from applying certain provisions of the German Banking Law under § 53 no. 2 German Banking Law Domestic permanent establishments of credit institutions with their registered seat in a non-EEA state that are not exempted from certain provisions of the German Banking Law under § 53c no. 2 German Banking Law shall in principle apply the actual dotation capital (core capital). The dotation capital must amount to at least 8 % of the sum of the weighted risk assets and market risk positions of the permanent establishment plus the surplus of 0.5 % (cf. sec. 2.1.3). Where the credit institution has actually applied a lower amount and demonstrates that this amount complies at least with the dotation capital that results from applying the capital allo157

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cation method based on the German Banking Law (sec. 2.1.2), the applied amount shall be acknowledged. In such cases, the minimum level of the endowment (cf. sec. 2.1.2 at the end) also corresponds to the minimum capital endowment pursuant to the German Banking Law; where necessary, under consideration of the verified proportion of the supplementary capital and third-tier funds in the overall balance sheet of the credit institution (cf. sec. 2.1.3). If the credit institution requests the application of the capital allocation method or minimum capital endowment method, under § 90 (3) General Fiscal Code it is required upon request to procure the necessary data for its application, to prepare and submit respective documentation, and, where required, explain it. 2.4 Adjustments Where a domestic permanent establishment of a foreign credit institution shows at the balance sheet date a lower dotation capital (dotation deficit) than required under the above stated principles (sec. 2.1 to sec. 2.3), its profit of the following business year must be determined in such manner as if it had been provided with a dotation capital in accordance with the principles. As a consequence, in this business year the permanent establishment is not permitted to deduct a respective interest portion for borrowed funds of the enterprise as a whole as a business expense. For example, an increase of the dotation capital at the end of the business year 04/ beginning of the business year 05 results in the permanent establishment’s reduction of the tax deductible interest expenses in the year 05 and accordingly, to a respective increase in profit in the year 05. All interest calculations necessary for adjustments shall be carried out under consideration of the average refinancing rate of the credit institution. For simplification purposes it is not objected to calculating of the average interest rate based on the 12-months EuRiBoR rate. Example: Actual dotation capital as of December 31, 2004: 10 million Euros, Required dotation capital as of December 31, 2004: 20 million Euros, Average refinancing rate of the credit institution: 2 %. The interest expenses of the year 05 must be reduced by 200,000 Euros.

3. Endowment of foreign permanent establishments of domestic credit institutions For tax profit allocation purposes, foreign permanent establishments of domestic credit institutions require a dotation capital taking into account the nature of the business of the permanent establishment. An endowment exceeding this cannot be accepted. Where the credit institution claims that, pursuant to the following principles, it may have apportioned 158

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to the permanent establishment a higher dotation capital for tax purposes than actually declared tax-wise, the endowment may, however, not be amended taking effect for the past as it may be assumed that economic reasons that are thus also substantial under the arm’s length principle had been material for the originally selected endowment. This does not apply to the extent that a respective adjustment of the dotation capital seems appropriate because of a subsequent modification of the allocation of functions, assets, and risks or the adjustment of other circumstances material for the endowment. 3.1 Endowment in compliance with domestic statutory obligations (minimum capital endowment method) An endowment of the foreign permanent establishment shall in principle be acknowledged to the extent the dotation capital does not exceed the statutorily required pro rata share in the minimum equity endowment (sec. 2.1.3) in accordance with German regulatory law within the enterprise as a whole and the taxation abroad is based on it. 3.2 Higher endowment (capital allocation method) In case the credit institution has allocated (if necessary, in accordance with the regulatory or tax law of the source state) to its foreign permanent establishment a dotation capital for tax profit allocation purposes and based it on taxation abroad that exceeds the threshold identified in sec. 3.1, this may not be objected to if the credit institution demonstrates that this endowment is appropriate as regards the functions and risks assumed and assets employed. If the dotation capital exceeds the amount that results from applying the capital allocation method under sec. 2.1.2, there is substantial indication that the endowment exceeds the threshold of appropriateness under sec. 3. In cases of minor importance the tax authority may, on grounds of equity, waive an adjustment if that should yield double taxation that may presumably not be solved in a mutual agreement procedure due to the legal equity requirements in the source state. For simplification purposes, detailed documentation on the capital allocation method should not be requested if a rough calculation, which must be submitted by the taxpayer upon request, reveals that the amount of the dotation capital applied for tax purposes is less than the amount that would result pursuant to this method. 3.3 Simplification provision for small permanent establishments In cases where the sum of the assets allocable to the permanent establishments of a state (“total assets”) amounts to no more than 500 million

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Euros at the end of the business year, it cannot be objected to applying a dotation capital of altogether 5 million Euros or 3 % of the total assets. 3.4 Adjustments Where the endowment of the foreign permanent establishment exceeds the amount resulting from the principles of sec. 3.1 and 3.2 (dotation surplus) at a balance sheet date, its profit of the following business year must be determined in such manner as if it had been allocated with a dotation capital in compliance with these principles. As a consequence, in this business year the permanent establishment must be allocated with an additional interest portion for borrowed capital of the enterprise as a whole. For example, a reduction of the dotation capital at the end of the business year 04/beginning of the business year 05 results to increased interest expenses for the permanent establishment in the year 05. Accordingly, in cases of exemptions under a double taxation agreement the income to be exempted for the year 05 is reduced effecting a higher domestic income subject to tax; in cases of credit, the foreign income of the year 05 is reduced, the amount of which has to be determined for purposes of calculating the credit amount (§ 34c Income Tax Act). All interest calculations necessary for adjustments shall be carried out under consideration of the average refinancing rate of the credit institution. For simplification purposes it is not objected to calculating the average interest rate based on the 12-month EuRiBoR rate.

4. Cooperation duties It is referred to the cooperation and documentation duties under § 90 (2) and (3) General Fiscal Code relating to issues involving foreign jurisdictions.

5. Application provisions 5.1 Coming into effect This provision substitutes sec. 4.1.3 of the circular of the Federal Ministry of Finance of December 24, 1999, the validity of which has partially expired at the end of December 31, 2000, and shall be applied to business years commencing after December 31, 2004. 5.2 Transitional provision for the time after December 31, 2000 until coming into effect under sec. 5.1 After the expiration of the validity of the non-objection provision of sec. 4.1.3 of the circular of the Federal Ministry of Finance of December 24, 1999 at the end of December 31, 2000 and until the effective date of 160

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this new regulation, the endowment shall be carried out in accordance with the general principles of sec. 2.5.1 of the circular of the Federal Ministry of Finance of December 24, 1999 in all unresolved cases of domestic permanent establishments of foreign credit institutions with their registered seat in an EEA state (§ 53b German Banking Law) and of domestic permanent establishment of foreign credit institutions with their registered seat in a non-EEA state that are relieved from applying certain provisions of the German Banking Law under § 53c no. 2 German Banking Law. – When applying sec. 2.5.1 of the circular of the Federal Ministry of Finance of December 24, 1999, it is not objected to taking into account a dotation capital amounting to at least 4.5 % in relation to the sum of the weighted risk assets and market risk positions for business years commencing prior to January 1, 2003. For business years commencing prior to January 1, 2005, a dotation capital may be applied that amounts to at least that resulting from the application of the minimum capital endowment method (sec. 2.1.3 of this circular). – When applying sec. 2.5.1 of the circular of the Federal Ministry of Finance of December 24, 1999 to small permanent establishments (allocable assets of no more than 500 m. Euros), the simplification provision (sec. 2.1.5 of this circular) may be applied to business years commencing prior to January 1, 2003 provided that the dotation capital corresponds to at least 2 % of the assets allocable to the permanent establishment (total assets). A percentage of at least 2.5 % applies to other business years commencing prior to January 1, 2005. Notwithstanding, it is permissive to determine the dotation capital for balance sheet dates up to December 31, 2000 according to the provisions set forth in sec. 4.1.3 of the circular of the Federal Ministry of Finance of December 24, 1999.

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D. Administrative Guidelines

VI. Procedures (2005) Administrative Circular on the Guidelines for the Examination of Income Attribution between Affiliated Parties with Cross-Border Business Transactions Regarding Investigation and Cooperation Duties, Adjustments as well as Mutual Agreement and EU-Arbitration Procedures (Administrative Guidelines – Procedures) Published on April 12, 2005 (IV B 4 – S – 1341 – 1/05, Federal Tax Gazette 2005 I p. 569)

With regard to the results of the discussion with the highest tax authorities of the Federal States, the following rules are applicable to the examination of income allocation between internationally affiliated companies concerning investigation and cooperation duties, adjustments as well as mutual agreement and EU-arbitration procedures: Content 1. General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2. Duties of the tax authorities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1 Principle of official investigation . . . . . . . . . . . . . . . . . . . . . . . 2.2 Request for information, documents, and records . . . . . . . . . . . . 2.3 Enlisting other persons not party to the proceeding. . . . . . . . . . . 2.4 Application of international legal and administrative cooperation 2.5 Utilization of questionnaires (checklists). . . . . . . . . . . . . . . . . . 2.6 Using comparable arm’s length data . . . . . . . . . . . . . . . . . . . . . 3. Cooperation duties (§ 90 General Fiscal Code). . . . . . . . . . . . . . . . . . 3.1 Parties subject to cooperation . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2 General cooperation duties (§ 90 (1) General Fiscal Code) . . . . . . 3.2.1 General principle, specific cooperation duties . . . . . . . . . . 3.2.2 Information duty pursuant to § 93 General Fiscal Code . . . 3.2.3 Retention of records, documents, and data (§ 147 General Fiscal Code) . . . . . . . . . . . . . . . . . . . . . . . 3.2.4 Submission of original documents . . . . . . . . . . . . . . . . . . 3.2.5 Translation of documents in foreign language (§ 87 (2) General Fiscal Code) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.6 Revision of tax returns (§ 153 General Fiscal Code) . . . . . . 3.3 Increased cooperation duties with respect to issues involving foreign jurisdictions (§ 90 (2) General Fiscal Code) . . . . . . . . . . . 3.3.1 General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.2 Duties regarding clarification of facts and provision of evidence (§ 90 (2) sent. 1 and 2 General Fiscal Code) . . . . . 3.3.3 Duty to collect evidence in advance (§ 90 (2) sent. 3 General Fiscal Code) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.4 Disclosure obligations pursuant to § 16 Foreign Tax Act . .

162

. . . . . . . . . . . . .

166 166 166 167 168 168 168 168 170 170 170 170 171

. 171 . 171 . 171 . 172 . 172 . 172 . 173 . 175 . 176

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3.4 Special documentation and submission duties (§ 90 (3) General Fiscal Code) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.1 General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.2 Prevention of mistakes with regard to documentation . . . 3.4.3 Form and retention of documentation (§ 147 General Fiscal Code) . . . . . . . . . . . . . . . . . . . . . . 3.4.4 Parties subject to documentation . . . . . . . . . . . . . . . . . . 3.4.5 Scope of application . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.5.1 Documentation and submission duties regarding permanent establishments . . . . . . . . . 3.4.5.2 Business relations in connection with co-entrepreneurships . . . . . . . . . . . . . . . . . . . . 3.4.5.3 Affiliated party within the meaning of § 1 (2) Foreign Tax Act. . . . . . . . . . . . . . . . . . . . 3.4.6 Effective date . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.7 Business year for which documentation has to be prepared. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.8 Time of the preparation of documentation . . . . . . . . . . . 3.4.8.1 General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.8.2 Contemporaneous documentation of extraordinary business transactions . . . . . . . . . . 3.4.8.3 Long-term relationships and continuing obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.8.4 Continuing obligations existing at the beginning of the documentation obligation and which are to be considered as extraordinary business transactions . . . . . . . . . . . . . . . . . . . . 3.4.9 Deadline for the submission of documentation (§ 90 (3) sent. 8 General Fiscal Code). . . . . . . . . . . . . . . . 3.4.10Documentation and transfer pricing methods . . . . . . . . . 3.4.10.1 General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.10.2 Classification of the company and transfer price formation . . . . . . . . . . . . . . . . . . . . . . . . 3.4.10.3 Transfer pricing methods. . . . . . . . . . . . . . . . . . 3.4.11Documentation of the facts (§ 1 (2) Ordinance on the Documentation of Income Attribution) . . . . . . . . . . . . . 3.4.11.1 General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.11.2 General information (§ 4 no. 1 Ordinance on the Documentation of Income Attribution) . . 3.4.11.3 Information on business relations with affiliated parties (§ 4 no. 2 Ordinance on the Documentation of Income Attribution) . . . . . . . 3.4.11.4 Functions, risks, assets, market conditions (§ 4 no. 3a Ordinance on the Documentation of Income Attribution) . . . . . . . . . . . . . . . . . . . . .

. . 177 . . 177 . . 178 . . 178 . . 178 . . 179 . . 179 . . 181 . . 181 . . 182 . . 182 . . 182 . . 182 . . 182 . . 183

. . 184 . . 185 . . 185 . . 185 . . 186 . . 187 . . 189 . . 189 . . 190

. . 190

. . 191

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3.4.11.5 Value chain and contributions to value chain (§ 4 no. 3b Ordinance on the Documentation of Income Attribution) . . . . . . . . . . . . . . . . . . . 3.4.12 Arm’s length documentation (§ 90 (3) sent. 2 General Fiscal Code, § 1 (1) and (3) Ordinance on the Documentation of Income Attribution) . . . . . . . . . . . . . 3.4.12.1 General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.12.2 Comparable arm’s length data, price comparison data, intercompany business data . . . . . . . . . . . 3.4.12.3 Serious efforts (§ 1 (1) sent. 2 Ordinance on the Documentation of Income Attribution) . . . . . . . 3.4.12.4 Documentation of information derived from databases or the internet . . . . . . . . . . . . . . . . . 3.4.12.5 Ranges and their narrowing . . . . . . . . . . . . . . . 3.4.12.6 Use of planning forecasts based on internal business planning data and profit forecasts to determine transfer prices . . . . . . . . . . . . . . . . . 3.4.12.7 Comparability . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.12.8 Subsequent pricing and price adjustments . . . . . 3.4.12.9 Multi-year analyses . . . . . . . . . . . . . . . . . . . . . 3.4.13 Aggregation of business transactions and internal transfer pricing guidelines . . . . . . . . . . . . . . . . . . . . . . . 3.4.14 Additional useful information . . . . . . . . . . . . . . . . . . . . 3.4.15 Required documentation in specific cases (§ 5 Ordinance on the Documentation of Income Attribution) . . . . . . . . 3.4.16 Documentation in foreign language . . . . . . . . . . . . . . . . 3.4.17 Reliefs from documentation duties (§ 6 Ordinance on the Documentation of Income Attribution) . . . . . . . . 3.4.18 Cross-check of the result. . . . . . . . . . . . . . . . . . . . . . . . 3.4.18.1 Verification with planning data, § 1 (3) sent. 4 Ordinance on the Documentation of Income Attribution . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.18.2 Other cross-checking methods . . . . . . . . . . . . . 3.4.19 Usability and non-usability of documentation. . . . . . . . . 3.4.20 Possible adjustments in case of usable documentation . . . 4. Legal consequences for breaching the cooperation duties . . . . . . . . . . 4.1 General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2 Burden of proof . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3 Reduction of the investigatory duties of the tax authorities regarding the clarification of facts . . . . . . . . . . . . . . . . . . . . . . . 4.4 Reduction of the degree of proof when cooperation duties are breached . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.5 Estimation pursuant to § 162 (1) and (2) General Fiscal Code . . . .

164

. 193

. 194 . 194 . 195 . 196 . 196 . 197

. . . .

202 205 207 208

. 208 . 209 . 210 . 211 . 212 . 212

. . . . . . .

212 212 213 214 217 217 218

. 218 . 218 . 219

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4.6 Special consequences for breaching documentation duties pursuant to § 90 (3) General Fiscal Code . . . . . . . . . . . . . . . . . 4.6.1 Statutory assumption of reducing income subject to domestic tax (§ 162 (3) sent. 1 General Fiscal Code) . . . . . 4.6.2 Estimation by exploiting ranges to the disadvantage of the taxpayer (§ 162 (3) sent. 2 General Fiscal Code). . . . 4.6.3 Assessment of a surcharge (§ 162 (4) General Fiscal Code) 4.6.4 Justifiable non-compliance with the obligations pursuant to § 90 (3) General Fiscal Code (§ 162 (4) sent. 5 General Fiscal Code) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5. Implementation of adjustments and their tax treatment . . . . . . . . . 5.1 Principles for an adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . 5.2 Adjustments reflected on the balance sheet . . . . . . . . . . . . . . . 5.3 Off-balance-sheet adjustments . . . . . . . . . . . . . . . . . . . . . . . . 5.3.1 Hidden profit distribution . . . . . . . . . . . . . . . . . . . . . . . 5.3.2 Withdrawal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.3.3 § 1 Foreign Tax Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.4 Crediting of foreign taxes of foreign affiliates to German income tax which is allocated to the adjustment amount pursuant to § 1 Foreign Tax Act . . . . . . . . . . . . . . . . . . . . . . . 5.5 Subsequent compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.5.1 Subsequent compensatory payments . . . . . . . . . . . . . . . 5.5.2 Avoidance of double taxation in cases of a disposal of a participation or liquidations . . . . . . . . . . . . . . . . . . . . . 6. Execution of transfer pricing adjustments and mutual agreement and arbitration procedures (EU) . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.1 General comments regarding the procedures . . . . . . . . . . . . . . 6.1.1 Relation of the German adjustment provisions to double taxation treaties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.1.2 Right to be heard of foreign persons concerned, information of the foreign tax authorities and the German competent tax authorities. . . . . . . . . . . . . . . . . 6.1.3 International procedures for the elimination of double taxation and/or double tax burden . . . . . . . . . . . . . . . . . 6.1.3.1 Mutual agreement procedures . . . . . . . . . . . . . . 6.1.3.2 Arbitration procedure (EU) . . . . . . . . . . . . . . . . 6.1.4 Additional comments on the procedures. . . . . . . . . . . . . 6.2 Protection of the German taxation right in mutual agreement or arbitration procedures (EU) . . . . . . . . . . . . . . . . . . . . . . . . . 6.2.1 Domestic adjustments . . . . . . . . . . . . . . . . . . . . . . . . . 6.2.2 Foreign adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . 7. Repeal of administrative regulations . . . . . . . . . . . . . . . . . . . . . . .

. . 220 . . 220 . . 221 . . 221

. . . . . . . .

. . . . . . . .

223 223 223 224 224 224 225 225

. . 226 . . 226 . . 226 . . 226 . . 227 . . 227 . . 227

. . 228 . . . .

. . . .

228 228 228 229

. . . .

. . . .

230 230 230 231

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1. General Subject to the provisions on thin capitalization (§ 8a Corporate Income Tax Act), this circular shall govern procedural principles for the examination of income allocation between internationally affiliated companies and between other affiliated parties with cross-border business transactions in terms of § 1 (4) Foreign Tax Act (transfer prices). It will be amended upon the revision of sec. 2.2 to 2.4 of the circular of the Federal Ministry of Finance of February 23, 1983 (Administrative Guidelines – Income Allocation 19831). Pursuant to § 90 (3) sent. 4 General Fiscal Code, the provisions of this circular regarding the documentation duties (in particular sec. 3.4) have to be applied to cases involving domestic enterprises with permanent establishments abroad and domestic permanent establishments of foreign enterprises.

2. Duties of the tax authorities 2.1 Principle of official investigation Pursuant to § 88 (1) General Fiscal Code the tax authorities determine the facts ex officio. According to the circumstances of the individual case they define the nature and the scope of the investigation and the necessary evidence. They also consider circumstances which are advantageous for the taxpayers (§ 88 (2) General Fiscal Code). Based on their responsible discretion, the tax authorities decide whether facts require clarification as they may be tax relevant. Exercising their investigatory function, the tax authorities may enlist the cooperation of the parties (§ 78 General Fiscal Code) to determine tax relevant facts to the extent it is possible, suitable, necessary, and not unreasonably burdensome (§ 2 (1) sent. 2 Tax Audit Ordinance 20002). For this purpose they may require the parties to provide information, furnish evidence, or prepare documentation. For the analysis of the submitted documents it has to be considered that in transfer pricing cases there is not only one arm’s length price which is decisive for taxation and one true result which is at arm’s length, respectively. In most cases only a range of prices or other comparable data may be determined. The objective burden of proof whether the transfer prices are at arm’s length is not borne by the taxpayer (sec. 4.2).

1 Federal Tax Gazette 1983 I p. 218. 2 Federal Tax Gazette 2000 I p. 358 et seq.

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2.2 Request for information, documents, and records For the preparation of the audit the tax authorities may (e.g. in the order of the audit) request information and require documents which are either available or may be obtained easily. This may include e.g. (a) Trial balances and journal of adjusting entries; (b) The financial statements which were submitted to the commercial register including the notes, management report, and if necessary reconciliations as well as the consolidated financial statements and group management report of a domestic parent company (§§ 290 to 315 German Commercial Code); (c) Information on which principles records and corresponding documentation is kept; (d) Information on permanent establishments and shareholdings within the meaning of § 138 (2) General Fiscal Code; (e) An overview on the nature and scope of cross-border business relations with affiliated persons; (f) Documentation within the meaning of § 90 (3) sent. 3 General Fiscal Code for extraordinary business transactions within the meaning of § 3 Statutory Regulation on the Nature, Content and Scope of Documentation Requirements (hereinafter: Ordinance on the Documentation of Income Attribution) including extraordinary continuing obligations pursuant to art. 97 § 22 sent. 2 Introductory Act to General Fiscal Code. To the extent it is required for the examination it may also be requested to submit minutes of the supervisory board and management board meetings and of shareholders’ meetings (decision of the Federal Fiscal Court of February 13, 1968, Federal Tax Gazette II p. 365 and decision of the Federal Fiscal Court of June 27, 1968, Federal Tax Gazette II p. 592 on the legal position pursuant to German Fiscal Code), articles of association, declarations on guarantee, patronage, and other warranty as well as annual reports and balance sheets which were prepared according to local accounting regulations by affiliated companies with which the domestic company to be audited has or has had business relations with. Sec. 3.3.2 (b) is to be considered. Such respective requests may be raised, supplemented, or amended at any time. If necessary, they must be explained. Pursuant to § 2 (6) Ordinance on the Documentation of Income Attribution, documentation within the meaning of § 90 (3) General Fiscal Code including the documentation for extraordinary business transactions is not to be requested for the entire group but only for the business lines or business transactions which shall be the subject of the audit and are relevant to it (§ 4 sent. 1 Ordinance on the Documentation of Income Attribu167

D. Administrative Guidelines

tion). The tax authorities may ask for documentation for the business lines and business transactions, respectively which they intend to audit by means of one inquiry or several inquiries (see sec. 3.4.9 regarding submission deadlines). 2.3 Enlisting other persons not party to the proceeding Other persons than the parties may only be enlisted in order to request information if the clarification of facts through the domestic party does not lead to results or seems unproductive. 2.4 Application of international legal and administrative cooperation Within their responsible discretion tax authorities decide to what extent the application of international administrative cooperation may be appropriate in individual cases (sec. 2.1.2 of the circular of the Federal Ministry of Finance of February 3, 1999, Federal Tax Gazette I pp. 228, 974, § 3 (2) EC Administrative Assistance Law; art. 26 OECD Model Tax Convention). Before the international legal and administrative cooperation is requested, the national investigative options including the cooperation duty of the parties (sec. 3) ought to be exhausted. Albeit, in some cases it is permitted and recommended to submit a request when there are indications that the party is unwilling or unable to provide the necessary information or to furnish evidence and records. 2.5 Utilization of questionnaires (checklists) In case model questionnaires or checklists are used in transfer pricing cases during the course of a tax audit, it has to be considered that the taxpayer shall not be disproportionally engaged even if he has increased cooperation duties (§ 90 (2) General Fiscal Code). To the extent it is possible, respective questionnaires have to be adjusted to the specific circumstances of the taxpayer and the precise information needs of the tax authorities. 2.6 Using comparable arm’s length data In order to obtain comparable arm’s length data (sec. 3.4.12.2) for the examination of transfer prices, within the scope of § 88 General Fiscal Code the tax authorities are eligible to employ all means available within the limits of the law. They may revert to sources which are freely accessibly and thus may be exploited without restricting the confidentiality in tax matters. They may also revert to documents of the taxpayer and other parties, e.g. such which are relevant to the business transactions of the taxpayer with independent third parties.

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Pursuant to the court decision (decision of the Federal Fiscal Court of October 17, 2001, Federal Tax Gazette 2004 II p. 171), the tax authorities are in principle eligible to draw on material and data on business transactions, business relations, and companies that was obtained from other tax procedures to examine the transfer prices. A tax inspector is authorized to request documents from tax files of comparable companies which may be useful for the determination of comparable data; the competent tax office shall provide these immediately (circular of application on General Fiscal Code1 regarding § 30, no. 4.1). Such material and data may not be disclosed stating the name of the comparable company and any court use of such data must be in anonymous form (§ 30 General Fiscal Code; decision of the Federal Fiscal Court of September 24, 1976, Federal Tax Gazette 1977 II p. 196 and decision of the Federal Fiscal Court of October 27, 1993, Federal Tax Gazette 1994 II p. 210 and circular of application on General Fiscal Code2 regarding § 30 General Fiscal Code, no. 4.5) unless the material and data may be obtained from sources which can be accessed freely or the taxpayer whose data shall be used approves to the disclosure. It may be reverted to anonymous data regardless of whether such data is generally accessible (decision of the Federal Fiscal Court of October 17, 2001, Federal Tax Gazette 2004 II p. 171). The license register of the Federal Office for Finance is commonly not accessible (circular of the Federal Ministry of Finance of April 29, 1997, Federal Tax Gazette I p. 541, sec. 1.1). Anonymous data used in tax court proceedings is subject to the free assessment of the evidence by the court. The court may ask questions regarding the compilation and origin of the anonymous data. In case these questions cannot be answered satisfactorily e.g. due to confidentiality in tax matters, this restricts the evidentiary value of the data (decision of the Federal Fiscal Court of October 17, 2001, Federal Tax Gazette 2004 II p. 171). In mutual agreement or EU arbitration procedures the identity of comparable companies whose data is used anonymously must also not be revealed. In all cases the taxpayer must be granted the opportunity to comment in detail on the consulted comparable data (decision of the Federal Fiscal Court of December 18, 1984, Federal Tax Gazette 1986 II p. 226).

1 Circular of the Federal Ministry of Finance of February 14, 1998, Federal Tax Gazette I p. 630. 2 Circular of the Federal Ministry of Finance of February 14, 1998, Federal Tax Gazette I p. 630.

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3. Cooperation duties (§ 90 General Fiscal Code) 3.1 Parties subject to cooperation Individuals, corporations, and co-entrepreneurships as defined in § 15 (1) sent. 1 no. 2 Income Tax Act, and representatives acting on behalf of the parties or taxpayers may be subject to cooperation duties. It is irrelevant whether the person who is obligated to cooperate is subject to non-resident or resident taxation. In transfer pricing cases someone may be required to cooperate as a party to the proceeding if the question arises whether or to what extent that person has generated domestic income within the meaning of § 49 Income Tax Act, e.g. as the recipient of a hidden profit distribution. See sec. 3.4.4 regarding the documentation duties within the meaning of § 90 (3) General Fiscal Code. 3.2 General cooperation duties (§ 90 (1) General Fiscal Code) 3.2.1 General principle, specific cooperation duties Pursuant to § 90 (1) General Fiscal Code, a party is required to cooperate regarding the clarification of facts. In this context, tax relevant issues must be disclosed completely and truthfully. There are specific statutory cooperation duties, e.g. the duty to – Provide information (§ 93 General Fiscal Code), – To file truthful tax returns that comply with the arm’s length principle (§ 149 General Fiscal Code) and, if need be, to revise the tax returns (§ 153 General Fiscal Code), – Notify the competent tax office about the formation of foreign permanent establishments and the participation in foreign partnerships and corporations (§ 138 General Fiscal Code and circular of the Federal Ministry of Finance of March 19, 2003, Federal Tax Gazette I p. 260), – Prepare required books and records completely, correct, timely, and sorted (§ 140 et seq. General Fiscal Code) and to keep them orderly stored (§ 147 General Fiscal Code), – Identify and to submit evidence (§§ 97 to 100 General Fiscal Code), – Provide evidence on trusts (§ 159 General Fiscal Code), – Name recipients of expenses (§ 160 General Fiscal Code), – Provide information, submit documents, and give necessary explanations in tax audits as well as to grant access to data within the meaning of § 147 (6) General Fiscal Code (sec. 3.4.3) (§ 200 General Fiscal Code). 170

VI. Procedures (2005)

3.2.2 Information duty pursuant to § 93 General Fiscal Code If it is relevant to the case, the tax authorities may require information to be provided in writing (§ 93 (4) General Fiscal Code). Foreign persons may be subject to the information duty as parties to the proceeding (§ 90 (2) General Fiscal Code) or as third parties (§ 93 (1) sent. 3 General Fiscal Code) within their legal or factual possibilities. 3.2.3 Retention of records, documents, and data (§ 147 General Fiscal Code) Those who are required to keep books and records pursuant to § 140 et seq. General Fiscal Code must assure within their legal and factual possibilities that tax relevant records, documents, and data will not be destroyed before the domestic duty to retain records (§ 147 (3), (4) General Fiscal Code) has expired regardless of whether those are kept domestically or abroad. This is also applicable if a domestic taxpayer participates in an international “cost sharing pool” as in this respect this constitutes an own (outsourced) activity of the taxpayer and thus the documents and data are such of the taxpayer himself (sec. 1.4 of the circular of the Federal Ministry of Finance of December 30, 1999 regarding cost sharing agreements1). § 146 (2) General Fiscal Code remains unaffected. Within his legal and factual scope a party to the proceeding must guarantee for evidence provision purposes that records, documents, and data of a foreign affiliated party that are relevant for his taxation will not be destroyed before the domestic duty to retain records has expired. This applies e.g. to evidence on selling prices of a foreign distribution subsidiary charged to independent third parties. 3.2.4 Submission of original documents Vouchers, certificates, or other documents must be retained by the parties in the original version or in electronic form. In case there is a statutory obligation to keep documents in the original version, they must be submitted to the tax authorities upon request. 3.2.5 Translation of documents in foreign language (§ 87 (2) General Fiscal Code) Documents in a foreign language must be translated into the German language upon request. Such translation requests must be limited to the necessary degree. If the translation applies to extensive contract or other documents in the English language, the demand for a translation ought to be restricted to essential parts of the contract. In case the documents were 1 Federal Tax Gazette 1999 I p. 1122.

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only partially translated, it cannot be concluded that with the mere submission of the document the tax authorities gain knowledge on parts which were not translated (e.g. § 173 General Fiscal Code, new facts). In substantiated cases the submission of a certified translation or such which was prepared by a publically appointed or sworn interpreter or translator may be requested. If a requested and for the audit necessary translation is not presented immediately, the tax authorities may either have the translation prepared at the expenses of the party (§ 87 (2) sent. 3 General Fiscal Code) or treat the documents as insignificant. In both cases the tax authorities shall inform the party about these consequences beforehand. The tax authorities are not required to communicate with foreign parties or their consultants in their native language or in another foreign language or to consult an interpreter at their own expenses. Otherwise, no. 1 circular of application on General Fiscal Code1 regarding § 87 General Fiscal Code is applicable. Special regulations (sec. 3.4.16) are applicable to foreign language documentation within the meaning of § 90 (3) General Fiscal Code. 3.2.6 Revision of tax returns (§ 153 General Fiscal Code) Declarations in tax returns must be made truthfully and to the best of one’s knowledge and belief (§ 150 (2) General Fiscal Code). If the taxpayer or a representative realizes that, after the tax return has been submitted, the tax return is incorrect or incomplete and thus resulted in a reduction of taxes (e.g. because services rendered were not invoiced or prices which were agreed with an affiliated party are inappropriate), the person is obliged to report this immediately to the tax authorities and to carry out the necessary correction (§ 153 (1) General Fiscal Code). If the taxpayer was aware that the prices in exceptional cases were inappropriate for tax purposes but legally agreed on and binding, it does not imply that the tax return may be filed based on these prices (sec. 3.2.1 second bullet point, sec. 4.1 last bullet point). It is referred to the duty to substantiate respective deviations in the documentation of the arm’s length analysis (sec. 3.4.12.1, para. 4). 3.3 Increased cooperation duties with respect to issues involving foreign jurisdictions (§ 90 (2) General Fiscal Code) 3.3.1 General Parties which are involved in issues that refer to activities outside the Federal Republic of Germany have to fulfill increased cooperation duties 1 Circular of the Federal Ministry of Finance of February 14, 1998, Federal Tax Gazette I p. 630.

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(§ 90 (2) General Fiscal Code). In order to meet these requirements, the parties especially have to – Clarify themselves issues that involve foreign jurisdictions, – Obtain information from abroad, – Present witnesses in Germany who live abroad, – Obtain necessary evidence which is located abroad, and – Make arrangements to collect evidence in advance within their statutory and factual scope also for cross-border transfer pricing cases. In case the taxpayer meets his cooperation duties pursuant to § 90 (2) General Fiscal Code, sec. 3.4.20 is applicable respectively with regard to the possibility of the tax authorities to carry out adjustments. 3.3.2 Duties regarding clarification of facts and provision of evidence (§ 90 (2) sent. 1 and 2 General Fiscal Code) (a) Among other things, the taxpayer has to explain how the agreed prices between him and affiliates were contracted, which contractual agreements exist, which functions, risks, and assets were taken into consideration with regard to pricing, which transfer pricing method has been used, which calculations were made, whether and what arm’s length tests the taxpayer carried out, and to what extent affiliated parties influenced the pricing. § 90 (2) General Fiscal Code does not include an independent obligation to document the arm’s length character of the transfer prices. As an exception, such obligation to explain the appropriateness exists in cases where pricing seemingly appears not to be at arm’s length, e.g. in cases of permanent losses of an associated distribution company (sec. 2 (a) of the decree of the Federal Ministry of Finance of February 26, 20041 and decision of the Federal Fiscal Court of October 17, 2001, Federal Tax Gazette 2004 II p. 171). § 90 (3) General Fiscal Code (sec. 3.4) is applicable to business years beginning after December 31, 2002 § 90 (3). The submission duties are also valid for documents which are either at hand or may be obtained and for which a preparation is required neither by law nor by the generally accepted accounting principles (decision of the Federal Fiscal Court of February 13, 1968, Federal Tax Gazette II p. 365). Such documents may be e.g. cost center accountings, budgets, calculations, sales projections, allocation of revenues and losses according to business lines, as well as transfer pricing policies, internal group reporting, and transfer pricing studies. 1 Federal Tax Gazette 2004 I p. 270.

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The submission duties especially include such evidence which is either kept in books, records, business papers, or other documents of foreign affiliated parties or is kept in electronic form and without which an entire clarification of the facts would not be possible. This is also applicable to documents of affiliated parties that enable the tax authorities to verify the arm’s length character of the prices and the results of business transactions, respectively independent of the transfer pricing method applied by the taxpayer. The submission duty also applies to expert opinions and statements on transfer pricing issues to the extent they are relevant to the determination of transfer prices or the income determination in connection with transfer prices (decision of the Federal Fiscal Court of October 17, 2001, Federal Tax Gazette 2004 p. 171). The tax authorities must grant the parties an appropriate time period in which they may clarify the facts and obtain evidence. (b) The party must exhaust all statutory and factual possibilities available to him in order to fulfill his duties regarding the clarification of facts and provision of evidence. This includes the possibilities resulting from shareholding relationships or from mutual interests. If a taxpayer claims the inability to furnish information or to submit records because an affiliated person possesses these exclusively and refuses a release, the party does not violate his cooperation duties if he has neither the legal (e.g. under company law) nor the factual possibility to obtain the information or documents from the affiliate and furthermore, he was unable to collect evidence in advance (sec. 3.3.3) or such was unreasonable. The refusal of an affiliated person to cooperate may be substantiated by submitting respective correspondence. The options of international legal and administrative assistance remain unaffected (sec. 2.4). If an affiliated person verifiably refuses to cooperate, the taxpayer has to fulfill his extended cooperation duties otherwise to the extent he is able to do so. In case the taxpayer is directly or indirectly the majority shareholder of the affiliated company or has the majority of the voting rights, the taxpayer as a rule possesses legal possibilities (under company law) to obtain information and evidence. In such cases he may not successfully refer to the refusal of the affiliated person to cooperate. In case a domestic subsidiary and a foreign affiliated company with which business transactions exist (e.g. parent company) are managed by the same persons (concurrent holding of management power), it may be assumed that the managing director – as legal representative of the subsidiary and as a representative of the parent company – has factual possibilities to furnish information and to obtain evidence. If in such cases a tax audit has been ordered for the parent company, pur174

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suant to § 93 (1) sent. 1 General Fiscal Code the managing director as a party to the proceeding may be engaged both as representative of the subsidiary and as representative of the parent enterprise concurrently. In case no order of an audit has been issued for the parent company, it constitutes “another person” in terms of § 93 (1) sent. 3 General Fiscal Code. If the taxpayer fails to provide information or to obtain evidence despite having the legal or factual opportunities, it results in legal consequences adverse to him (see sec. 4). (c) It is referred to sec. 9 of the circular of the Federal Ministry of Finance of December 30, 19991 regarding the cooperation duties in cases where internationally affiliated companies organize their relations with each other by means of cost sharing. (d) Sec. 5 of the circular of the Federal Ministry of Finance of November 9, 2001 (“Administrative Guidelines – Personnel Secondment”), Federal Tax Gazette I p. 796 is applicable to cases of personnel secondments between internationally affiliated companies with regard to the cooperation duties. (e) As a rule, a party that breaches his duties within the meaning of § 90 (2) General Fiscal Code may not refer successfully to the legal provisions of a foreign state even though these may prohibit the disclosure of information to the German tax authorities (decision of the Federal Fiscal Court of April 16, 1986, Federal Tax Gazette II p. 736). The refusal to cooperate may be justified if it is shown by way of exception that the party or his employees might face severe sentences abroad due to breaching these legal provisions. In such cases the party must exhaust all other possibilities to obtain information. Recommendations of foreign tax authorities to reject the request of the domestic tax authorities to disclose information are immaterial (decision of the Federal Fiscal Court of January 21, 1976, Federal Tax Gazette II p. 513). 3.3.3 Duty to collect evidence in advance (§ 90 (2) sent. 3 General Fiscal Code) Pursuant to § 90 (2) sent. 3 General Fiscal Code a party to the proceeding may not claim its inability to clarify the facts or to obtain evidence if, according to the circumstances of the case, he could have organized his relations in such manner as to provide for these (collecting of evidence in advance). The taxpayer may also comply with the duty to collect evidence in advance at the commencement of the business relations with affiliated parties by contractually securing the right to access information and evi1 Federal Tax Gazette 1999 I p. 1122.

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dence which may be necessary for the determination, allocation, and accrual of income for German tax purposes and which only these persons dispose of. It is assumed that the taxpayer is capable of collecting evidence in advance if the requested documents of the affiliated person constitute the prerequisite for an accurate determination of (transfer) prices and thus, a prudent business manager (§ 43 GmbH-Act) would have contractually secured a right to request the submission of the documents. This is applicable e.g. in the following cases: – Participation in a pool (circular of the Federal Ministry of Finance of December 30, 19991) regarding the proof of the total of the expenses to be allocated and the application of the allocation key; – Invoicing of services based on costs accrued concerning the verification of these costs (including the re-invoicing of transitory items); – Transfer of intangible assets (e.g. trademarks, know-how) against royalties based on sales with regard to the verification of sales revenues that were generated by the licensee from these assets; – Application of the resale price method in terms of sales prices of the distributor which he charged to independent third parties; – Application of the profit split method with respect to the total profit (or loss) as well as the allocation key to the extent that this method may be permissible pursuant to sec. 2.4.6 of the Administrative Guidelines – Income Allocation 19832 (sec. 3.4.10.3). In individual cases it may be impossible for the party to meet the obligation to collect evidence in advance (sec. 3.3.2 (b) (2)). Sec. 3.2.3 is applicable with respect to the obligation of foreign affiliated parties to retain business records which are tax relevant documents. 3.3.4 Disclosure obligations pursuant to § 16 Foreign Tax Act Pursuant to § 16 Foreign Tax Act, sec. 16 of the circular of the Federal Ministry of Finance of May 14, 2004 (Circular of Application on Foreign Tax Act3), special disclosure obligations apply to a taxpayer who maintains business relations either with a foreign enterprise or a person or partnership with their seat abroad and whose income from these business relations is not or only immaterially subject to taxation. In cases where based on the disclosure of the relations it is revealed that the foreign business partner constitutes an affiliated person within the meaning of § 1 1 Federal Tax Gazette 1999 I p. 1122. 2 Federal Tax Gazette 1983 I p. 218. 3 Federal Tax Gazette 2004 I Special Edition 1/2004.

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Foreign Tax Act, the appropriateness of the agreed transfer prices must be verified independently from the application of §§ 7 to 14 Foreign Tax Act (decision of the Federal Fiscal Court of March 19, 2002, Federal Tax Gazette II p. 644). In case the identity of such foreign business partner cannot be established beyond doubt and the business relations of the taxpayer with the business partner result in direct deliveries or services by the taxpayer to a company with its residency in a third state (tax treaty state), international administrative cooperation with the third country ought to be requested regarding the examination of the membership in a controlled group and the arm’s length character of the transfer prices (triangular relationship). The application of § 160 General Fiscal Code has to be considered. 3.4 Special documentation and submission duties (§ 90 (3) General Fiscal Code) 3.4.1 General For cross-border business relations with affiliated persons the taxpayer is obliged to prepare documentation on the nature and scope of the business relations (§ 90 (3) sent. 1 General Fiscal Code in connection with § 1 (2) Ordinance on the Documentation of Income Attribution, Documentation of the Circumstances, sec. 3.4.11) as well as their economic and legal bases (§ 90 (3) sent. 2 General Fiscal Code in connection with § 1 (3) Ordinance on the Documentation of Income Attribution, arm’s length documentation, sec. 3.4.12). The documents must enable a competent third party to ascertain within a reasonable time period which facts the taxpayer has realized in his cross-border business relations with affiliated parties as well as whether and to what extent he has complied with the arm’s length principle (sec. 3.4.10.2). The taxpayer must make serious efforts (§ 1 (1) sent. 2 Ordinance on the Documentation of Income Attribution) to substantiate the arm’s length character of his transfer prices (sec. 3.4.10.1); furthermore, he must apply a suitable transfer pricing method (§ 2 (2) Ordinance on the Documentation of Income Attribution). The documentation which was submitted by him usually forms the basis for the audit (sec. 3.4.20 (a)) provided it is usable (sec. 3.4.19 (a)). In case the taxpayer changes the manner in which the transfer prices are determined (e.g. due to the introduction or change of his documentation system), the use of available judgmental leeway may lead to different results than in the past. The taxpayer ought to substantiate such changes thoroughly and upon request document the reasons. In cases where documentation is requested it must be adhered to § 2 (6) and § 4 sent. 1 Ordinance on the Documentation of Income Attribution.

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3.4.2 Prevention of mistakes with regard to documentation If an explicit case shows that the efforts of the taxpayer to fulfill his documentation duties (sec. 3.4.12) may result in considerable difficulties, these may be discussed in advance with the tax authorities responsible for the tax audit. This does not include the approval of the transfer prices. 3.4.3 Form and retention of documentation (§ 147 General Fiscal Code) Documentation within the meaning of § 90 (3) General Fiscal Code has to be prepared either in writing or electronically pursuant to § 2 (1) Ordinance on the Documentation of Income Attribution. It is referred to the reliefs in certain cases (§ 6 Ordinance on the Documentation of Income Attribution and sec. 3.4.17). Documentation must be carried out appropriately and in principle retained for ten years (§ 147 (1) no. 1 in connection with § 147 (3) General Fiscal Code). The retention period does not expire to the extent that and as long as the documents are relevant with regard to tax for which the statute of limitations for the tax assessment period has not yet expired (§ 147 (3) General Fiscal Code). § 147 (6) General Fiscal Code is applicable to documentation that was prepared electronically and the underlying data processing systems. It is referred to the circular of the Federal Ministry of Finance on the generally accepted accounting principles in computer-assisted accounting systems of November 7, 1995, Federal Tax Gazette I p. 738, and to the principles on data access and auditing of digital documents of July 16, 2001, Federal Tax Gazette I p. 415. § 146 (2) General Fiscal Code must be considered with regard to the retention of documentation in the domestic territory or abroad (sec. 3.2.3). 3.4.4 Parties subject to documentation The documentation duties are applicable to taxpayers (§ 33 General Fiscal Code) i.e. individuals and legal persons subject to limited or unlimited income or corporate taxation. The duties are equally valid for co-entrepreneurships within the meaning of § 15 (1) sent. 1 no. 2 Income Tax Act which are required to keep books and records under § 140 et seq. General Fiscal Code. This is applicable irrespective of the fact that only partners themselves and not co-entrepreneurships as such are taxpayers under the Income Tax Act, Corporate Income Tax Act, and § 1 Foreign Tax Act (sec. 5.5.2 last paragraph on disposition cases). Only the individual business partner is obliged to prepare documentation for business relations of co-entrepreneurships that do not have the duty to maintain books and records. Such co-entrepreneurships may also include foreign co-entrepreneurships as they are not required to keep books and 178

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records neither according to German commercial law nor German tax law. In case a trustee or another representative has been appointed for the entity’s domestic business partners, it is sufficient that this person prepares the documentation and that the domestic business partner ensures the submission in due time. This regulation is equivalently applicable to other associations of persons whose members or owners generate income within the meaning of § 1 (1) Foreign Tax Act. 3.4.5 Scope of application § 90 (3) General Fiscal Code applies to business relations of a taxpayer within the meaning of § 1 (1) and (4) Foreign Tax Act with affiliated parties (§ 1 (2) Foreign Tax Act) and that have international dimensions (sec. 1.4 of the Circular of Application on Foreign Tax Act1). Business relations may also exist where no exchange of compensation takes place like in cases of pool allocations (circular of the Federal Ministry of Finance of December 30, 19992) and international personnel secondments (circular of the Federal Ministry of Finance of November 9, 2001, Federal Tax Gazette I p. 796). When determining whether a business relation exists, it is irrelevant whether under a relationship ex contractu an appropriate, an inappropriate, or no compensation had been agreed upon. The equity contribution under the articles of association to a company (e.g. in cases of restructurings or mergers) does not constitute a business relation within the meaning of § 1 (4) Foreign Tax Act. 3.4.5.1 Documentation and submission duties regarding permanent establishments The documentation obligations are applicable equivalently to cases where, for domestic tax purposes, profits are to be allocated between a domestic enterprise and its foreign permanent establishment or the profit of the domestic permanent establishment of a foreign enterprise is to be determined (§ 90 (3) sent. 4 General Fiscal Code and § 7 Ordinance on the Documentation of Income Attribution). This applies irrespective of the fact that neither head office nor permanent establishment as parts of a single enterprise may establish business relations themselves within the meaning of § 1 (1) and (4) Foreign Tax Act. The proper bookkeeping itself for the permanent establishment does not fulfill the documentation duties under § 90 (3) General Fiscal Code. The profit of the unitary entire enterprise (head office/permanent establishment) is primarily allocated to head office and permanent establishment according to functional aspects by means of the direct method and in exceptional cases the indirect method (sec. 2 of the circular of the Fed-

1 Federal Tax Gazette 2004 I Special Edition 1/2004. 2 Federal Tax Gazette 1999 I p. 1122.

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eral Ministry of Finance of December 24, 1999 – Administrative Guidelines – Permanent Establishments1). (a) Direct method The provisions of § 7 Ordinance on the Documentation of Income Attribution, differentiates between two types of documentation duties in the unitary entire enterprise: – Transfer of assets or rendering of services within the meaning of sec. 3.1.2 and 3.1.3 Administrative Guidelines – Permanent Establishments2; documentation must be prepared which corresponds to that required for comparable business transactions between affiliates. When assets are transferred, documentation on their arm’s length price at the time of the transfer to another permanent establishment of the unitary entire enterprise has to be prepared. Furthermore, it may be required to document the value at the time of the withdrawal from the other permanent establishment. – Allocation or charge of expenses; in order to proof a functionally appropriate allocation it is required to prepare documentation pursuant to sec. 9 of the circular of the Federal Ministry of Finance of December 30, 19993. Especially costs for advertisement and market development (sec. 3.2 Administrative Guidelines – Permanent Establishments4), interest and financing costs (sec. 3.3 Administrative Guidelines – Permanent Establishments5), as well as executive and general administrative expenses (sec. 3.4 Administrative Guidelines – Permanent Establishments6) can be considered for the allocation (sec. 2.7 Administrative Guidelines – Permanent Establishments7) (decision of the Federal Fiscal Court of July 20, 1988, Federal Tax Gazette 1989 II p. 140). Instead of the contractual agreements common among unaffiliated companies, comparable intercompany documents must be prepared for both types which include necessary information on the profit allocation like the condition and the arm’s length price of an asset at the time of the transfer, and standards for the allocation of management costs to head office and permanent establishment. Refer to sec. 3.4.17 regarding the relief as defined in § 6 Ordinance on the Documentation of Income Attribution for cross-border permanent establishment cases.

1 2 3 4 5 6 7

Federal Tax Gazette 1999 I p. 1076. Federal Tax Gazette 1999 I p. 1076. Federal Tax Gazette 1999 I p. 1122. Federal Tax Gazette 1999 I p. 1076. Federal Tax Gazette 1999 I p. 1076. Federal Tax Gazette 1999 I p. 1076. Federal Tax Gazette 1999 I p. 1076.

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(b) Indirect method The application of the indirect method requires documentation on the existence of the necessary prerequisites, especially uniform functions, comparable use of assets and comparable risk structures, of the entire profit which was generated, and on the chosen allocation key and its substantiation (sec. 2.3.2 Administrative Guidelines – Permanent Establishments1). (c) Foreign business relations through permanent establishments Business relations between affiliated parties may also exist through domestic and foreign permanent establishments, respectively (see examples in sec. 1.4.3 of the Circular of Application on Foreign Tax Act2). In such cases the provisions regarding the documentation duties under § 90 (3) General Fiscal Code and the Ordinance on the Documentation of Income Attribution are applicable to business relations with international dimensions for tax purposes. Examples: – The business relations that a domestic subsidiary maintains with its domestic parent company are attributable to a foreign permanent establishment of the parent company for tax purposes. – The business relations that a foreign parent company maintains with its foreign subsidiary business relations are attributable to a domestic permanent establishment of the subsidiary for tax purposes.

3.4.5.2 Business relations in connection with co-entrepreneurships The arm’s length principle (§ 1 Foreign Tax Act) is to be applied to crossborder business relations of a co-entrepreneurship with affiliates which are based on the law of obligations (not on the articles of association) (cf. sec. 1.3.2.1 sent. 2 Administrative Guidelines – Income Allocation 19833); accordingly, documentation in terms of § 90 (3) General Fiscal Code and the Ordinance on the Documentation of Income Attribution must be submitted. This is also applicable to cross-border business relations within the meaning of § 15 (1) sent. 1 no. 2 second clause of the sentence Income Tax Act, even if goods or services are rendered gratuitously. 3.4.5.3 Affiliated party within the meaning of § 1 (2) Foreign Tax Act Whether a taxpayer is affiliated with another party is determined pursuant to § 1 (2) Foreign Tax Act (sec. 1.3.2.1 et seq. Administrative Guidelines – Income Allocation 19834). Direct and indirect participations of a taxpayer must be aggregated (analogues application of the decision of the 1 2 3 4

Federal Tax Gazette 1999 I p. 1076. Federal Tax Gazette 2004 I Special Edition 1/2004. Federal Tax Gazette 1983 I p. 218. Federal Tax Gazette 1983 I p. 218.

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Federal Fiscal Court of June 28, 1978, Federal Tax Gazette II p. 590, on § 17 (1) Income Tax Act). 3.4.6 Effective date Pursuant to art. 97 § 22 Introductory Act to General Fiscal Code, the special documentation and submission duties pursuant to § 90 (3) General Fiscal Code are first applicable to business years commencing after December 31, 2002. For business years that began prior to December 31, 2002 (sec. 3.3), in particular the provisions of § 90 (2) General Fiscal Code are valid. 3.4.7 Business year for which documentation has to be prepared For the preparation of documentation under § 90 (3) General Fiscal Code the decisive economic and legal circumstances are those of the business year in which the contract (obligation agreement) has been entered establishing the business relationship or in which the economic conditions may have changed so considerably that independent third parties would either have contracted an adjustment of the terms and conditions or withdrawn from the contract (see also § 2 (4) Ordinance on the Documentation of Income Attribution). 3.4.8 Time of the preparation of documentation 3.4.8.1 General Irrespective of his obligation pursuant to § 90 (3) sent. 8 General Fiscal Code (sec. 3.4.9), the taxpayer is in principle not obliged to prepare documentation without a request by the tax authorities (see sec. 3.4.8.2 for exceptions). For documentation which is based on data and documents that were collected or prepared a considerable time after the business transaction it must be examined whether they provide for a subsequent justification of the results (e.g. permanent losses). To the extent that the taxpayer bases his arm’s length documentation on budgeted data (sec. 3.4.12.6 and 3.4.18.1), this data must actually have been available at the time the respective business was concluded and been used as basis for setting prices but needed not to be separately recorded in every case. If data is collected after the planning period has been closed, it may be used for actual costing at the most (sec. 3.4.12.1). 3.4.8.2 Contemporaneous documentation of extraordinary business transactions Business transactions are extraordinary (§ 90 (3) sent. 3 General Fiscal Code) if they exceed ordinary day-to-day business with regard to nature, content, purpose, scope, or risk, thus having an exceptional nature and if 182

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they are significantly important for the amount of the taxpayers’ income either in the year they took place or in the future. Extraordinary transactions are not restricted to those specified in § 277 (4) German Commercial Code. Extraordinary business transactions especially include – Essential changes of functions and risks within the company (restructuring measures, relocation of function and risks), e.g. transition from fully fledged distributor to commission agent or transition from own manufacturer to toll manufacturer or from an autonomous research company to contract researcher, especially in connection with the transfer of essential tangible and intangible assets to an affiliated person; – Business transactions in connection with a significant change in business strategy affecting transfer pricing, e.g. business transactions for which prices are calculated differently due to a changed business strategy; – Conclusion and modification of long-term contracts with considerable importance. For such business transactions it is vitally important that also an independent third party would collect such reliable preliminary calculations in advance in order to determine whether and on what conditions it would enter into such business transactions under consideration of the connected economic chances and risks. In such cases the effects on the remaining functions and risks, the application of the transfer pricing method used hitherto, and the turnover and earnings of the enterprise must also be documented. Documentation will still be considered as contemporarily prepared when it is compiled within six months after the end of the business year in which the respective business transaction has occurred (§ 3 (1) Ordinance on the Documentation of Income Attribution), i.e. in which the agreement has been concluded. The documentation of extraordinary business transactions always has to be prepared for each individual business transaction (sec. 3.4.13). 3.4.8.3 Long-term relationships and continuing obligations Long-term relationships are: – Business relations which are regularly repeated between the same contractual partners; – Continuing obligations, e.g. loan, rent, leasing, distribution, or cost sharing agreements where during their duration new contractual obligations permanently arise. 183

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Permanent circumstances must be documented relating to that business year in which the respective agreement based on the law of obligations was concluded. In case of a change of the essential circumstances affecting the appropriateness (e.g. with regard to important contractual conditions, functions assumed, risks borne, assets employed, market conditions, or the invoicing method), upon a request of the tax authorities the taxpayer must also prepare documentation for the business year in which the change occurred. This must enable an examination of whether and at what point in time independent third parties would have agreed on an adjustment of the contractual conditions or withdrawn from the contract. If according to the circumstances independent third parties would have terminated the agreement and the termination did not take place, an appropriate adjustment of the contractual conditions may be assumed for tax purposes. 3.4.8.4 Continuing obligations existing at the beginning of the documentation obligation and which are to be considered as extraordinary business transactions Pursuant to art. 97 § 22 sent. 3 Introductory Act to General Fiscal Code, documentation regarding the relevant economic and legal bases had to be prepared for continuing obligations at the latest six months after the Ordinance on the Documentation of Income Attribution had come into effect, i.e. until December 31, 2003 the latest if they were considered as extraordinary business transactions within the meaning of § 90 (3) sent. 3 General Fiscal Code (sec. 3.4.8.2) and were constituted in business years beginning prior to January 1, 2003 and still existed in business years beginning after December 31, 2002. Such documentation may also be important for audit years which ended prior to January 1, 2003. Therefore, upon request it must be submitted for the examination of such assessment periods pursuant to the provisions of § 2 (6) Ordinance on the Documentation of Income Attribution. In case the circumstances on which the agreement of the continuous obligation was based cannot be clarified with reasonable effort or the originally contracted prices were changed considerably, documentation on the economic and legal circumstances at the beginning of the business year commencing after December 31, 2002 must be prepared until December 31, 2003 the latest. Example: The tax audit of a domestic distribution company (the business year equals the calendar year) of a foreign company group includes the audit years 1996 to 2000. In July 2004 the tax inspector requests documentation regarding the distribution contract which was negotiated in 1994 with the foreign parent company in order to determine whether the concluded agreements were appropriate or whether independent third parties later would have carried out adjustments or terminated the contract. In this case, the business transaction is assumed to be extraordinary. In 2003, the contract remains effective unmodified.

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VI. Procedures (2005) Pursuant to art. 97 § 22 sent. 3 Introductory Act to General Fiscal Code, the economic and legal bases for the continuing obligation of the year in which the contract was concluded are decisive for the audit. Within the scope of the official investigations principle (§ 88 General Fiscal Code) the tax inspector is authorized and, if need be, required to request documentation as it is important for the audit period 1996 to 2000 (§ 8 (3) Tax Audit Ordinance 20001). In case no documentation is submitted, the sanctions pursuant to § 162 (3) and (4) General Fiscal Code do not take effect though, as they are only applicable to business years beginning after December 31, 2003. It is referred to sec. 4.

3.4.9 Deadline for the submission of documentation (§ 90 (3) sent. 8 General Fiscal Code) Upon request, documentation must be submitted within 60 days. The period of time begins with the announcement of the request, and not with the beginning of the audit in the enterprise of the taxpayer. The tax authorities may also demand the submission within the time period in case the tax audit is postponed upon request of the taxpayer. The taxpayer is bound to take necessary precautions to comply with the submission deadline. The tax authorities assume that taxpayers routinely and contemporarily collect the data and facts essential for the transfer pricing and keep them appropriately and available (sec. 1.11 sent. 2, sec. 1.68 sent. 5, sec. 5.28 sent. 1 OECD-Guidelines 19952). The tax authorities responsible for the execution of the audit may extend the deadline in substantiated individual cases (§ 90 (3) sent. 9 General Fiscal Code). 3.4.10 Documentation and transfer pricing methods 3.4.10.1 General The taxpayer is required to document why he considers each transfer pricing method applied by him as suitable (§ 2 (2) sent. 2 Ordinance on the Documentation of Income Attribution; sec. 1.68 sent. 2 OECD-Guidelines 19953). A sound and prudent business manager (sec. 2.1.1 sent. 3 Administrative Guidelines – Income Allocation 19834) will choose for his tax transfer prices or his profit determination the method which complies best with his circumstances; in cases of doubt he will apply the method from which, in terms of data quality, comparable arm’s length data with the most suitable comparability and reliability can be determined (sec. 2.4.1 (b) Administrative Guidelines – Income Allocation 19835). The taxpayer is required to explain whether and to what extent his actual in1 Federal Tax Gazette 2000 I p. 358 et seq. 2 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995. 3 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995. 4 Federal Tax Gazette 1983 I p. 218. 5 Federal Tax Gazette 1983 I p. 218.

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voicing procedures are based on the applied transfer pricing method on which he relies to justify his transfer prices or why deviations were necessary (sec. 3.2.6). The taxpayer is not required to verify his results pursuant to other methods (sec. 3.4.18 (a)). Neither is he obliged to justify why he considers other methods as less suitable (§ 2 (2) sent. 3 Ordinance on the Documentation of Income Attribution). This does not affect the duty to prepare, pursuant to § 1 (3) sent. 4 Ordinance on the Documentation of Income Attribution, both documentation on arm’s length data (sec. 3.4.12.2) and on intercompany data (§ 1 (3) sent. 4 Ordinance on the Documentation of Income Attribution) and to furnish information and to submit documents to the tax authorities to enable them to review the results (sec. 3.4.18). 3.4.10.2 Classification of the company and transfer price formation The determination of transfer prices in context of the computation of the taxable income and its audit must be based on whether independent third parties in the same or a similar situation as the taxpayer would have agreed on the respective business transactions on the same or similar terms (arm’s length principle). For this it will regularly be indispensable to carry out a classification of the company with regard to each business relation to be audited in order to determine whether and which of the participating companies exercises routine functions, which bears the essential entrepreneurial risk, and which exercises more than only routine functions without bearing the essential risks. (a) An enterprise that exercises merely routine functions (e.g. renders intra-group services which may easily be purchased in the market from independent third parties, or exercises simple distribution functions), employs assets on a small scale only, and bears only marginal risks does not incur losses in the usual course of business but rather generates regularly small but relatively stable profits (“company with routine function”). This is also applicable to a so-called toll manufacturer or a so-called “low risk distributor” who bears only risks similar to a commission agent with regard to bad debt losses and market development. (b) An enterprise which has tangible and intangible assets that are essential for carrying out business transactions exercises the material functions which are decisive for the corporate success and assumes the essential risks (often referred to as “central entrepreneur” or “strategic leader” is regularly (together with other companies that assume an “entrepreneur” function) entitled to the respective group result (sec. 1.23 sent. 2 and sec. 1.27 OECD-Guidelines 19951) which remains

1 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995.

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after the functions of other affiliated companies have been compensated. Whether the result generated by an “entrepreneur” is at arm’s length can regularly not be determined using comparable arm’s length data in the absence of comparable companies; the result rather constitutes a residual value. (c) An enterprise which under consideration of its functions performed, assets employed, and risks assumed can neither be seen as one with routine functions nor as the “central entrepreneur” must determine its transfer prices based on planning forecasts data (sec. 3.4.12.6 (a) and (b)) to the extent that uncontrolled prices can be determined for its business transactions whereas it must pursue the forecasted results and, if need be, react to deviations thereof (sec. 3.4.12.6 (c)). In this context, the transactional net margin method does not constitute a suitable method (sec. 3.4.10.3 and 3.4.19 (c)). The classification of companies to one of these groups may only be carried out according to the circumstances of the respective case. The reasons must be demonstrated using a functional and risks analysis. 3.4.10.3 Transfer pricing methods (a) In order to set up his transfer prices, the taxpayer may apply the socalled standard methods. These are the comparable uncontrolled price method (sec. 2.2.2 Administrative Guidelines – Income Allocation 19831, sec. 2.6 et seq. OECD-Guidelines 19952), the resale price method (sec. 2.2.3 Administrative Guidelines – Income Allocation 19833, sec. 2.14 et seq. OECD-Guidelines 19954), and the cost plus method (sec. 2.2.4 Administrative Guidelines – Income Allocation 19835), sec. 2.32 et seq. OECD-Guidelines 19956). (b) Subject to a revision of the provisions on the application of transfer pricing methods (sec. 2.2 and 2.4 Administrative Guidelines – Income Allocation 19837, sec. 1), the taxpayer may apply the transactional net margin method (TNMM, sec. 3.26 et seq. OECD-Guidelines 19958) if the following prerequisites are fulfilled. This method applies (net) profit level indicators of comparable enterprises (net margins, cost mark1 Federal Tax Gazette 1983 I p. 218. 2 “Transfer Pricing Guidelines for Multinational of the OECD, Paris 1995. 3 Federal Tax Gazette 1983 I p. 218. 4 “Transfer Pricing Guidelines for Multinational of the OECD, Paris 1995. 5 Federal Tax Gazette 1983 I p. 218. 6 “Transfer Pricing Guidelines for Multinational of the OECD, Paris 1995. 7 Federal Tax Gazette 1983 I p. 218. 8 “Transfer Pricing Guidelines for Multinational of the OECD, Paris 1995.

Enterprises and Tax Administrations”

Enterprises and Tax Administrations”

Enterprises and Tax Administrations”

Enterprises and Tax Administrations”

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up, profit data relating to the capital employed, assets employed, operative costs, turnover etc.) to individual kinds of business transactions or to business transactions permissibly aggregated pursuant to § 2 (3) Ordinance on the Documentation of Income Attribution. For the application of the transactional net margin method the following is applicable: – It may only be referred to the method in case the standard methods cannot be applied due to arm’s length data which is either missing or insufficient (sec. 3.4.12.2) (sec. 2.49 OECD-Guidelines 19951). – The method is only applicable to companies with routine functions (sec. 3.4.10.2 (a)). If such companies merely carry out one type of (aggregable, sec. 3.4.13) business transactions, a comparison between the business transactions of the audited company and those of comparable companies is permitted. As the comparable companies with routine functions assume comparable low risks, a sufficient relationship between the profit level indicators of the comparable companies and the result of the audited company may be established on a transactional level, hence substantiating that those results are at arm’s length (and thus, the transfer prices). The principles are also valid if the companies with routine functions have several business divisions to the extent that the revenues and business expenses which are to be allocated to the individual business divisions are recorded separately (segmented accounting). – In addition, this method may only be applied in cases where it can be proven that the comparable enterprises are (at least restrictedly) comparable (sec. 3.4.12.7) and where special, actually earned profits or losses of the audited company are considered even though these are not represented in the profit level indicators of the comparable companies. The transactional net margin method is not applicable to companies which perform more than routine functions without being “central entrepreneur” (sec. 3.4.10.2 (c)). Profit level indicators of functionally comparable unaffiliated companies are insufficient to substantiate that prices and results are at arm’s length as such companies bear significant individual risks and it can regularly not be determined whether these are sufficiently represented in the profit level indicators of the comparable companies and vice versa. Furthermore, it is regularly possible to aggregate more complicated business activities by type of transaction or to assign weights to them. Profit level indicators may at the most be used for purposes of validation, verification, or if appropri-

1 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995.

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ate, estimation (sec. 4.5). Instead, for such companies planning forecasts may be considered which substantiate that transfer prices have been set on a transactional basis in accordance with the arm’s length principle (sec. 3.4.12.6). In case a “central entrepreneur” (sec. 3.4.10.2 (b)) for whom profit level indicators cannot be applied in the absence of comparable enterprises also exercises allocable routine functions and/or functions within the meaning of sec. 3.4.10.2 (c), the respective (partial) results may be determined pursuant to the aforementioned regulations. (c) It may only be referred to the transactional profit split method (sec. 3.5 et seq. OECD-Guidelines 19951) if the standard methods cannot be applied or are not reliable. This may e.g. be the case for profit allocations of cross-border business transactions between several affiliated group companies exercising “central entrepreneur” functions (sec. 2.4.6 Administrative Guidelines – Income Allocation 19832), sec. 3.1 OECDGuidelines 19953) and which mutually participate in the preparation, execution, and conclusion stages whereas the individual contributions cannot be allocated (e.g. global trading). In such cases the arm’s length profit allocation criteria must be documented. (d) The comparable profit method does not lead to results complying with the arm’s length standard. It does not take a transactional approach and utilizes net profits of business divisions and companies, respectively which are unsuitable for a comparability study (sec. 3.4.12.7). Therefore, this method is not acknowledged. See sec. 3.4.19 (c). 3.4.11 Documentation of the facts (§ 1 (2) Ordinance on the Documentation of Income Attribution) 3.4.11.1 General For the documentation of the facts the taxpayer is required to prepare documentation on the nature, content, and scope of his business relations with affiliates as well as on the economic and legal conditions. In this context it must be recorded how the agreed prices between him and his affiliated parties were accomplished, to what extent affiliated parties influenced the pricing, which functions and risks were assumed, which assets were employed, which transfer pricing method was applied, how prices were calculated, and which arm’s length tests were performed.

1 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995. 2 Federal Tax Gazette 1983 I p. 218. 3 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995.

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D. Administrative Guidelines

3.4.11.2 General information (§ 4 no. 1 Ordinance on the Documentation of Income Attribution) Pursuant to § 1 no. 1a Ordinance on the Documentation of Income Attribution it is required to document the ownership relationships between the taxpayer and the affiliated parties (including holding quotas) with which he has business relations with foreign elements. This is also applicable to affiliated parties with which the taxpayer does not directly maintain business relations with foreign elements but through intermediaries not assuming essential functions or bearing risks (affiliates or independent third parties, taxpayers that are subject to unlimited or limited taxation and persons with no tax liability in the domestic territory at all). It is referred to the possibilities for the determination of triangular relationships (sec. 3.3.4). The aforementioned information constitutes a necessary part of the documentation of the facts as only business relations with affiliated parties are covered by § 90 (3) General Fiscal Code. For the same reasons other circumstances which constitute an “affiliation” must also be documented pursuant to § 4 no. 1b Ordinance on the Documentation of Income Attribution. This includes all forms of affiliation in terms of § 1 (2) Foreign Tax Act (sec. 1.3.2.4 to 1.3.2.7 Administrative Guidelines – Income Allocation 19831). The provisions of § 4 no. 1c Ordinance on the Documentation of Income Attribution require an illustration of all organizational and operative group structures as well as their changes. For this purpose it must be stated how the group is organized regionally, legally (legal forms of the group companies), and operationally (allocation of functions). 3.4.11.3 Information on business relations with affiliated parties (§ 4 no. 2 Ordinance on the Documentation of Income Attribution) The business relations which are carried out with individual affiliated parties must be presented in an overview revealing their nature and the amount of the remuneration in figures. For loan relationships the loan amount must also be documented. Furthermore, an overview must be prepared on the contracts and their amendments on which the business relations are based. In addition, a list must be provided stating the essential intangible assets which belong to the taxpayer and which he uses in the business relations with the affiliates or surrenders for use. Intangible assets exist, regardless of whether they may be capitalized or not, at least when they are registered or are part of a separate agreement under the law of obligations or

1 Federal Tax Gazette 1983 I p. 218.

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VI. Procedures (2005)

are not merely a subordinate part of a service relationship. Therefore, “know how” may also be included in the list. It cannot be determined independently from the individual circumstances in which cases intangible assets are “essential”. According to the circumstances of the respective company it must be examined whether the intangible asset is essentially important to its business activity (e.g. a patent on which the production activity of the company is completely or partially based). 3.4.11.4 Functions, risks, assets, market conditions (§ 4 no. 3a Ordinance on the Documentation of Income Attribution) The taxpayer is obliged to carry out a functional and risk analysis for his business relations with affiliates (sec. 2.1.3 Administrative Guidelines – Income Allocation 19831, sec. 1.20 to 1.3.5 OECD-Guidelines 19952, § 4 no. 3a Ordinance on the Documentation of Income Attribution). In this context, information must be documented and, if necessary, explained regarding the essential assets employed, the contractual terms and conditions, the chosen business strategy, as well as the market and competitive conditions substantial for the pricing. It is permitted to prepare a table (so-called “star chart”). The following information is in particular important: (a) For research and development – Functions: e.g. basic research, product development, product design, licensing, patent development; – Assets employed: e.g. patents, licenses; – Risks: e.g. failed research, substitution risk, market risk, patent disputes, and staff turnover (b) For manufacturing of products – Functions: e.g. manufacture, packaging, assembly, quality assurance; – Assets employed: e.g. licenses, product and/or process know-how, trademarks, land, manufacturing facilities; – Risks: e.g. false investments, excess capacities, bad debt losses, production of deficient products, environmental risks, quality risk, product liability, governmental interventions (e.g. environmental protection regulations, minimum wages).

1 Federal Tax Gazette 1983 I p. 218. 2 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995.

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D. Administrative Guidelines

(c) For distribution – Functions: e.g. purchases, warehousing, advertising, sales, financing, transportation, customs clearance, assembly, technical support, after-sales services; – Assets employed: e.g. distribution right, trademark right, customer base, vehicles, storage facilities; – Risks: e.g. sales risk (change in public taste, economic slowdown), decline in prices, warranty risks, bad debt losses, exchange rate variations, transportation risk, storage risk; (d) For company administration – Functions: e.g. management, coordination, strategy development, controlling, financing, accounting, recruitment and training of employees; – Assets employed: e.g. specific software, land, buildings; – Risks: e.g. business risk, liquidity risk, logistics. (e) For business strategy (sec. 1.31 to 1.35 OECD-Guidelines 19951) – Cost leadership; – Business activity in special fields or greatest possible diversification of business activities (diversification); – Market leadership. (f) For market and competitive conditions – Competitive position and negotiating power of the purchasers (number of suppliers and potential consumers, volume of supply and demand, sales directly to the end customer or dealers or chains) and the suppliers (high quality products); – Intensity of competition between suppliers, probability of new market parties and competing products entering the market (number, price, quality, substitution risk); – Size of the market and market level, purchasing power of the consumers, costs for capital, labor, and environmental protection, economic situation; – Price controls, import restrictions, currency transfer restrictions; – Time of the business transactions. 1 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995.

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3.4.11.5 Value chain and contributions to value chain (§ 4 no. 3b Ordinance on the Documentation of Income Attribution) Pursuant to § 4 no. 3b Ordinance on the Documentation of Income Attribution the taxpayer is obliged to describe the entire value chain and to illustrate his own contribution to the value chain. The term value chain relates to the complete process of producing goods and services which commences with research and development and which ends with the delivery to the end consumer. The added value (contribution to the value chain) of a group, company, or company division results from the difference between the value which the purchaser is ready to pay for a good or service received (market price for the good or service provided) and the production costs for the good or service of the supplier. The added value may also be calculated by adding a profit markup to the production costs of the good or service. The contributions to the value chain include the result of all activities which are directly connected with the manufacture of the products and the rendering of services, their sales and delivery to the customers, as well as after sales services (e.g. purchase, production, warehousing, delivery of products, rendering of services, marketing, distribution, and after sales service) and which serve to maintain and support the aforementioned activities (e.g. research and development, procurement management, personnel management, communications, business management and organization, accounting, financing). The contribution of the taxpayer to the value chain is often evident from the functional and risks analysis and the respective arm’s length documentation. If this is not the case, the taxpayer must submit a description of the respective value chain within his legal and factual scope (sec. 3.3.2 (b)). The functional and risks analysis is performed for individual affiliated companies whereas the value added analysis regularly refers to cross-company processes within the group. In order to obtain indication from the analysis of the value chain contributions which prices, cost markups, margins etc. are deemed to be appropriate in light of the value chain contributions of the individual companies it must be proceeded as follows: Initially, the individual business processes which are relevant for the added value of the group must be identified. Subsequently, the relative significance of the individual business processes for the entire added value must be weighted and proportionally determined so that the importance of the individual business processes for the added value for the entire group becomes evident. Finally it has to be analyzed which contribution the respective affiliated company makes to the individual business processes. This contribution must be set in relation to the contributions to the value chain of the affiliated parties. On this basis the share of the individual companies in the entire added value 193

D. Administrative Guidelines

must be determined (sec. 3.16 to 3.18 OECD-Guidelines 19951 on the application of value added analyses with the profit split method). See sec. 3.4.12.6 (b) on the application of value added analyses in the preparation of internal planning forecasts. 3.4.12 Arm’s length documentation (§ 90 (3) sent. 2 General Fiscal Code, § 1 (1) and (3) Ordinance on the Documentation of Income Attribution) 3.4.12.1 General The documentation must enable a competent third party within an appropriate time period to examine whether and to what extent the allocation of income between the taxpayer and the affiliated party and the affiliated companies, respectively complies with the arm’s length principle (§ 1 (1) Foreign Tax Act, § 8 (3) Corporate Tax Act, sec. 3.4.10.2). Apart from the documentation of facts, a documentation on the appropriateness of the transfer prices must also be prepared. It relates to the economic and legal bases from which can be derived that the taxpayer adhered to the arm’s length principle regarding the allocation of income. The arm’s length documentation must substantiate the serious effort of the taxpayer (§ 1 (1) sent. 2 Ordinance on the Documentation of Income Attribution, sec. 3.4.12.3) to adhere to the arm’s length principle when determining his taxable income. The documentation shall reflect the considerations made and render them understandable. For this purpose the taxpayer must substantiate from his point of view the suitability of the transfer pricing method actually applied as well as the appropriateness of the prices set or the results reported for tax purposes. For instance, with regard to royalties paid or received the taxpayer must illustrate the appropriateness under consideration of the arm’s length standard by characterizing significant circumstances relevant to the amount of the remuneration from a technical aspect (e.g. description and life circle of the products, if applicable, costs incurred for research and development), legal aspect (e.g. exclusiveness, right for sublicensing, territory protection, if need be, existing restrictions for use, maturity of the contract, registration of patents) and economic aspect (e.g. cost-benefitanalysis or comparable uncontrolled licenses). Pursuant to sec. 3.4.12.6 planning forecasts may be used for the determination of transfer prices, e.g. by combining comparable arm’s length data with intercompany data (sec. 3.4.18.1). The arm’s length documentation must generally be based on the actually concluded agreement. In case the taxpayer concluded a legally binding contract which contains an inappropriate price but has adjusted that price 1 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995.

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for tax purposes, the documents must refer to the price applied for taxation (sec. 3.2.6). Regardless of the transfer pricing method that the taxpayer applied, he may additionally substantiate the appropriateness of price agreements with actual cost and revenue overviews or other transfer pricing methods. He may for instance use external comparable arm’s length data he obtained at a later time to support the appropriateness of a service fee which was originally calculated under the cost plus method. The preparation of an arm’s length documentation does not become dispensable because the audited company is organized according to a “profit center” model or has a remuneration system according to which the remuneration of business managers depends on the profit of the company. The same is applicable if intra-group arbitration committees exist to settle transfer pricing disputes or if certain transfer pricing methods, cost markups etc. are applied consistently within the whole group (intra-group comparison, sec. 1.5 OECD-Guidelines 19951). However, from the aforementioned circumstances additional evidence may be derived which shows that the agreed prices comply with the arm’s length standard. An arm’s length documentation is not to be requested with regard to business expenses connected to a business relation as defined in § 1 Foreign Tax Act and which do not reduce the income. It is referred to sec. 4.2. In case an arm’s length documentation is requested, § 2 (6) and § 4 sent. 1 Ordinance on the Documentation of Income Attribution must be regarded. 3.4.12.2 Comparable arm’s length data, price comparison data, intercompany business data The appropriateness of prices and results must be exhibited in the documentation using comparable external and internal comparable arm’s length data (and the chosen transfer pricing method) to the extent that it is possible and not unreasonably burdensome under the given circumstance of the case. Comparable arm’s length data constitutes data from business transactions between unrelated business partners (§ 1 (3) sent. 3 Ordinance on the Documentation of Income Attribution, sec. 1.12 sent. 2 OECD-Guidelines 19952). The following business transactions may be considered: – Transactions between independent third parties (external arm’s length test); 1 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995. 2 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995.

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– Transactions between the taxpayer and independent third parties (internal arm’s length test); or – Transactions between parties which are affiliated with the taxpayer and independent third parties. Arm’s length data may include arm’s length prices (price comparison data) and other data (gross margins, cost markups, net margins). They must refer to business transactions of the audited company, either to individual transactions or to exactly defined transactions that were permissibly aggregated pursuant to § 2 (3) Ordinance on the Documentation of Income Attribution (sec. 3.4.11). Additionally, pursuant to § 1 (3) sent. 4 Ordinance on the Documentation of Income Attribution documentation on internal business data, e.g. on sales numbers, quantities, costs, and cost allocations must be prepared for a plausibility check (sec. 3.4.18.1). 3.4.12.3 Serious efforts (§ 1 (1) sent. 2 Ordinance on the Documentation of Income Attribution) The taxpayer must make serious efforts in order to set prices for his income determination that comply with the arm’s length principle. Accordingly, he must explain his assessment by means of objective criteria and, to the extent possible, with comparable arm’s length data (sec. 3.41.2.2). The appropriateness of price agreements and the result must (to the extent it is not unreasonably burdensome) be supported by his chosen method and the required, obtainable data. § 90 (3) General Fiscal Code and the Ordinance on the Documentation of Income Attribution do not lead to a change of the allocation of the burden of proof (sec. 2.1 and 4.2). Merely in the special case as defined in § 162 (3) sent. 1 General Fiscal Code a disputable statutory assumption arises (sec. 4.6.1). 3.4.12.4 Documentation of information derived from databases or the internet Usually, information derived from databases is insufficient to examine the comparability of facts (sec. 3.4.12.7). This is also applicable in case the database research was carried out properly. Thus, circumstances which are unknown yet significant for the comparison must be determined by other means. The taxpayer must clarify comparable situations according to all available and/or with reasonable effort obtainable information. Information from the internet websites of the comparable companies may also be considered. Data derived from mere “database screening” is by itself regularly unusable (sec. 3.4.19 (c)).

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If it is uncertain whether the facts are (at least restrictedly) comparable, such data is unusable (sec. 3.4.19). In case it is determined that the facts are only restrictedly comparable (sec. 3.4.12.7), sec. 3.4.12.5 is applicable. If significant deficiencies in the database itself are detected (see below), these deficiencies may also result in information in its entirety being unusable (sec. 3.4.19 (c)). The taxpayer is not obliged to conduct a database supported net profit level comparison. A comparability analysis by the tax authorities requires that the search process within the databases is verifiable and examinable within the limits of technical possibilities. Within the scope of § 147 (5) and (6) General Fiscal Code the data must be made available to the tax authorities electronically so they can carry out independent alternative calculations based on the data used by the taxpayer and can determine whether he considered all relevant information applying different, appropriate search criteria. The following information must be recorded by the taxpayer for a databased net profit level comparison: – Exact information on the database (name, provider, version, medium, license period); – Criteria of the database provider for accepting corporate data in the database; – General description of the total corporate data included in the databases; – Explanation of the structure of the profit and loss statement as well as the balance sheet (total cost type of accounting, cost of sales type of accounting) used in the database; – The selection criteria and the reasons for their application in light of the functional and risks profile of the audited company; – Illustration of the underlying industry classifications in the database and substantiation of the selected industry; – Explanation of any adjustment calculations; – Explanation of any employed calculation models and software programs (e.g. CAPM-model, regression analysis); – Description of all enterprises which were excluded based on a manual selection procedure, i.e. based on grounds of subjective assessment (socalled qualitative screening). Furthermore, the reasons for the exclusion must be presented in each case. 3.4.12.5 Ranges and their narrowing (a) The determination of comparable arm’s length data (sec. 3.4.12.2) regularly yields a range of possible values (sec. 1.12 last sentence OECD197

D. Administrative Guidelines

Guidelines 19951). If, according to the actual circumstances of the case, one of the values has the highest probability of being the correct one, all reasons thereof must be documented. In general, only this value (if required, with adjustment calculations) is decisive for tax purposes. A range originates where several values seem to be equally accurate. Regardless of the number of comparable values, this range is only then to be considered in its entirety in case that, based on reliable (data quality) and full information, it has been established that the business terms and conditions are unrestrictedly comparable (sec. 3.4.12.7 (a)). (b) In case the range consists of only restrictedly comparable values (sec. 3.4.12.7 (c)) or the unrestricted comparability of the business terms and conditions cannot be determined reliably due to information and data deficiencies, no sufficient comparability has been shown. In such cases the range is regularly too wide in order to reasonably base the transfer pricing determination or the audit on it. It must then be narrowed. For this purpose further analysis of the data is required in order to determine whether it has to be eliminated entirely or partly due to an insufficient comparability of the circumstances (sec. 3.4.12.7; sec. 1.47 OECD-Guidelines 19952) or whether reliable adjustment calculation may be carried out. If such additional analysis is not carried out, e.g. because no enhancement of the comparability is expected or because the analysis is connected with considerable (unreasonable) effort, the only restrictedly comparable data is unusable, except for the provisions of (c) and (d). (c) In order to nevertheless use only restrictedly comparable comparative data for the arm’s length documentation and its audit, the determined range must be narrowed by other means with the aim to reach a sufficient level of probability. For instance, verification calculations using other transfer pricing methods may be carried out to narrow the range (sec. 3.4.18.2). To the extent that the taxpayer has applied several transfer pricing methods for the same business line or functional area, each range of results has to be illustrated (sec. 1.46 OECD-Guidelines 19953). An overlapping range does not necessarily have to be seen as the range decisive for taxation. If the verification method considers certain aspects of the actual individual case in a better way, this may lead to a narrowing of the previous range. In case the verification method demonstrably takes

1 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995. 2 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995. 3 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995.

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the company circumstances better into account than the method originally used by the taxpayer, only the range which results from the application of the verification method may be considered. The range may also be narrowed by means of plausibility considerations, e.g. whether an appropriate profit can possibly be generated within a predictable time period or whether the taxpayer had the negotiating power in the actual situation to enforce certain prices within the range. It does not comply with arm’s length practice if an enterprise constantly accepts a marginal price least favorable or it leaves the entire price leeway incessantly to its business partner (sec. 2.1.9 Administrative Guidelines – Income Allocation 19831). (d) In case the attempted necessary narrowing of the range by means of other transfer pricing methods and plausibility considerations is unsuccessful, the narrowing may be carried out using mathematical methods so that the only restrictedly comparable values do not have to be neglected altogether. In such cases the tax authority carries out the narrowing by eliminating 25 % of the lowest and 25 % of the highest values. It is internationally common practice to narrow a range by forming quartiles and the method is applied by various tax authorities. The narrowing of the range with this method is not suspended if only a small number of comparable values is available. The taxpayer may apply other methods to narrow ranges in case he can demonstrate credibly that these are more suitable to the circumstances of his case. See sec. 3.4.20 (b) for adjustments by the tax authorities of prices on which the taxpayer agreed or of generated results due to the fact that e.g. the price or the result is outside the range or the range was not narrowed. Example: The domestic X-GmbH is a member of a group and distributes a certain range of products produced by its foreign parent company. X-GmbH exercises only routine functions (sec. 3.4.10.2 (a)). In order to illustrate the arm’s length character of the pricing between the manufacturing parent company and X-GmbH in the years one to three, X-GmbH prepared a net profit level comparison which was submitted to the tax authorities. A database research identified 20 independent third companies as possible comparable companies. Further research revealed that 13 of these companies are at least restrictedly comparable. In order to reduce special effects of individual years, the results of a threeyear period were used instead of the results of one single year (multi-year analysis, sec. 3.4.12.9).

1 Federal Tax Gazette 1983 I p. 218.

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Net margins (operating results) of comparable companies Monitored comparable companies

Year 1

Year 2

Year 3

Comparable Value(Average)

C-1

–1.5 %

–1.2 %

–0.9 %

–1.2 %

C-2

0.7 %

0.8 %

0.3 %

0.6 %

C-3

1.9 %

2.0 %

2.4 %

2.1 %

C-4

2.4 %

2.2 %

2.0 %

2.2 %

C-5

2.3 %

2.4 %

2.2 %

2.3 %

C-6

2.5 %

2.7 %

2.9 %

2.7 %

C-7

3.2 %

3.0 %

2.8 %

3.0 %

C-8

3.1 %

3.2 %

3.0 %

3.1 %

C-9

3.4 %

3.2 %

3.3 %

3.3 %

C-10

3.6 %

3.4 %

3.2 %

3.4 %

C-11

4.0 %

3.6 %

3.8 %

3.8 %

C-12

4.2 %

4.6 %

4.4 %

4.4 %

C-13

5.6 %

5.8 %

6.0 %

5.8 %

Solution: As X-GmbH exercises only routine functions (sec. 3.4.10.2 (a)), the necessary arm’s length documentation may be prepared based on a database analysis including the net profit levels of comparable uncontrolled companies (sec. 3.4.10.3 (b) and 3.4.12.7). As XGmbH illustrates only a restricted comparability with these uncontrolled companies and did not apply more suitable methods to narrow the range, the interquartile range of the comparable values (1st to 3rd quartile) must be seen as the decisive range. The 1st quartile is determined according to the following three steps: 1. The comparable values are sorted in ascending order (see table above), 2. The number of observed companies is multiplied by 25 % (13 observed companies × 25 % = 3.25). As interim result it can be stated that the quartile value to be determined lies between the comparable value of the third monitored company (=2.1) and the comparable value of the fourth monitored comparable company (=2.2). 3. The following (internationally common) approach may be chosen regarding the decision when and, if necessary, how it must be interpolated between two values: If no whole number is derived from the second step yet (e.g. 3.25 or 3.5 or 3.75), the value for the 1st quartile is determined according to the value of the next higher observed company (here: the comparable value for C-4 = 2.2). If the second step had resulted in a whole number (e.g. 3.0), the 1st quartile would have resulted from the mean value (arithmetic means) of the values for C-3 and C-4 (2.1 + 2.2: 2 = 2.15). The values for the 3rd quartile or the median are determined in the same manner. Yet in the second step the number of observed companies must be multiplied by 75 % (if the 3rd quartile is to be determined) and by 50 % (if the median is to be determined). The 3rd

200

VI. Procedures (2005) quartile is thus calculated as follows: Number of observed companies × 75 % = 13 × 75 % = 9.75. As 9.75 does not constitute a whole number, the comparable value (=3.4) of the next higher observed company (C-10) is decisive for the determination of the 3rd quartile. Solution:

Observed comparable company

Comparable values (average)

C-1 C-2 C-3 C-4 C-5 C-6 C-7 C-8 C-9 C-10 C-11 C-12 C-13

-1.2% 0.6% 2.1% 2.2% 2.3% 2.7% 3.0% 3.1% 3.3.% 3.4% 3.8% 4.4% 5.8%

1st Quartile = 2.2% Comparable margin 2.2% to 3.4%

Median = 3.0%

3rd Quartile = 3.4%

The three-year average leads to a decisive arm’s length profit range of 2.2 % to 3.4 %. Modification: The quartiles and the median would be calculated as follows for a smaller number of monitored arm’s length comparable companies: n= observations

n = 12

C-1

–1.2 %

C-2

0.6 %

C-3

2.1 %

C-4

n = 11

n = 10

n=9

–1.2 %

–1.2 %

–1.2 %

0.6 %

0.6 %

0.6 %

2.1 %

2.1 %

2.1 %

2.2 %

2.2 %

2.2 %

2.2 %

C-5

2.3 %

2.3 %

2.3 %

2.3 %

C-6

2.7 %

2.7 %

2.7 %

2.7 %

C-7

3.0 %

3.0 %

3.0 %

3.0 %

C-8

3.1 %

3.1 %

3.1 %

3.1 %

C-9

3.3 %

3.3 %

3.3 %

3.3 %

C-10

3.4 %

3.4 %

3.4 %

C-11

3.8 %

3.8 %

C-12

4.4 %

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1st quartile

12x25 % = 3.0(2.1+2.2):2 = 2.15

11x25 % = 2.75C-3=2.1

10x25 % = 2.5C-3=2.1

9x25 % = 2.25C-3=2.1

Median

12x50 % = 6.0(2.7+3.0):2 = 2.85

11x50 % = 5.5C-6=2.7

10x50 % = 5.0(2.3+2.7):2 = 2.5

9x50 % = 4.5C-5=2.3

3rd quartile

12x75 % = 9.0(3.3+3.4):2 = 3.35

11x75 % = 8.25C-9 = 3.3

10x75 % = 7.5C-8 = 3.1

9x75 % = 6.75C-7 = 3.0

It is permitted to apply other mathematical calculations like other table calculations or statistical programs to determine quartile values.

3.4.12.6 Use of planning forecasts based on internal business planning data and profit forecasts to determine transfer prices Taxpayers may determine transfer prices based on internal business planning data (sec. 3.4.12.2) and careful profit forecasts (“planning forecasts”) if the following prerequisites are met. The price determination must be based on planning forecasts which were available at the time the business deal was actually concluded. The planning forecasts must serve as basis for the documentation (sec. 5.3 OECD-Guidelines 19951). (a) The application of planning forecasts may e.g. be considered in the following cases: – If price-related arm’s length data like third party prices, cost markups, or margins cannot be determined with reasonable effort, is not (at least restrictedly) comparable, is not sufficiently reliable (data quality), and/or not representative and thus the result of the audited company may not be derived directly from such data; or – If in the individual case the direct (or, after adjustment calculations) deduction of the income of the audited company from arm’s length data yields to significant doubt regarding the plausibility; or – If differences regarding the employed assets, the performed functions, and the assumed risks between the audited company and the (at least restrictedly) comparable companies cannot be adjusted comprehensibly; or – Even though (at least restrictedly) comparable companies can be identified, it is impossible to derive the result of the audited company from the profit level indicator as more than just routine functions (sec. 3.4.10.2 (a)) are performed.

1 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995.

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This is especially applicable to companies with a “central entrepreneur” function (sec. 3.4.10.2 (b)) and for companies as defined in sec. 3.4.10.2 (c). The transfer pricing determination may not be based on planning forecasts in case arm’s length prices (sec. 3.4.12.2, para. 3) may be determined with reasonable effort. (b) Arm’s length documentation which refers to planning forecasts must be supported, to the extent it is possible, by arm’s length data (sec. 3.4.12.2) like arm’s length profit markups or interest on capital usual in the market. Transfer pricing based on planning forecasts has to refer to the application of a method suitable in the individual case. The planning assumptions taken as basis (sec. 3.4.12.2 on planning data) must be substantiated in detail according to the results of previous periods and professional, economically sound, and careful forecasts (decision of the Federal Fiscal Court of February 17, 1993, Federal Tax Gazette II p. 457). In case the actual result deviates substantially from the prepared forecast, the taxpayer is required to document these deviations and to illustrate that these are based on unexpected circumstances (e.g. extraordinary expenses) which could not be considered in his careful business forecast. Letter (c) is to be regarded. Planning forecasts must permit an allocation of the forecasted earnings and expenses to individual or permissibly aggregated business transactions. With regard to the forecasted profits, it must be demonstrated in each case that independent third parties would have agreed on transfer prices in this amount (sec. 3.4.10.2). For this purpose it may be relied on several circumstances and calculations, e.g.: – Profit level indicators of functionally (at least restrictedly) comparable companies in the respective business line (sec. 3.4.12.6 (a), 4th bullet point). Thereby it must be considered that the sound and prudent business manager does not schematically refer to the ceiling or the floor of a range (sec. 1.16 sent. 2 and sec. 1.54 last sentence OECD-Guidelines 19951) and will base a careful profit forecast on a mean value (median) unless for the individual case special circumstances are presented with regard to the range possibly to be narrowed (sec. 3.4.12.5). With regard to each audited company, sec. 3.4.10.2 must be regarded. The restricted reliability of profit level indicators of (at least restrictedly) comparable companies regarding the direct determination of income of an audited company as defined in sec. 3.4.10.2 (c) (sec. 3.4.10.3 (b), penultimate paragraph) may be accepted regarding the preparation of planning forecasts as in 1 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995.

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this connection the profit level indicators only serve to provide evidence for a careful, commercial profit expectation of the audited company. Its tax result is derived from its own business transactions for which the transfer prices were determined using planning forecasts. The result does not have to match the identified profit level indicators of (at least restrictedly) comparable companies. – The illustration that upon the establishment of the tested business relation and due to the entrepreneurial activity higher earnings were most probably expected rather from the investment within the company than from a risk-adequate investment in the market. The taxpayer is obliged to add functions and risks-related premiums on a risk free interest rate (minimum return) and to substantiate these both in principle and as to their amount and illustrate their calculation in a comprehensive manner. Adjustment calculations based on rough estimates and “business experience” not specifically substantiated are insufficient (decision of the Federal Fiscal Court of October 17, 2001, Federal Tax Gazette 2004 II pp. 171, 176). Furthermore, it must be explained and documented to which affiliated company “excessive profits” (which exceed the forecasted profits) are to be allocated. – The illustration that – under consideration of its functions performed, assets employed, and risks borne – and based on the applied transfer prices each individual group company receives an appropriate share of the expected profit of the whole group (profits forecast based on functional profit allocation). This has to be carried out according to an analysis on the value chain contribution of all participating group companies (sec. 3.4.11.5 and sec. 3.16 to 3.18 OECDGuidelines 19951). Accordingly, the profit expectation for the whole group must be shown credibly by comprehensible analyses, for instance based on the assessment by independent third parties (e.g. stock market analysts, rating agencies, investment banks, or independent management consultants) or by economically funded, careful profit forecasts prepared in advance (decision of the Federal Fiscal Court of February 17, 1993, Federal Tax Gazette II p. 457) which are to be compiled considering the previous results and adjusted by expected extraordinary influences. In case a company consists of one central entrepreneur and in addition of companies which exercise only routine functions (sec. 3.4.10.2 (b) and (a), respectively), it is noted that with regard to the allocation the transfer prices or the results may also be determined pursuant to sec. 3.4.10.3 (b). The appropriateness of the profit expectation of the individual group company is to be derived from proper criteria (e.g. contributions to the value chain, expenses, sales revenues, evaluating comparison of the 1 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995.

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functions and risks assumed in relation with those of the whole group). In order to substantiate that the profit or the agreed prices were at arm’s length, it is insufficient to illustrate that, based on economic planning forecasts, generally a profit of some amount can be anticipated, that the forecasted profit corresponds to an industry average value (which does not consider the assets actually employed, functions performed, and risks assumed), that intra-group targets which are not based on the arm’s length test are fulfilled, or that prices are being negotiated freely within the corporate group and that the persons responsible for it are remunerated with profit-related salaries or pay elements (sec. 3.4.12.1, para. 6). (c) In case the taxpayer determines his transfer prices based on planning forecasts, the adherence to the arm’s length principle requires that comparisons between the estimated and actual numbers are regularly carried out by the taxpayer in order to react in time to an altered course of business. Measures taken in this regard must be substantiated and documented. A regular target/actual analysis does not generally justify retroactive price adjustments (sec. 3.4.12.8). In business practice, monthly or quarterly reports are also regularly prepared for revision or controlling purposes. The target/actual analysis and these reports constitute a part of the documentation and must be submitted to the tax authorities together with planning forecasts upon request. It is referred to sec. 3.4.20 (c). 3.4.12.7 Comparability A comparison of the business relations between independent third parties on the one hand and between affiliated parties on the other hand as well as a comparison of the results of independent companies with those of the audited company is only then meaningful if the business terms and conditions have been identified and are comparable. For the comparability examination it must be resorted to all criteria which may have an impact on pricing. These include: – The characteristics and particularities of the relevant assets (e.g. physical features, quality, nature of intangible assets, reliability, availability, quantity delivered) and of the services (sec. 1.19 OECD-Guidelines 19951); – The functions performed, risks assumed, and assets employed (sec. 3.4.10.2; sec. 1.20 to 1.27 OECD-Guidelines 19952); 1 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995. 2 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995.

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– The contractual terms and conditions (e.g. maturity of contracts, terms of payment, etc.; sec. 1.28 and 1.29 OECD-Guidelines 19951); – The economic circumstances in the relevant market (sec. 3.4.11.4 (f); sec. 1.30 OECD-Guidelines 19952); – The business strategy (sec. 3.4.11.4 (e); sec. 1.31-1.35 OECD-Guidelines 19953). (a) Unrestricted comparability An unrestricted comparability exists if – The terms and conditions are identical; or – Differences in the terms and conditions have no essential impact on the pricing; or – Differences in the terms and conditions (e.g. different terms of payment) have been eliminated by sufficiently precise adjustments and the identified data is qualitatively reliable. It is referred to the principles of the comparability examination in sec. 1.15 to 1.18 OECD-Guidelines 19954). In case a range of arm’s length prices results from the unrestricted comparability of the terms and condition, all prices within this range are in principle to be accepted for tax purposes. If the price applied by the taxpayer lies outside the range, an adjustment must be made to the price within the range which is most favorable to the taxpayer. (b) Incomparability Incomparability exists in case the terms and conditions which have essential impact on the price and the profit, respectively, differ from each other so significantly that the differences cannot be eliminated by adjustment calculations. This is especially applicable to cases where special, particularly valuable intangible assets are of importance or the relevant functions or risks differ considerably. The same is applicable when arm’s length data is in such manner fragmentary, non-verifiable (mass data of several hundred or thousand companies without a comparability analysis) or with regard to the quality of relevant data so unreliable that it has no informative value. It cannot be relied on docu1 “Transfer Pricing Guidelines of the OECD, Paris 1995. 2 “Transfer Pricing Guidelines of the OECD, Paris 1995. 3 “Transfer Pricing Guidelines of the OECD, Paris 1995. 4 “Transfer Pricing Guidelines of the OECD, Paris 1995.

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mentation which is exclusively based on arm’s length comparable data which is not at least restrictedly comparable (sec. 3.4.19 (c)). Permanent losses especially of group distribution or service companies indicate that the facts cannot be compared, e.g. that the audited company pursues a different business strategy than the comparable companies (sec. 1.35 and 1.52 OECD-Guidelines 19951). (c) Restricted Comparability It cannot be decided in general in which cases the differences in the decisive comparability criteria of external comparative values still yield a restricted comparability or whether incomparability exists. To a large extent the assessment of the degree of comparability of products, services, functions performed, and risks is a question of an assessment of the circumstances in the individual case. Incomparable third party data does not become restrictedly comparable merely because it is provided in large number. In case differences are determined with regard to the comparability criteria between the audited company and its business relations in relation to the comparable companies, the following must be illustrated and documented regarding the examination whether at least a restricted comparability exists – What differences exist in detail (functional and risks analysis also of the comparable companies); – What adjustment calculations were made with regard to the differences and, if applicable, why adjustment calculations were either omitted or impossible; – Why at least restricted comparability may be assumed despite the omitted adjustment calculations. If, in spite of these differences in the terms and conditions, the taxpayer submits no documentation or only incomprehensible documentation regarding the comparability examination, it must be assumed that the circumstances are incomparable (sec. 3.4.19 (c)). 3.4.12.8 Subsequent pricing and price adjustments In principle, subsequent pricing (calculation of the absolute price amount) after the conclusion of the business is only then to be accepted for tax purposes if a supply relationship against remuneration as well as all pricing criteria were agreed in advance. These shall not be subject to further influence of the parties involved. Only then it can be ensured that subsequent pricing is based on calculations defined in advance (decision of the Federal 1 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995.

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Fiscal Court of December 17, 1997, Federal Tax Gazette 1998 II p. 545). A subsequent price calculation must be attributable to one or several price components for which an uncertainty existed and was identified at the time the contract was concluded (e.g. calculation of the interest rate according to the reference interest rate of the European Central Bank, determination of natural gas prices according to the development of crude oil prices) but not to the result which is generated for one of the parties. It is referred to sec. 3.4.20 (e). In exceptional cases subsequent pricing arrangements or price adjustments are to be acknowledged if the taxpayer shows credibly using documentation that those would have also been arranged between independent third parties under comparable circumstances (decision of the Federal Fiscal Court of August 14, 1974, Federal Tax Gazette 1975 II p. 123) e.g. shortly after a delivery has been made or a service has been rendered. 3.4.12.9 Multi-year analyses In order to identify economic circumstances of business transactions (e.g. product and economic cycles) and extraordinary influences, it may be appropriate to prepare and document multi-year analyses (sec. 1.49 OECDGuidelines 19951). The permissibility of such analyses does not mean that average considerations are to be acknowledged in any case. 3.4.13 Aggregation of business transactions and internal transfer pricing guidelines Documentation of extraordinary business transactions (sec. 3.4.8.2) and of extraordinary continuing obligations must always be prepared referring to the individual business transaction and the individual continuing obligation, respectively. Documentation of ordinary business transactions generally has to be prepared with reference to each individual transaction (§ 2 (3) sent. 1 Ordinance on the Documentation of Income Attribution, sec. 2.1.2 Administrative Guidelines – Income Allocation 19832). An aggregation of business transactions that are connected with respect to the subject or time (e.g. so-called sales mix considerations) or ordinary long-term relationships is permitted pursuant to § 2 (3) Ordinance on the Documentation of Income Attribution (sec. 1.42 et seq. OECD-Guidelines 19953) if – The aggregation is usual for business transactions between independent third parties (e.g. sale of a printer and its maintenance); or 1 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995. 2 Federal Tax Gazette 1983 I p. 218. 3 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995.

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– Aggregation is performed according to verifiable and documented predetermined rules and the business transactions are comparable considering the functions performed, assets employed, and risks assumed; or – In case the examination of the appropriateness of a business relationship depends more on the assessment of the package deal than on that of the individual business transaction, e.g. for causally connected business transactions and partial services within the scope of a package deal. In case a group of affiliated companies has internal transfer pricing guidelines that provide for pricing for certain business transactions according to the arm’s length principle, it may be refrained from transactional individual documentation if the taxpayer can show using randomly selected test cases that it is complied with the guidelines. The taxpayer determines the content and structure of his guidelines. These may e.g. aggregate business transactions into groups under the prerequisites of § 2 (3) Ordinance on the Documentation of Income Attribution, describe the functions performed and risks assumed by individual enterprises and then, based thereon, stipulate one or several suitable transfer pricing methods for the determination of prices, profit level indicators, etc. To that extent the guidelines may constitute an important part of the documentation to be prepared. Even though such guidelines are applied, all information required pursuant to §§ 4 and 5 Ordinance on the Documentation of Income Attribution (e.g. group structure, nature and scope of the business relations, presence and application of comparable arm’s length data, sec. 3.4.12.2, planning forecasts) must be available upon request within the deadline of § 90 (3) sent. 8 General Fiscal Code. If the taxpayer deviates from the guidelines in individual cases, he must substantiate the deviation and document the reasons with reference to the respective business transaction. The tax authorities shall examine whether the intercompany transfer pricing guidelines comply with the arm’s length principle and whether it was adhered to the guidelines in individual test cases which they shall select. If deviations from the guidelines are determined in cases for which no particular documentation was submitted or the reasons for the deviation may not be clarified (e.g. due to personnel changes), then, depending on their scope and importance this may lead to adjustments of the income (if applicable, also using estimations) or, in especially serious cases, may result in the documentation being unusable (sec. 3.4.19, see sec. 4.6 on the impacts). 3.4.14 Additional useful information Apart from the generally required documentation pursuant to § 4 Ordinance on the Documentation of Income Attribution and the necessary documentation regarding specific cases pursuant to § 5 Ordinance on the 209

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Documentation of Income Attribution, which the taxpayer may have to prepare and submit, he may also collect additional useful information or documents to support his documentation, e.g. – Available cross-check calculations (sec. 3.4.18); – Information on responsibilities for decision making; – Market analyses; – Illustration of the process and the period of the price negotiations, correspondence describing contrary negotiation positions (sec. 5.27 OECD-Guidelines 19951); – Report of the executive board of a controlled company regarding the relations with affiliated companies pursuant to § 312 Stock Corporation Act; – Employee organizational chart and job descriptions. In case the taxpayer has the respective documents available or he has respective information, pursuant to § 90 (2) General Fiscal Code he is required to provide these to the tax authorities upon request (sec. 3.3). 3.4.15 Required documentation in specific cases (§ 5 Ordinance on the Documentation of Income Attribution) The following records are to be included in the documentation regarding specific cases: – Documents on changes in business strategies or the implementation of a set-off of benefits (sec. 2.3 Administrative Guidelines – Income Allocation 19832) on which the taxpayer substantiates his transfer prices (§ 5 no. 1 Ordinance on the Documentation of Income Attribution). – It is referred to sec. 9 of the circular of the Federal Ministry of Finance of December 30, 19993 regarding cost allocations (§ 5 no. 2 Ordinance on the Documentation of Income Attribution). – Documentation of advance pricing agreements or transfer pricing arrangements with foreign tax authorities without the involvement of Germany (§ 5 no. 3 Ordinance on the Documentation of Income Attribution) which directly or indirectly influence the pricing of the taxpayer in his business relations with affiliates. The taxpayer is also obliged to provide information with regard to mutual agreement or EU arbitration procedures applied for which influence his transfer prices 1 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995. 2 Federal Tax Gazette 1983 I p. 218. 3 Federal Tax Gazette 1999 I p. 1122.

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and in which Germany did not participate, give a written statement on the status and on (temporary) notices already issued, and provide for submitted documents regarding his application or the procedure; the tax authorities shall regularly request such information and documents during a tax audit. – Documentation of subsequent price adjustments (§ 5 no. 4 Ordinance on the Documentation of Income Attribution) and their substantiation (e.g. due to transfer pricing adjustments or unilateral advance rulings by other countries). – Unless losses from business relations with affiliated parties accrue only temporarily (§ 5 no. 5 Ordinance on the Documentation of Income Attribution), it must be documented when the taxpayer identified the loss situation and which countermeasures he undertook (alternatives). 3.4.16 Documentation in foreign language Pursuant to § 2 (5) Ordinance on the Documentation of Income Attribution the documentation must in principle be prepared in the German language. Upon application, the tax authorities may approve of compiling documentation in another living language. The office in charge of tax assessments is obliged to decide on the application immediately. The office executing the audit will decide on the application in case it is submitted after the audit has been announced. Respective applications shall be granted under the prerequisite that translations required by the tax authorities during (future) tax audits will be submitted without delay, at the latest within the time limit of § 90 (3) sent. 8 General Fiscal Code. The application may already be filed prior to preparing the documentation. At the latest, it must be filed immediately after documentation has been requested by the tax authorities. The taxpayer may not successfully claim that he was unable to adhere to the time limit of § 90 (3) sent. 8 General Fiscal Code in case he did not file the application immediately after the request for documentation. Regarding extraordinary business transactions, the request must be issued in time so that the documentation may be prepared within the time limit of § 3 (1) sent. 2 Ordinance on the Documentation of Income Attribution. The expert third person within the meaning of § 2 (1) sent. 2 Ordinance on the Documentation of Income Attribution does not have to possess language skills that enable him to understand and examine documents in foreign languages. As a rule, the effort for the taxpayer to prepare a required translation has to be reasonable (sec. 3.2.5). Documentation which is only submitted in a 211

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foreign language may be unusable (sec. 3.4.19. (c)). Otherwise, § 87 (2) General Fiscal Code is applicable accordingly (sec. 3.2.5). 3.4.17 Reliefs from documentation duties (§ 6 Ordinance on the Documentation of Income Attribution) The main aspect of the reliefs as defined in § 6 (1) Ordinance on the Documentation of Income Attribution is that, instead of submitting documentation, information may be given orally and available documents may be submitted in due time (§ 90 (3) sent. 8 General Fiscal Code). In case these requirements are not fulfilled, sec. 4.6.3 must be regarded. In substantiated cases § 93 (4) sent. 2 remains unaffected. With regard to extraordinary business transactions it is refrained from the obligation to submit documentation contemporarily (§ 90 (3) sent. 3 General Fiscal Code) and supplementary documentation (art. 97 § 22 sent. 3 Introductory Act to General Fiscal Code). Compensation (without VAT, § 10 (1) sent. 2 Value Added Tax Act) received from foreign affiliated persons as well as compensation for deliveries made and services rendered to these persons have to be aggregated for the examination whether the thresholds within the meaning of § 6 (2) Ordinance on the Documentation of Income Attribution are exceeded. Goods and commodities in terms of this provision may be all tangible and intangible assets. Due to § 7 Ordinance on the Documentation of Income Attribution, actual transactions and cost allocations quoted in sec. 3.4.5.1 (a) must be considered at the applicable tax values in cross-border permanent establishments cases. Business relations with domestic affiliated parties remain unconsidered for the calculation. 3.4.18 Cross-check of the result 3.4.18.1 Verification with planning data, § 1 (3) sent. 4 Ordinance on the Documentation of Income Attribution It is possible and generally not unreasonably burdensome for the taxpayer to prepare documentation of internal planning data (sec. 3.4.12.2) as he may revert to his own documents and estimates in this respect. It is regularly to be refrained from requesting planning data in case the taxpayer has submitted unrestrictedly comparable arm’s length data (sec. 3.4.12.7 (a)). 3.4.18.2 Other cross-checking methods (a) In cases of restricted comparability (sec. 3.4.12.7) the taxpayer may cross-check the identified comparable values and/or any arm’s length range resulting therefrom in order to validate their usability and to support the appropriateness of his transfer pricing. The same is appli212

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cable to uncertainties due to discovered differences in the facts which may have essential impact on the prices or profits (e.g. differences in functions and risks, economies of scale from different quantity volumes). For continuing obligations (e.g. cost allocation or license agreements) the taxpayer may use a multi-year analysis to cross-check whether the remuneration or the costs charged are at arm’s length and economically acceptable (sec. 3.4.12.9). In order to cross-check or support the result for distribution companies e.g. calculations may be used according to which the company generates an appropriate total profit within a reasonably foreseeable time frame based on the agreed prices or margins (see also sec. 2 (a) of the circular of the Federal Ministry of Finance of February 26, 20041). (b) In case uncertainties regarding the comparability (sec. 3.4.12.7) may not be eliminated in the course of a tax audit, the tax authorities shall attempt to carry out cross-checking calculations themselves in order to assess whether the result of the taxpayer should be approved or refused. Upon request, the taxpayer is obliged to submit documents available to him and his own cross-checking calculations as well as to furnish further information (§ 90 (2) General Fiscal Code). 3.4.19 Usability and non-usability of documentation (a) Pursuant to § 2 (1) sent. 3 Ordinance on the Documentation of Income Attribution, documentation is usable if it enables an expert third party within a reasonable time period to determine and to examine which facts have been realized by the taxpayer (“documentation of the facts”) and whether and to what extent the taxpayer has complied with the arm’s length principle (“arm’s length documentation”) (sec. 3.4.10.2). Usable documentation shall form the basis for the examination of the transfer prices without excluding adjustments by the tax authorities (sec. 3.4.20). (b) Whether documentation is substantially unusable within the meaning of § 162 (3) and (4) General Fiscal Code may only be decided in the individual case. In each case the question has to be answered separately with regard to an individual request (subject of the audit). Both the documentation of the facts and the documentation of the appropriateness are of importance regarding the assessment. The result depends on the quality of the submitted documentation and not on its quantity (§ 2 (1) sent. 3 Ordinance on the Documentation of Income Attribution).

1 Federal Tax Gazette 2004 I p. 270.

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The decision whether specific documentation is usable does not affect documentation of other subjects under audit (sec. 4.6.3 (d)). Documentation does not become substantially unusable merely because it is incomplete or deficient regarding individual points. Documentation is not considered in any case substantially unusable merely because the arm’s length documentation is supported by a low number of comparable arm’s length data (circular of the Federal Ministry of Finance of February 26, 20041). (c) If the tax authorities conclude that documentation is substantially unusable, they are obliged to inform the taxpayer immediately and ask him to make subsequent improvements because non-usability can trigger legal consequences as defined in § 162 (3) and (4) General Fiscal Code (sec. 4.6). Regardless of the taxpayer’s efforts, the tax authorities are obliged to assess in the individual case whether it is possible for them to cause the documentation usable without further involving the taxpayer in order to avoid tax surcharges or to keep those at a minimum (restriction of commensurability). An arm’s length documentation is “substantially unusable” if documentation is submitted in a foreign language without the approval of the tax authorities as laid down in § 2 (5) Ordinance on the Documentation of Income Attribution and if the taxpayer does not translate it despite a request. It is referred to sec. 3.4.16. The same is applicable in cases where the taxpayer submits an arm’s length documentation which merely shows that the transfer prices were imposed by an affiliated party or in specific cases where only the transfer pricing method and its suitability is illustrated to substantiate the transfer prices without a comparison with comparable arm’s length data or without sufficient planning forecasts. The same is applicable if the arm’s length documentation is only supported by data which does not permit an arm’s length test (sec. 3.4.12.7 (b) and (c)) or if a domestic distribution company performing routine functions (sec. 3.4.10.2 (a) merely submits a database study of profit level indicators of unaffiliated companies (so-called pure database screening, sec. 3.4.12.4); this is all the more applicable to companies performing more than just routine functions (sec. 3.4.10.2 (b) and (c)). 3.4.20 Possible adjustments in case of usable documentation (a) The submission of usable documentation does not exclude income adjustments. The tax authorities may request further information and 1 Federal Tax Gazette 2004 I p. 270.

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documents exceeding the submitted documentation (§ 88 General Fiscal Code) and may make cross-checks according to other methods (sec. 3.4.18.2). Usable documentation constitutes the basis for the audit. The tax authorities bear the burden of determining the basis of an income adjustment in case the facts or the appropriateness of the transfer prices cannot be completely clarified despite having fulfilled the cooperation duties. Identified deficiencies in the justification of the taxpayer regarding the appropriateness of his transfer prices are insufficient for an adjustment. It is rather the prerequisite that the result of the taxpayer most likely does not comply with the arm’s length test and that the result supported by the tax authorities is at least more likely. (b) If the taxpayer supports his transfer pricing with comparable arm’s length data which leads to ranges, adjustments may result, e.g.: – In case unrestrictedly comparable arm’s length data is identified and the result applied by the taxpayer lies outside the obtained range, an adjustment has to be carried out to the value within the range which is most favorable to the taxpayer (sec. 3.4.12.5 (a), para. 2). – If only restrictedly comparable arm’s length data can be determined and the price agreed on by the taxpayer lies outside the narrowed range (sec. 3.4.12.5 (c) and (d)), the adjustment must be made to the point in the narrowed range which is most favorable for the taxpayer. – In case the taxpayer did not make possible adjustment calculations to restrictedly comparable arm’s length data, such must be made subsequently. – If the taxpayer refrains from the necessary narrowing of the range (sec. 3.4.12.5), the result has to be determined using the values within the narrowed range. – The range identified by the taxpayer may include values which are either incomparable or less comparable; in such cases the range must be re-calculated without using such values. – Even though the transfer pricing carried out by the taxpayer is supported by arm’s length data with restrictedly comparable values within a narrowed range, adjustments are not excluded. Example: The purchase prices of a group distribution company lie within its calculated, narrowed arm’s length range. It may not generate profits with such prices, though. Despite generating permanent losses it continues with its business activity. An adjustment has to be made (decisions of the Federal Fiscal Court of February 17, 1993, Federal Tax Gazette II

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(c) If a taxpayer bases his transfer pricing on planning forecasts (sec. 3.4.12.6), adjustments can be made despite usable documentation, e.g.: – The tax authorities provide evidence for reasonable comparable arm’s length data (e.g. at least restrictedly comparable enterprises) which leads to different results. – The assumptions on which planning forecasts was based on (e.g. price development, quantity of units, costs, and cost allocation) were not economically substantiated at the time the planning forecasts were made. The tax authorities may adjust the transfer prices based on conservatively and economically substantiated assumptions. The same is applicable to cases in which a comparison of target figures with actual figures is to be prepared regularly (sec. 3.4.12.6 (c)) and it is revealed that the originally underlying assumptions were correct but do not comply with the actual development and the taxpayer has not immediately adjusted the planning forecasts in such manner as that an appropriate profit can be expected in the future. – The functions and risks-related premiums added to a risk-free interest rate which serve to generate a risk-adequate return are inapplicable or are only roughly estimated, e.g. with reference to “experience”. – The tax authorities determine that according to the planning forecasts applied by the taxpayer the affected group company does not share appropriately in the expected total profit of the whole group, e.g. because the predicted total profit has been estimated inaccurately, because the functions performed by that group company have been assessed incorrectly, or because the valuation was based on rough estimates due to lacking better criteria. (d) In case the tax authorities apply a different method than the taxpayer in the examination, it may lead to adjustments if the results of the alternative method show a higher degree of probability.

1 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995.

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(e) Adjustments to the profit or loss that are carried out by the taxpayer for the past and that are not based on concluded advance agreements as laid down in sec. 3.4.12.8 are not to be accepted for tax purposes. This is especially applicable to retrospective “price adjustments” made by means of subsequent payments or debits/credits which adjust the result of an enterprise within the meaning of sec. 3.4.10.2 (c) to the net profit level indicators of comparable companies.

4. Legal consequences for breaching the cooperation duties 4.1 General Taxpayers who do not or only partially fulfill their cooperation pursuant to § 90 (1) to (3) General Fiscal Code have to expect unfavorable consequences, e.g.: – Reduction of the duties of the tax authorities to investigate (§ 88 General Fiscal Code), – Rejection of liabilities and expenses (§ 160 General Fiscal Code), – Application of coercive measures (§§ 328 et seq. General Fiscal Code), e.g. in case the taxpayer does not submit documentation within the meaning of § 90 (3) General Fiscal Code or fails to comply with the request to mend deficient documentation (sec. 3.4.19 (c)), – Rejection of declarations and evidence submitted in out-of-court appeals procedures (§ 364b General Fiscal Code), – Reduction of the standard of proof (sec. 4.4), – Shift of the burden of proof to the disadvantage of the taxpayer (e.g. disputable assumption pursuant to § 162 (3) General Fiscal Code, sec. 4.6.1), – If necessary, estimation of tax basis by exploiting a determined range to the disadvantage of the taxpayer (§ 162 (1), (2), and (3) General Fiscal Code, sec. 4.6.2), – Assessment of a surcharge (§ 162 (4) General Fiscal Code, sec. 4.6.3), – Execution of criminal or fiscal offence proceedings pursuant to § 369 et seq. General Fiscal Code; the opening may e.g. be considered in case the taxpayer was aware of reliable arm’s length prices at the time the transfer prices were determined yet he did not apply these in order to save tax or in case the requirement to adjust pursuant to § 153 General Fiscal Code was breached. The provisions of § 162 (3) and (4) General Fiscal Code which are applicable for the first time for business years commencing after December 31,

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2003 supplement the already existing regulations and do not substitute these. 4.2 Burden of proof In principle, the tax authorities bear the objective burden of proof (burden of assessing the facts) for such facts which constitute or increase a tax claim (sec. 2.1). The question who bears the burden of proof arises in cases where a fact material to a determination cannot be completely clarified despite exploiting all accessible and reasonable investigatory options. In case the taxpayer breaches his cooperation duties, this provision with respect to the burden of proof does not apply unqualified (decision of the Federal Fiscal Court of February 15, 1989, Federal Tax Gazette II p. 462 and decision of the Federal Fiscal Court of August 9, 1991, Federal Tax Gazette 1992 II p. 55). The standard of proof is reduced (sec. 4.4). 4.3 Reduction of the investigatory duties of the tax authorities regarding the clarification of facts In cases where a taxpayer breaches his cooperation duties, the investigatory duties of the tax authorities are reduced accordingly (resolution of the Federal Fiscal Court of July 9, 1986, Federal Tax Gazette 1987 II p. 487, decision of the Federal Fiscal Court of April 28, 1988, Federal Tax Gazette II p. 748 and decision of the Federal Fiscal Court of February 15, 1989, Federal Tax Gazette II p. 462). Even in such cases the tax authorities are required to clarify the facts to the extent it is possible for them with reasonable effort (decision of the Federal Fiscal Court of December 20, 2000, Federal Tax Gazette 2001 II p. 381). 4.4 Reduction of the degree of proof when cooperation duties are breached If the taxpayer breaches his cooperation duties e.g. by not disclosing facts within his knowledge, the standard of proof is reduced in favor of the tax authorities (decision of the Federal Fiscal Court of February 15, 1989, Federal Tax Gazette II p. 462, decision of the Federal Fiscal Court of August 9, 1991, Federal Tax Gazette 1992 II p. 55 and decision of the Federal Fiscal Court of October 17, 2001, Federal Tax Gazette 2004 II p. 171; circular of the Federal Ministry of Finance of February 26, 20041). In case facts cannot be clarified with the utmost probability possible (normative standard of proof), a smaller degree of probability is sufficient for levying taxes. In cases where the breach of the cooperation duties has an impact on several elements of an income adjustment provision, the standards of proof are reduced for all affected elements of the adjustment provision (circular 1 Federal Tax Gazette 2004 I p. 270.

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of the Federal Ministry of Finance of February 26, 20041). If it is determined, or it may be assumed due to the breach of duty that e.g. in the case of a hidden profit distribution the element of inducement by the shareholder relationship is given, then there is also reason to assume that this inducement has also resulted in business terms and conditions (especially prices) that do not comply with the arm’s length principle. To that extent, the standard of proof is reduced. In this situation the taxpayer is obliged to demonstrate that and for what reason his prices nevertheless comply with the arm’s length test. If he is unable to do so, the tax authorities may presume facts and circumstances for their estimation (sec. 4.5) that are unfavorable to the taxpayer, provided that these are probable. Example: Against its obligation, a domestic subsidiary fails to furnish usable information on technical characteristics and the condition (e.g. year of manufacture, machine type and running time, defects, overhauls) of a machine it had sold to its foreign parent company. Sound documents are not available. If the tax authorities are unable to clarify the facts after exploiting their investigatory means reasonably available to them, they are entitled to presume that the price was induced by the shareholder relationship as well as a particularly good technical condition of the machine. Subsequently, the market value for a machine in such particularly good technical condition is to be determined. In case a range of prices is yielded for such a machine, the most probable value is to be applied within the scope of the estimation pursuant to § 162 (2) General Fiscal Code. Unless there is further indication, this will be the mean value of the range.

4.5 Estimation pursuant to § 162 (1) and (2) General Fiscal Code It is the purpose of estimation to assess such tax bases which have the best probability of being accurate and which are closest to reality (decision of the Federal Fiscal Court of January 19, 1993, Federal Tax Gazette II p. 594). Each estimation must be consistent, economically reasonable, and as correct as possible (decision of the Federal Fiscal Court of December 18, 1984, Federal Tax Gazette 1986 II p. 226 and decision of the Federal Fiscal Court of December 20, 2000, Federal Tax Gazette 2001 II p. 381). The estimation does not become illegitimate just because it does not comply with the actual circumstances. Factual deviations cannot be avoided as full knowledge of the true circumstances is missing. Estimation becomes only then illegitimate when the estimation range which was determined by the tax authorities based on their knowledge of this case is exceeded. In cases where the tax authorities deliberately and arbitrarily assess to the disadvantage of the taxpayer (punitive estimation), the estimation notice may become void (decision of the Federal Fiscal Court of October 1, 1992, Federal Tax Gazette 1993 II p. 259 and decision of the Federal Fiscal Court of December 20, 2000, Federal Tax Gazette 2001 II p. 381).

1 Federal Tax Gazette 2004 I p. 270.

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If the taxpayer is obliged to accept that the tax bases have to be estimated because he e.g. breached his cooperation duties pursuant to § 90 (2) General Fiscal Code, uncertainties will be to his disadvantage (reduced standard of proof, sec. 4.4). Gross violations of the taxpayer which require significant changes to the statements made in the tax return generally enable and oblige the tax authorities to assess the tax bases to a fact which is most unfavorable to the taxpayer, yet still possibly correct (decision of the Federal Fiscal Court of March 9, 1967, Federal Tax Gazette II p. 349). The “person corrupting evidence” may not draw a benefit from his misbehavior (decision of the Federal Fiscal Court of February 15, 1989, Federal Tax Gazette II p. 462). Yet, punitive estimations are not permissible in such cases, either. In transfer pricing cases estimation pursuant to § 162 (2) General Fiscal Code shall result in the taxation of the profit which would have been generated if arm’s length prices had been applied. No exaggerated demands shall be made regarding evidence which is to be provided by the tax authorities (decision of the Federal Fiscal Court of June 23, 1993, Federal Tax Gazette II p. 801). In case the prerequisites for estimation pursuant to § 162 (2) General Fiscal Code are met, the tax bases may be assessed according to methods and based on data the probative value of which would be insufficient for an income adjustment in circumstances other than the estimation (e.g. indicative rate settlements, yield of capital employed pursuant to § 1 (3) Foreign Tax Act, industry average values). The authorization to estimate does not depend on the fact that the tax authorities have previously made use of international legal and administrative assistance (sec. 2.4). 4.6 Special consequences for breaching documentation duties pursuant to § 90 (3) General Fiscal Code The legal consequences named hereinafter (see § 162 (3) and (4) General Fiscal Code) for breaching documentation duties pursuant to § 90 (3) General Fiscal Code are applicable to business transactions in business years commencing after December 31, 2003. 4.6.1 Statutory assumption of reducing income subject to domestic tax (§ 162 (3) sent. 1 General Fiscal Code) If taxpayers breach their documentation duties by – not submitting documentation or only such which is primarily unusable despite the request by the tax authorities, or

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– not preparing documentation of extraordinary business transactions contemporarily (§ 3 Ordinance on the Documentation of Income Attribution), it is disputably assumed according to § 162 (3) sent. 1 General Fiscal Code that the income from business relations with affiliated parties was reduced by pricing which was inconsistent with the arm’s length standard. In such cases the taxpayer bears the burden of proving that no income reduction has occurred. If documentation is submitted late, § 162 (4) sent. 3 General Fiscal Code is to be applied (sec. 4.6.3). In case the documentation of extraordinary business transactions is prepared late, the delay (circumstantial evidence) shall be considered when the probative value of the document is recognized. 4.6.2 Estimation by exploiting ranges to the disadvantage of the taxpayer (§ 162 (3) sent. 2 General Fiscal Code) In cases where breaches of the taxpayer as stated in § 162 (3) sent. 1 General Fiscal Code make estimation necessary pursuant to § 162 (3) sent. 2 General Fiscal Code and the tax authorities have identified a range of estimated values, they may exploit the range to the disadvantage of the taxpayer (see sec. 3.4.12.5 for the narrowing of ranges; see sec. 4.5 regarding the necessary degree of probability for an estimation). An estimation may be examined and adjusted during subsequent mutual agreement or (EU) arbitration proceedings (sec. 6.1.3). 4.6.3 Assessment of a surcharge (§ 162 (4) General Fiscal Code) If a taxpayer breaches his documentation duties pursuant to § 90 (3) General Fiscal Code despite a request from the tax authorities by – not submitting documentation, or – submitting substantially unusable documentation (sec. 3.4.19 (b) and (c)), or – providing usable documentation late, a surcharge will be imposed. This is also applicable to respective offences in cases of cross-border permanent establishments and business partnerships (§ 90 (3) sent. 4 General Fiscal Code and § 7 Ordinance on the Documentation of Income Attribution) and in the cases of § 6 Ordinance on the Documentation of Income Attribution (sec. 3.4.17) where the requirements regulated therein are not met. The assessment of the surcharge constitutes an administrative act but is not a tax assessment notice.

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Two types of cases must be differentiated regarding the assessment of the surcharge: – Non-submission of documentation or submission of unusable documentation; in such cases the assessed surcharge amounts to at least 5 % and 10 % at the most of any positive additional income from business relations with affiliated parties, yet at least 5,000 Euros. The tax authorities are obliged to set the surcharge within these limits at their responsible discretion. The minimum surcharge of 5,000 Euros is to be assessed in cases where no adjustments are made or where the percental surcharge would amount to less than 5,000 Euros. – Late provision of usable documentation; regardless of an adjustment a surcharge is to be assessed in such cases amounting to at least 100 Euros for each full day the time limit has been exceeded and to 1,000,000 Euros at the most for each assessment period in all instances of submitting usable documentation (see (d) below). The tax office which issues the assessment notice based on the tax audit report is responsible for the imposition of the surcharge. It must be adhered to the following with regard to the assessment and the legal evaluation of the surcharge: (a) The surcharge is a collateral tax burden pursuant to § 3 (4) General Fiscal Code which is charged to income and corporate tax, respectively. It is not deductible (§ 12 no. 3 Income Tax Act and § 10 no. 2 Corporate Income Tax Act). (b) The assessment of a surcharge pursuant to § 162 (4) General Fiscal Code excludes neither the imposition of a late filing penalty (§ 152 General Fiscal Code) nor the introduction of criminal or fiscal offence proceedings (§ 369 et seq. General Fiscal Code). (c) The surcharge may be imposed on any person committed to such duties that are constituted by § 90 (3) General Fiscal Code (sec. 3.4.4), yet not twice for the same matter, e.g. on a business partnership and its partners. A joint liability exists within the meaning of § 44 General Fiscal Code. If the documentation duties are breached, the surcharge pursuant to § 162 General Fiscal Code is to be appointed primarily to those that need to prepare and submit the documentation, i.e. in case of coentrepreneurships normally to the co-entrepreneurship (sec. 3.4.4). (d) The surcharge is to be assessed uniformly for each assessment period for which documentation was requested and has to relate to the respective documentation that the tax authorities have required. Under consideration of the restrictions of § 2 (6) Ordinance on the Documentation of Income Attribution, the request may relate e.g. to documentation of the audit subject selected by the tax authorities and ultimately to the documentation of the individual (e.g. extraordinary) business transaction. 222

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The aggregation of business transactions which is in principle permissible must be regarded (§ 3 Ordinance on the Documentation of Income Attribution). Accordingly, the uniform surcharge may relate to several breaches of duties and in each case in relation to the different requirements of the tax authorities: the non-submission of documentation, the submission of unusable documentation, the late submission of usable documentation. The assessment has to illustrate the individual elements of the surcharge. The exercise of discretion is to be explained for each case. In this regard, especially the extent to which the taxpayer was at fault, the period by which the deadline had been exceeded, and the taxpayer’s benefits have to be considered. (e) To the extent that an assessed surcharge pursuant to § 162 (4) sent. 1 and 2 General Fiscal Code is based on the fact that during the tax audit the taxpayer failed to submit documentation or submitted substantially unusable documentation and on the fact that an income increase was carried out based on a legitimate estimation pursuant to § 162 (3) General Fiscal Code, amendments to the surcharge may be possible within the scope of § 130 et seq. General Fiscal Code if in an appeal proceeding, mutual agreement procedure, or EU arbitration procedure the respective income is assessed lower than that in the tax audit. In such cases an amendment of the surcharge (recalculation) may only be considered if the taxpayer submits usable documentation. In case usable documentation is subsequently submitted in the aforementioned proceedings, the surcharge as such is to be recalculated based on § 162 (4) sent. 3 and 4 General Fiscal Code due to late submission. 4.6.4 Justifiable non-compliance with the obligations pursuant to § 90 (3) General Fiscal Code (§ 162 (4) sent. 5 General Fiscal Code) § 162 (4) sent. 1 to 3 General Fiscal Code are inapplicable if the non-compliance with the obligations pursuant to § 90 (3) General Fiscal Code appears to be justifiable or the scope of default is only minor. Such a case may e.g. exist if documentation or its underlying documents have been destroyed through no fault or if documentation is submitted in German after the expiry of the 60-day period because after having requested the documentation the tax authorities failed to decide immediately on an application to submit documentation in a foreign language.

5. Implementation of adjustments and their tax treatment 5.1 Principles for an adjustment The general provisions regarding an allocation of assets and income as well as on the determination of the tax assessment basis (e.g. §§ 39 to 42 General Fiscal Code) precede the adjustments on and off the balance sheet, respectively (sec. 5.2 and 5.3). An adjustment is to be carried out for 223

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the fiscal year in which the respective income reduction or the prevented increase in business property took place. The adjustment amount is to be allocated to the same income category as the adjusted income. A writedown to going concern value with respect to the income adjustment amount may only be considered in cases where the adjustment was reflected on the balance sheet. 5.2 Adjustments reflected on the balance sheet In cases where an application of the general provisions (sec. 5.1) cannot be considered, it is to be examined whether a correction on the balance sheet according to the principles regarding balance sheet adjustments may be carried out under consideration of an interest charge, if applicable. This may be the case where an already legally valid receivable has to be capitalized subsequently (decision of the Federal Fiscal Court of September 14, 1994, Federal Tax Gazette 1997 II p. 89; circular of the Federal Ministry of Finance of December 19, 1996, Federal Tax Gazette 1997 I p. 112). Receivables that are disputed and barred by the statute of limitations can generally not be capitalized subsequently (decision of the Federal Fiscal Court of April 26, 1989, Federal Tax Gazette 1991 II p. 213 and decision of the Federal Fiscal Court of February 9, 1993, Federal Tax Gazette II p. 543). To the extent that the prerequisites of a hidden capital contribution to the business property of an affiliated company are fulfilled, the acquisition costs on the participation of the domestic shareholder and the current shareholder’s income must be increased pursuant to § 6 (6) sent. 2 Income Tax Act by the going-concern value of the contributed assets (decision of the Federal Fiscal Court of April 16, 1991, Federal Tax Gazette 1992 II p. 234 and decision of the Federal Fiscal Court of July 29, 1997, Federal Tax Gazette 1998 II p. 652). Sec. 5.3.3 must be regarded in case both the prerequisites of a hidden capital contribution and those of § 1 Foreign Tax Act are fulfilled. 5.3 Off-balance-sheet adjustments 5.3.1 Hidden profit distribution To the extent the prerequisites of a hidden profit distribution within the meaning of § 8 (3) sent. 2 Corporate Income Tax Act are met, an off-balance-sheet adjustment has to be carried out (circular of the Federal Ministry of Finance of May 28, 2002, Federal Tax Gazette I p. 603 and decision of the Federal Fiscal Court of June 29, 1994, Federal Tax Gazette 2002 II p. 366). The arm’s length price constitutes the standard for such an adjustment (decision of the Federal Fiscal Court of October 17, 2001, Federal Tax Gazette 2004 II p. 171). This price regularly complies with the fair market value. According to the general principles, the corporation is obliged to withhold and pay withholding tax. 224

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5.3.2 Withdrawal A transfer of property (asset, benefit of use, service) between an individual or a business partnership on the one side and affiliated parties on the other side is to be treated pursuant to the principles governing withdrawal. Pursuant to § 6 (1) no. 4 Income Tax Act, the transfer is in principle to be evaluated at the going concern value. The replacement costs constitute the upper limit for the evaluation of the withdrawal. Withdrawals of the use of assets must be evaluated at cost (decision of the Federal Fiscal Court of May 24, 1989, Federal Tax Gazette 1990 II p. 8). In case the adjustment amount (withdrawal value/going concern value pursuant to § 6 (1) no. 4 Income Tax Act) is less than the arm’s length price and a business relation in terms of § 1 (4) Foreign Tax Act exists, § 1 Foreign Tax Act is applicable in addition to § 6 (1) no. 4 Income Tax Act (sec. 5.3.3). 5.3.3 § 1 Foreign Tax Act § 1 Foreign Tax Act leaves other provisions regarding the adjustment unaffected and yields priority to these. This is especially applicable to hidden profit distributions and hidden capital contributions. The supply of assets is only then to be treated as a hidden capital contribution in case the transfer leads to equity also according to foreign company law (decision of the Federal Fiscal Court of May 30, 1990, Federal Tax Gazette II p. 875). In contrast, adjustments are based solely on § 1 Foreign Tax Act if a domestic taxpayer grants the use of assets or renders services to a foreign subsidiary without appropriate remuneration. The arm’s length price constitutes the standard for the adjustment pursuant to § 1 Foreign Tax Act. In relation to the provisions governing withdrawal (§ 4 (1) and § 6 (1) no. 4 Income Tax Act) and the hidden capital contribution to a corporation (§ 6 (6) sent. 2 Income Tax Act), § 1 Foreign Tax Act constitutes an ideal concurrence. Besides the legal consequences from these provisions further adjustments of income pursuant to § 1 Foreign Tax Act are required to the extent that these are necessary to implement the arm’s length principle (sec. 1.1.2 of the Circular of Application on Foreign Tax Act1). § 1 Foreign Tax Act is to be applied to cases where the income of the taxpayer was reduced due to agreements on inappropriate prices as well as to cases where no remuneration was agreed and thus no income was generated. The latter case exists e.g. where a company subject to unlimited tax liability grants within the scope of business relations an interest-free loan to an affiliated foreign company.

1 Federal Tax Gazette 2004 I Special Edition 1/2004.

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5.4 Crediting of foreign taxes of foreign affiliates to German income tax which is allocated to the adjustment amount pursuant to § 1 Foreign Tax Act Within the scope of §§ 34c Income Tax Act, 26 Corporate Income Tax Act and the corresponding provisions of double taxation agreements, taxes that are levied to an affiliated party abroad on a part of the foreign profit which corresponds with the adjustment amount for the taxation in Germany cannot be credited to German tax which is allocated to the adjustment amount. 5.5 Subsequent compensation 5.5.1 Subsequent compensatory payments Parties in transfer pricing cases may compensate an adjustment carried out by the German tax authorities with compensatory payments which create a situation that would have occurred under consideration of the arm’s length principle; in such cases this adjustment is (a) In principle to be treated as a capital contribution in cases where an adjustment was based on the assumption of a hidden profit distribution of a domestic corporation (decision of the Federal Fiscal Court of May 29, 1996, Federal Tax Gazette 1997 II p. 92); (b) In principle to be treated as shareholder earnings within the meaning of § 20 (1) no. 1 Income Tax Act in cases where an adjustment was based on the assumption of a hidden contribution to a foreign corporation; (c) To be treated as a capital contribution in cases where an adjustment was based on the assumption of a withdrawal and as a withdrawal in cases where an adjustment was based on a capital contribution; (d) On grounds of equitableness, to be set off outside of the balance sheet against the additional income amount assessed for transactions where an adjustment was based on § 1 Foreign Tax Act (decision of the Federal Fiscal Court of May 30, 1990, Federal Tax Gazette II p. 875). This is only applicable if the compensatory payments are actually made within one year after the adjusted tax assessment notice has been issued. 5.5.2 Avoidance of double taxation in cases of a disposal of a participation or liquidations In case a participation in an affiliated foreign company is sold or such a company is being dissolved and transactions of previous assessment periods led on the level of the shareholder to an adjustment pursuant to § 1 Foreign Tax Act which has not yet been set off (sec. 5.5.1 (d)), the assets of the foreign company are greater than they would have been had the com226

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pany paid an arm’s length compliant price. In order to avoid double taxation, the off-balance-sheet adjustment amount (sec. 5.3.3) may be deducted in such cases from the profit on grounds of equitableness. The deduction may also result in a negative amount. If the shareholder receiving the profit or earnings is a corporation, the deduction is to be allocated to the tax-exempt result pursuant to § 8b (2) Corporate Income Tax Act. The deduction does not affect the application of § 8b (3) Corporate Income Tax Act. Hence, 5 % of the unreduced profit or remuneration is considered as a non-deductible business expense for the shareholder. If the shareholder is subject to income tax, the deduction must be considered when applying the half income exemption system (§§ 3 no. 40, 3c (2) Income Tax Act). In cases of liquidations, the deduction must be carried out in the assessment period in which, according to the generally accepted accounting principles, a possible liquidation profit is to be recognized as income. Thus, a deduction at the time of the resolution of liquidation can only be considered if the winding-up does not take place due to lacking assets and a liquidation profit does not accrue. In cases where a participation in a foreign company is sold, a set-off may only considered for the taxpayer for whom an adjustment pursuant to § 1 Foreign Tax Act has been carried out. It must be regarded that only partners participating in a business partnership are considered to be taxpayers within the meaning of § 1 (1) Foreign Tax Act, and not the partnership itself (decision of the Federal Fiscal Court of December 17, 1997, Federal Tax Gazette 1998 II p. 321).

6. Execution of transfer pricing adjustments and mutual agreement and arbitration procedures (EU) 6.1 General comments regarding the procedures 6.1.1 Relation of the German adjustment provisions to double taxation treaties Pursuant to German tax law, business relations between affiliated parties must be examined under consideration of the arm’s length principle (sec. 1.1.2 to 1.2.2 of the Administrative Guidelines – Income Allocation 19831 and pursuant to art. 9 (1) OECD Model Tax Convention). Double taxation treaties safeguard the adjustment options under national tax law and determine the arm’s length standard as the adjustment standard. Art. 9 OECD Model Tax Convention only covers cases of inappropriately invoiced service relationships under the law of obligations. In contrast, services to the controlling partner which lack explicit and unambiguous advance agreements are not included in art. 9 OECD Model Tax Convention. 1 Federal Tax Gazette 1983 I p. 218.

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6.1.2 Right to be heard of foreign persons concerned, information of the foreign tax authorities and the German competent tax authorities In transfer pricing cases the taxpayer must be informed about the option of notifying foreign parties affected about the intended domestic income adjustment so that they may contact the foreign tax authorities to establish their legal opinion (if necessary, the willingness for a corresponding adjustment). Certifications which are required for a processing abroad shall be issued by the domestic tax authorities to the extent possible (sec. 1.2.5 Administrative Guidelines – Income Allocation 19831). In case parties to the proceeding file during the tax audit with their competent tax authorities an application regarding the opening and conduction of a mutual agreement procedure, it has to be submitted through the official channels to the competent domestic tax authorities responsible for conducting the mutual agreement procedure immediately or at the latest after the clarification of facts has been finalized. 6.1.3 International procedures for the elimination of double taxation and/ or double tax burden 6.1.3.1 Mutual agreement procedures It is referred to the leaflet on International Mutual Agreement Procedures and Arbitration Procedures Regarding Tax Issues (circular of the Federal Ministry of Finance of July 1, 19972). See sec. 3.2.1 regarding the breaches of cooperation duties and sec. 5.1 of the circular of the Federal Ministry of Finance of July 1, 19973 regarding the taxpayer waiving the initiation of a mutual agreement procedure, e.g. on the occasion of an agreement during a tax audit. 6.1.3.2 Arbitration procedure (EU) In the cases comprised under art. 1 Convention 90/436/EEC on the Elimination of Double Taxation in Connection with the Adjustment of Profits of Associated Enterprises of July 23, 1990 (EU Arbitration Convention, Federal Tax Gazette 1993 I p. 819), pursuant to art. 6 (1) EU Arbitration Convention an enterprise may present the respective fact to the German tax authorities within three years after the measure has first been announced if it is subject to tax in Germany on a resident basis or if an affected permanent establishment of the enterprise is situated in Germany. If neither Germany nor the affected other contractual state(s) reach a mutual agreement regarding the elimination of double taxation within two years of the initial submission of the case pursuant to art. 6 (1) EU Arbitration Convention, pursuant to art. 7 (1) EU Arbitration Convention the 1 Federal Tax Gazette 1983 I p. 218. 2 Federal Tax Gazette 1997 I p. 717. 3 Federal Tax Gazette 1997 I p. 717.

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states are required to engage an advisory commission assigned to give a statement on how this double taxation shall be eliminated. It is referred to the code of conduct for an efficient execution of the EU Arbitration Convention procedures. Pursuant to art. 8 (1) EU Arbitration Convention, the initiation of an arbitration procedure may be denied if, through actions that resulted in a profit adjustment, one of the involved enterprises has committed a violation of tax regulations which is subject to a severe penalty. Such violation is given if it may be punished with imprisonment, a punitive fine, or an administrative fine. The surcharge pursuant to § 162 (4) General Fiscal Code is neither a criminal nor an administrative fine. Pursuant to art. 8 (2) EU Arbitration Convention an arbitration procedure may be suspended until respective court or administrative procedures that are concurrently pending have been finalized. 6.1.4 Additional comments on the procedures (a) Cooperation duties (§ 90 General Fiscal Code) and mutual agreement and arbitration procedures (EU) The option to execute a mutual agreement procedure pursuant to the Double Taxation Treaty or the EU Arbitration Convention or the application for the initiation or the actual initiation of a mutual agreement or arbitration procedure during the course of a tax audit does not release the parties from their cooperation duties pursuant to § 90 General Fiscal Code. (b) Tax audit and mutual agreement or arbitration procedure (EU) An application for the opening and the actual opening of a mutual agreement procedure or a preliminary proceeding pursuant to art. 5 EU Arbitration Convention does not exclude the continuation and conclusion of a tax audit. To the extent possible, the assessments necessary for conducting a potential mutual agreement procedure shall be made during the tax audit. (c) Statute of limitations and mutual agreement or arbitration procedure (EU) An application for the opening of a mutual agreement or arbitration procedure shall be treated as an application for the amendment of the tax assessment notice and affects the statute of limitations for the assessment of tax (§ 171 (3) General Fiscal Code). (d) Implementation of a mutual agreement settlement Pursuant to § 175a General Fiscal Code a mutual agreement arrangement shall be implemented regardless of the administrative finality of a tax assessment notice. Details are governed by the bulletin on the In229

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ternational Mutual Agreement Procedures and Arbitration Procedures regarding Tax Issues (sec. 4 of the circular of the Federal Ministry of Finance of July 1, 19971). 6.2 Protection of the German taxation right in mutual agreement or arbitration procedures (EU) 6.2.1 Domestic adjustments A German adjustment of transfer prices may have an impact on the taxation of foreign affiliated companies abroad and result in a mutual agreement or arbitration procedure (EU), e.g. in case the affected group applies for a corresponding adjustment by the other contractual state for the foreign affiliated company. With regard to such procedures, it is required to illustrate adjustments explicitly in the audit report to enable the competent authorities to comprehend the facts, legal basis, and the justification for the adjustment as well as the amount of the adjustment based on the information given in the audit documents and files. In this context, the factual and legal bases for the adjustment have to be explained in detail in the audit report. It is permissible to refer to appendices or documents that the taxpayer knows of if the documents are available thereinafter. Regarding the audited subjects, the audit report should include the information required by §§ 4 and 5 Ordinance on the Documentation of Income Attribution. This is also applicable to cases in which a factual agreement has been reached with the taxpayer or if no mutual agreement procedure is to be expected. Reliefs from these requirements are only justifiable in case the taxpayer waives the right to execute a mutual arbitration procedure (sec. 5.2 of the circular of the Federal Ministry of Finance of July 1, 19972). In cases where remuneration for goods or services is not acknowledged due to the lack of a prior, explicit and unambiguous advance agreement (sec. 6.1.1), it has to be illustrated to what extent the remuneration paid by the taxpayer complies with the arm’s length test as regards the amount. 6.2.2 Foreign adjustments An income adjustment by foreign tax authorities may result in double taxation with regard to the profit of the domestic affiliated company. If the domestic company thereupon adjusts its future transfer prices, it is obliged to document such measures pursuant to § 5 (4) Ordinance on the Documentation of Income Attribution (sec. 3.4.15). The tax authorities shall request these documents in every case. 1 Federal Tax Gazette 1997 I p. 717. 2 Federal Tax Gazette 1997 I p. 717.

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The impact on the German taxation of the parties involved is to be examined. Such “corresponding adjustment” shall only be acknowledged to the extent it is permissible under German substantive and procedural tax law. In cases where the examination of cross-border business transactions of a resident taxpayer results in no objections (e.g. because such were not or only partially subject of the audit), foreign tax authorities may carry out adjustments for an affiliated foreign company with regard to those business transactions which result in the initiation of a mutual agreement and arbitration procedure (EU). If a taxpayer announces that a foreign adjustment will probably result in a mutual agreement procedure, he is obliged to submit all significant documents (§ 90 (2) General Fiscal Code), to prepare documentation also outside the tax audit (§ 90 (3) sent. 6 General Fiscal Code), and to supplement these immediately upon the request of the German tax authorities.

7. Repeal of administrative regulations Sec. 8 and 9 of the circular of the Federal Ministry of Finance of February 23, 1983, Federal Tax Gazette I p. 218 are repealed and replaced by this circular.

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VII. Business Relationship (2005) Administrative Circular on the Business Relationship with Foreign Countries within the Meaning of § 1 (1) and (4) Foreign Tax Act; Decision of the Federal Fiscal Court of April 28, 2004, I R 5, 6/02 (Federal Tax Gazette 2005 II p. 516) Published on July 22, 2005 (IV B 4 – S-1341 – 4/05, Federal Tax Gazette 2005 I p. 818)

Pursuant to the abovementioned decision of the Federal Fiscal Court of April 28, 2004, a business relationship “with foreign countries” within the meaning of § 1 (1) and (4) Foreign Tax Act assumes that a personal relationship of a resident taxpayer with a foreign affiliated person exists. The Federal Fiscal Court assumes that a personal relationship is a contractual relationship (in the case decided: a loan agreement). According to the opinion of the Senate, such relationship with a foreign country is absent if a domestic taxpayer grants to a domestic affiliated person an interest-free loan even though the funds transferred serve the purposes of the affiliated person’s permanent establishment situated in a foreign country and are actually used for it. It shall not depend on how the financial means are used. The effects of reducing the income generated through the interestfree loan are restricted merely to the domestic domain because the corresponding benefit is subject to tax in the domestic country at the level of the recipient of the loan. Therefore, the transaction is not covered by § 1 (1) and (4) Foreign Tax Act. Based on the discussion with representatives of the highest tax authorities of the Federal States, the decision is not to be applied for other than the decided case: When a taxpayer enters into a business relationship with an affiliated person by granting him a loan, it constitutes a business relationship within the meaning of § 1 Foreign Tax Act between the taxpayer and the affiliated person. Even though the contractual relationship is established with a domestic affiliated person (subject to unlimited taxation) it may constitute a business relationship with a foreign country within the meaning of § 1 Foreign Tax Act. This is the case when that person maintains a foreign permanent establishment and the business relationship cannot be attributed to the domestic head office but rather to the foreign permanent establishment. The attribution is functionally determined under the so-called direct method and regularly results from the usage of the funds. § 1 Foreign Tax Act applies to whether the business relationship “with a foreign country” exists and not to whether a personal relationship (e.g. under the laws of obligation) was agreed on with a foreign affiliated person (not subject to unlimited taxation). Contrary to the opinion of the Federal Fiscal Court, § 1 (1) and (4) Foreign Tax Act cover the factual matter of a business relationship to a foreign country and not to a foreign person. 232

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The interpretation of the Federal Fiscal Court also contradicts the spirit and purpose of § 1 Foreign Tax Act. The provision shall prevent that income which does not comply with the arm’s length principle is transferred abroad. Contrary to the explanations given in the decision of the Federal Fiscal Court, the lender’s income reduction caused by the interest-free loan does not always yield to an actual taxation of the corresponding increase in the income of the domestic borrower. If the business relationship as well as the benefit from it are functionally connected to the foreign permanent establishment, then the respective higher income of the permanent establishment shall mostly be exempted from German taxation under a double taxation agreement.

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VIII. Mutual Agreement and Arbitration Procedures (2006) Bulletin Regarding the International Mutual Agreement and Arbitration Procedures for Taxes on Income and Capital (Administrative Bulletin – Mutual Agreement and Arbitration Procedures) Published on July 13, 2006 (IV B 6 – S 1300 – 340/06, Federal Tax Gazette 2006 I p. 461)

Based on the results of the discussions with the highest tax authorities of the Federal States, the following bulletin applies to international mutual agreement and arbitration procedures for taxes on income and capital: Content A. General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1. Mutual agreement and arbitration procedure in general . . . . 1.1 Legal nature and legal basis . . . . . . . . . . . . . . . . . . . . 1.2 Mutual agreement clauses under double taxation agreements and Arbitration Convention . . . . . . . . . . . 1.3 Subject and purpose of the procedure . . . . . . . . . . . . . 1.4 Responsibilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . B. Mutual agreement procedures under double taxation agreements . 2. Initiation of the mutual agreement procedure . . . . . . . . . . . 2.1 Application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2 Application deadline. . . . . . . . . . . . . . . . . . . . . . . . . 2.3 Content of the application. . . . . . . . . . . . . . . . . . . . . 2.4 Initiation of the mutual agreement procedure and legal protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5 Initiation of the mutual agreement procedure by foreign tax authorities. . . . . . . . . . . . . . . . . . . . . . . . 3. Implementation of the mutual agreement procedure . . . . . . 3.1 General procedural principles . . . . . . . . . . . . . . . . . . 3.2 Clarification of facts and reaching a mutual agreement 3.3 Involvement and rights of the party entitled to treaty benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4 Mutual agreement . . . . . . . . . . . . . . . . . . . . . . . . . . 4. Implementation of mutual agreements . . . . . . . . . . . . . . . . 4.1 Legal validity of assessment notices and statute of limitation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2 Consent of the applicant . . . . . . . . . . . . . . . . . . . . . . 5. Waiver of a mutual agreement procedure . . . . . . . . . . . . . . . 6. Mutual agreement procedure and tax audit . . . . . . . . . . . . . 7. Mutual agreement procedure and international exchange of information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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8. Consequences of the failure of a mutual agreement procedure . 9. Costs of the mutual agreement procedure under double taxation agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . C. Mutual agreement and arbitration procedures under the EU Arbitration Convention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. Preliminary proceedings under § 5 Arbitration Convention . . . 11. Initiation of the mutual agreement procedure . . . . . . . . . . . . 11.1 Application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.2 Application deadline. . . . . . . . . . . . . . . . . . . . . . . . . . 11.3 Content of the application. . . . . . . . . . . . . . . . . . . . . . 11.4 Initiation of the mutual agreement procedure upon application in the domestic territory . . . . . . . . . . . . . . 11.5 Initiation of the mutual agreement procedure upon application in a foreign state . . . . . . . . . . . . . . . . . . . . 12. Implementation of the mutual agreement procedure . . . . . . . 12.1 General procedural principles . . . . . . . . . . . . . . . . . . . 12.2 Procedure for an application filed in the domestic territory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12.3 Procedure for applications filed in foreign states . . . . . . 13. Arbitration procedure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13.1 General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13.2 Appointment of the advisory commission . . . . . . . . . . 13.3 Composition of the advisory commission . . . . . . . . . . . 13.4 Procedural principles . . . . . . . . . . . . . . . . . . . . . . . . . 13.5 Opinion of the advisory commission and decision of the competent authorities . . . . . . . . . . . . . . . . . . . . 13.6 Notification of the opinion of the advisory commission and the decision of the competent authorities . . . . . . . . 14. Costs of the mutual agreement and arbitration procedure under the Arbitration Convention. . . . . . . . . . . . . . . . . . . . . D. Application provisions and publication . . . . . . . . . . . . . . . . . . . . Appendix 1: Form regarding the forwarding of an application for the initiation of a mutual agreement procedure to the Federal Central Tax Office (see sec. 2.1.4) Appendix 2: Overview on double taxation agreements containing special deadlines for the applicants in the mutual agreement clauses

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A. General 1. Mutual agreement and arbitration procedure in general 1.1 Legal nature and legal basis 1.1.1 International mutual agreement and arbitration procedures are intergovernmental procedures for the homogeneous application of double taxation agreements or the convention of July 23, 1990 no. 90/436/EEC on the Elimination of Double Taxation in Connection with the Adjustment of Profits of Associated Enterprises (see Federal Law Gazette 1993 II pg. 1308, Federal Tax Gazette 1993 I pg. 818 and Federal Law Gazette 1995 II pg. 84, Federal Tax Gazette 1995 I pg. 166 – Arbitration Convention). 1.1.2 The legal basis is provided by the mutual agreement clauses of the double taxation agreements (cf. art. 25 OECD Model Tax Convention) or art. 6 et seq. Arbitration Convention. They include provisions according to which the competent authority in Germany may directly communicate with the competent authority of the other states in order to reach an agreement in individual cases regarding taxation in Germany or another state. The Arbitration Convention only refers to the profit allocation between affiliated companies and the allocation in cases of permanent establishments. Pursuant to the mutual agreement clauses of the double taxation agreement, an agreement may also be reached between the competent authorities as regards general questions. 1.1.3 The Arbitration Convention applies in relationships with Belgium, Denmark, France, Greece, Great Britain, Ireland, Italy, Luxemburg, the Netherlands, Portugal, and Spain and pursuant to the convention of December 21, 1995 (see Federal Law Gazette 1999 II pg. 1010 and Federal Law Gazette 2006 II pg. 575) also in relationships with Austria, Finland, and Sweden. The Convention, signed by Germany on December 8, 2004, on the accession of the Republic of Estonia, the Republic of Latvia, the Republic of Lithuania, the Republic of Malta, the Republic of Poland, the Slovak Republic, the Republic of Slovenia, Czech Republic, the Republic of Hungary and the Republic of Cyprus to the Convention (see Official Journal EU 2005 no. C 160 pg. 1) will, pursuant to its art. 5, enter into force between the contracting states that have ratified, accepted or approved it on the first day of the third month following the deposit of the last instrument of ratification, acceptance or approval by these states (see also Federal Law Gazette 2006 II pg. 554). The protocol of May 25, 1999 on the amendment of the Arbitration Procedure (see Federal Law Gazette 1999 II pg. 1082 and Federal Law Gazette 2005 II pg. 635) entered into force on November 1, 2004. Accordingly, the Arbitration Convention was extended indefinitely with retrospective effect from January 1, 2000. 236

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1.1.4 The mutual agreement clauses of double taxation agreements and the Arbitration Convention were enforced as directly applicable domestic law by the implementing legislation and take precedence over German tax laws pursuant to § 2 General Fiscal Code. 1.2 Mutual agreement clauses under double taxation agreements and Arbitration Convention 1.2.1 The mutual agreement clauses of double taxation agreements usually provide the following: – A mutual agreement procedure may be initiated if a person requests so and demonstrates that the measures of one or both contracting states result or will result in a taxation not corresponding with the treaty and which cannot be remedied by measures taken by the state in question (arbitration procedure in the constricted sense); – Mutual agreement procedures may in general be initiated in order to eliminate difficulties or doubt arising from the interpretation or the application of the agreement; for this purpose an individual case may provide the occasion or constitute the subject, e.g. if instructions or guidelines of the foreign tax authority are available that might result in a taxation contrary to the agreement (consultation procedure); – Mutual agreement procedures may also be initiated regarding issues not contractually governed, e.g. regarding the avoidance of double taxation in cases not governed by the respective double taxation agreement. A mutual agreement procedure may also be initiated if an existing double taxation agreement does not provide for a mutual agreement procedure of the nature in question. The Federal Ministry of Finance is responsible for making a decision in such a case. It has to be noted that the mutual agreement clauses of double taxation agreements regularly do not include the obligation to reach an agreement unlike the procedures under the Arbitration Convention. 1.2.2 The mutual agreement clause of the Arbitration Convention (art. 6) provides for a mutual agreement procedure in the constricted sense only with regard to issues involving the profit allocation between affiliated companies and the allocation in cases of permanent establishments. If this mutual agreement procedure fails (so-called phase I of the Arbitration Convention), it will automatically be replaced by an arbitration procedure (so-called phase II of the Arbitration Convention). The question whether a permanent establishment exists is not an issue of a procedure under the Arbitration Convention.

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1.3 Subject and purpose of the procedure 1.3.1 This bulletin is exclusively concerned with mutual agreement procedures in a constricted sense under double taxation agreements and the Arbitration Convention (cf. sec. 1.2) that are initiated due to measures taken by Germany or the other state. The claims of both contracting states under international law derived from double taxation agreements or the Arbitration Convention are the subject of the procedure; these are directed at a taxation of the party entitled to treaty benefits that corresponds to a double taxation agreement or the Arbitration Convention. It is the purpose of the procedure to implement the right of the party entitled to treaty benefits to be taxed pursuant to the agreement in both jurisdictions. 1.3.2 The bulletin does not include any special provisions regarding the procedures on bilateral and multilateral advance mutual agreement procedures on the basis of double taxation agreements in order to issue any binding advance pricing agreements between internationally affiliated companies and permanent establishments. 1.4 Responsibilities The Federal Ministry of Finance has transferred the responsibility for performing the function of the competent authority regarding mutual agreement and arbitration procedures under double taxation agreements and the Arbitration Convention to the Central Federal Tax Office (see decree of the Federal Ministry of Finance of November 29, 2004 IV B 6 – S 1300320/04, Federal Tax Gazette I pg. 1144). The Federal Central Tax Office acts in agreement with the competent highest or assigned state tax authority. The state tax authorities are responsible for implementing the mutual agreement or the decision in the domestic territory (cf. sec. 4). The Federal Ministry of Finance reserves itself the right to conduct a mutual agreement procedure in individual cases.

B. Mutual agreement procedures under double taxation agreements The provisions of this section are applicable to requests for the initiation of a mutual agreement procedure under a double taxation agreement (cf. sec. 1.1). In addition to the provisions of this section, sec. 10 to 12 of part C are applied analogously to relationships with states in which the Arbitration Convention is applicable to the extent that the initiation of a mutual agreement procedure is requested and the procedure applied for relates to issues regarding the allocation of profits between affiliated companies or the profit allocation in cases of permanent establishments.

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2. Initiation of the mutual agreement procedure 2.1 Application 2.1.1 The mutual agreement procedure in the constricted sense requires an application of the party entitled to treaty benefits. If a mutual agreement procedure is supported by a double taxation agreement, the application must make it clear that it is based on the mutual agreement clause of the applicable double taxation agreement. 2.1.2 The application may also be filed by another person than the party entitled to treaty benefits if the applicant is affected by a taxation contrary to the agreement, e.g. in cases of liability. 2.1.3 The application must be submitted to the competent authority in the state of residence. In cases of discrimination, the application shall be filed with the competent authority of the state of which the party entitled to treaty benefits is a citizen (cf. art. 3 (1) (g) OECD Model Tax Convention). If more than one taxpayer is affected (e.g. parent company and subsidiary), the application should for practical reasons be filed in the state of the higher-ranking taxpayer. 2.1.4 In Germany an application for the initiation of a mutual agreement procedure may be filed – with the local tax office responsible for the taxation of the party entitled to treaty benefits; it will give a statement on the application to the extent German tax measures are affected and – with regard to actions required towards the foreign state that may be subject to deadlines – will forward it contemporaneously to the Federal Central Tax Office through official channels for a decision on initiation of the mutual agreement procedure. The application will also promptly be forwarded to the Federal Central Tax Office in cases where no final statement may be given at the time the application is filed, e.g. because the result of a current tax audit must be awaited or the taxpayer has decided to suspend the mutual agreement procedure and to pursue an appeal procedure or court proceedings for the time being. In this case the application is forwarded to the Federal Central Tax Office using the form attached as appendix 1 to this bulletin. It may also be downloaded from the website of the Federal Central Tax Office (http://www.bzst.de). – with the Federal Central Tax Office; it will forward the application immediately through official channels to the state tax authority responsible for the taxation of the party entitled to treaty benefits for a statement provided that German tax measures are affected by it.

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The competent state tax authorities will comment in their statement in addition to the matters addressed in sec. 2.3.3 on the compliance with the application deadline (cf. sec. 2.2) and the taxation contrary to the treaty as claimed by the party entitled to treaty benefits (see sec. 2.3.1 and 2.3.2). 2.1.5 The filing of an application on initiation of a mutual agreement procedure is not impeded by the fact that pursuant to German tax law or the law of the other state an appeal is pending or legal remedies have not yet been exhausted. It is noted though, that the national law of some states does not permit the implementation of a mutual agreement that achieves a result that differs from the decision by a national court. The party entitled to treaty benefits may therefore consider which procedure it wishes to pursue. Helpful information on the competent authorities and procedural rules of foreign states is included in the OECD database “Country profiles on mutual agreement procedures” that may be accessed using the search function of “http://www.oecd.org”. 2.1.6 The mutual agreement procedure does not substitute the procedure for the refund or reduction of foreign tax withheld at source. An application for the refund or reduction of foreign withholding tax may thus only be the subject of a mutual agreement procedure if the application has either been finally rejected by the foreign tax authority or it was submitted at least two years ago. Sec. 2.1.7 applies correspondingly. 2.1.7 If double taxation results from the failure to comply with procedural rules (e.g. expiration of exclusionary deadline), it does not constitute a taxation contrary to the treaty that gives rise to a mutual agreement procedure. 2.2 Application deadline 2.2.1 The application should be filed as soon as possible after notification of a German or foreign tax measure that results in taxation contrary to the treaty. If this taxation is based on tax measures of the German and the foreign tax authority, the announcement of the latest assessment notice shall be relevant. 2.2.2 The mutual agreement clauses of many agreements contain specific deadlines for the filing of the application. Appendix 2 of this bulletin includes an overview of the agreements with specific deadlines. When filing an application in the domestic territory, the receipt of the application by the locally competent tax office or the Federal Central Tax Office shall be relevant for complying with the deadline. 2.2.3 If the applicable double taxation agreement does not specify an application deadline, the German tax authorities will not agree to initiate a mutual agreement procedure if the taxpayer has allowed a period of more 240

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than four years to pass between the announcement of the relevant tax measure and the application and special circumstances did not exclude a previous claim. 2.2.4 If a mutual agreement cannot be implemented without a deadline under the law of a foreign state, this has to be observed when filing the application (in relation to Switzerland, see decree of the Federal Ministry of Finance of June 30, 1997 IV C6 – S 1301 Schz – 34/97, Federal Tax Gazette I pg. 651). 2.3 Content of the application 2.3.1 The application for the initiation of a mutual agreement procedure is only permissive if it is claimed that taxation contrary to the treaty exists or such is imminent. This does not need be substantiated unless the agreement requires such evidence. To the extent that a tax measure only might result in a double taxation which by its nature should be avoided by the agreement (cf. e.g. sec. 2.4.2), the application may already be based on it without having established which state is contractually obliged to eliminate the double taxation. 2.3.2 Examples for taxation not in compliance with the double taxation agreement: – Income that is not taxable in the other state under a double taxation agreement is assessed for tax by this state; – Income taxable in the other state is inappropriately allocated on the common legal basis of the double taxation agreements; under the German interpretation of the agreement this applies under the arm’s length principle to internationally affiliated companies even in the absence of special clauses in the double taxation agreement; – The taxation in the other state violates a non-discrimination principle of the double taxation agreement; – The other state has been remiss in a way sustainably affecting the rights under the double taxation agreement when granting tax reliefs from taxation pursuant to the double taxation agreement; – A qualification conflict results in double taxation the nature of which should be avoided by the double taxation agreement. 2.3.3 In order to accelerate the procedure, the application for the initiation of a mutual agreement procedure should generally already include: – Name, address (registered office), tax number, and locally competent tax office of the party entitled to treaty benefits;

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– Detailed information on the facts and circumstances relevant for the case; – Information on the tax periods affected by the application; – Copies of tax assessment notices, the tax audit report, or similar documents from which the alleged double taxation results, and further significant documents (e.g. contracts, applications for refund/reduction of foreign withholding tax); – Detailed description of potential out-of-court or court appeals proceedings and available domestic or foreign court decisions concerning the case; – Information and documents requested under sec. 11.3.2 in cases of income allocation between affiliated companies and for permanent establishments; – A statement by the party entitled to treaty benefits to what extent, in its own opinion, the domestic or foreign taxation does not comply with the agreement; – The application of the party entitled to treaty benefits. 2.4 Initiation of the mutual agreement procedure and legal protection 2.4.1 Prior to initiating the mutual agreement procedure it has to be examined whether the substance of the request made by the party entitled to treaty benefits may be remedied using German national measures. Where necessary, the competent German tax authorities will take the necessary measures ex officio. 2.4.2 As a rule, a mutual agreement procedure shall only be initiated if a contracting state has already taken measures that result or will result in taxation contrary to the agreement. In individual cases a mutual agreement procedure may already be initiated if it is indicated that such measure is imminent. This may for example be the case if the foreign tax authority has announced certain tax measures during a tax audit or has issued a binding ruling on the issue in question. 2.4.3 In case the examination of the Federal Central Tax Office reveals that the substantive requirements for the mutual agreement procedure have been sufficiently presented, it will initiate the mutual agreement procedure. In case the application for the initiation of a mutual agreement procedure is rejected by the Federal Central Tax Office, it will immediately inform the party entitled to treaty benefits and the competent state tax authority about the decision.

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2.4.4 If the application for the initiation of a mutual agreement procedure is filed prior to the announcement of the tax assessment notice, the tax assessment may be issued provisionally (§ 165 General Fiscal Code) to the extent it is uncertain whether the prerequisites for the arising of the tax are fulfilled. 2.5 Initiation of the mutual agreement procedure by foreign tax authorities If a foreign tax authority initiates a mutual agreement procedure, the Federal Central Tax Office shall examine the formal prerequisites. It will immediately forward the initiation letter of the foreign tax authority to the competent highest state tax authorities.

3. Implementation of the mutual agreement procedure 3.1 General procedural principles 3.1.1 The Federal Central Tax Office will conduct the mutual agreement procedure by directly communicating with the competent authority of the other state in accordance with international practice. The details depend on the circumstances of the individual case and the principle of expediency. The general procedural principles apply. 3.1.2 All information that the German tax authority obtains in the course of a mutual agreement procedure is subject to tax secrecy (§ 30 General Fiscal Code). To the extent necessary, the Federal Central Tax Office will assure the respective protection of such information in the foreign state pursuant to its applicable law, e.g. by obtaining assurances. Any obligation of confidentiality as included in the double taxation agreement itself remains unaffected in cases where information has been given in the course of the mutual agreement procedure pursuant to the provisions of international administrative assistance. 3.1.3 The Federal Central Tax Office shall inform the competent highest or assigned state tax authority about the content and the progress of the procedure. The competent highest or assigned state tax authorities will inform the Federal Central Tax Office about developments in the tax case if these are relevant to the mutual agreement procedure. 3.1.4 Letters of foreign tax authorities will be translated into German by the Federal Central Tax Office. However, letters in English of a simple nature and their enclosures will not be translated into German unless necessary in the individual case.

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3.2 Clarification of facts and reaching a mutual agreement 3.2.1 If the purpose of the mutual agreement procedure (see sec. 1.3) requires, the facts have to be clarified ex officio applying the provisions of the General Fiscal Code. In principle, the local tax offices are responsible. The applicant is required to cooperate (§ 90 General Fiscal Code). 3.2.2 During the course of the mutual agreement procedure it also shall be referred to the findings the tax authorities from the other state obtained from the clarification of the facts. 3.2.3 With the consent of the competent authority of the other state, certain staff members may be authorized by the German or foreign tax authority to prepare a joint report that – contains a joint clarification of facts; – jointly assesses facts; and – proposes basic data for necessary estimations. Prior to its discussion by the competent authorities, the report shall be presented to the taxpayers involved who shall give a statement on it. It may be refrained from preparing such a report if the issue may otherwise be amicably resolved with the taxpayer. 3.2.4 If the clarification of the facts by the German and foreign competent tax authorities reveals contradictions, these may be resolved by a coordinated investigation by both authorities or by mutual agreement discussions. 3.2.5 In order to determine the facts and to bring about an agreement, – an oral exchange of opinions may take place with the competent authority of the other state; – a specific commission with representatives from the competent authorities may be established for the purpose of such an exchange of opinions; – an individual having special experience may be selected to promote the agreement, e.g. by giving an expert opinion. 3.2.6 An agreement on the assumption of specific circumstances and specific treatment of the issue is permissive under the applicable general prerequisites (cf. Application Decree to the General Fiscal Code of July 15, 1998, Federal Tax Gazette I pg. 630, to § 88 General Fiscal Code – principle of investigation).

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3.3 Involvement and rights of the party entitled to treaty benefits 3.3.1 Only the competent authorities of the contracting states are parties to the mutual agreement procedure. The party entitled to treaty benefits is obliged to contribute to the procedure by disclosing his relations, describing and, where appropriate, providing documentary evidence. The Federal Central Tax Office shall inform the party entitled to treaty benefits about the status and progress of the procedure. The party entitled to treaty benefits may – file applications; – comment on the facts and legal questions relevant to the agreement; – authorize an agent to be represented by. The Federal Central Tax Office shall inform the party entitled to treaty benefits of the result of the procedure. 3.3.2 As regards the question of the extent to which the party entitled to treaty benefits is willing to withdraw appeals or objections, the party entitled to treaty benefits does not have to express itself before it is presented with an agreement proposal. 3.4 Mutual agreement As a rule, the mutual agreement shall be in writing (e.g. by means of a final correspondence). It is generally subject to the applicant’s declared consent thereto and the completion of pending appeal procedures (see also sec. 4.2).

4. Implementation of mutual agreements 4.1 Legal validity of assessment notices and statute of limitation Pursuant to § 175a General Fiscal Code, the mutual agreement may be implemented notwithstanding the legal validity of German assessment notices. In this respect, the assessment period will not end prior to the expiration of one year after the mutual agreement has come into effect. The application for the initiation of a mutual agreement procedure with a domestic tax authority will delay the assessment period in accordance with § 171 (3) General Fiscal Code if the amendment of the tax assessment notice is requested at the same time.

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4.2 Consent of the applicant When implementing the mutual agreement, the locally competent tax office has to assure, considering the necessary consent (cf. sec. 3.4 sent. 2), that prior to issuing the (amended) assessment notice – the applicant will declare his consent to the implementation in writing; – pending appeal procedures will be settled; and – the applicant will waive any appeal following the notification of the tax assessment notice implementing the mutual agreement procedure to the extent it implements the results of the mutual agreement procedure correctly (partial waiver). It is referred to §§ 354 (1a) and 362 (1a) General Fiscal Code and §§ 50 (1a) and 72 (1a) Tax Court Code. The Federal Central Tax Office has to be informed to the extent that difficulties or doubts shall arise.

5. Waiver of a mutual agreement procedure In order to accelerate or simplify its tax procedure (e.g. in order to avoid delays and expenses regarding the otherwise involved necessary clarification of facts for purposes of a potential mutual agreement procedure), the party entitled to treaty benefits may declare that it will not file an application for the initiation of a mutual agreement procedure. In cases that regard permanent establishments or affiliated companies, action must be taken to ensure that foreign companies of which the permanent establishment is part or the affiliated foreign company, respectively, refrain from applying for the initiation of a mutual agreement procedure in order to assure German taxation. The foreign state is not bound to the party’s declared waiver of a mutual agreement procedure towards the competent German tax authority. If such waiver is available though, the German tax authority will generally not give its consent to conduct a mutual agreement procedure. In cases regarding affiliated companies and permanent establishments, this only applies if a declaration of waiver of the foreign company of which the permanent establishment is part or a declaration of both the domestic and the foreign affiliated company is available.

6. Mutual agreement procedure and tax audit 6.1 In a mutual agreement procedure conducted in the course of a tax audit, it has to be in particular be referred to the provisions set forth in sec. 1.2.2 to 1.2.6 of the Administration Principles (see decree of the Federal Ministry of Finance of February 23, 1983 IV C 5 – S 1341-4/83, Federal Tax Gazette I pg. 218). They apply correspondingly to the allocation of 246

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profits between permanent establishments of internationally active companies. 6.2. As regards a potential mutual agreement procedure, adjustments shall be identified in the tax audit report in such explicit manner that the Federal Central Tax Office is able to comprehend the facts, legal basis and the reasons for the adjustment as well as the amount of the adjustment volume from the details given in the audit documents and files (see also sec. 6.2.1 of the Administrative Circular on the Guidelines for the Examination of Income Attribution between Affiliated Parties with Cross-Border Business Transactions Regarding Investigation and Cooperation Duties, Adjustments as well as Mutual Agreement and EU-Arbitration Procedures (Administrative Guidelines – Procedures, decree of the Federal Ministry of Finance of April 12, 2005 IV B 4 – S 1341-1/05, Federal Tax Gazette I pg. 570)).

7. Mutual agreement procedure and international exchange of information The information clauses of double taxation agreements and the provisions of the EC Mutual Assistance Law are also applied in mutual agreement procedures. To the extent that the information clauses of the respectively applicable double taxation agreement or the EC Mutual Assistance Law provide for it, all required information may also be exchanged in the mutual agreement procedure. The principles of the “Bulletin on International Administrative Assistance by Exchange of Information in Tax Matters” (decree of the Federal Ministry of Finance of January 25, 2006 IV B 1 – S 1320-11/06, Federal Tax Gazette I pg. 26) must be observed.

8. Consequences of the failure of a mutual agreement procedure 8.1 In case a mutual agreement procedure fails, the Federal Central Tax Office will immediately notify the party entitled to treaty benefits and the competent state tax authority of this decision. 8.2 The locally competent tax office shall examine whether double taxation may be avoided under the prerequisites of § 163 General Fiscal Code under the aspect of substantive inequity. The separate provisions of responsibility and the involvement of the Federal Ministry of Finance have to be observed in cases of inequitable measures. An inequitable measure is in particular inapplicable if the taxpayer did not observe procedural provisions (cf. sec. 2.1.7) and in cases where the taxpayer – did not sufficiently comply with his tax duties in the domestic territory or abroad (e.g. inadequate cooperation regarding the clarification of facts); or 247

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– gave false statements (e.g. sham domicile) in a tax or any other administrative procedure (e.g. in a work permit procedure) and thus also caused the arising double taxation. This also applies if pursuant to § 34c (6) sent. 5 Income Tax Act a deduction of the foreign tax under § 34c (3) Income Tax Act is precluded as of the assessment period 2000 because the foreign taxation of domestic income is caused by a structure for which economic or other substantial reasons are absent. 8.3 The Federal Central Tax Office will suggest the initiation of an arbitration procedure to the extent this is provided for by the respective double taxation agreement and is indicated by the status of the agreement negotiation. Pursuant to art. 25 (5) double taxation agreement with Austria, the party entitled to treaty benefits is eligible to commit the contracting states to submit the case as an arbitration procedure to the European Court of Justice once three years have expired since the initiation of the procedure.

9. Costs of the mutual agreement procedure under double taxation agreements The contracting states bear the expenses incurred by the mutual agreement procedure themselves; the expenses incurred by the party entitled to treaty benefits will not be reimbursed.

C. Mutual agreement and arbitration procedures under the EU Arbitration Convention The provisions of this section apply to applications requesting the initiation of a mutual agreement procedure under art. 6 (1) Arbitration Convention (cf. sec. 1.1).

10. Preliminary proceedings under § 5 Arbitration Convention 10.1 If the tax authority intends to adjust the profit of a company pursuant to art. 4 Arbitration Convention, it is obliged to inform the company thereof in good time and give it the opportunity to notify the affected affiliated companies in the other contracting states. The other companies then have the opportunity to discuss the issue with their competent tax authorities to obtain a corresponding adjustment. 10.2 If the tax authorities and companies involved agree to the adjustment and the corresponding adjustment, a mutual agreement and arbitration procedure remains out of consideration.

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11. Initiation of the mutual agreement procedure 11.1 Application 11.1.1 Pursuant to art. 6 (1) Arbitration Convention, an application by the affected company is required for the mutual agreement procedure. The application must make it clear that the company refers to the Arbitration Convention. 11.1.2 For practical reasons the application should be filed in the state of the higher-ranking taxpayer. This applies correspondingly if the allocation of the profits of a permanent establishment under art. 4 no. 2 Arbitration Convention is in question; for purposes of the Arbitration Convention, the permanent establishment is deemed to be a company of the other contracting state (art. 1 (2) Arbitration Convention). 11.1.3 In case the application is submitted in the domestic territory, the mutual agreement procedure has to be filed with the Federal Central Tax Office. 11.1.4 Sec. 2.1.5 applies correspondingly (see sec. 13.1.3 and 13.1.4, though). 11.2 Application deadline 11.2.1 Under art. 6 (1) sent. 2 Arbitration Convention, the application has to be presented within three years of the first notification of the action which results or is likely to result in to double taxation within the meaning of art. 1 Arbitration Convention, e.g. following a transfer pricing adjustment. This deadline shall begin with the notification of the first assessment notice resulting in double taxation (e.g. amended tax assessment notice). When filing the application in the domestic territory, the receipt of the application by the Federal Central Tax Office shall be relevant for complying with the deadline. 11.2.2 Sec. 2.2.1 applies accordingly. 11.3 Content of the application 11.3.1 The application is only permissive if it is claimed that the principles set out in art. 4 Arbitration Convention have not been observed (art. 6 (1) sent. 1 Arbitration Convention). 11.3.2 The application shall include the following information and documents:

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1. name, address (registered office), tax number and the locally responsible tax office of the applying company in the contracting state and of the other parties involved in the business transactions in question; 2. detailed information on the facts and circumstances relevant to this case (including details about the relationships between the companies and the other parties involved in the business transactions in question); 3. information on the tax periods affected by the application; 4. copies of tax assessment notices, the tax audit report, or similar documents from which the alleged double taxation resulted; 5. detailed description of potential out-of-court or court appeals proceedings that the company or the other parties involved in the business transactions in question have initiated and of any existing court decisions regarding the case; 6. an explanation by the company of the extent to which, in its opinion, the principles set out in art. 4 Arbitration Convention have not been observed; 7. a commitment by the company that it will as quickly as possible and comprehensively answer all questions of any competent authority and will provide the competent authorities with necessary documents. 11.3.3 In order to avoid delays, a written application should be submitted in triplicate. 11.3.4 Further information on standard details and documents to be included in the application may be derived from the website of the Federal Central Tax Office under “http://www.bzst.de”. 11.4 Initiation of the mutual agreement procedure upon application in the domestic territory 11.4.1 The Federal Central Tax Office will forward the application of the company immediately to the competent highest state tax authority or to the locally competent tax office taxing the company and will confirm to the company the receipt of its application within one month. At the same time the Federal Central Tax Office will notify the competent authority of the other contracting states involved of the receipt of the application by sending a copy of the company’s application. 11.4.2 The Federal Central Tax Office will examine whether the information required under sec. 11.3.2 for the initiation of a mutual agreement procedure is available and may necessarily request of the company within two months after having received the application to submit missing or additional information. It is referred to sec. 13.1.2.

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VIII. Mutual Agreement and Arbitration Procedures (2006)

The Federal Central Tax Office is at liberty to request supplementary information at a later time. 11.4.3 If the substance of the request made by the party entitled to treaty benefits may be remedied using domestic measures, the competent German tax authorities will take the necessary measures ex officio. The Federal Central Tax Office will inform the company and the competent authorities of the other contracting states involved of this decision immediately, yet at the latest at the date specified in sec. 11.4.4. 11.4.4 If the examination reveals that the application is permissive and has been sufficiently substantiated and the competent German tax authorities are unable to find a satisfying solution, the Federal Central Tax Office shall initiate the mutual agreement procedure pursuant to art. 6 (2) Arbitration Convention with the competent authorities of the other contracting states involved no later than four months after the later one of the following dates: (a) the date of the tax assessment notice by which the decision about the increase in income was assessed or determined; or (b) the date on which the application of the company and the information under sec. 11.3.2 and 11.4.2 sent. 1 are available to the Federal Central Tax Office. 11.4.5 The Federal Central Tax Office shall notify the applying company of the initiation of the mutual agreement procedure and shall inform it whether the application was submitted in due time and on what date the two-year-period set out in art. 7 (1) Arbitration Convention commenced. 11.5 Initiation of the mutual agreement procedure upon application in a foreign state If the competent authority of another contracting state notifies the Federal Central Tax Office of the receipt of an application for the initiation of a mutual agreement procedure or if the competent authority of another contracting state initiates the mutual agreement procedure, the Federal Central Tax Office will examine the formal requirements and, where appropriate, request the other authority of the other contracting state to forward the information and documents set forth in sec. 12.2.2 sent. 1. The Federal Central Tax Office will forward the letter of the foreign tax authority immediately to the competent highest state tax authority and to the locally competent tax office taxing the company for their comments.

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D. Administrative Guidelines

12. Implementation of the mutual agreement procedure 12.1 General procedural principles 12.1.1 If the application for the initiation of a mutual agreement procedure is filed in the domestic territory, the Federal Central Tax Office shall notify the company of any significant developments. Information regarding legal opinions expressed or received (e.g. in position papers) is in principle not disclosed. 12.1.2 Sec. 3, 4, 5, 6, and 7 apply correspondingly. 12.1.3 The contracting states are bound by the arm’s length principle set out in art. 4 Arbitration Convention. It complies with the arm’s length principle set forth in art. 9 OECD Model Tax Convention. 12.1.4 Under art. 8 (2) Arbitration Convention, a mutual agreement or arbitration procedure may be suspended if judicial or administrative proceedings are pending for one of the companies involved and with which it shall be determined whether the company is liable to a serious penalty by violating tax law with actions giving rise to an adjustment of profits under art. 4. If such infringement is found, the obligation under art. 8 (1) Arbitration Convention to initiate a mutual agreement procedure or to establish an advisory commission shall no longer apply. 12.2 Procedure for an application filed in the domestic territory 12.2.1 Adjustment of profits by the domestic tax authorities In case the measure that has resulted or may result in double taxation within the meaning of art. 1 Arbitration Convention was taken by a domestic tax authority, the Federal Central Tax Office will usually forward a position paper together with the opening letter to the competent authorities of the other contracting states involved, yet no later than the date specified in sec. 11.4.4. It includes the following information and documents: – Confirmation that the case was submitted within the deadlines in art. 6 (1) Arbitration Convention; – Notification of the commencement of the two-year-period pursuant to art. 7 (1) Arbitration Convention (cf. sec. 13.1.2 and 13.1.3 regarding the two-year-period); – Presentation of the case by the applicant; – Assessment of the facts and circumstances by the Federal Central Tax Office, e.g. for what reasons double taxation exists or may probably set in; 252

VIII. Mutual Agreement and Arbitration Procedures (2006)

– Proposal of how the case may be resolved regarding the elimination of the double taxation including comprehensive explanation of the proposed solution; – Full justification of the tax assessment or the adjustments; – Enclosure of all documents significantly important for the presentation of the point of view; – List of all additional documents used to make the adjustment. In order to prepare the position paper, the competent state tax authority shall transmit to the Federal Central Tax Office a respective comment together with the necessary documents and a proposal for solution at the latest three months after the later date set forth in sec. 11.4.4 (a) and (b). 12.2.2 Adjustment of profits by the foreign tax authority In case the measure that resulted or may result in double taxation within the meaning of art. 1 Arbitration Convention was taken by a foreign tax authority, the Federal Central Tax Office shall include in its opening letter to the competent authorities of the other contracting states involved (sec. 11.4.4) the following information and documents: – The information specified in sec. 11.3.2 and 11.4.2; – Confirmation that the case was presented within the deadline set forth in art. 6 (1) Arbitration Convention; – Notification of the commencement of the two-year-period under art. 7 (1) Arbitration Convention. If the review that is conducted after receipt of the reply of the foreign tax authority reveals that double taxation (a) exists or is imminent and there is agreement with the solution proposed in the reply by the foreign tax authority, the Federal Central Tax Office shall inform the competent authorities of the contracting states involved in this case within six months after receipt of the reply. Sec. 2.4.1 sent. 2 applies correspondingly. (b) does neither exist nor is imminent or there is no agreement with the solution proposed in the reply by the foreign tax authority, the Federal Central Tax Office will forward a position paper to the competent authorities of the contracting states involved in this case. This will be sent no later than six months after receipt of the reply. In its letter, the Federal Central Tax Office shall offer a non-binding schedule of how to proceed with the case. Where appropriate, the Federal Central Tax Office shall also propose a date for a mutual agreement discussion that should take place no later than 18 months after the later date defined in sec. 11.4.4 (a) and (b). 253

D. Administrative Guidelines

In order to prepare the position paper, the competent state tax authorities will communicate to the Federal Central Tax Office a respective comment with the necessary documents and a proposed solution no later than one month prior to the date set forth in sent. 2. 12.3 Procedure for applications filed in foreign states 12.3.1 Adjustment of profit by the domestic tax authority In case the measure that has resulted or may result in double taxation within the meaning of art. 1 Arbitration Convention was taken by a domestic tax authority, the Federal Central Tax Office shall, after initiation of the mutual agreement procedure by the foreign state, forward a position paper to the competent authorities of the other contracting states involved in the case. It shall include all information and documents specified in sec. 12.2.1 unless it is already included in the opening letter of the foreign state. The forwarding of the position paper will be carried out within four months of the later of the following dates: – Date of the tax assessment notice by which the decision on the increase in income was assessed or determined; – Receipt by the Federal Central Tax Office of the initiation of the mutual agreement procedure by the competent authority of the other contracting state and receipt of the information pursuant to sec. 12.2.2 sent. 1. In order to prepare the position paper, the competent state tax authority will forward a respective comment to the Federal Central Tax Office including all necessary documents and a proposal for solution no later than one month prior to the time specified in the preceding sentence. 12.3.2 Adjustment of profit by the foreign tax authority If the measure that has resulted or may result in double taxation within the meaning of art. 1 Arbitration Convention was taken by a foreign tax authority and if the examination to be carried out after receipt of the comment by the foreign tax authority reveals that double taxation a) exists or is imminent and there is agreement with the solution proposed by the foreign tax authority in its comment, the Federal Central Tax Office shall notify the competent authorities of the other contracting states involved. The notification shall take place within six months after the later of the following dates: – date of the assessment notice by which the decision on the increase in income was assessed or determined;

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– receipt by the Federal Central Tax Office of the comment given by the foreign tax authority and receipt of the information in accordance with sec. 12.2.2 sent. 1. b) does neither exist nor is imminent, or there is no agreement with the solution proposed in the comment by the foreign tax authority, the Federal Central Tax Office shall for its part forward a position paper to the competent authorities of the contracting states involved in this case. This will be sent no later than the date specified under (a) of this section. In its letter, the Federal Central Tax Office shall offer a non-binding schedule of how to proceed with the case. Where appropriate, the Federal Central Tax Office shall also propose a date for a mutual agreement discussion that should take place no later than 18 months after the later dates set forth in sec. 11.4.4 (a) and (b). In order to prepare the position paper, the competent state tax authorities will communicate to the Federal Central Tax Office a respective comment with the necessary documents and a proposed solution no later than one month prior to the date set forth in (a) of this section.

13. Arbitration procedure 13.1 General 13.1.1 If the mutual agreement procedure does not lead to an agreement within two years, the competent authorities of the contracting states involved are required to establish an advisory commission and to obtain its opinion (art. 7 Arbitration Convention). The competent authorities may extend the two-year-period given the consent of the companies involved (art. 7 (4) Arbitration Convention). 13.1.2 The two-year-period specified in art. 7 (1) Arbitration Convention commences on the day the case was for the first time submitted to one of the competent authorities (Federal Central Tax Office or if the application is filed with foreign tax authorities, the competent authority of this other contracting state). The case shall be deemed to have been presented on the later of the following dates: – Date of the tax assessment notice by which the decision on increase in income was assessed or determined; – The date of receipt by the competent authority of all information and documents specified in sec. 11.3.2 and any additional information that the competent authority requested within two months after receipt of the application of the company. 13.1.3 In case the taxation issue is submitted to a court after appeals were made, the two-year-period referred to in art. 7 (1) Arbitration Convention shall not commence until the date on which the decision given by the final court of appeal has become final (art. 7 (1) Arbitration Convention). 255

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13.1.4 If a contracting state is unable to derogate from the decisions of the fiscal courts during the arbitration procedure, the arbitration procedure requires that the company withdraw from or waive any appeals to the extent these relate to the subject of the arbitration procedure (art. 7 (3) Arbitration Convention). This limitation does not apply to Germany as, pursuant to § 175a General Fiscal Code, tax assessment notices for which the legal validity has been confirmed by courts may be amended based on the decision in an arbitration procedure (§ 110 (2) Tax Court Code). 13.2 Appointment of the advisory commission 13.2.1 To the extent the competent authorities of the contracting states involved in the case do not agree otherwise, the contracting state that issued the first tax assessment notice, i.e. the final decision of the tax authority on the increase in income or an equivalent measure that resulted or may result in double taxation within the meaning of art. 1 Arbitration Convention, shall take the initiative in appointing the advisory commission and organize its sessions in consultation with the competent authorities of the other contracting states involved in the case. 13.2.2 The place at which the advisory commission shall meet and the place at which it has to deliver its opinion may be specified in advance by the competent authorities of the contracting states involved in the case. 13.2.3 The Federal Central Tax Office will communicate to the advisory commission prior to its first session all records and information relevant to the specific case, in particular all documents, reports, correspondence, and conclusions made from the mutual agreement procedure. 13.3 Composition of the advisory commission 13.3.1 As a rule, the advisory commission consists of an independent chairman, two representatives of each of the competent authorities, and an even number of – usually two – independent persons (art. 9 (1) Arbitration Convention). The members of the advisory commission are subject to the confidentiality obligations of art. 9 (6) Arbitration Convention. 13.3.2 The advisory commission shall be supported by a secretariat provided by the contracting state that initiated the advisory commission unless otherwise agreed by the competent authorities of the contracting states involved in the case. For reasons of independence, this secretariat is under subordinate to the chairman of the advisory commission. The members of the secretariat are also subject to the confidentiality obligations of art. 9 (6) Arbitration Convention.

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13.4 Procedural principles 13.4.1 The procedure is carried out before the advisory commission in the official language(s) of the contracting states involved unless otherwise agreed by the competent authorities of the contracting states involved in the case under consideration of the wishes of the advisory board. Declarations and documents have to be translated to the language(s) where necessary. 13.4.2 The advisory commission may request the competent authorities of the contracting states involved in the case to appear before the advisory commission. 13.4.3 The companies concerned have the right to appear or to be represented (art. 10 (2) Arbitration Convention). They are at liberty to give their opinion on the factual and legal situation before the advisory commission and to submit evidence and documents that they deem necessary (art. 10 (1) Arbitration Convention). Upon request by the advisory commission, the companies concerned are obliged to disclose information or to submit evidence or documents and to appear before the commission or to be represented before the commission. Opinions and documents that are submitted or provided by an affected company for the first time in the arbitration procedure must be translated by it to the official language(s) of the procedure pursuant to sec. 13.4.1. 13.4.4 In order to prepare the decision, the advisory commission may hear witnesses or experts. 13.5 Opinion of the advisory commission and decision of the competent authorities 13.5.1 The advisory commission has to issue its decision within six months. In doing so, it is bound to the arm’s length principle of art. 4 Arbitration Convention (art. 11 (1) Arbitration Convention). The opinion shall be adopted by a simple majority of its members (art. 11 (2) Arbitration Convention). 13.5.2 The period for giving the opinion shall start at the date on which the chairman confirms that all members of the commission have received all relevant documents and information in accordance with sec. 13.2.3 from all competent authorities of the contracting states involved in the case. 13.5.3 The opinion of the advisory commission should contain the following: (a) The names of the members of the advisory commission; (b) The names and addresses of the companies involved;

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(c) The competent authorities involved; (d) A description of the facts on which the case in dispute is based; (e) A clear and unambiguous statement of what the applicant requests; (f) A short summary of the procedure; (g) The arguments and methods on which the decision given in the opinion is based; (h) The opinion; (i) Place and date of the opinion; (j) The signatures of the members of the advisory commission. 13.5.4 Following the opinion issued by the advisory commission, the competent authorities of the contracting states involved in the case have another six months to reach an agreement. They may deviate from the opinion given by the advisory commission provided that double taxation is avoided. If they are unable to agree on a different settlement, they are bound by the opinion given by the advisory commission as an arbitration ruling (art. 12 (1) Arbitration Convention). 13.6 Notification of the opinion of the advisory commission and the decision of the competent authorities 13.6.1 After the decision of the competent authorities of the contracting states involved in the case regarding the avoidance of double taxation is available, the competent authority to which the case was submitted shall forward to each of the companies involved the decision of the competent authorities and the opinion of the advisory commission. 13.6.2 If the competent authorities of the contracting states involved in the case agree to the publication of the decision and the opinion, the publication shall be withheld until all companies involved have informed in writing the competent authority to which the case was submitted that they have no objections to the publication of the decision and the opinion (art. 12 (2) Arbitration Convention). If the companies involved agree, the competent authorities of the contracting states involved in the case may agree to publish the decision and the opinion without stating the names of the companies involved whereby all further information that may reveal the identity of the companies involved has to be made anonymous. 13.6.3 The opinion of the advisory commission shall be issued in three original copies, of which two will be transmitted to the competent authorities of the contracting states involved in this case and one to the European Commission for archiving. Where more than two contracting states are involved in the case, additional copies of the original opinion of the advisory commission shall be prepared. If there is agreement on the publi258

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cation of the opinion, it is published in the original language(s) on the website of the European Commission (“http://www.ec.europa.eu/”). 13.6.4 Sec. 4 applies correspondingly regarding the implementation of the decision.

14. Costs of the mutual agreement and arbitration procedure under the Arbitration Convention 14.1 Sec. 9 applies correspondingly regarding the costs of the mutual agreement procedure. 14.2 The costs of the advisory commission procedure are shared equally by the contracting states involved (art. 11 (3) Arbitration Convention). These include the administrative costs of the advisory commission and the fees and expenses of the independent persons. 14.3 Unless the competent authorities of the contracting states involved in the case agree otherwise, (a) the reimbursement of costs for the independent persons shall be limited to the amount of usual reimbursement of costs for high-ranking employees of the contracting state that initiated the appointment of the advisory commission; and (b) the gross fee for an independent person amounts to 1,000 Euros for each day the advisory commission meets; the chairman shall receive a fee that is 10 % above the fee of the other independent persons. 14.4 The reimbursement of the costs of the advisory commission procedure shall be carried out by the contracting state that initiated the appointment of the advisory commission unless the competent authorities of the contracting states involved in the case agree otherwise. 14.5 Costs incurred by the affected companies in connection with the mutual agreement or arbitration procedure shall not be reimbursed (sec. 11(3) Arbitration Convention).

D. Application provisions and publication This bulletin replaces the bulletin of July 1, 1997 IV C 5 – S 1300-189/96, Federal Tax Gazette I 1997 pg. 717.

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Appendix 1 Tax office

Date

Tax no.

Person in charge Telephone (ext.)

via w

Regional tax office/other competent federal state tax authority

via w

Minister of finance/federal state minister of finance

To

Bundeszentralamt für Steuern (Federal Central Tax Office)D-53221 Bonn

Notice on an application for the initiation of a mutual agreement procedure under Double Taxation Agreement/Arbitration Convention received by the tax office Enclosures: – copy of the application – in transfer pricing cases: copy of the tax audit report Taxpayer Application of Legal basis of the procedure

w w

Subject of the procedure

w w w

Transfer pricing adjustment Permanent establishment Employee (art. 15 OECD Model Tax Convention) w Artist (art. 17 OECD Model Tax Convention) w Others

In cases of transfer pricing adjustment: Who carried out the primary adjustment?

w w

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Germany Foreign country

VIII. Mutual Agreement and Arbitration Procedures (2006)

Type of tax Year

Value in dispute

Tax assessment notice dated1

Appeals proceedings in Germany Appeal filed suspension (yes/no) of enforcement granted (yes/no)

Security (yes/no)

Appeals proceedings abroad known Taxes paid in Germany

w

Yes

w

Taxes paid abroad?

w w w

Yes No n/a

In cases of foreign withholding taxes withheld: Have refund applications been filed abroad?

w w

No Refund application dated

No

w

Short description of the facts:

w

Prior to initiating the mutual agreement procedure, further investigations are required. I already have taken the following actions:

w

The mutual agreement procedure shall be suspended until it has been decided on the appeal/lawsuit

Signature

1 Date of the tax assessment notice that is subject of the mutual agreement procedure (e.g. in cases of domestic transfer pricing adjustment, the date of the amended tax assessment notice in Germany; in cases of foreign transfer pricing adjustment, the date of the foreign tax assessment notice marked with (A)). If the tax assessment or the afflicting amendment is only intended, please mark the tax assessment notice below the date with (-).

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Appendix 2 Overview of all double taxation agreements (hereinafter: DTA) including special deadlines for the applicants in the mutual agreement clauses (see art. 25 OECD Model Tax Convention) two years

three years

four years

OECD Model Tax Convention DTA Belgium

DTA Egypt

DTA Indonesia

DTA Azerbaijan

DTA Italy

DTA Bangladesh

DTA Canada

DTA Bulgaria

DTA Pakistan

DTA China

DTA Portugal

DTA Denmark

DTA Venezuela

DTA Estonia DTA India DTA Yugoslavia DTA Kazakhstan DTA Kenya DTA Korea DTA Kuwait DTA Latvia DTA Lithuania DTA Malta DTA Mauritius DTA Mexico DTA Mongolia DTA Namibia DTA Norway DTA Austria DTA Poland DTA Romania DTA Russian Federation DTA Simbabwe DTA Tajikistan DTA Ukraine DTA Uzbekistan DTA United Arab Emirates DTA Vietnam

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IX. Advance Pricing Agreements (2006)

IX. Advance Pricing Agreements (2006) Bulletin Regarding Bilateral or Multilateral Advance Mutual Agreement Procedures Based on Double Taxation Agreements with the Purpose of Issuing Binding Advance Pricing Approvals on Transfer Prices among Internationally Affiliated Companies (Advance Pricing Agreements – APAs) (Administrative Bulletin – Advance Pricing Agreements) Published on October 5, 2006 (IV B 4 – S 1341 – 38/06, Federal Tax Gazette 2006 I p. 594)

Based on the results of the discussions with the highest tax authorities of the Federal States, the following applies to advance mutual agreement procedures under double taxation agreements with the purpose of issuing binding advance pricing approvals on transfer prices among internationally affiliated companies (Advance Pricing Agreements – APAs): Content 1. Preface. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1 Purpose of the regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2 The term “APA”, classification, legal bases . . . . . . . . . . . . . . . . 1.3 Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2. Initiation of the procedure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1 Competences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2 Preliminary talks (prefiling) . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3 Application requirements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3. Content of the APA, documents to be submitted, rejection of the APA application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1 General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2 Specification of the scope of application . . . . . . . . . . . . . . . . . . 3.3 Transfer pricing method, additional criteria for the transfer pricing determination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4 Substantiation of the method and transfer pricing determination. 3.5 Documents to be provided . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.6 Special features for cost sharing agreements. . . . . . . . . . . . . . . . 3.7 Critical assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.8 Duration. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.9 Rejection of the APA application, reasons for rejection . . . . . . . . 4. Implementation of the APA procedure, procedural principles . . . . . . . 4.1 General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2 Involvement of the applicant in the advance mutual agreement procedure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3 Cooperation of federal and federal state authorities. . . . . . . . . . . 4.4 Cooperation with the other state (or other states) . . . . . . . . . . . .

. . . . . . . .

264 264 265 267 268 268 268 269

. 270 . 270 . 270 . . . . . . . . .

270 271 271 272 273 274 275 276 276

. 276 . 277 . 277

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5.

6.

7.

8. 9.

4.5 Conclusion of the advance mutual agreement procedure with the other state . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.6 Approval by the applicant, waiving the right to appeals (§ 354 (1a) General Fiscal Code). . . . . . . . . . . . . . . . . . . . . . . . Implementation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.1 Implementation in Germany by the competent federal state tax authority . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.2 Implementation in the other state. . . . . . . . . . . . . . . . . . . . . . Measures during the duration, binding effect . . . . . . . . . . . . . . . . . 6.1 Taxpayer’s obligations for reporting and furnishing evidence (yearly compliance report). . . . . . . . . . . . . . . . . . . . . 6.2 Review of the critical assumptions . . . . . . . . . . . . . . . . . . . . . 6.3 Binding effect on the tax authorities . . . . . . . . . . . . . . . . . . . . 6.4 Binding effect on the applicant/taxpayer . . . . . . . . . . . . . . . . . 6.5 Revocation or restriction of the impact of the APA . . . . . . . . . . 6.5.1 Failure to implement the facts . . . . . . . . . . . . . . . . . . . . 6.5.2 Failure to implement critical assumptions . . . . . . . . . . . Additional procedural provisions . . . . . . . . . . . . . . . . . . . . . . . . . . 7.1 Amendments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.2 Withdrawal of the APA application . . . . . . . . . . . . . . . . . . . . . 7.3 Roll back of the APA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.4 Extension of the APA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.5 Initial modifications by a third state after conclusion of an APA Simplified procedure for small and medium-sized enterprises. . . . . . Publication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . 278 . . 278 . . 279 . . 279 . . 279 . . 279 . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . .

279 280 280 280 281 281 281 282 282 282 282 283 283 284 284

1. Preface 1.1 Purpose of the regulation This circular is concerned with the procedure for the application, examination, and execution as well as the impacts and the implementation of advance mutual agreements under double taxation agreements with the purpose of issuing binding advance approvals on transfer prices among internationally affiliated companies (APA). It is its purpose to improve the chances of enterprises to obtain an APA, to appoint their rights, obligations, and duties in an APA procedure and a procedure on advance pricing approvals and to govern the treatment of APA applications by the Federal Central Tax Office and the tax authorities of the federal states (collectively: “tax authorities”). The German tax authorities conduct APA procedures with the objective of possibly resolving disputes concerning transfer pricing methods between tax jurisdictions of several states and the enterprises amicably in advance and thus to avoid an imminent economic double burden or dou264

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ble taxation. APAs shall announce more legal certainty for the enterprises and provide for more efficiency when examining transfer prices. The German tax authorities thus follow the practice that is applied by the majority of industrial states and recommended by the OECD (sec. 4.161 et seq. OECD-Guidelines 19951). This circular shall apply correspondingly to cases of advance mutual agreements where profits are attributed at arm’s length to a domestic enterprise and its foreign permanent establishment and to the profit determination of domestic permanent establishments of foreign enterprises. Unless this circular includes any special provisions, the Bulletin on the International Mutual Agreement and Arbitration Procedure for Taxes on Income and Capital2 applies in addition. 1.2 The term “APA”, classification, legal bases Under international interpretation, an APA constitutes an agreement between one or several taxpayers and one or several tax administrations; prior to implementing business transactions among affiliated companies of several states it determines an arm’s length transfer pricing method in order to determine transfer prices for specific business transactions within a specified time period (sec. 2.2 and sec. 2.4 Administrative Guidelines – Income Allocation, sec. 3.4.10 Administrative Guidelines – Procedures, sec. 4.124 OECD-Guidelines 19953, sec. 3 OECD-Guidelines for Conducting Advance Pricing Arrangements Under the Mutual Agreement Procedure “MAP APA”4); in addition, further criteria for the determination of transfer pricing may be agreed, e.g. determination of comparable arm’s length data and provisions for updating them within the APA period, appropriate adjustment calculations, so-called critical assumptions with respect to future events (“critical assumptions”, sec. 3.7). Tax agreements between a taxpayer and the German tax authorities are not permissible under German tax law. Instead, based on a double taxation agreement including a clause on the mutual agreement and consultation procedure pursuant to art. 25 (1) and (3) OECD Model Tax Convention that is applicable to that extent, an advance mutual agreement may be negotiated with the other state upon request of the taxpayer (sec. 4.10 and sec. 4.42 OECD-Guidelines5). Germany is bound by such an agree1 OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris 1995. 2 Federal Tax Gazette 2006 I p. 461. 3 “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” of the OECD, Paris 1995. 4 OECD, Transfer Pricing Guidelines, Appendix: OECD-Guidelines for Conducting Advance Pricing Arrangements Under the Mutual Agreement Procedure (“MAP APA”), p. AN 19 et seq. 5 OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris 1995.

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ment, i.e. it is to be implemented with the stipulated content (art. 25 (2) sent. 2 OECD-Model Tax Convention). This is governed by a respective advance pricing approval towards the taxpayer and by issuing respective tax assessment notices. Parties to the application procedure under art. 25 OECD-Model Tax Convention are the taxpayer (applicant) and the Federal Central Tax Office as the “competent authority”. Parties to the actual advance mutual agreement procedure are the “competent authorities” of the contracting states, not the taxpayer nor his affiliated company (Bulletin on the International Mutual Agreement and Arbitration Procedure for Taxes on Income and Capital1, sec. 4 OECD-Guidelines for Conducting Advance Pricing Arrangements Under the Mutual Agreement Procedure “MAP APA”2). Parties to the advance pricing approval procedure are the taxpayer (applicant) and the locally competent federal state tax authority (tax office). Under German interpretation, the advance mutual arrangement and the advance pricing approval together constitute the APA (sec. 4 OECDGuidelines for Conducting Advance Pricing Arrangements Under the Mutual Agreement Procedure “MAP APA”3). In cases where a double taxation agreement containing a mutual agreement clause exists with the state of a foreign enterprise, transfer pricing approvals on business transactions shall only be given to the affiliated German company if an agreement was reached with the other state; to that extent the successful conclusion of the advance mutual agreement procedure is a mandatory prerequisite for a respective advance pricing approval (sec. 5.1). In all other cases (e.g. where no double taxation agreement exists), upon request and with the consent of the Federal Central Tax Office directing the APA procedure the competent federal state tax authority may commit itself unilaterally towards the taxpayer for future transfer pricing issues provided that the specific individual case is suitable therefore and there is legitimate interest. Arguments in favor of rejecting such applications are that unilateral measures cannot reliably avoid double taxation and may even provoke taxation gaps. If the taxpayer concludes a one-sided (unilateral) APA with another state under its applicable law without the German tax authorities being present, the German tax authorities are not bound by it. If the German tax1 OECD, Transfer Pricing Guidelines, Appendix: OECD-Guidelines for Conducting Advance Pricing Arrangements Under the Mutual Agreement Procedure (“MAP APA”), p. AN 19 et seq. 2 OECD, Transfer Pricing Guidelines, Appendix: OECD-Guidelines for Conducting Advance Pricing Arrangements Under the Mutual Agreement Procedure (“MAP APA”), p. AN 19 et seq. 3 OECD, Transfer Pricing Guidelines, Appendix: OECD-Guidelines for Conducting Advance Pricing Arrangements Under the Mutual Agreement Procedure (“MAP APA”), p. AN 19 et seq.

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payer requests that in accordance with the APA the local competent federal state tax authority shall commit itself unilaterally towards him, in agreement with the Federal Central Tax Office the application is only accepted provided that it can be determined without extraordinary effort that the APA with the other state does not conflict with German taxation interests. In case the application is rejected, the result of the tax audit that usually follows in such cases must be awaited in addition. APAs must be differentiated from other binding approvals (§§ 204 et seq. General Fiscal Code – based on a tax audit) and from binding rulings based on good faith (circular of the Federal Ministry of Finance of December 29, 2003 – IV A 4 – S 0430 – 7/03 – Federal Tax Gazette I p. 742 – legal opinions) especially due to their legal foundation in double taxation agreements. In all cases where the German tax authorities are legally bound towards the taxpayer regarding transfer pricing issues, an information duty exists towards affected EU member states not involved in the proceeding1. 1.3 Principles Like the initiation of a mutual agreement procedure, the APA procedure requires an application (sec. 2.1.1 Bulletin on the International Mutual Agreement and Arbitration Procedure for Taxes on Income and Capital2); it does not constitute a tax audit procedure within the meaning of § 193 et seq. General Fiscal Code. An applicant is obliged to submit to the tax authorities all facts known to him that are relevant for an appropriate transfer pricing examination and must support them unrestrictedly in the course of further clarification. The applicant shall be engaged to a larger extent than in an ordinary mutual agreement procedure (sec. 4.2), especially the transfer pricing method to be proposed by him (sec. 3.3 and sec. 3.4) requires an intensive discussion with the applicant. Due to the principle of judicial investigation (§§ 88 (2) General Fiscal Code), the tax authorities are obliged to consider all circumstances that are revealed in the course of the APA procedure to the advantage and the detriment of the taxpayer, even if the APA fails eventually. The tax authorities may transmit information obtained by means of exchange of information to other affected states under the provisions set forth in the General Fiscal Code, the Law on EC Administrative Assistance, and double taxation agreements. The provisions on confidentiality in tax matters (§ 30 General Fiscal Code) remain unaffected. An application for the implementation of an advance mutual agreement procedure with the purpose of issuing an advance approval in transfer pri1 Decision of the ECOFIN dated June 4, 2002 with regard to the report of the Code of Conduct Group (business taxation) to the Council (economic and financial affairs). 2 Federal Tax Gazette 2006 I p. 461.

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cing issues (APA application) does not have a direct impact on other court and out-of-court procedures (e.g. suspension of enforcement or appeals procedures); it may be required to take measures of coordination with regard to the APA procedure, e.g. to hold protests in abeyance. Moreover, an APA procedure does not conflict with the implementation or continuation of a tax audit, especially as it regularly relates to other assessment periods; in specific cases it may e.g. be useful to amicably agree on a prolongation of the audit until an agreement in the APA procedure has been reached (“roll back”, sec. 7.3).

2. Initiation of the procedure 2.1 Competences The Federal Central Tax Office is authorized to conduct an advance mutual agreement procedure as the competent authority within the meaning of double taxation agreements. The Federal Central Tax Office coordinates the content of an advance mutual agreement on transfer prices with the competent federal state tax authorities. The local federal state tax authorities are responsible for issuing advance pricing approvals on transfer prices and corresponding tax assessment notices. Advance pricing approvals are given to implement the advance mutual agreement procedures (pursuant to art. 25 (2) sent. 2 OECD-Model Tax Convention); see sec. 1.2 third to last paragraph regarding special cases. It is referred to sec. 4.3 regarding the cooperation between the federal tax authority and the federal state tax authorities. 2.2 Preliminary talks (prefiling) As a first step, the taxpayer should file for the implementation of preliminary talks (prefiling) with the Federal Central Tax Office in order to discuss the procedure and e.g. to arrange the appropriate subject and content of the APA application (sec. 3) and which documents will be required in his case (sec. 3.5 and 3.6). The affected federal state has to join (sec. 4.3). In addition, it may be discussed how the Central Federal Tax Office evaluates the prospects of reaching an agreement with the other “competent authority” in the APA procedure. The taxpayer has to be notified that the German tax authorities will only conclude an advance mutual arrangement if he waives the right under § 354 (1a) General Fiscal Code to file objections against tax assessment notices correctly implementing the results of the arrangement for the duration (sec. 4.6). Furthermore, a joint and non-binding evaluation should be made as of how much time the conclusion of the APA will require. The evaluation shall be made as early as possible, be arranged with all parties to the proceeding, and, where re-

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quired, be jointly amended in the course of the proceeding in the event of any changes. It is permissive to carry out the prefiling in anonymous form (without announcing the taxpayer concerned). However, in such cases all statements given by the tax authorities exceeding the comments regarding the procedure are non-binding; the tax authorities do not carry out any specific preliminary works. 2.3 Application requirements Only parties entitled to treaty benefits (pursuant to art. 1 OECD-Model Tax Convention) are permitted to file an APA application (pursuant to art. 25 (1) OECD-Model Tax Convention) with the “competent authority” (Federal Central Tax Office). Regardless, the applicant will not be a party to the actual advance mutual agreement procedure (sec. 1.2). The applicant must demonstrate a legitimate interest in the implementation and the conclusion of the APA procedure. The application has to be filed in writing and bear the applicant’s personal signature. In addition, an application for issuing a binding advance pricing approval may be filed with the locally competent federal state tax authority which cannot be approved prior to having finalized the advance mutual agreement procedure; it is referred to sec. 5.1. The APA application has to be filed with the Federal Central Tax Office that is competent for the APA procedure including the required application documents (sec. 3.5) in quadruplicate. The Federal Central Tax Office will forward without delay one copy of each to the highest tax authority of the federal state concerned (competent highest federal state tax authority) or to its authorized federal state tax authority (assigned authority) and the locally competent federal state tax authority (tax office). If an APA application or an application for issuing an advance pricing approval for which an advance pricing arrangement is required is submitted to the taxpayer’s locally competent federal state tax authority, it shall notify the taxpayer that he has to file the APA application with the Federal Central Tax Office responsible for it; receipt of the application by the Federal Central Tax Office has impact on the date on which the duration of the APA may commence at the earliest (sec. 3.8). Regardless, the locally competent federal state tax authority ensures that the Federal Central Tax Office is notified about the application and receives a copy. It regularly does not conflict with the application that the international transfer prices of the taxpayer are the subject of a tax audit. It is referred to sec. 1.3 regarding potential impacts of the application on other procedures (e.g. the tax audit procedure).

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3. Content of the APA, documents to be submitted, rejection of the APA application 3.1 General The taxpayer determines the content of the APA with his application. The application has to include the description of the scope of application as regards subject (sec. 3.2) and time (sec. 3.8); the other state with which an advance mutual agreement shall be reached has to be named. Where it is applied for a multilateral APA procedure, several applications for the implementation of bilateral procedures have been filed from a legal perspective. The applicant must explain his application in detail and furnish all necessary documentation (sec. 3.5 and 3.6). The tax authorities may at any time ask additional questions and request further information and documents pertaining to the application. In order to avoid unnecessary delays, the applicant is obliged to comply with such requests immediately. If there are any changes in the underlying facts or in the respective planning of the taxpayer after having filed the application, the Federal Central Tax Office must be notified thereof instantly. The time of receipt of the application by the Federal Central Tax Office has impact on the date on which the term of the APA may commence at the earliest (sec. 3.8). Upon request of the tax authorities, the applicant is at any step of the procedure obliged to (where required, partially) translate documents he submitted at his own costs (§ 87 (2) sent. 2 and 3 General Fiscal Code). 3.2 Specification of the scope of application The applicant may limit his APA application, e.g. to specific, explicitly defined types of business transactions (e.g. product lines, enterprises, divisions of enterprises), or to business transactions with specific, explicitly specified affiliated persons, or to business relations with affiliated parties in certain states. If there is the possibility that third states not involved may question the results of the APA at a later time (sec. 7.5), the applicant should make note thereof. Restrictions must be appropriate and substantiated. It is referred to the option to reject the application due to random restriction (sec. 3.9). 3.3 Transfer pricing method, additional criteria for the transfer pricing determination The Federal Central Tax Office will in principle conclude advance mutual agreements on transfer prices only with respect to the acceptance of one or several transfer pricing methods for specific business transactions or certain types of business transactions by agreeing on critical assumptions. 270

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A provision exceeding the agreement on a method may only be considered provided that criteria related to the method that may be safeguarded by the determination of critical assumptions are ascertained in the individual case (sec. 3.7). Where e.g. the remuneration of a toll manufacturer is at question, a specific range of markups exceeding the applicable method (cost plus) may only be agreed in case reliable, at least restrictedly comparable arm’s length data can actually be verified for the years of the APA period. If this is impossible (e.g. because at a later time comparable enterprises are no longer registered in data bases), a contractual basis for the APA (“critical assumptions”) has become obsolete. It is referred to sec. 6.4 regarding the consequences. In order to avoid compromising the APA due to unfulfilled critical assumptions, identifiable, potential fluctuations in the relevant circumstances should be considered by stipulating adjustment mechanisms (sec. 3.7). If the proposed method is inappropriate (see sec. 2.4.1 Administrative Guidelines – Income Allocation (1983)1 and sec. 3.4.10 Administrative Guidelines – Procedures (2005)2 on the decision about the appropriateness of transfer pricing methods), the Federal Central Tax Office will promote the application of an appropriate method; it is referred to the option of rejecting the APA application (sec. 3.9). 3.4 Substantiation of the method and transfer pricing determination The applicant’s substantiation must demonstrate that the application of his proposed transfer pricing method complies with the arm’s length principle with respect to business transactions that shall be included in the APA. The method has to be described in detail; all necessary documents and calculations for the application of the method must be submitted; it ordinarily includes a detailed calculation scheme. In addition, arm’s length data (e.g. prices, gross margins, cost markups) that has been collected contemporaneously and is at least restrictedly comparable (sec. 3.4.12.7 (c) Administrative Guidelines – Procedures3) must be illustrated and adjustment calculations that may be necessary in the future must be explained. 3.5 Documents to be provided It cannot be determined for all cases which documents and documentation must be submitted as it depends on the circumstances of the respective case and the objective possibilities of gathering information (with respect to future business transactions). Inter alia, it is part of the preliminary talks to provide clarification in the specific case (sec. 2.2). 1 Federal Tax Gazette 1983 I p. 218. 2 Federal Tax Gazette 2005 I p. 570. 3 Federal Tax Gazette 2005 I p. 570.

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Where an APA application has been filed and an affected tax year (sec. 3.8) ends while the APA negotiations are still carried out, the applicant is obliged to immediately submit documents showing the results on the actual data of that particular tax year that originate from applying the intended transfer pricing method. Upon request, respective documentation must be submitted at the latest within the submission deadline set forth in § 90 (3) sent. 8 and 9 General Fiscal Code; it is referred to sec. 3.9. The non-exhaustive list below specifies documents and documentation that will be required in many cases for the implementation of an APA procedure: a) Illustration of the shareholding relationships; b) Illustration of organizational and operative group structure; c) Description of the area of activity to the extent necessary for the APA (sec. 3.2); d) Illustration of the business transactions with affiliated companies (intended contractual arrangements); e) Illustration and explanation of functions and risks assumed; f) Identification and brief description of the essential assets (in particular, intangible assets) that are significant for the affected business transactions; g) Illustration of the market and competitive conditions and the selected business strategy/strategies; h) Description and valuation of the proposed value-added chains and the contributions of the concerned enterprises; i) Identification of all unresolved tax issues (also in relation to other tax administrations) that are related to the business transactions to be included in the APA. The documents must be submitted provided that they relate to the APA period and are relevant to the specific APA. It should also be explained whether any changes are anticipated for the APA period and how these may impact the implementation of the proposed transfer pricing method. The “questionnaire” of the Federal Central Tax Office available under www.bzst.de contains further information regarding the application. 3.6 Special features for cost sharing agreements Where cost sharing arrangements or cost contribution agreements shall be the subject of the APA, at least the following documents and documentation must be submitted: 272

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a) The designated (where necessary, amended) cost sharing agreement including appendixes, enclosures, and supplementary agreements; b) Documents on the anticipated benefit for all parties including the presentation of the method applied and forecasts; c) Documents on the intended application of the allocation key; d) Unless included in the cost sharing agreement, documents on the anticipated standards regarding invoice checking, adjustment mechanisms (upon changing circumstances), the authorization to access necessary cost sharing documents, and the attribution of the rights of use. Apart from this, the requirements for documentation to be submitted under an APA application based on cost sharing agreements can be derived from the documentation duties and the obligation to furnish evidence as regards cost sharing agreements as set forth in the circular of the Federal Ministry of Finance of December 30, 1999 – IV B 4 – S 1341 – 14/991. 3.7 Critical assumptions With regard to future business transactions, it is necessary to take certain suppositions as basis that materially influence the business transactions as “critical assumptions”. Such critical assumptions provide for an explicitly agreed on contractual basis in the relationship between the contractual partners in the advance mutual agreement (states involved under the double taxation treaty). Based on the subject matter of his APA application, the applicant shall make suggestions what critical assumptions from his perspective shall apply to the effectiveness of the APA, e.g. with regard to the relations of the enterprise or a business partner or with regard to general industrial, business, or economic conditions. In addition, he should explain to what extent the method proposed by him allows for the consideration of changes in the critical assumptions. The critical assumptions and the subject matter of the APA must be interdependent in such manner that it seems likely that changes in the agreed critical assumptions influence or question the material agreements of the APA. Critical assumptions may comprise: a) Unchanged ownership structure; b) Unchanged relations regarding market conditions, market share, business volume, selling prices (e.g. no radical changes due to new technologies), each specifying a framework; c) Unchanged relations e.g. with regard to the right of supervision, customs, import and export restrictions, international payments;

1 Federal Tax Gazette 1999 I p. 1122.

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d) Unchanged distribution of functions and risks and capital structure, unchanged business model; e) Unchanged relations regarding exchange rates and interest rates; f) Enforcement of taxation in line with the APA in the other state; g) No essential changes in the tax framework in the other state; h) Transfer pricing adjustments that have an impact on the APA made by a third state not involved. Potential consequences that may occur if critical assumptions are not (cannot be) met are discussed in sec. 6.4. 3.8 Duration Considering that APAs are directed towards the future, the duration usually commences with the beginning of the business year in which the application is formally filed. It may be approved of an earlier start if neither a tax return has been filed nor the statutory deadline for the submission of the tax return (§ 149 General Fiscal Code) has expired for an earlier business year at the time the APA application was filed with the Federal Central Tax Office (see sec. 2.3). In order to take the practice of other states into account, a commencement deviating thereof may be agreed, provided that this does not conflict with any interests of the German tax authorities. It is referred to the option to extend the results of an APA to previous years (“roll back”, sec. 7.3) under certain circumstances. In order to determine an appropriate duration, the following aspects must inter alia be considered: – The continuity and stability of the recorded business transactions, – The interest of the taxpayer in and reservations of the tax authority about a long-term commitment, – The practice of the other state involved. It ought to be avoided that upon conclusion of an APA the duration of such has already expired entirely or for its most part; where necessary, the applicant should amend his application accordingly. The disadvantage of only a short duration may in individual cases be compensated by (simplified) options for a renewal (sec. 7.4). The duration should be at least three years and not exceed five years.

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3.9 Rejection of the APA application, reasons for rejection The decision not to initiate the APA procedure constitutes a decision on the APA application and thus represents an administrative act within the meaning of § 118 General Fiscal Code; the decision is based on the responsible discretion of the Federal Central Tax Office competent for conducting the mutual agreement procedure and will be made in agreement with the competent highest federal state tax authority (sec. 4.3). When deciding upon the initiation of the procedure, all due care and diligence shall be given to the interest of the taxpayer in the safe prevention of potential double taxation and the interest of the administration in a mutual settlement of the transfer pricing issue, that otherwise may become a complex subject of a tax audit or an ordinary mutual agreement procedure. Individual issues to be considered when weighing up the interests may be for instance: – Conformity of content of the application with German transfer pricing principles, international enforceability, APA practice of the other state; – Foreseeable difficulties or doubts when interpreting the applicable double taxation agreement that should rather be resolved prior to implementing the respective business transactions (interest of approval by the administration); – Seriousness of the business transactions to be assessed, hypothetical transactions, visible test of the position of the tax administration, tax prevention as a verifiable motive for the application; – Dispute in an ongoing tax audit that indirectly may be resolved by concluding an APA due to the same facts. Arguments against the initiation of an APA procedure are for example that the taxpayer has restricted his application without objective justification, that he does not have any justified interest or only an interest in avoiding tax, that considerable delays have occurred for which he is accountable, that he refuses to provide the tax authorities with sufficient information, or that he insists on applying a method that the tax authorities consider as inappropriate. Where the taxpayer does not meet the prerequisites required for initiating the procedure, following notification it is in the responsible discretion of the Federal Central Tax Office to reject the application for an APA with the consent of the competent highest federal state tax authority or the authorized authority; sec. 1.3 has to be observed with respect to the consideration of insights gained due to the application. Prior to issuing the

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decision on the rejection, the applicant shall be given the opportunity to eliminate the respective reason for rejection.

4. Implementation of the APA procedure, procedural principles 4.1 General In addition to a continuous flow of information among the tax authorities involved and with regard to the taxpayer especially the time coordination and the swift implementation of the procedure are material regarding a successful conclusion of an APA procedure; this affects all phases (preliminary talks, submission of application, negotiations with the applicant, notification of the tax administration of the other state, negotiations with the other state, conclusion of a mutual agreement, approval by the applicant, issuance of a binding advance pricing approval). In order to facilitate a swift conclusion, apart from a close cooperation of all parties to the proceeding it is especially necessary to agree on a realistic timetable for the entire APA procedure and for each step of the procedure, even though it is not binding. Whenever one party has difficulties in meeting the schedule, it shall inform all other parties to the proceeding immediately. The decision to discontinue with an APA procedure after its initiation shall be made under consideration of the aspects addressed in sec. 3.9. 4.2 Involvement of the applicant in the advance mutual agreement procedure The applicant is not a party to the proceeding in the actual advance mutual agreement procedure (sec. 1.2). It remains unaffected that the APA procedure may be terminated at any time by withdrawing the APA application (“voluntariness”) (it is referred to sec. 7.2 regarding a potential transition to a consultation procedure not requiring an application). The Federal Central Tax Office regularly notifies the applicant about the stage reached in the procedure. As the “competent authority” it decides together with the other state on the personal presence of the applicant or his representatives in parts of the negotiations or on the option of the taxpayer of expressing his position to both states in person and to debate with these; this may be appropriate to accelerate the procedure. Apart from that, the applicant is a party to his application procedure and the procedure on the advance pricing approval; as such, he is obliged to cooperate, procure information, and to submit records and documents; this may also include rendering possible investigations on his premises. It is referred to sec. 1.3 with respect to the utilization of knowledge gained from information furnished by the applicant in the APA procedure.

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4.3 Cooperation of federal and federal state authorities The Federal Central Tax Office notifies the competent highest federal state tax authority without delay about the implementation of a prefiling and whenever possible, requests its engagement. The highest federal state tax authority may appoint a representative for this purpose. After receipt of the APA application, by involving the competent highest federal state tax authority or the authorized authority the Federal Central Tax Office will establish for each APA an “APA team” that consists of a representative of the competent department of the Federal Central Tax Office and at least one representative of the federal state involved. The representatives of the federal state should include a tax auditor who, based on the organization of the federal state, is its auditor responsible for the enterprise, the affected industry, or the APA in general; several auditors may be appointed. For each APA procedure, the federal state involved shall give to the Federal Central Tax Office the name of one contact person who is a member of the APA team and assumes responsibility for continuously briefing the federal state tax authorities authorized to make decisions (highest federal state tax authority, regional finance office, tax office making the assessments). The competent department of the Federal Central Tax Office decides upon involving an auditor of the federal tax audit department in the APA team; the involvement will in particular be appropriate if the federal tax audit department participates in the tax audit of the enterprise or has special knowledge about the industry or transfer prices. The Federal Central Tax Office (“competent authority”) assumes the task of “team coordinator”, i.e. it conducts the advance mutual agreement procedure with the other state and coordinates assignments with the auditors involved (e.g. compliance with the timetable). Employing the appointed representative of the federal state, it is its responsibility to reach an agreement at each step of the procedure with the federal state tax authorities authorized to make decisions. 4.4 Cooperation with the other state (or other states) The applicant should file his APA applications simultaneously with the Federal Central Tax Office and the foreign tax authority including the same documents. At the beginning of the APA procedure the Federal Central Tax Office attempts to coordinate the procedure – especially with respect to the time aspect (sec. 4.1) – with the foreign “competent authority”. The purpose of the cooperation is to achieve a full exchange of information and to reach the same level of information at both states.

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4.5 Conclusion of the advance mutual agreement procedure with the other state In agreement with the federal state involved, the Federal Central Tax Office as the “competent authority” concludes the advance mutual arrangement with the “competent authority” of the other state in writing. The declaration of intent required by the Federal Central Tax Office for this purpose shall be made with the reservation that the applicant acknowledges the agreement and at the same time declares waiving his right to any appeal under § 354 (1a) General Fiscal Code (sec. 4.6). Upon receipt of the respective declarations from the taxpayer, the other state shall be notified about the date on which the APA has become effective, i.e. the reservation has expired. The agreement shall be concluded in German and, where appropriate, also in the language of the other state. Several bilateral APA procedures based on one application may be concluded under a unitary written agreement. In such cases, for simplification purposes solely the version in one language (regularly English) may amicably be declared as binding; in consultation with the Federal Central Tax Office the applicant is required to furnish a German translation that shall constitute the basis of the binding ruling (sec. 5.1). The potential content of an agreement may be derived from the sample (Appendix) enclosed. 4.6 Approval by the applicant, waiving the right to appeals (§ 354 (1a) General Fiscal Code) After the advance mutual agreement has been signed, the Federal Central Tax Office notifies the applicant about the result in writing. The applicant is obliged to declare his approval to the APA immediately (sec. 4.2 of the Bulletin on the International Mutual Agreement and Arbitration Procedure for Taxes on Income and Capital1) in writing (bearing signature). In accordance with the reservation (Sec. 4.5), the agreement shall only take effect if the applicant waives to the locally competent tax authority (§ 354 (2) sent. 1 General Fiscal Code) his right under § 354 (1a) General Fiscal Code to appeal against tax assessment notices that correctly implement the results of the APA for the APA period. In addition, he is required to declare that he is aware of the fact that the German tax authorities shall only be required to abide by the agreement if the facts underlying the APA are fulfilled (sec. 6.5.1), the critical assumptions are met (sec. 6.5.2), and the tax authorities are provided with the necessary annual financial statements (sec. 6.1).

1 Federal Tax Gazette 2006 I p. 461.

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5. Implementation 5.1 Implementation in Germany by the competent federal state tax authority In accordance with art. 25 (2) OECD Model Tax Convention, the competent federal state tax authority (tax office) is obliged to issue upon application (sec. 2.3) after the conclusion of the advance mutual agreement procedure a binding advance pricing approval containing the same content (sec. 4.5). With regard to sec. 6.4 and sec. 6.5.2, a reservation to revocation must be included in the advance pricing approval. Where all other requirements are met regarding the APA period, respective tax assessment notices shall be issued in accordance with the APA (sec. 6.3). 5.2 Implementation in the other state The implementation in the other state is irrelevant to the implementation in the domestic territory and the domestic procedure. If the taxpayer discovers that the implementation in the other state results in difficulties or it leads to deviations from the advance pricing arrangement there, he notifies the Federal Central Tax Office that may contact the other state and, in agreement with the competent highest federal state tax authority, decides whether to pursue negotiations again.

6. Measures during the duration, binding effect 6.1 Taxpayer’s obligations for reporting and furnishing evidence (yearly compliance report) The obligation of the taxpayer to prepare and to submit a yearly report (“compliance report”) in order to demonstrate that the facts underlying the agreement have been fulfilled in the business year in question and in particular that the critical assumptions have been met (sec. 3.7) constitutes part of the agreement with the other state. In this context, the taxpayer shall explicitly refer to any deviation and state whether and what adjustments he made. If the taxpayer breaches this duty, it may result in detrimental consequences (sec. 4.6). If, according to the report, the critical assumptions have not been met, the taxpayer should offer recommendations for respective adjustments to be made to the mutual agreement. Supplementary questions asked by the tax authorities in this context shall be answered by the taxpayer without delay. The report should be submitted simultaneously to the Federal Central Tax Office and the locally competent federal state tax authority (tax office) in German or in a foreign language including a German translation 279

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prior to expiration of the statutory deadline for filing tax returns for the respective business year. At the latest, it shall be submitted at the earlier one of the following dates: – simultaneously to submitting it to the other state; – in combination with the tax return for the respective assessment period. 6.2 Review of the critical assumptions The Federal Central Tax Office is in charge of examining whether the critical assumptions have been fulfilled according to the report. In case of any doubt, it shall be clarified in cooperation with the locally competent tax authority. Where appropriate, it shall point out to the Federal Central Tax Office any inconsistencies between the compliance report and the tax return submitted to it. In agreement with the highest competent federal state tax authority, the Federal Central Tax Office will decide whether it is necessary to take measures with respect to the APA, e.g. to terminate the contract or to enter negotiations with the other state (sec. 6.5). In a later tax audit it shall be determined whether the taxpayer has complied with the APA during the audit years, in particular whether the stated facts have been implemented (sec. 6.5.1) and whether the critical assumptions have been met (sec. 6.5.2). 6.3 Binding effect on the tax authorities The tax authorities are bound by the APA if the facts underlying the APA have been fulfilled and the critical assumptions have been met. In audits and assessments, they are not entitled to deviate from the results that are based on the correct application of the APA. They may e.g. not make any changes due to another transfer pricing method. Under a tax audit carried out at a later time, the tax authorities are entitled to determine whether the relevant facts have actually been implemented and whether the agreed on critical assumptions (including the statements in the compliance reports to be submitted by the taxpayer, sec. 6.1) have been met during the APA period. Where the critical assumptions (sec. 3.7) are not met, the binding effect on the tax authority shall in principle be revoked; respective consequences are authorized therewith (sec. 6.5.2). 6.4 Binding effect on the applicant/taxpayer Based on the APA, the applicant/taxpayer is not obliged to implement the facts underlying the APA. Sec. 6.5.1. applies to cases where he fails to implement the facts. 280

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In case the taxpayer implements the facts on which the APA has been based, he shall also be bound by the provisions in the APA he has initiated and explicitly agreed to (sec. 4.5). If he charges other prices than those agreed in the APA, albeit the other settlement of accounts the tax authorities may base taxation on the provisions laid down in the APA. The Federal Central Tax Office immediately notifies the other state about respective circumstances. In individual cases, in cooperation with the other state the tax authorities may treat the APA as if it had not been concluded and revoke the advance pricing approval (sec. 5.1). When the taxpayer appeals to a tax assessment notice properly recognizing the APA, the appeal shall be invalid provided that according to sec. 4.6 the right to appeal has been waived (§ 354 (1a) General Fiscal Code). 6.5 Revocation or restriction of the impact of the APA In all cases where the impact of an APA is either revoked or restricted, it must be observed that the tax authorities are obliged under § 88 General Fiscal Code (principle of judicial investigation) to consider all insight gained during the procedure to the benefit or the detriment of the taxpayer and other persons for tax purposes (sec. 1.3). 6.5.1 Failure to implement the facts If the taxpayer fails to implement the facts on which the APA has been based, both the advance pricing arrangement and the advance pricing approval become obsolete and do not have any future legal effect. 6.5.2 Failure to implement critical assumptions If the critical assumptions are not implemented in essential respects, the APA is deprived of its basis; the advance pricing approval may be revoked (sec. 5.1) as of the date on which the critical assumptions are not fulfilled (any longer). The Federal Central Tax Office notifies the other state about these circumstances without delay. Provided that only insignificant deviations exist, the Federal Central Tax Office may with the consent of the competent highest federal state tax authority preserve the validity of the APA or, after consultation (in writing) with the other state, amend it with the consent of the taxpayer; after having ascertained the deviation, the Federal Central Tax Office notifies the other state immediately of the position of the German tax authorities. In all other cases, the Federal Central Tax Office may, in agreement with the competent highest federal state tax authority, enter into negotiations with the other state in order to amend the APA to the changed conditions. This requires an application of the taxpayer that is submitted including all necessary documents (application for amendment). If such application 281

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is not submitted or it is impossible to reach an amicable amendment with the other state, the validity of the APA becomes obsolete as of the date on which the critical assumptions are not fulfilled (any longer); accordingly, the advance pricing approval may be revoked (sec. 5.1). It is referred to sec. 1.3.

7. Additional procedural provisions 7.1 Amendments The applicant is entitled to amend his APA application at any time until the legal conclusion of the advance mutual arrangement (sec. 4.5 and 4.6). A significant amendment of the application shall be considered as a new application (a respective later date of receipt may possibly affect the duration, sec. 3.8). The tax authorities may reject such new application if there is reason to believe that the applicant has not prepared the procedure in earnest, or conducts it sincerely, or that purposes exceeding the procedure are pursued (e.g. “testing” of the tax authorities, sec. 3.9). 7.2 Withdrawal of the APA application As the APA procedure is, like the mutual agreement procedure, based on an application, upon its withdrawal the basis of its applicability becomes obsolete; the procedure is terminated. Regardless, the contracting states may conduct a consultation procedure (pursuant to art. 25 (3) OECD-Model Tax Convention), that is to be distinguished from the APA procedure and does not require an application, if during the negotiations difficulties and doubts with respect to the double taxation agreement (also in individual cases) have been recognized that shall be resolved by amicable arrangement. Facts that have become known during the procedure have to be considered in the domestic territory under the principle of judicial investigation (sec. 1.3) 7.3 Roll back of the APA Where the taxpayer applies for a retroactive application of a transfer pricing method on which it has been agreed in the APA to assessment periods that precede the contractual period of an APA (so-called roll back), this may be feasible under certain circumstances, in particular if the other state agrees. A roll back requires the taxpayer to furnish evidence that the facts implemented in the previous years concerned comply with the facts of the APA years. In addition, documentation on the assessment of previous years that is in accordance with documentation regarding the APA period has to be provided.

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Formally, the previous years may not be included in the APA (see sec. 3.8). A roll back as regards content may be feasible, e.g. due to a mutual agreement procedure that shall be initiated additionally pursuant to art. 25 (1) OECD-Model Tax Convention, which may also be conducted in combination with the APA yet will be concluded separately in legal terms. With regard to prior years, the tax authorities are at liberty to examine whether the results of such should have been determined using the approach agreed on in the APA procedure, provided that the facts are the same. In this context it must be observed that an arm’s length determination of transfer prices may often be carried out in a different manner and with different (acceptable) results for same facts (sec. 2.1 Administrative Guidelines – Procedures1). Accordingly, the tax authorities may only make an adjustment for previous years if the treatment of the previous years was incorrect or deficient. In such cases, § 153 (1) General Fiscal Code has to be observed. 7.4 Extension of the APA An extension of the APA exceeding the period covered may be feasible with the consent of the other state, provided that a respective application is filed in time and it is credibly shown that the facts implemented comply with the facts on which the APA has been based. In such cases it is likely that it may be agreed on the extension (where applicable, including certain amendments) in an uncomplicated and swift procedure because, in contrast to an original application, this procedure will not require the submission of all documents (sec. 3.5). The duration of the extended agreement depends on the circumstances of the individual case and will refer to the durations that generally shall be contracted for APAs (sec. 3.8). 7.5 Initial modifications by a third state after conclusion of an APA If double taxation arises to a taxpayer subject to unlimited taxation after the conclusion of an APA with regard to a third state not party to the APA because this state does not acknowledge the results of the APA and carries out initial modifications (sec. 3.2), the Federal Central Tax Office will commence with this state a mutual agreement procedure or will take part in such a procedure with the aim to cause the third state to eliminate the double taxation by amending the respective foreign tax assessment notice. The state with which the APA has been concluded shall be informed immediately and, where required, be involved in the mutual agreement procedure with the third state. If double taxation cannot be avoided with such mutual agreement procedure, depending on the circumstances of the individual case different options have to be considered in order to main1 Federal Tax Gazette 2005 I p. 570.

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tain the APA on the one hand and to avoid an imminent double taxation on the other hand. In agreement with the competent highest federal state tax authorities, the Federal Central Tax Office shall decide on the course of action to be taken by the German tax authorities in the specific case. The taxpayer shall be given the opportunity to present his interests; they shall be considered appropriately in the decision.

8. Simplified procedure for small and medium-sized enterprises Upon application of a taxpayer whose transactions covered by the APA will presumably not exceed the amounts set forth in § 6 (2) Ordinance on the Documentation of Income Attribution, the Federal Central Tax Office may grant reliefs with respect to the requirements set forth in sec. 3.4 and sec. 3.5 to the extent the purpose of the APA – based on clear facts, to provide for the taxpayer’s legal certainty and to reach an agreement with the other state – shall not be compromised.

9. Publication This circular will be published in the Federal Tax Gazette I. Appendix Draft Advance Pricing Agreement – Model agreement Wording proposal for an Advance Pricing Agreement (APA) between (competent authorities involved) regarding (affected affiliated companies)

1. Parties to the APA Competent authorities of the states involved

2. Affiliated companies to which the APA applies (taxpayers/ applicants) Company A: Name Address

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Company B: Name Address Any other additional affiliated companies

3. Business transactions involved in the APA (See Appendix 1 regarding explanations on every nature of the business transactions involved)

4. Transfer pricing method(s) 4.1 Transfer pricing method(s) (See Appendix 1 for further explanations) 4.2 Additional provisions (Additional special agreements e.g. on treatment of warranties, sales promoting measures, advertisement, special services included within the group, etc.)

5. Duration This advance pricing agreement shall apply to the following business years:

6. Roll back The transfer pricing method to be utilized for the APA will retroactively be applied for the following years and the following business transactions (formally separate procedure outside the APA, conclusion may be possible in a uniform document):

7. Critical assumptions The following critical assumptions are (e.g.) agreed: – Unchanged ownership structure; – Unchanged business relations between the companies involved (or between the involved dependent parts of the company); – Unchanged relations regarding market conditions, market share, business strategy, sales volume, selling prices;

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– Unchanged allocation of functions and risks and unchanged capital structure; – Unchanged profit determination provisions with respect to commercial and tax law regarding the business transactions material for the APA; – Unchanged applicability of arm’s length data of (at least restrictedly) comparable companies referred to; – Taxation in the other state according to the agreement – (Statement of other critical assumptions, if need be – depending on the agreement)

8. Submission of the annual report, content For each year to which the APA applies, the taxpayers are obliged to submit an identical report to the respective competent authorities in which they explain whether they have settled the registered business transactions pursuant to the APA and whether the critical assumptions have been met. The report must be presented to both competent authorities at the same time, at the latest it shall be attached to the tax return of the affected business year; it contains at least the following: – The financial statement(s) including further explanations revealing that the business transactions have been settled under the agreed transfer pricing method. – The results of the calculation carried out under the agreed method for the respective business year (prices, gross and net sales returns, cost mark-ups, etc.). – Details on compliance with each critical assumption laid down in sec. 7; specific description of all deviations and, if required, explanation of the adjustments or statement of the reasons why adjustments have been unnecessary. – The amount of, the reason for, and the calculation of all compensation payments (possibly) made in the affected business year. – (Any further required information)

9. Renewal of the APA Upon request of the taxpayer the APA may be renewed with the consent of the other contractual state, if the circumstances in the following years remain unchanged. If this is the case, both partners will make an effort to conclude the renewal based on the stipulations of the contracted APA.

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The application for renewal ought to be filed with both competent authorities no later than six months prior to expiration of the APA.

10. Revocation or amendment of the APA The competent authorities of Germany and … agree to consult and to notify each other prior to any amendment or revocation of the APA (or the respective domestic implementation of the APA).

11. Cancelation of the APA Each of the competent authorities involved is authorized to cancel the APA unilaterally in the following cases: – Inaccurate or false presentation of facts by the taxpayer and non-submission of relevant information in the procedure that have become known only after the conclusion of the APA. – Inaccurate or false presentation of facts as well as non-submission of relevant information in the annual report. The cancelation may, after having consulted with the other competent authority and after having heard the taxpayer, be pronounced with retroactive effects (revocation).

12. Secrecy Information that is exchanged within the scope of the procedure is subject to the provisions on the exchange of information under art. … Double Taxation Agreement between the parties. Its use and disclosure is subject to the provisions of the respective double taxation agreements.

13. Reservation of the Federal Republic of Germany, third-party effect This APA takes effect once the taxpayers have pronounced their consent in writing. The consent of the Federal Republic of Germany is made with the reservation that in addition the taxpayer declares within one month after signing a waiver of his right to any appeal under § 354 (1a) General Fiscal Code as regards tax assessment notices, to the extent these implement the APA correctly. The competent authority of the Federal Republic of Germany will immediately notify the competent authority of the other state about the time of effectiveness (receipt of the respective declaration of the taxpayer).

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14. Implementation This APA does not govern its implementation in the legal systems of the parties; this is reserved to the respective domestic law. Where difficulties or different interpretations arise regarding the result or the implementation, the competent authorities will start consultations in order to solve the differences.

15. Contact person To the extent notifications shall address the parties of the APA, respective notifications must be addressed to the respective competent authority. To the extent notifications shall address the taxpayer, the following delivery address is valid, to the extent that verifiably no other address is explicitly provided at a later time as regards this APA: … Signatures: Competent Authority State A: Competent Authority State B: Any other competent authority/authorities

Appendix 1

1. Business transactions covered by the APA Final description of the included business transactions

2. Applied transfer pricing method(s) 2.1 Comparable uncontrolled price method E.g. explanation: Prices calculated for … shall range between … Euros and … Euros 2.2 Resale price method E.g. explanation: The taxpayer shall achieve a result for the business transactions covered by the APA that complies with a gross margin (defined as the ratio between gross profit and sales) of between x% and y%. 288

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2.3 Cost plus method E.g. explanation: The taxpayer shall achieve a result for the business transactions covered by the APA that complies with a ratio between gross profit and manufacturing costs of between x% and y% (arm’s length range). This yields an operating result that lies between x% and y% of the manufacturing costs. A risk-adequate return on investment that lies between x% and y% may not be exceeded. 2.4 Cost plus method with the Berry ratio profit level indicator E.g. explanation: The taxpayer shall achieve a result for the business transactions covered by the APA that complies with a ratio between gross profit and (valueadded) business expenditures of between x% and y% (arm’s length range). This yields an operating result that lies between x% and y% of the operating expenses (relevant to added value). A risk-adequate return on investment that lies between x% and y% may not be exceeded. 2.5 Transactional net margin method E.g. explanation: The taxpayer shall achieve a result for the business transactions covered by the APA that complies with an operating margin (defined as the ratio between operating result and sales) of between x% and y%. A risk-adequate return on capital that lies between x% and y% may not be exceeded. 2.6 Other profit split methods Explanation: The taxpayer shall achieve a result that is calculated as follows.

3. Adjustments In cases where a result arises in a (sequence of several) business year(s) to which the APA applies that does not comply with an agreed ratio in accordance with sec. 2.2 to 2.5, the taxpayer is obliged to make arm’s length adjustments to achieve the agreed on ratio.

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Appendix 2 Definition of terms applied in the APA to the extent these are required for the specific APA, e.g. Gross margin Gross profit divided by sales Operating margin Operating result divided by sales Operating result The operating result constitutes the profit prior to the financial result, extraordinary result, and taxes. Sales Sales within the meaning of the APA constitutes the net turnover (minus …) Advertising expenses Guarantees Sales promoting measures Services within the group [Any additional defined terms used in the specific APA.]

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X. Business Relationship (2010) Administrative Circular on the Interpretation of the Term “Business Relationship” as Set Forth in § 1 Foreign Tax Act for Assessment Periods Prior to 2003 (Prior to the Revised Version of § 1 (4) Foreign Tax Act in the Version of Article 11 Number 1 Tax Benefit Reduction Act of May 16, 2003)1 Published on January 12, 2010 (IV B 5 – S-1341/07/10009, 2010/0002173, Federal Tax Gazette 2010 I p. 34)

The Federal Fiscal Court ruled in its decision of August 27, 2008 – I R 28/ 07 that a business relationship within the meaning of § 1 (1) Foreign Tax Act in connection with § 1 (4) Foreign Tax Act in the version of the Tax Amendment Act 1992 does not exist and thus a profit adjustment pursuant to this provision could not be considered in cases where a domestic controlling company supplies its foreign group finance company insufficiently with equity and instead of a function-adequate equity takes support measures free of charge for the benefit of the subsidiary that an independent third party would not have supported. The dispute involved an unconditional and irrevocable guarantee (so-called firm letter of comfort) for a corporate bond given out by the subsidiary (finance) company without which the subsidiary would have been unable to exercise its function. The decision was delivered regarding the legal status prior to the version of § 1 (4) Foreign Tax Act (now: § 1 (5) Foreign Tax Act in the version of the Corporate Tax Reform Act 2008 of August 14, 2007, Federal Law Gazette I p. 914) which was revised by the German Tax Benefit Reduction Act of May 16, 2003 (Federal Law Gazette I p. 660). Thus, the Federal Fiscal Court confirms its jurisdiction in the decision of November 29, 2000, I R 85/99 (Federal Tax Gazette II p. 720) and not in accordance with the circular of the Federal Ministry of Finance of October 17, 2002 – IV B 4 – S 1341 – 14/02 – (Federal Tax Gazette I p. 1025). With regard to the discussion with the highest fiscal authorities of the Federal States, the decision shall be applied to assessment periods prior to 2003, i.e. before § 1 (4) Foreign Tax Act in the version of German Tax Benefit Reduction Act (now: § 1 (5) Foreign Tax Act) came into force, for all open cases in which a domestic controlling group company grants to its foreign subsidiary support measures substituting equity, e.g. a so-called firm letter of comfort. This is also applicable to binding credit guarantees substituting equity for the benefit of a foreign subsidiary that is not a financing company. The decision shall also be applied to assessment periods prior to 2003 to the extent that involves cases where interest-free loans or such with favorable rates were issued from a domestic controlling company to its for1 This circular of the Federal Ministry of Finance has been revoked by the circular of the Federal Ministry of Finance of April 4, 2011 for all facts that are realized after December 31, 2009.

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eign subsidiary if the granting of such loans results in subsequent acquisition costs for the participation because of a (hidden) capital contribution (see decision of the Federal Fiscal Court of May 30, 1990, I R 97/88, Federal Tax Gazette 1990 II p. 875). The decree of the Federal Ministry of Finance of October 17, 2002 – IV B 4 – S 1341 – 14/02 – (Federal Tax Gazette I p. 1025) is herewith repealed.

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XI. Relocation of Functions (2010) Administrative Circular on the Guidelines for the Examination of Income Allocation between Affiliated Persons in Cases of Cross-Border Relocations of Functions (Administrative Guidelines – Relocation of Functions) Published on October 13, 2010 (IV B 5 – S 1341/08/10003, 2010/0598886, Federal Tax Gazette 2010 I p. 774)

With regard to the results of the discussion with the highest tax authorities of the Federal States, the following rules are applicable regarding the income allocation between internationally affiliated companies in the case of cross-border relocations of functions: Content 1. Preface. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1 Purpose of the provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2 Scope of the provisions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2.1 § 1 Foreign Tax Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2.2 Relation of § 1 Foreign Tax Act to other domestic provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2.3 Provisions of double taxation agreements complying with art. 9 OECD-Model Tax Convention. . . . . . . . . . . . . 1.3 General provisions regarding the application of the arm’s length principle to relocations of functions . . . . . . . . . . . . . . . . 2. Comments on § 1 (3) sent. 9 to 12 Foreign Tax Act and on the Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . . 2.1 Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1.1 Function, § 1 (1) Ordinance on the Relocation of Functions 2.1.1.1 Business activity, § 1 (1) sent. 1 Ordinance on the Relocation of Functions. . . . . . . . . . . . . . . . . 2.1.1.2 Organic part, § 1 (1) sent. 2 Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . 2.1.2 Relocation of functions, § 1 (3) sent. 9 Foreign Tax Act, § 1 (2) Ordinance on the Relocation of Functions. . . . . . . . 2.1.2.1 Case groups . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1.2.2 Discontinuing or restricting the function at the level of the transferring enterprise . . . . . . . . . . . . 2.1.2.3 Temporary relocation, § 1 (2) sent. 2 Ordinance on the Relocation of Functions . . . . . . . . . . . . . . 2.1.2.4 Aggregation of business transactions (five-year period), § 1 (2) sent. 3 Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . 2.1.3 Transfer package, § 1 (3) sent. 9 Foreign Tax Act, § 1 (3) Ordinance on the Relocation of Functions . . . . . . . . . . . .

. . . .

297 297 298 298

. 299 . 299 . 300 . 301 . 301 . 301 . 302 . 302 . 302 . 303 . 303 . 304

. 304 . 305

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2.1.4 Profit potentials, § 1 (3) sent. 6 Foreign Tax Act, § 1 (4) Ordinance on the Relocation of Functions . . . . . . . . . . . 2.1.4.1 Net profit after tax . . . . . . . . . . . . . . . . . . . . . . 2.1.4.2 Definition “taxes” . . . . . . . . . . . . . . . . . . . . . . 2.1.4.3 Differentiation of the profit potential from business opportunities . . . . . . . . . . . . . . . . . . . 2.1.5 Definition of the term “essential”, § 1 (3) sent. 10 Foreign Tax Act, § 1 (5) Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1.5.1 Standards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1.5.2 Substantiation . . . . . . . . . . . . . . . . . . . . . . . . . 2.1.6 Duplication of function, § 1 (6) Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . . . . . . 2.1.6.1 Differentiation from the relocation of functions . 2.1.6.2 Duplications of functions that become relocations of functions. . . . . . . . . . . . . . . . . . . 2.1.6.2.1 Relevant point in time . . . . . . . . . . . . . . . . . . 2.1.6.2.2 Restriction of a function based on other reasons 2.1.6.2.3 Directness . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1.6.2.4 Bagatelle arrangement. . . . . . . . . . . . . . . . . . . 2.1.7 Negative apportionment, § 1 (7) Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . . . . . . 2.1.7.1 Differentiation when services are rendered and assets are disposed or transferred for use, § 1 (7) sent. 1 Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1.7.2 Differentiation when personnel is seconded, § 1 (7) sent. 2 first half sent. Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . 2.1.7.3 Starting a new business activity . . . . . . . . . . . . . 2.1.7.4 Arm’s length transaction, § 1 (7) sent. 2 half sent. 2 Ordinance on the Relocation of Functions . . . . 2.2 Regulations on the transfer package, § 2 Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2.1 General provisions on pricing, § 2 (1) Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . . . . . . 2.2.1.1 Standard methods for the determination of transfer prices . . . . . . . . . . . . . . . . . . . . . . . . 2.2.1.2 Hypothetical arm’s length test. . . . . . . . . . . . . . 2.2.2 Routine enterprise, § 2 (2) Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2.2.1 Relocation of functions to a routine enterprise, § 2 (2) sent. 1 Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . . . . . . . . .

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. . 306 . . 306 . . 307 . . 308

. . 308 . . 308 . . 308 . . 309 . . 309 . . . . .

. . . . .

310 310 310 310 311

. . 312

. . 312

. . 312 . . 314 . . 314 . . 315 . . 315 . . 315 . . 315 . . 316

. . 316

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2.3

2.4

2.5

2.6

2.7

2.2.2.2 Relocation of functions by expanding a function, § 2 (2) sent. 2 Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2.3 Escape clauses, § 1 (3) sent. 10 Foreign Tax Act . . . . . . . . . 2.2.3.1 Escape clause, § 1 (3) sent. 10 first alternative Foreign Tax Act . . . . . . . . . . . . . . . . . . . . . . . . . 2.2.3.2 Escape clause, § 1 (3) sent. 10 second alternative Foreign Tax Act, § 2 (3) Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . 2.2.3.3 Escape clause, § 1 (3) sent. 10 third alternative Foreign Tax Act . . . . . . . . . . . . . . . . . . . . . . . . . Valuation of the transfer package, § 3 Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.1 Present value determination, § 3 (1) Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . . . . . . . 2.3.2 Calculation of the profit potentials, § 3 (2) Ordinance on the Relocation of Functions. . . . . . . . . . . . . . . . . . . . . . . 2.3.2.1 Valuation methods . . . . . . . . . . . . . . . . . . . . . . . 2.3.2.2 Regional advantages and synergy effects . . . . . . . . 2.3.2.3 Degree of debt financing . . . . . . . . . . . . . . . . . . . 2.3.2.4 Relocations of functions due to corporate strategy . 2.3.2.5 Alternatives for action . . . . . . . . . . . . . . . . . . . . Elements of the transfer package. . . . . . . . . . . . . . . . . . . . . . . . 2.4.1 Allocating the value of the transfer package, § 4 (1) Ordinance on the Relocation of Functions. . . . . . . . 2.4.2 Assumptions for the provision for use, § 4 (2) Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . . 2.4.3 Subsequent calculation of the present value, § 4 (3) Ordinance on the Relocation of Functions . . . . . . . . . . . . Interest rate for capitalization, § 5 Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5.1 Base rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5.2 Term . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5.3 Functions and risks adequate premiums . . . . . . . . . . . . . . 2.5.4 Consideration of taxes . . . . . . . . . . . . . . . . . . . . . . . . . . Capitalization period, § 6 Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.6.1 Uniform capitalization period for both enterprises. . . . . . . 2.6.2 Specifics for limited capitalization periods . . . . . . . . . . . . Calculation of the range of mutual consent, § 7 Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . . . . . . . 2.7.1 Minimum price in cases of profits, § 7 (1) Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . . 2.7.2 Minimum price and liquidation value, § 7 (2) Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . .

. 317 . 317 . 318

. 318 . 319 . 321 . 321 . . . . . . .

321 322 323 324 324 324 325

. 325 . 325 . 326 . . . . .

326 326 327 327 327

. 328 . 329 . 329 . 329 . 329 . 330

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2.7.3 Minimum price in cases of losses, § 7 (3) Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . . 2.7.4 Maximum price, § 7 (4) Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.7.5 Transfer price in specific cases of § 7 (5) Ordinance on the Relocation of Functions. . . . . . . . . . . . . . . . . . . . . . . 2.7.6 Value within the range of mutual consent, mean value, § 1 (3) sent. 7 Foreign Tax Act . . . . . . . . . . . . . . . . . . . . . 2.7.6.1 Mean value . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.7.6.2 Waiver of an adjustment . . . . . . . . . . . . . . . . . . . 2.8 Claims for damages, indemnity, and compensation, § 8 Ordinance on the Relocation of Functions . . . . . . . . . . . . . . 2.9 Adjustment provisions, § 1 (3) sent. 11 Foreign Tax Act, § 9 Ordinance on the Relocation of Functions . . . . . . . . . . . . . . 2.10 Substantial deviations from the profit trend in cases of disposition, § 1 (3) sent. 11 Foreign Tax Act, § 10 Ordinance on the Relocation of Functions . . . . . . . . . . . . . . . . . . . . . . . . . 2.11 Appropriate adjustments, § 1 (3) sent. 12 Foreign Tax Act, § 11 Ordinance on the Relocation of Functions . . . . . . . . . . . . . 3. Additional remarks and individual questions . . . . . . . . . . . . . . . . . . 3.1 Managerial discretion of disposition; decisiveness of business transactions concluded . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2 Transparency of information . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3 Cooperation and documentation duties . . . . . . . . . . . . . . . . . . . 3.3.1 Documentation duties for relocations of functions (extraordinary business transactions) . . . . . . . . . . . . . . . . 3.3.1.1 Date at which a relocation of functions “occurs”. . 3.3.1.2 Information on documentation requirements . . . . 3.3.2 Other functional changes . . . . . . . . . . . . . . . . . . . . . . . . 3.4 Investigation options by the tax authority . . . . . . . . . . . . . . . . . 3.4.1 Existence of a relocation of functions on its merits . . . . . . 3.4.2 Consequences for breaching cooperation and documentation duties . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.3 Determination of value of the transfer package in cases of estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4.3.1 Determination of present value . . . . . . . . . . . . . . 3.4.3.2 Determination of the profit potential of the relocated function . . . . . . . . . . . . . . . . . . . . . . . 3.4.3.3 Interest rate for capitalization . . . . . . . . . . . . . . . 3.4.3.4 Capitalization period . . . . . . . . . . . . . . . . . . . . . 3.5 German accounting tax law consequences from a relocation of functions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.6 Deliveries of goods and services after the relocation of functions .

296

. 331 . 332 . 333 . 333 . 334 . 334 . 334 . 335

. 336 . 337 . 337 . 337 . 338 . 339 . . . . . .

340 340 340 341 341 341

. 342 . 343 . 343 . 344 . 345 . 345 . 345 . 346

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3.7 Withholding tax, tax deduction for taxpayers subject to limited taxation, and value added tax . . . . . . . . . . . . . . . . . . . . . . . . . . 3.8 Notes on relocation of functions in case of business partnerships 3.9 Notes on relocations of functions between permanent establishments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.10 Treatment of relocations of functions up to and including assessment period 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.10.1 Principle of the double sound and prudent business manager (§ 1 (1) sent. 2 Foreign Tax Act) . . . . . . . . . . . . . 3.10.2 Overall evaluation with focus on capitalized earnings value, § 1 (3) sent. 5 et seq. Foreign Tax Act. . . . . . . . . . . 3.10.3 Value in the range of mutual consent, mean value, § 1 (3) sent. 7 Foreign Tax Act . . . . . . . . . . . . . . . . . . . . 3.10.4 Price adjustment clauses . . . . . . . . . . . . . . . . . . . . . . . . 3.10.5 Exhaustion of the range of estimation due to a breach of cooperation duties of a foreign affiliated person, § 162 (3) sent. 3 General Fiscal Code. . . . . . . . . . . . . . . . 4. Special aspects of specific relocations of functions. . . . . . . . . . . . . . . 4.1 Relocation of production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.1.1 Relocation of production to a manufacturer . . . . . . . . . . 4.1.2 Reorganization from production to toll manufacturer . . . 4.1.3 Relocation of a production to a toll manufacturer . . . . . . 4.1.4 Reorganization from toll manufacturer to manufacturer . 4.2 Relocation of distribution. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2.1 Relocation of distribution to a distributor (or authorized dealer) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2.2 Reorganization of a full distributor to commission agent or agent. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3 Relocation of research and development . . . . . . . . . . . . . . . . . . 4.4 Relocation of services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.5 Relocation of purchasing department . . . . . . . . . . . . . . . . . . . .

. 346 . 347 . 347 . 347 . 348 . 348 . 349 . 350

. . . . . . . .

352 352 352 352 353 354 354 355

. 355 . . . .

355 356 357 358

1. Preface 1.1 Purpose of the provisions 1 This circular governs the administrative principles regarding the examination of income allocation of domestic taxpayers in cases of crossborder relocations of functions within the meaning of § 1 (3) sent. 9 and 10 Foreign Tax Act and for the application of the arm’s length principle in these cases. The arm’s length principle is the internationally acknowledged standard with which transfer prices are determined for cross-border business relations between affiliated companies (affiliated persons within the meaning of § 1 (2) Foreign Tax Act). The determination of transfer prices is not an “exact science” but rather requires an appropriate assess297

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ment in the individual case (sec. 1.13 OECD-Guidelines). The principles in this circular shall especially contribute to avoiding double taxation in accordance with international principles and to solving taxation disputes while respecting the managerial discretion of disposition. 2 If taxpayers observe the principles set forth in this decree when determining their income, there will be no income adjustments pursuant to § 1 Foreign Tax Act. The effects of domestic regulations may possibly be restricted by the application of the arm’s length principle which Germany has laid down in its double taxation agreement in accordance with art. 9 OECD-Model Tax Convention. 3 The principles of this decree are also applicable to relocations of functions to Germany. 1.2 Scope of the provisions 1.2.1 § 1 Foreign Tax Act 4 § 1 Foreign Tax Act governs the application of the arm’s length principle as standard for income adjustments for cross-border business relations and thus constitutes the national legal basis for Germany’s taxation rights internationally granted by the double taxation agreements. Regarding other domestic regulations, see recital 8 and regarding the double taxation agreements concluded by Germany see recital 9. 5 § 1 (3) Foreign Tax Act governs how arm’s length transfer prices shall be determined for business relations within the meaning of § 1 (1) sent. 1 Foreign Tax Act to which relocations of functions also belong. A business relationship may include one or several business transactions. In cases where business transactions are linked or economically connected, it is not appropriate to examine them isolated because independent third parties would also consider such nexus for their pricing (sec. 3.9 et seq. OECD-Guidelines). 6 In cases of relocations of functions, as a rule the transfer prices must be determined based on the relocation of the function as a whole (transfer package) (§ 1 (3) sent. 9 Foreign Tax Act in connection with § 1 (2) Ordinance on the Relocation of Functions). An unaffiliated party being in the situation of the acquiring enterprise would put emphasis on assuming the function (and the profit prospects connected with it) and not primarily on acquiring or using individual assets. In specific cases individual pricing for the assets and benefits concerned is permitted pursuant to § 1 (3) sent. 10 Foreign Tax Act (recital 69 et seq.). 7 If sufficient arm’s length data may be determined for the transfer package, § 1 (3) sent. 1 to 4 Foreign Tax Act is applied. Otherwise, a hypothetical arm’s length test pursuant to § 1 (3) sent. 5 to 8 Foreign Tax Act shall be conducted (recital 62 et seq.). 298

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1.2.2 Relation of § 1 Foreign Tax Act to other domestic provisions 8 If the application of the arm’s length principle within the meaning of § 1 Foreign Tax Act in the case of a relocation of functions results in further adjustments than the application of other provisions on the determination or correction of income (e.g. § 8 (3) Corporate Tax Act regarding the hidden profit distribution and hidden capital contribution; § 4 (1) Income Tax Act regarding withdrawals and capital contributions), the additional adjustments shall be carried out on top of the legal consequences from the other provisions (§ 1 (1) sent. 1 and 3 Foreign Tax Act). 1.2.3 Provisions of double taxation agreements complying with art. 9 OECD-Model Tax Convention 9 The arm’s length principle laid down in art. 9 OECD-Model Tax Convention (and also in art. 7 OECD-Model Tax Convention) that is applied domestically in § 1 Foreign Tax Act is incorporated in all double taxation agreements concluded by Germany. Double taxation agreements restrict on the one side the taxation rights of Germany and on the other side they define the scope within which Germany may exercise – with international approval – its taxation rights based on its domestic legal basis. As a rule, the interpretation of the term arm’s length principle as regards the double taxation agreements and § 1 Foreign Tax Act follows the OECDCommentary on art. 9 and art. 7 as well as the publications of the OECD on the arm’s length principle (OECD-Guidelines and OECD-Report on Permanent Establishments). 10 Relocations of functions shall be assessed based on the general system of the OECD regarding the application of the arm’s length principle. The following statements of the OECD are especially important for this purpose: – the considerations regarding intangible assets (chapter VI, especially sec. 6.13 et seq. OECD-Guidelines); – the statements regarding the aggregation of several business transactions if individual transactions are either that closely related or that rapidly succeed each other making an assessment of each individual transaction inappropriate (sec. 3.9 to 3.12 OECD-Guidelines, inter alia regarding the feasible formation of transfer packages – “package deals”). The OECD statements regarding business restructurings – especially those in sec. 9.48 et seq. (part II “Arm’s length compensation for the restructuring itself”) of chapter IX1 OECD-Guidelines – are important when assessing relocations of functions. The term business restructurings in1 Following the resolution of the Council of the OECD dated July 22, 2010, the OECD report “Transfer Pricing Aspects of Business Restructurings” was published as new chapter IX of the OECD-Transfer Pricing Guidelines 1995.

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cludes the cross-border relocation of functions, assets and/or risks (sec. 9.1 OECD-Guidelines). 1.3 General provisions regarding the application of the arm’s length principle to relocations of functions 11 When applying the arm’s length principle to cases of relocations of functions, it is necessary to understand the material economic reasons (sec. 9.50 et seq. OECD-Guidelines). This includes a review of the business relationship at the level of all enterprises participating in it (sec. 9.63 OECD-Guidelines). It shall be differentiated between – the business relations between the affiliated parties prior to the relocation of functions; the original allocation of opportunities and risks may inter alia be derived from it, – the relocation of functions itself; – the business relations after the relocation of functions (recital 174 et seq.). 12 For the assessment it is important to understand on the one hand why, from the point of view of the group of enterprises, a cross-border relocation of functions makes sense economically (§ 3 (2) sent. 2 Ordinance on the Relocation of Functions), e.g. for using synergy effects at the group level (sec. 9.57 OECD-Guidelines). In case the relocation of functions is economically reasonable for the group, it may in principle be assumed that transfer prices that yield an arm’s length result for all participating enterprises (sec. 9.179 OECD-Guidelines) may be determined at the time of the relocation of functions (recital 156). 13 On the other hand, unaffiliated third parties being in the situation of the individually participating enterprises would require their transactions on the occasion of the relocation of functions between them to be subject inter alia to the following criteria: – explicit more advantageous economic alternatives that the participating enterprises realistically had available if they were unaffiliated (recital 96). It includes e.g. the option of the transferring enterprise to refuse approving an agreement about a relocation of functions or to request a special adjustment or compensation when giving approval, or the option of the acquiring enterprise to establish a relocation of functions without necessarily giving consent, e.g. by properly cancelling the contract (recital 131 et seq., sec. 9.59 et seq. OECD-Guidelines); – the expected profit potential of the participating enterprises after and based on the relocation of functions (recital 30) whereas the calculation of the respective marginal price may only be based on the relations of the enterprise concerned in the individual case. As a rule, the

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actual assumption of higher risks is associated with higher profit expectations (sec. 9.10 OECD-Guidelines); – the amount of remuneration that the transferring enterprise receives for the transfer of the assets and other benefits required for carrying out the function as well as for waiving future use of the profit potential (sec. 9.72 et seq. OECD-Guidelines).

2. Comments on § 1 (3) sent. 9 to 12 Foreign Tax Act and on the Ordinance on the Relocation of Functions 2.1 Definitions 2.1.1 Function, § 1 (1) Ordinance on the Relocation of Functions 14 A function is a business activity that consists of an aggregation of similar operational tasks performed by the personnel in specific positions or divisions of an enterprise. A function represents an organic part of an enterprise that does not necessarily assume a separable part of a business for tax purposes. Individual functions result from the division of tasks within an enterprise. The respective tasks do not have to include all elements essential for the added value. 15 As functions may be considered: business activities that are part of management, research and development, material procurement, warehousing, production, packaging, distribution, assembly, processing or refinement of products, quality control, financing, transport, organization, administration, marketing, after-sales service etc. 16 In order to unambiguously distinguish a function from the remaining business activity in cases where functions are relocated, it is necessary to define the function concerned with focus on the activity and the objective based on the assets employed (especially intangible assets) and benefits as well as the precise opportunities and risks connected with the specific business activity. § 1 (2) sent. 1 Ordinance on the Relocation of Functions with respect to the relocation of functions and §§ 3 and 4 (1) Ordinance on the Relocation of Functions with respect to their assessment are based on this interpretation. To that extent, a function may e.g. concern the production of a specific product or product group, the distribution of a specific product, a specific product group, or a specific business activity for a specific region. Only if a restriction of the business activity (recital 22 et seq.) is determined, it shall depend on whether this restriction is based on the relocation of a “function”.

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2.1.1.1 Business activity, § 1 (1) sent. 1 Ordinance on the Relocation of Functions 17 A business activity also exists when it is only performed within the group. It is not necessary to become active towards unaffiliated participants in the market. 2.1.1.2 Organic part, § 1 (1) sent. 2 Ordinance on the Relocation of Functions 18 A function is an organic part of the enterprise when it represents either at the level of the transferring or the acquiring enterprise a purposeful and definable activity employing specific assets, especially intangible assets, and benefits in order to generate contributions to the profit. From an economic point of view it is sufficient that the subtasks concerned indicate an inner economic and organizational coherence, i.e. in cases of a relocation a specific cash flow and/or appropriately definable effects on the profit may be determined for the participating enterprises regarding the business activity (function) in question. This implies that a function needs to possess a certain economic independence that especially allows to allocate to it specific income and expenses as well as specific opportunities and risks. 2.1.2 Relocation of functions, § 1 (3) sent. 9 Foreign Tax Act, § 1 (2) Ordinance on the Relocation of Functions 19 A relocation of functions exists when an enterprise (transferring enterprise) relocates or provides for use assets and other benefits as well as the opportunities and risks connected with it to another affiliated company (acquiring enterprise) so that the other enterprise may perform functions that hitherto were performed by the transferring enterprise and thus the transferring enterprise is restricted in exercising the function concerned (see § 1 (6) and (7) Ordinance on the Relocation of Functions regarding the classification). If several individual functions are relocated, it presents a unitary relocation process in case the relocations of the individual functions are economically linked (recital 5). 20 The fact of a relocation of functions does not depend on whether the profit expectations of the transferring enterprise will increase from such respective process (e.g. relocation of the manufacture of components to a contract manufacturer under the cost plus method) or will be reduced (e.g. reorganization from a distributor to a commission agent). For realizing the facts, it is irrelevant whether at the time of the relocation of functions, the transferring enterprise had factually or legally been able to unrestrictedly perform the function concerned itself in the future. Such circumstances may have an impact on the pricing (cf. example in recital 120).

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2.1.2.1 Case groups 21 Within the meaning of § 1 (2) sent. 1 Ordinance on the Relocation of Functions, the discontinuation of a function or the restriction of a function are forms of relocations of functions. Typical examples (cf. recital 201 et seq.) are: – Termination of the activity as manufacturer and the relocation connected to it; – Conversion of a manufacturer to a toll manufacturer; – Outsourcing of production to a toll manufacturer; – Conversion of a toll manufacturer to manufacturer – Termination of the activity as distributor and the relocation connected to it; – Conversion of distributor to commission agent; – Conversion of commission agent to distributor. 2.1.2.2 Discontinuing or restricting the function at the level of the transferring enterprise 22 A relocation of functions only exists if the transferring enterprise will, due to the transfer process, either discontinue or at least restrict the function concerned (cf. recital 48 et seq. and 58). Example (discontinuation): Product A that was hitherto exclusively manufactured and distributed by the domestic group parent company (M) and in the future will only be manufactured and distributed by its foreign subsidiary (T). The tangible and intangible assets will be relocated to T. M will dismiss the personnel concerned. The manufacture and distribution of product A fulfils the fact of the function (recital 14 et seq.). The element “discontinuation of the function” within the meaning of § 1 (2) Ordinance on the Relocation of Functions is fulfilled as the function “production and distribution of product A” will no longer be applied by M due to the process. Example (restriction): In the future, T will also produce product A independently abroad and distribute it to existing and new customers. M suffers from a considerable decline in production and a respective drop in sales. The factual characteristic “restriction of a function” within the meaning of § 1 (2) Ordinance on the Relocation of Functions is fulfilled as the function “production and distribution of product A” will be reduced by M due to the process.

23 The reduction of staff and/or the omission of individual debtors may be an important indication for the start of the examination whether a relocation of functions exists (recital 159 et seq.). The factual characteristic of “discontinuation” or “restriction” of the function relates to the specific 303

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turnover generated with that function and also includes cases where one function is substituted for another. Example (alternative): As above (example discontinuation), but: In the future, the parent company (T) produces and distributes the replacement product B it has developed and that is essentially based on other intangible assets. Without altering its employment of staff, it generates higher sales than with the preceding product A. The factual characteristic of the discontinuation of the function within the meaning of § 1 (2) Ordinance on the Relocation of Functions is fulfilled as the specific function “production and distribution of product A” no longer applies for the domestic market. Different functions apply for the production and distribution of product A and the production and distribution of product B because other intangible assets are primarily employed (recital 16). It is irrelevant that M does not reduce its personnel and even generates higher sales with product B (cf. recital 119 regarding the possible valuation to be made in such cases of substitutions). Note: If product B is primarily based on the same intangible assets like product A, it may constitute a duplication of function which may result in a relocation of functions in case M reduced its production at a later point in time.

24 It shall be irrelevant whether, together with the assets and benefits relocated or provided for use, the acquiring enterprise exercises the function in the same manner as the transferring enterprise. 2.1.2.3 Temporary relocation, § 1 (2) sent. 2 Ordinance on the Relocation of Functions 25 A relocation of functions may also apply in cases where an enterprise exercises the business activity concerned only temporarily, e.g. where the distribution rights for individual products, markets, or customers are transferred temporarily or where individual employees are temporarily transferred along with their scope of work. See recital 54 et seq. regarding the classification on the secondment of personnel. 2.1.2.4 Aggregation of business transactions (five-year period), § 1 (2) sent. 3 Ordinance on the Relocation of Functions 26 The process of a relocation of functions may cover several business years. If the taxpayer intends to carry out a relocation of functions right from the beginning, he is obliged to determine the transfer prices for all concerned business transactions considering this fact (art. 3.9 OECDGuidelines). In addition, § 1 (2) sent. 3 Ordinance on the Relocation of Functions requires an aggregation of all business transactions that are realized within five business years and economically constitute parts of a uniform relocation process. Example: The domestic enterprise (P) is the leading manufacturer of certain electronic components. On November 1 the management decides to establish for the Asian market in situ a new production facility for a certain product line that hitherto was exclusively pro-

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XI. Relocation of Functions (2010) duced domestically – including for the sales in Asia. It is intended to transfer to the new foreign subsidiary (T) the required intangible assets (right to use the name, patents, customer base) for use. On January 2 several unaffiliated companies are contracted to determine the basis on which grounds the location will be selected. On December 2 the building contract was awarded to build a new facility in Asia. The production in Asia will commence on February 4, at the same time the production will be discontinued in the domestic market. As the relocation of functions covers several business years, an aggregated consideration will be necessary. This already results from P’s planning. If, considered separately, the individual business transactions do not constitute a relocation of functions, the economic link will result in a – unitary – relocation of functions. The relocation of functions has been realized in 04 as the factual characteristic of the relocation has been fulfilled in this year, even if further business transactions follow that are economically linked with the relocation of functions. Furthermore, this does not constitute a duplication of function as production and distribution will be cancelled at the level of P regarding the Asian market.

27 If it is subsequently determined that a relocation of functions took place, this shall be realized at the moment when the requirements (§ 1 (2) sent. 1 Ordinance on the Relocation of Functions) are economically fulfilled with their joint implementation, i.e. when the fact has been accomplished. In order to assume a unitary transfer process covering several assessment periods, it shall be referred to the objective criteria and not the intention in the participating enterprises. 2.1.3 Transfer package, § 1 (3) sent. 9 Foreign Tax Act, § 1 (3) Ordinance on the Relocation of Functions 28 A transfer package comprises of a function, the opportunities and risks connected with it, the assets and benefits included in the function that are relocated or provided for use from the transferring enterprise to the acquiring enterprise as well as the services rendered in this connection. Prior to the relocation, the transfer package including its elements must have been either legally or economically attributable to the transferring enterprise. Criteria for the attribution are inter alia: – With regard to the generated profit potential, the transferring enterprise has borne costs for which it did not receive any arm’s length remuneration. – Prior to the relocation of functions the transferring enterprise had all or at least the essential assets (in particular intangible assets) and the personnel to realize the profit potential itself, also by engaging third parties if necessary. 29 As a rule, the transfer package is the starting point for the determination of the transfer prices in cases of relocations of functions. It is referred to the escape clause of § 1 (3) sent. 10 Foreign Tax Act (recital 69 et seq.). The unitary process of a relocation of functions regularly includes several business transactions that are so closely linked that an assessment of each individual business transaction is not appropriate (recital 5, art. 3.9 et seq. OECD-Guidelines). Benefits that are usually difficult to recognize when 305

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determining individual prices for assets relocated or provided for use may be identified based on the examination of the entire function to be relocated including its opportunities and risks. Unaffiliated third parties would be prepared to agree on remuneration by considering these benefits appropriately without these having yet to materialize in an asset. Respective benefits may e.g. be elements creating goodwill like good reputation, well-trained employees, or a well-established organization of the enterprise (art. 9.93 et seq. OECD-Guidelines). 2.1.4 Profit potentials, § 1 (3) sent. 6 Foreign Tax Act, § 1 (4) Ordinance on the Relocation of Functions 30 As a rule, relocations of functions are usually connected with a change of the profit situation and the profit allocation within an internationally active enterprise (art. 9.6 OECD-Guidelines). The profit expectations to be quantified by both sound and prudent business managers for the application of the arm’s length principle (profit potentials, art. 9.65 et seq. OECD-Guidelines) shall comply with the net present values of the net profits to be expected after taxation from the function relocated (future earnings value, sec. 5 IDW S 1 (IDW Standard: Principles for the performance of business valuations dated April 2, 2008)). From the transferring enterprise’s point of view, a sound and prudent business manager within the meaning of § 1 (2) sent. 2 Foreign Tax Act would not waive such profit expectations without receiving remuneration (art. 9.67, 9.72 et seq. OECD-Guidelines). From the acquiring enterprise’s point of view, such business manager would be willing to pay remuneration for it (art. 9.93 OECD-Guidelines). Considering transparency of information (§ 1 (1) sent. 2 Foreign Tax Act, recital 149), this approach simulates such a negotiation situation between the transferring and the acquiring enterprise that includes the different negotiation positions and the respective negotiation strengths based on the individual business relations from the point of view of both sound and prudent business managers. See recital 82 et seq. for the valuation. 2.1.4.1 Net profit after tax 31 When determining the net profit after tax (§ 1 (4) Ordinance on the Relocation of Functions), value-relevant is only the financial surplus after cost of debt and taxes from the transfer package available to the respective sound and prudent business manager as net income during the expected economic lifetime of the transfer package (direct method in relation to the function). In principle, this is derived from the annual results planned for the future. The underlying budgeting may be prepared under commercial, legal, or other regulations (e.g. IFRS, US-GAAP) as is usual practice in the respective enterprise (group of enterprises). The annual results shall appropriately be corrected by profit elements which have no cash impact. A proper derivation of the cash flows relevant for the valuation assumes, 306

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for planning purposes, corresponding balance sheets, profit and loss accounts, and financial modeling (sec. 27 IDW S 1). Where appropriate, supporting calculations for the determination of the tax assessment bases may be necessary. In contrast, it shall be irrelevant whether the financial surpluses may be distributed under consideration of circumstances relating to company law. 32 If the calculations are economically comprehensible, the taxpayer may apply the “indirect method” instead of the direct method. Under this method, a valuation is carried out for both the transferring and acquiring enterprise according to respective principles prior to and after the relocation of functions. 2.1.4.2 Definition “taxes” 33 The taxes to be considered when determining the present value are such that are presumably to be assessed or actually were assessed and paid as well as taxes reduced by a presumably occurring or an already occurred claim for reduction. This also includes tax effects resulting from the values to be applied from the transfer package for both the transferring and acquiring enterprise (recital 118 and 125). The level of the nominal tax rate shall be irrelevant. 34 Generally, it may be assumed for corporations that the net inflow from the transfer package and the net inflow from comparable alternative investments in cases of distributions at the shareholders’ level are subject to a comparable personal taxation and thus, it may be refrained from directly considering these tax impacts (cf. sec. 30 and 45 IDW S 1). In such cases, taxes within the meaning of § 1 (4) Ordinance on the Relocation of Functions constitute only taxes on income of the enterprise. The taxpayer may optionally determine and include the shareholders’ personal income tax based on the distribution of respective profits. 35 It can principally not be refrained from considering personal income tax for business partnerships (Sec. 47 IDW S 1). Typically, the taxes to be assessed may be applied in the amount of the taxes on income that would have accrued if corporations instead of business partnerships had participated in the relocation of functions. In this case, fictitious personal income taxes of fictitious taxpayers based on distributions of respective profits shall not be considered. The enterprise may possibly determine and include the business partners’ actual personal income taxes resulting from the profits of the enterprise. 36 If the taxpayer incorporates the personal income tax burden in the calculation of the after-tax profit, it must also be regarded in the discount rate to guarantee equivalence (recital 108).

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2.1.4.3 Differentiation of the profit potential from business opportunities 37 The term “profit potential” must be differentiated from the term “business opportunity”: whereas the business opportunity itself neither presents an asset nor is suitable to develop into an asset, in cases of hypothetical arm’s length tests the “profit potential” describes the respective profit expectations that set the basis for the determination of the value of an asset and a transfer package, respectively. 2.1.5 Definition of the term “essential”, § 1 (3) sent. 10 Foreign Tax Act, § 1 (5) Ordinance on the Relocation of Functions 2.1.5.1 Standards 38 In cases of relocations of functions, the intangible assets and benefits are essential within the meaning of § 1 (3) sent. 10 Foreign Tax Act if they are required for the function relocated (qualitative standard) and if their arm’s length price altogether amounts to more than 25 % of the sum of the individual prices of all assets and benefits included in the transfer package (quantitative standard). 39 In order to determine whether the quantitative standard has been fulfilled, the elements of the transfer package (where applicable, including the elements creating goodwill) need to be considered independent from them being disclosed as an asset. 2.1.5.2 Substantiation 40 If “substantiation” is required, the taxpayer is obliged to explain that the fact claimed is predominantly probable. The fact claimed may only serve as basis if its existence is more probable than its non-existence; otherwise, the claim has conceptually not been shown to be “credible”. 41 In order to justify the essentiality of the intangible assets (25 %), the taxpayer is obliged to submit documents pursuant to § 90 (3) General Fiscal Code in connection with § 2 (2) Ordinance on the Documentation of Income Attribution upon a request. The documents must indicate the essential reasons underlying the business decision regarding the implementation of the relocation of functions. The taxpayer is especially obliged to substantiate the specifications given on the intangible assets and benefits relocated or provided for use with the relocation of the function and their relative value in relation to the value of the sum of all elements included in the transfer package.

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2.1.6 Duplication of function, § 1 (6) Ordinance on the Relocation of Functions 2.1.6.1 Differentiation from the relocation of functions 42 A relocation of functions pursuant to § 1 (2) Ordinance on the Relocation of Functions does not exist if the acquisition of a function by an enterprise does not result in a restriction of exercising this function for the enterprise active hitherto. This is also applicable if all other prerequisites of § 1 (2) Ordinance on the Relocation of Functions are fulfilled. At the most, such cases refer to a duplication of function to which § 1 (3) sent. 9 Foreign Tax Act (transfer package) shall not be applied. 43 The duplication of function exercised exist e.g. if the production and distribution activity carried out hitherto by the domestic enterprise is carried out unaltered despite assuming production abroad. In contrast, a relocation of functions exists if the distribution function is newly picked up abroad and therewith the distribution function of the transferring enterprise is restricted (indicator: sales) e.g. because the acquiring enterprise supplies the existing customers of the transferring enterprise. Example: The foreign manufacturing group (K) no longer envisions any growth opportunities in Europe and thus establishes in Asia the distribution subsidiary VA that shall penetrate the market there. The marketing concept for the Asian market has been developed by the domestic distribution company VI that inter alia maintains sales contacts to Asia. After the establishment of VA, VI continues to supply its customers in Asia. A duplication of function exists. The transferred marketing concept has to be remunerated at arm’s length. A relocation of functions occurs though, if the customer base of VI will partially be transferred to VA within the next five years which in return will considerably restrict the sales of VI in Asia (recital 49).

44 With regard to all services rendered and the assets and benefits transferred or provided for use in connection with the duplication of function, appropriate transfer prices shall be determined applying the arm’s length principle. Unlike the relocation of functions, duplications of functions assume that the sum of the individual prices that consist of the assets and benefits transferred or provided for use as well as the services rendered corresponds with the price of the transfer package. This assumption is especially based on the fact that the exercise of the function will not be restricted for the enterprise active hitherto (§ 1 (2) sent. 1 Ordinance on the Relocation of Functions) and thus it may as a standard be assumed that in this connection intangible assets are merely provided for use and specific, important intangible assets like the customer base or parts thereof do not constitute an element of the process.

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2.1.6.2 Duplications of functions that become relocations of functions 2.1.6.2.1 Relevant point in time 45 Under § 1 (6) sent. 2 Ordinance on the Relocation of Functions, the duplication of function becomes a relocation of functions at the time when the missing element of the restriction of the function is fulfilled. At that point in time the relocation of functions has “occurred” (§ 3 (1) Ordinance on the Documentation of Income Attribution, recital 156). It does not constitute a “retrospective” relocation of functions even if already completed business transactions that originally included a duplication of function are affected by the relocation of functions due to the economic nexus. 2.1.6.2.2 Restriction of a function based on other reasons 46 A relocation of functions pursuant to § 1 (6) sent. 2 Ordinance on the Relocation of Functions does not exist even though the enterprise active hitherto suffers from a restriction of a function within five years after the duplication of function in case the taxpayer may credibly explain that the restriction is not directly economically linked to the duplication of function. In this connection, the need for substantiation (recital 40) requires a feasible explanation of all actual objective circumstances from which the conclusion can be drawn that no direct economic link between the (subsequent) restriction of the function concerned of the originally active enterprise and the assumption of the function by the other enterprise exists. Example: The domestic enterprise (P) produces exclusively in the domestic territory and distributes its products in Europe. P decides to establish a new production in Asia. The distribution in Asia shall be carried out there. For the new construction, P transfers to its newly established subsidiary (T) patents and production know-how for use. The duplication of function does not affect the exercise of the function in the domestic market. The function is not restricted. This is also applicable if the production in the domestic market should considerably be restricted within five years without being directly economically linked to the duplication of function (recital 49) (e.g. “market collapse in Europe”). A relocation of functions does occur though, if e.g. the products manufactured in Asia are distributed in Europe by P and thus P suffers from a restricted domestic production.

2.1.6.2.3 Directness 47 A direct economic link (see decision of the Federal Fiscal Court of January 9, 1986 – Federal Tax Gazette 1986 II pg. 479) may be assumed if the (subsequent) restriction of the function concerned is caused by the same event, i.e. by the original duplication of function (cf. decision of the Federal Fiscal Court of October 11, 1989 – Federal Tax Gazette 1990 II pg. 88). The relevant benchmarks that refer to the causality are the sales that cease to exist for the transferring enterprise and the sales that arise for the acquiring enterprise based on the process. 310

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2.1.6.2.4 Bagatelle arrangement 48 If a duplication of function merely results in a minor restriction for the transferring enterprise as regards the function concerned, the provisions on relocations of functions pursuant to § 1 (3) sent. 9 Foreign Tax Act (respective application of § 1 (7) sent. 2 second alternative Ordinance on the Relocation of Functions) no longer apply. In such cases it remains a duplication of function (reference to recital 44). It is not required to justify that the restriction was not directly economically linked to the duplication of function. 49 A restriction (recital 22) is substantial (no insignificance) if, within the five-year period in terms of § 1 (6) Ordinance on the Relocation of Functions, the sales resulting from the function that the originally active enterprise within the meaning of § 1 (2) Ordinance on the Relocation of Functions generated during the last complete business year prior to the change of the function decline in one business year by 1,000,000 Euros. Example: Enterprise P manufactures refreshment drinks in the domestic market and distributes these in Europe. The sales have increased steadily for years. P would like to penetrate the American market and commissions an unaffiliated foreign distribution company (commission agent) with the distribution in America. As of the year 01, the commission agent also distributes the domestically manufactured refreshment drinks in the American market. After two years, in the year 03, P decides to establish a production facility in America based on positive sales numbers and for this purpose establishes a subsidiary (T). The production begins in the year 04. In the year 04, the commission agent is supplied by T and P and as of the year 05 exclusively by T. In the year 04, the function was not restricted by P. In the year 05, P’s sales decline by 2,000,000 Euros; however, the production facilities are not shut down and staff is not laid off. P assumes that its sales will increase to 14,000,000 Euros no later than the year 07. The sales figures develop as follows: Year

Total sales

Sales P

Sales T

Export to America

01

10,000,000 t

10,000,000 t

0t

200,000 t

02

12,000,000 t

12,000,000 t

0t

1,000,000 t

03

14,000,000 t

14,000,000 t

0t

3,000,000 t

04

15,000,000 t

14,000,000 t

1,000,000 t

3,000,000 t

05

16,000,000 t

12,000,000 t

4,000,000 t

0t

The decline in P’s sales in the year 05 constitutes a considerable restriction: the sales have declined by more than 1,000,000 Euros compared with the sales in year 03. For want of other information on the facts, the decline in the sales is directly based on the manufacturing and distribution activity of P in America. In this regard it is irrelevant whether production facilities were shut down or staff has been laid off. It is also irrelevant whether the sales in the following years will increase again. P is free to show credibly that the drop in sales is based on other reasons.

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D. Administrative Guidelines

2.1.7 Negative apportionment, § 1 (7) Ordinance on the Relocation of Functions 50 It must be distinguished between relocations of functions, duplications of functions (recital 42 et seq.), and cases where a new business activity is started (recital 57). Neither the rendering of services (recital 51 et seq.), the participation in a cost sharing agreement (see Administrative Guidelines – Cost Sharing Agreements) especially in the field of research and development, nor the secondment of personnel (recital 54 ff.) present, on a stand alone basis, a relocation of functions. As a rule, especially for the transfer or provision for use of intangible assets and benefits arm’s length transfer prices have to be determined for each individual business transaction unless it is appropriate to aggregate those with other business transactions as they already are closely economically linked (recital 5). The same applies accordingly to other facts that are not treated as relocations of functions as they are based on bagatelle arrangements. 2.1.7.1 Differentiation when services are rendered and assets are disposed or transferred for use, § 1 (7) sent. 1 Ordinance on the Relocation of Functions 51 The disposal or transfer for use of any kind of assets or the rendering of services by itself does not result in a relocation of functions pursuant to § 1 (2) Ordinance on the Relocation of Functions. Such business transactions may constitute part of a relocation of functions though (cf. recital 26 et seq.), and are then a component of the transfer package. 52 For instance, in cases where employees of the transferring enterprise work in an economic context with a relocation of functions for the acquiring enterprise, it may in principle be assumed that they render services on behalf of the transferring enterprise. To the acquiring enterprise such services and the benefits connected to these are components of the transfer package. The benefits may e.g. include knowledge of the product or process know-how, knowledge of research projects, know-how of the business organization, personal network relationships to other enterprises of the groups, knowledge of the market or the industry, or personal assignments in the consultancy business. 53 In cases where the business transactions are only connected by the time component with the relocation of functions (no economic connection), transfer prices have to be determined under the general principles. 2.1.7.2 Differentiation when personnel is seconded, § 1 (7) sent. 2 first half sent. Ordinance on the Relocation of Functions 54 As a rule, the secondment of personnel within the group within the meaning of the Administrative Guidelines – Personnel Secondment as

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such does not present a relocation of functions within the meaning of § 1 (2) Ordinance on the Relocation of Functions. 55 Nevertheless, when the relocation of functions is actually implemented the secondment of personnel may occur if it is economically connected to it. In such cases the Administrative Guidelines – Personnel Secondment may not be applied as the secondment is a component of the transfer package. The secondment of personnel is included regardless of whether the respective employment contracts govern claims of compensation, non-competition obligations etc. for the event that employees should rotate to an external enterprise. Example: During the year 01 the domestic, internationally active automotive supplier P establishes a subsidiary (T) abroad. T builds a new factory to manufacture air conditioners for cars. As the business shall commence contemporarily, T receives several production machines from P. Furthermore, by means of a secondment of personnel ten employees of P (engineers, technicians) will be employed for four months in order to train the new employees on-site. T uses patents developed by P for its production. The air conditioners are sold directly by T to present customers of P abroad while exploiting the right to use the name and the trademark. This results in a reduced business activity of P. T receives a service package including tangible assets (machines) and intangible assets (patents, rights, customer base). Along with the secondment of experts technology is also transferred because production know-how is transferred to T (sec. 4.2 Administrative Guidelines – Personnel Secondment). This constitutes a relocation of functions within the meaning of § 1 (3) sent. 9 Foreign Tax Act. The transfer of production know-how has to be included in the transfer package. Continuation: Due to high plant utilization, T requires further personnel and receives in the year 02 ten of P’s employees (trained professionals) as “temporary help” to work on the conveyor belt. Both enterprises conclude a service contract for this purpose according to which T remunerates to P all personnel costs plus an arm’s length profit mark-up (cost plus method). This is not a case where personnel are seconded because the services are rendered in order to fulfill the service contract (sec. 2.1 Administrative Guidelines – Personnel Secondment). T does not become an economic employer because the secondment does not exceed three months (sec. 2.2 Administrative Guidelines – Personnel Secondment). A remuneration based on the cost plus method is appropriate (sec. 3.2.3.2 Administrative Guidelines – Income Allocation). Based on the work performed by the trained professionals, no transfer of technology may be recognized. A relocation of functions does not exist.

56 In cases where personnel are seconded, a relocation of functions may exist if for instance the seconded personnel maintain their original scope of responsibility they had in the transferring enterprise and after the secondment exercise the same tasks in the acquiring enterprise. As a rule, this results in a restriction of the business activity of the transferring enterprise (recital 22 et seq.) as assets and benefits are either relocated or provided for use and opportunities and risks are relocated. In such cases, the provisions governing the relocation of functions take precedence.

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D. Administrative Guidelines

2.1.7.3 Starting a new business activity 57 Relocation of functions must be distinguished from cases where a business activity that has not yet been exercised is newly started. Example: Based on new technology, the domestic automotive supplier (P) developed a new transmission N that is ready for production. P establishes a subsidiary (T) in order to manufacture and distribute the transmission abroad where T builds a new plant using P’s production and process know-how. Neither a relocation of functions nor a duplication of function takes place because the activity “production and distribution of transmission T” was previously not performed by P. The activity of P is not restricted. Nevertheless, the intangible assets transferred shall be remunerated at arm’s length. As new and unique knowledge is employed, no sufficiently comparable values can be expected and thus, the hypothetical arm’s length test would have to be applied to determine the transfer price.

2.1.7.4 Arm’s length transaction, § 1 (7) sent. 2 half sent. 2 Ordinance on the Relocation of Functions 58 Transactions that unaffiliated third parties would not consider as disposition or acquisition of a function shall not be treated pursuant to the principles on the relocation of functions. It may refer to minor or temporary relocations (e.g. trivial occurrences with drops in sales amounting to less than 1,000,000 Euros, cf. recital 49) or the transfer of a single order. Example: M is a leading manufacturer of pharmaceuticals in the domestic market. As it currently has a high capacity utilization, a new order at the domestic manufacturing site may e.g. only be fulfilled by additional extra shifts. Instead, the capacity restraint will be compensated by involving a foreign subsidiary (T) for three months. As agreed, the customer is supplied directly and independently by T. Formally, a relocation of functions takes place, yet it is temporarily restricted (recital 25). If the examination reveals that there was no relevant impact on the sales of M (indicator), this already excludes that the treatment as a transfer package can be considered for a relocation of functions (bagatelle arrangement). The transfer of the order to T has to be remunerated at arm’s length, though.

59 Transactions that formally fulfill the element of a relocation of functions but, pursuant to the arm’s length principle, are actually carried out in such manner that under the prevailing opinion they cannot be regarded as a relocation of functions are exempted from the application scope of the treatment as a transfer package. Example: A parent company centrally controls in the different manufacturing facilities the production that is based on the same technology and is carried out worldwide by several legally independent subsidiaries. This central service is charged to the subsidiaries applying the cost plus method. The orders that are acquired by all group enterprises are issued to the subsidiaries depending on the respective logistic circumstances and the current production capacity of the manufacturing facilities. Hereby, an optimized capacity utilization of all manufacturing sites is accomplished even if in the individual case temporary limitations of production may occur that exceed the bagatelle arrangement as noted in recital 49.

314

XI. Relocation of Functions (2010) The central and optimized production control and therewith connected the allocation of all orders received does not constitute a relocation of functions to the extent that all parties benefit from it within a manageable period of time. If individual parties do not appropriately benefit from the central control it must be examined whether under an arm’s length consideration a compensatory payment ought to be paid for the disadvantage suffered.

60 Furthermore, the termination of agreements by giving notice in due time or the expiration of contractual relationships for instance does not constitute relocations of functions. In such cases § 8 Ordinance on the Relocation of Functions has to be observed (sec. 9.100 et seq. OECD-Guidelines). 2.2 Regulations on the transfer package, § 2 Ordinance on the Relocation of Functions 2.2.1 General provisions on pricing, § 2 (1) Ordinance on the Relocation of Functions 2.2.1.1 Standard methods for the determination of transfer prices 61 In order to determine the transfer prices for the transfer package, § 1 (3) sent. 1 to 4 Foreign Tax Act shall take precedence. As a rule, the hypothetical arm’s length test (§ 1 (3) sent. 5 to 8 Foreign Tax Act) shall be – as is applicable to all transfer pricing cases – subordinate when applied to relocations of functions. 2.2.1.2 Hypothetical arm’s length test 62 Regardless of recital 61, it will in principle not be possible to determine unrestrictedly or restrictedly comparable arm’s length data within the meaning of § 1 (3) sent. 1 and 2 Foreign Tax Act for a transfer package that includes a bundle of tangible and intangible assets and benefits etc. As a rule, transfer packages include individual elements and often comprise unique intangible assets and benefits (e.g. synergy effects) that cannot readily be recognized and have such features that complicate the identification of comparable third party data (sec. 6.13 OECD-Guidelines). Existing significant difficulties in searches for comparable data for single intangible assets especially intensify when several intangible assets and benefits together form elements of a transfer package. This is the more applicable if it affects high-quality and unique intangible assets (sec. 6.26 OECD-Guidelines). An “active market” where homogeneous goods are offered, where purchasers and vendors are ordinarily willing to enter into an agreement at any time, and where prices are announced is absent for such business transactions because of the included intangible assets (sec. 19 et seq. IDW S 5 (IDW Standard: Principles for the valuation of intangible assets dated May 25, 2010)). This does not suggest that business transactions that do not take place between unaffiliated third parties do not com-

315

D. Administrative Guidelines

ply with the arm’s length principle for this reason alone (sec. 1.11, 9.52 and 9.173 OECD-Guidelines). 63 Due to the aforementioned reasons, pursuant to § 1 (3) sent. 5 to 8 Foreign Tax Act the hypothetical arm’s length test will as a result usually have to be applied for cases of relocations of functions. As regards the transfer pricing determination in such cases, especially the financial benefit anticipated for the future from the transfer package (and the intangible assets concerned, respectively) is relevant which is derived based on an economic assessment under a method based on a capital value approach and that is nationally (e.g. IDW S 1 or IDW S 5) or internationally (e.g. ISO 10668) acknowledged (recital 82 ff., in particular recital 87 et seq.). 64 If prices and data from comparable business transactions shall be used for relocations of functions, it is indispensable to give a logical and detailed explanation regarding the selection of the comparable data and the ratio derived thereof (see sec. 21 IDW S 5). If the data employed is neither unrestrictedly nor restrictedly comparable, it shall be disregarded. In individual cases though, it may be used to additionally support the result determined by the hypothetical arm’s length test. 65 The hypothetical arm’s length test may consider elements of a factual arm’s length behavior. This is e.g. applicable if the taxpayer employs an internal calculation scheme or pricing procedure in comparable situations both to affiliated and unaffiliated companies with regard to relocation of functions (and for the provision for use of intangible assets, respectively), e.g. license systems that comply with business principles and follow the anticipated earnings of the licensee (e.g. IDW S 5). However, this does not suggest that under the hypothetical arm’s length test license rates may be derived from data bases. 2.2.2 Routine enterprise, § 2 (2) Ordinance on the Relocation of Functions 2.2.2.1 Relocation of functions to a routine enterprise, § 2 (2) sent. 1 Ordinance on the Relocation of Functions 66 If the acquiring enterprise exclusively carries out the function relocated to the transferring enterprise (sec. 9.99 OECD-Guidelines regarding “outsourcing”) and if it is appropriate to determine the remuneration to be charged for exercising the function and the rendering of respective services using the cost plus method (e.g. toll manufacturer, recital 206 et seq.), it shall be assumed that no essential intangible assets and benefits are either relocated or provided for use with the transfer package and thus, § 1 (3) sent. 10, first alternative, Foreign Tax Act applies (recital 71). The cost plus method shall especially apply if the acquiring enterprise within the meaning of sec. 3.4.10.2 (a) Administrative Guidelines – Procedures merely exercises “routine functions” and bears only minor risks. In such 316

XI. Relocation of Functions (2010)

cases the current remuneration for the services performed by the acquiring enterprise is restricted to a mere compensation for work. 67 This is correspondingly applicable if an acquiring enterprise that becomes active as set forth recital 66 permissibly applies, after having carried out the relocation of functions, a transactional net margin method based on costs in order to determine its transfer prices or if such enterprise receives a commission considering the minor risk. It is a prerequisite that this yields comparable results and that the acquiring enterprise exclusively renders the function relocated to the transferring enterprise. 2.2.2.2 Relocation of functions by expanding a function, § 2 (2) sent. 2 Ordinance on the Relocation of Functions 68 If an acquiring enterprise as defined by recital 66 et seq. will in the future partially or entirely render the routine services it previously performed exclusively to the transferring enterprise as an independent contractual partner to other enterprises, it must be differentiated between two alternatives: – For its services the acquiring enterprise does not use any intangible assets and benefits provided by the transferring enterprise. This is indicated in a situation in which the remuneration paid by unaffiliated third parties complies with the remuneration previously paid by the transferring enterprise as defined by recital 66 et seq. for services provided. The provisions regarding the relocations of functions are inapplicable. – The acquiring enterprise charges prices to the other enterprises that are higher than the remuneration under recital 66 et seq. or pursuant to the arm’s length principle, higher prices would have to be set. As regards sales, remuneration for the assets and benefits previously supplied by the transferring enterprise for the provision of services must be agreed at the point in time when the performance to the other enterprise is carried out for the first time. The assets and benefits concerned are regarded as one transfer package to the extent that the prerequisites of the individual case are fulfilled, e.g. if a previous toll manufacturer converts to an independent manufacturer (cf. recital 208 et seq.). 2.2.3 Escape clauses, § 1 (3) sent. 10 Foreign Tax Act 69 If the elements regarding a relocation of functions are fulfilled, the determination of the transfer prices pursuant to § 1 (3) sent. 9 Foreign Tax Act will as a rule be carried out based on the assessment of the transfer package (cf. recital 82 et seq.). If the prerequisites of one of the three autonomous escape clauses of § 1 (3) sent. 10 Foreign Tax Act that have to be reviewed independently of each other are fulfilled, the taxpayer may re317

D. Administrative Guidelines

frain from using the treatment as a transfer package. In this case, the individual transfer prices of the elements of the transfer package that are affected by the relocation of functions have to be determined based on the general provisions (§ 1 (3) sent. 1 to 8 Foreign Tax Act). To the extent it regards high-quality and unique intangible assets and benefits, the hypothetical arm’s length test (recital 62 et seq.) will have to be applied. In its application, the financial benefit anticipated for the future that is derived from an economical assessment under a method based on capital value will be relevant (e.g. IDW S 5 or ISO 10668 regarding trademark). 70 The option to refrain from using the treatment as a transfer package pursuant to § 1 (3) sent. 10 Foreign Tax Act does not alter the fact that the element of a relocation of functions is fulfilled. The documentation requirements (recital 55) shall especially be regarded, i.e. documents must be provided from which quantifiably the economic reasons for the relocation of functions, in particular the specific benefits and disadvantages, may be derived both for the entire group and for the affiliated companies concerned (sec. 9.57, 9.81, 9.178 OECD-Guidelines). 2.2.3.1 Escape clause, § 1 (3) sent. 10 first alternative Foreign Tax Act 71 The taxpayer may refrain from using the treatment as a transfer package if he shows credibly that no essential intangible assets and benefits were part of the relocation of functions (§ 1 (3) sent. 10 first alternative Foreign Tax Act, § 1 (5) Ordinance on the Relocation of Functions). Pursuant to the definition of the term “essential” (§ 1 (5) Ordinance on the Relocation of Functions) and barring the question whether the intangible asset or benefit is required for the relocation of function, this is applicable if the arm’s length price does not exceed the quantitative threshold (25 %) neither for an individual intangible asset or benefit nor for several intangible assets and benefits affected by the relocation of functions (recital 38 et seq.). It is not required to perform a precise calculation of the value regarding the transfer package. Example (see also recital 80): Within the scope of a relocation of functions the taxpayer shows credibly that, apart from several tangible assets, three intangible assets that each amount to 20 % of the total of the individual values of all elements of the transfer package are affected. As the total of the values of the intangible assets exceeds 25 % of the sum of the individual values of all elements of the transfer package, the first escape clause is inapplicable (addition). The taxpayer is obliged to determine the transfer price based on a treatment as a transfer package.

2.2.3.2 Escape clause, § 1 (3) sent. 10 second alternative Foreign Tax Act, § 2 (3) Ordinance on the Relocation of Functions 72 The transfer pricing determination based on the transfer package shall not be relevant if the taxpayer shows credibly (recital 40) that the sum of the individual transfer prices for the elements of the transfer pack318

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age measured by the value of the transfer package complies with the arm’s length principle (§ 1 (3) sent. 10 second alternative Foreign Tax Act). Pursuant to § 2 (3) Ordinance on the Relocation of Functions, in such cases both the range of mutual consent and the value of the transfer package have to be determined under § 1 (3) sent. 9 Foreign Tax Act in connection with § 1 (3) sent. 7 Foreign Tax Act which means that these escape clauses require precise calculations based on the transfer package. The sum of the individual transfer prices of the individual elements of the transfer package calculated pursuant to § 1 (3) sent. 1 to 8 Foreign Tax Act may only be applied if it is within the range of mutual consent (see also explanatory statement on § 1 (3) sent. 10 Foreign Tax Act, printed matter of the Federal Council 16/4841 pg. 86). The application of this escape clause may be useful to credibly explain a specific point within the range of mutual consent (recital 128). 73 In order to substantiate this, it is especially required that the taxpayer explains the difference in the sum of the individual transfer prices and the value of the transfer package and to justify why the sum of the individual transfer prices equals the arm’s length principle. 2.2.3.3 Escape clause, § 1 (3) sent. 10 third alternative Foreign Tax Act 74 If the taxpayer shows credibly in the documentation he is required to prepare upon request under § 90 (3) General Fiscal Code in connection with § 3 (2) Ordinance on the Documentation of Income Attribution that at least one essential intangible asset is part of the relocation of functions and he identifies it precisely, then the individual transfer prices of the elements of the transfer package shall be acknowledged (§ 1 (3) sent. 10 third alternative Foreign Tax Act). 75 An intangible asset is considered “essential” if with regard to this asset both the qualitative criterion and the quantitative threshold (25 %) are exceeded when analogously applying § 1 (5) Ordinance on the Relocation of Functions (corresponding with recital 38 et seq.). A substantiation (recital 40) does not require to exactly calculate the value of the transfer package. 76 An essential intangible asset will frequently be unique and of high quality (recital 62) and to that extent the hypothetical arm’s length test will have to be applied. As it is required to include the profit expectations of the enterprises concerned, elements creating goodwill and regional advantages may have an impact on the transfer pricing determination if unaffiliated third parties would consider those in their price determination (sec. 9.94 OECD-Guidelines). It cannot be presumed that this is in principle the case. 77 The term “at least” indicates that, in order to apply this escape clause, several (essential) intangible assets that have to be entirely and precisely identified based on the cooperation and documentation require319

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ments under § 90 (3) General Fiscal Code in connection with Ordinance on the Documentation of Income Attribution (recital 150 et seq.) may be the object of a relocation of function. 78 An intangible asset is clearly identified if, based on the details given by the taxpayer, it can be precisely identified in such manner that either sufficient comparable data may be determined (§ 1 (3) sent. 1 to 4 Foreign Tax Act) or an appropriate price determination under the hypothetical arm’s length test (§ 1 (3) sent. 5 to 8 Foreign Tax Act) may be possible. The transfer pricing determination is based on the documents of the enterprise that materially influenced its decision to carry out the relocation of functions. 79 The third escape clause shall also apply to relocations of functions that affect a business or a separable part of a business as the wording does not include any restrictions to that extent. Pursuant to § 1 (3) sent. 10 Foreign Tax Act, it is also possible in such cases to individually determine the prices of the elements of the transfer package with the effect that the hypothetical arm’s length test may possibly have to be carried out individually for several intangible assets (including a factually included goodwill). If a business or a separable part of a business is relocated, the obligation to perform an overall assessment may only result from other provisions to which § 1 Foreign Tax Act is subordinate (recital 8). 80 The escape clause does not take effect if several intangible assets are elements of the transfer package and each separately does not fulfill the requirement of essentiality as set forth in § 1 (3) sent. 10 third alternative Foreign Tax Act. This is also applicable if the sum of the individual values of the intangible assets concerned altogether exceeds the quantitative threshold. Example (see also recital 71): During the audit of a relocation of functions it is revealed that of such three intangible assets are affected and each amounting to 20 % of the sum of the individual values of the elements of the transfer package. As the taxpayer did not identify any intangible asset the value of which amounts to more than 25 % of the sum of all individual values of the elements of the transfer package, the third escape clause is inapplicable (no aggregation). The taxpayer is obliged to determine his transfer prices based on a treatment as a transfer package.

81 If the taxpayer aggregates several intangible assets for which a mutual assessment under the application of acknowledged economic methods is appropriate (e.g. in the individual case patent and production knowhow is used to manufacture those assets, cf. recital 5) and with it the threshold of 25 % is exceeded, this does not raise any objections if the intangible assets aggregated in such manner are treated as one uniform intangible asset for purposes of determining transfer prices (and the respective valuation).

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2.3 Valuation of the transfer package, § 3 Ordinance on the Relocation of Functions 2.3.1 Present value determination, § 3 (1) Ordinance on the Relocation of Functions 82 In the cases of the hypothetical arm’s length test (recital 62 et seq.) an economically substantiated total value (present value) has to be determined for the transfer package (recital 29 et seq. and recital 63). In order to assess the intrinsic value of the transfer package, the actual relations and the cognitive possibilities and discretionary powers of the two imagined sound and prudent business managers (of both the transferring and the acquiring enterprise) has to be applied at the time the relocation of function took place. The point in time at which the relocation of function occurred and the facts (recital 19) were fully implemented is relevant. Pursuant to § 1 (3) sent. 3 Foreign Tax Act, it must be relied on all circumstances that the participating enterprises (including corporate headquarters) had knowledge of at this time or from which may it be assumed that sound and prudent business managers would have considered those if the intrinsic value of the transfer package at the relevant time may be concluded from these. See recital 150 et seq. regarding the cooperation requirements of the participating enterprise and, where appropriate, the corporate headquarters. 2.3.2 Calculation of the profit potentials, § 3 (2) Ordinance on the Relocation of Functions 83 In order to determine the profit potentials, a functional and risk analysis with regard to the respective business activities connected with the function has to be performed prior to and after the relocation of functions both for the transferring and the acquiring enterprise (cf. recital 32 regarding the application of the “direct” and “indirect” method). 84 In particular, three criteria are relevant for the present value determination: – First, the net profits after taxes anticipated for the function relocated have to be calculated seen from the perspective of both sound and prudent business managers within the meaning of § 1 (1) sent. 2 Foreign Tax Act. In doing so, the same standard has to be applied for the transferring and the acquiring enterprise. – Second, the capitalization period has to be determined that must be identified depending on the individual circumstances of exercising the function (§ 6 Ordinance on the Relocation of Functions and recital 109 et seq.). – Third, the respective net profits after tax have to be discounted by an appropriate interest rate for capitalization that considers the respective 321

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opportunities and risks that are connected to the function (§ 5 Ordinance on the Relocation of Functions and recital 104 et seq.). 85 The profit potentials from the function relocated may be deducted from the total profit, e.g. based on cost center accounting, product costing, or direct costing. Actually existing and clearly beneficial alternatives for action (recital 96), respective regional advantages or disadvantages and anticipated synergy effects (recital 93) influence the profit expectations and thus the price determination from the perspective of unaffiliated third parties. It is referred to the cases set forth in § 7 (2) Ordinance on the Relocation of Functions in which the minimum price of the transferring enterprise equals the liquidation value (recital 120). 86 The taxpayer may use documents that are based on generally applied internal operational grounds and methods of assessment (§ 3 (2) sent. 2 Ordinance on the Relocation of Functions) to support his budget calculations (sec. 3.4.12.6 Administrative Guidelines – Procedures). This is applicable if the documents themselves and the calculations based on these are feasible. 2.3.2.1 Valuation methods 87 In principle, the hypothetical arm’s length test requires a valuation method (method based on capital value, e.g. pursuant to IDW S 1 or IDW S 5) to be applied that determines the respective present value based on the respectively anticipated “net profit after tax” (§ 1 (4) Ordinance on the Relocation of Functions, recital 31). This is based on the assumption that the value of a relocated function results from its feature to generate future profit contributions by means of surplus revenues. 88 Based on this, the range of mutual consent (§ 7 Ordinance on the Relocation of Functions) and the relevant value within the range of mutual consent (recital 128 et seq.) shall be determined. It is permissible to apply an economically substantiated discounted cash flow method in order to determine the relevant present value because both the capitalized value method and the discounted cash flow method rely in principle on the very same conceptual basis and yield the same result in valuation if the valuation assumptions or simplifications are the same (sec. 101 IDW S 1). 89 Whether a valuation method that complies with IDW S 1 or IDW S 5 (sec. 22 to 47) or another economically acknowledged method shall be applied depends on the character and the significance of the relocation of functions. If in particular intangible assets are affected by the relocation of functions, it is suggested to apply a valuation method that complies with IDW S 5. A valuation method that complies with IDW S 1 is appropriate if the individual case reveals that a relocation of functions presents a relocation of a business or a separable part of a business with its own viability.

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90 From an economic perspective, the value of a function results from the financial benefit anticipated for the future that may or may no longer be derived from the function. When carrying out the valuation, it is relevant to begin by identifying specific income and expenses that have to be added to the function to be evaluated (pursuant to sec. 24 IDW S 5). This especially rests on documents based on which the enterprise decided altogether on the relocation of functions (§ 3 (2) sent. 2 Ordinance on the Relocation of Functions). From these documents it shall be derived what assumptions were made, in particular which income and expenses on the one side will be withdrawn from the transferring enterprise due to the relocation of functions and what income and expenses on the other side will incur to the acquiring enterprise based on the relocation of functions. As a rule, it complies with economic principles to prepare detailed forecasts for the initial years and to use such values as basis for lump sums for subsequent years. 91 The value of the transfer package is derived from considering the profit potentials that result from the change (as a rule a reduction) of the capitalized value of the transferring enterprise as well as from the increase of the capitalized value of the acquiring enterprise and from which the lower price limit and the upper price limit of the enterprises (decision value) may be calculated. This yields a fictitious negotiation situation and enables the determination of a value of the transfer package (present value) within the range of mutual consent. 92 See recital 98 et seq. and appendix, example 1 (I. modification to case A) regarding the allocation of the present value to the assets and benefits of the transfer package (regardless of whether the transferring enterprise may be able to capitalize these). 2.3.2.2 Regional advantages and synergy effects 93 The respective capitalized values include all regional advantages or disadvantages and synergy effects of all participating enterprises. It may be indicated which enterprise causes these advantages/disadvantages through its activity but ultimately this is not crucial. It is important which enterprise might use or would have to bear these advantages/disadvantages during the fictitious price negotiations. This depends on the specific alternatives for action (recital 96) and the respective power of negotiating (sec. 9.57, 9.148 et seq. OECD-Guidelines) that result from the objective circumstances. Examples for possible regional advantages or disadvantages of the acquiring enterprise may be differences in wage or material costs, financing terms, the quality of infrastructure or the reliability and qualification of the personnel and supply of material. In addition, differences in the tax burden and investment support to be considered in the price determination may constitute regional advantages or disadvantages, without justifying the assumption of an abuse tax wise (sec. 9.181 et seq. OECD-Guidelines). 323

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2.3.2.3 Degree of debt financing 94 In order to determine the value of the transfer package, it may generally be assumed that the degree of debt financing with regard to the function concerned will be at the same level for the acquiring enterprise as for the transferring enterprise. If the taxpayer claims a different degree of debt financing, he is obliged to document the facts and to explain to what extent the differences in the financing of the acquiring enterprise as compared to that of the transferring enterprise affect the interest rate to be employed for capitalization. It has to be considered that in cases of higher debt financing an investor would regularly expect a higher return on equity because of the increased risk. 2.3.2.4 Relocations of functions due to corporate strategy 95 If a relocation of functions is based on corporate strategy and less on profit-oriented considerations, the effects on earnings (cash flow effects, respectively) have to be determined in each case and the economic effects of the strategic business decision by applying the arm’s length principle have to be assessed (cf. sec. 26 IDW S 5) in order to be able to determine appropriate transfer prices. 2.3.2.5 Alternatives for action 96 The legal and economic position of the participating contractual partners that gives significant indication on an appropriate pricing must be considered for the arm’s length test to be performed (see decision of the Federal Fiscal Court of January 28, 2004 – Supreme Jurisdiction on Financial Law (HFR) 2004, pg. 552, with further references.). If for instance the acquiring enterprise, as a fictitious independent enterprise, has specific, realistic, and undoubtedly more advantageous options to acquire the service offered to it (sec. 9.59, 9.64 OECD-Guidelines), because of his alternatives for action available, a sound and prudent business manager will attempt to use its negotiating advantage to reduce the price. On the other hand, the sound and prudent business manager of the transferring enterprise would not agree to surrender either entirely or partially an economic advantage without compensation if e.g. he had the specific option to obtain a higher price for surrendering the function. He would rather attempt to achieve an ideal result for the transferring enterprise represented by him. The rate of his achievement would depend on his negotiating position and his alternatives for action available, e.g. to exercise the function himself and, where appropriate, to compete with the acquiring enterprise, to relocate the function to a toll manufacturer, or to accept a more favorable offer. It is the purpose of the arm’s length principle to find a solution for the fictitious contrast between the interests under the specific circumstances (where applicable, including other corporate enterprises) without ignoring the factually implemented and legally binding business transactions. Those that refer in their own favor to having specific, realistic and 324

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undoubtedly more advantageous alternatives for action available are obliged to prove their prerequisites and to credibly show the arising tax benefits. 2.4 Elements of the transfer package 97 The legal and contractual structuring of a relocation of functions rest on the managerial discretion of disposition (recital 145 et seq.). The decisions have to be accepted by the tax authorities on their merits if they comply with the arm’s length principle. Especially for complex business transactions like relocations of functions the exercise of the discretionary disposition should be carried out by means of contracts agreed on in advance that are explicit and unambiguous (preferably in writing) for verification purposes (recital 151). If such contracts are unavailable, it cannot be excluded that verification problems may arise with the participating tax authorities. 2.4.1 Allocating the value of the transfer package, § 4 (1) Ordinance on the Relocation of Functions 98 Under a relocation of functions, separate agreements (recital 97) will be available regarding the transfer of assets (sale), the provision of assets for use (e.g. rent, licensing), and the rendering of services (e.g. personnel secondments) or will be assumed pursuant to the arm’s length principle (sec. 3.12 OECD-Guidelines). Altogether, the sum of the individual transfer prices has to equal the value of the transfer package pursuant to § 3 Ordinance on the Relocation of Functions (present value) under consideration of the respective profit potentials (including opportunities, risks, and benefits). 99 If the taxpayer submits only one calculation of the value for the transfer package without allocating this value to the individual assets, benefits, and services (§ 4 (1) Ordinance on the Relocation of Functions), the tax authorities may in substantiated cases verify the present value of the transfer package with the transfer prices of the individual assets, other benefits, and services rendered and, where appropriate, request the taxpayer to explain any deviations. This is e.g. applicable if there is indication that the value calculated by the taxpayer for the transfer package is below the sum of the arm’s length prices of all elements of the transfer package. 2.4.2 Assumptions for the provision for use, § 4 (2) Ordinance on the Relocation of Functions 100 If within the scope of a relocation of functions no written agreements were made, based on an analysis of the overall circumstances of the individual case it must be examined whether and to what extent an irrevocable relocation or only a temporarily restricted provision for use 325

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occurred with regard to the individual assets. The recognizable effort of the parties at the time the relocation of functions took place is essentially important for the assessment (decision of the Federal Fiscal Court of December 7, 1977 – Federal Tax Gazette 1978 II pg. 355) if this will can unambiguously be determined or verified. For instance, accounting documents promptly prepared may be provided as evidence. 101 If the conformable will cannot be determined without doubt for want of written documents or other evidence, the actual course of action and the handling by the parties shall be relevant. The course of action will as a rule indicate whether the assets concerned and the profit potential were in any case attributable to the transferring enterprise and in its possession until the relocation of functions was carried out and if so, whether the assets concerned and the profit potential were indeed used by the acquiring enterprise after the relocation of functions. 102 With the consent of the taxpayer, in cases of doubt a provision for use of individual assets and benefits of the transfer package and not a disposal shall be assumed (§ 4 (2) Ordinance on the Relocation of Functions). 2.4.3 Subsequent calculation of the present value, § 4 (3) Ordinance on the Relocation of Functions 103 In cases of duplications of functions (§ 1 (6) sent. 1 Ordinance on the Relocation of Functions, recital 42 et seq.) that subsequently become a relocation of functions (§ 1 (6) sent. 2 Ordinance on the Relocation of Functions, recital 45), pursuant to the arm’s length principle such transfer prices have to be applied for the business transactions last realized that combined with the business transactions first realized equal the total value of the transfer package (§ 3 Ordinance on the Relocation of Functions). Thus, it may be avoided that changes occur for the transfer prices of the business transactions first realized and with it international double taxation disputes. This applies correspondingly to cases regarding the relocation of functions within the meaning of § 1 (2) sent. 3 Ordinance on the Relocation of Functions (recital 26 et seq.). 2.5 Interest rate for capitalization, § 5 Ordinance on the Relocation of Functions 2.5.1 Base rate 104 From the national customary interest for an investment “quasi riskfree” originates the determination of the appropriate interest rate for capitalization (base rate, sec. 116 IDW S 1) that has to be determined and documented both for the transferring and the acquiring enterprise (e.g. interest for public bonds with an equivalent maturity in the respective country, for the domestic market the yield curve of the German Federal Bank, www.bundesbank.de). Premiums for country risks shall not be added. The 326

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taxpayer is at liberty to use the domestic risk-free interest rate for the foreign enterprise if existing country risks may be regarded via an appropriate premium. 2.5.2 Term 105 The interest rates for risk-free investments depend on the term. As a rule, where the capitalization period is indicated by the circumstances of exercising the function (§ 6 Ordinance on the Relocation of Functions) it must be relied on risk-free investments the term of which e.g. equals that of the estimated period the function will be exercised or the life of the essential intangible assets. If pursuant to § 6 Ordinance on the Relocation of Functions an unlimited capitalization period shall be considered as basis, a preferably long-term comparable investment has to be assumed. In such cases, the base rate may also be determined based on a projection that is based on the yield curve. 2.5.3 Functions and risks adequate premiums 106 Functions and risks adequate premiums have to be made on the base rate in order to consider the future opportunities and risk connected to the function relocated compared to those connected to a risk-free investment. The premiums for both enterprises shall be based on returns customary in the market that are achieved for exercising comparable functions if sufficient comparable return expectations may be determined. If this is not possible, the functions and risks adequate premium for the enterprises concerned has to be derived from the profit expectations of the group or the group of affiliated companies and an appropriate share in the expected overall profit has to be allocated to the function relocated (contribution analysis, see sec. 3.4.12.6 (b), third bullet point Administrative Guidelines – Procedures). A risk assessment has to be performed for the transferring and the acquiring enterprise which results from the remaining business activity of the respective enterprise or group of affiliated companies. 107 The interest rate for capitalization to be applied to the acquiring enterprise guarantees that a functions and risk adequate minimum profit will probably remain for it. 2.5.4 Consideration of taxes 108 If the anticipated profits from the transfer package (for corporations) are reduced by the taxes of the partners, the interest rate for capitalization also has to be reduced by the taxes of the partner (equivalence principle). If the anticipated profits from the transfer package are only reduced by the taxes of the enterprise, the interest rate for capitalization does not have to be reduced (sec. 122 IDW S 1). The same applies to partnerships if the pro327

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visions for relief of recital 35 are used. In all other cases the personal taxes have to be considered. 2.6 Capitalization period, § 6 Ordinance on the Relocation of Functions 109 In principle, an unlimited capitalization period is applied if the function relocated includes one enterprise, a separable part of a business, or at least one unit that is economically independently viable and to a large extent equals a separable part of a business (see sec. 85 IDW S 1). Yet, the further the function relocated is below the threshold of a separable part of a business the more appropriate it may be to apply a limited capitalization period. As the term of the capitalization period significantly affects the minimum price and the maximum price, this aspect presents a relevant audit issue. 110 Whoever refers to a capitalization period that depends on the circumstances of exercising the function (e.g. supported by the circumstances that the function was only relocated temporarily or that a patent has only a limited duration) needs to show this credibly unless such circumstances are evident. Indication for the determination of the duration of the capitalization period may be e.g.: the technological cycle, the life cycle of products, the duration of a patent protection, the duration of a distribution right, or the guaranteed period for exercising the function. If the individual elements of the transfer package have a different life (e.g. patents with a different remaining duration), it is appropriate to be guided by the longest life under consideration of a weighting that may have to be performed where appropriate. 111 If in the determination of the profit expectations of the acquiring enterprise own expenses have been considered for the maintenance or replacement of intangible assets, this speaks for a longer life and thus a longer capitalization period of the function. Regardless of whether such expenses were observed in the profit expectations, it may be appropriate to assume decreasing profit expectations during the economic lifetime for the essential intangible assets concerned. If no expenses regarding the maintenance or replacement of intangible assets are included in the profit expectations of the acquiring enterprise, this does not automatically result in a short capitalization period. Example: If the production of a vacuum cleaner model is relocated, the capitalization period may not readily be restricted to the presumed production period of a specific vacuum cleaner model if it can be assumed that during the relocation of production not only the technology for manufacturing a specific model will be relocated but rather that for manufacturing vacuum cleaners as a whole. In such cases it has to be expected that in the future modernized replacement products will be manufactured by the acquiring enterprise because it concerns a technically mature product for which no innovations are expected (no usage of primarily new intangible assets).

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2.6.1 Uniform capitalization period for both enterprises 112 A uniform capitalization period may generally be assumed for both the transferring and the acquiring enterprise for simplification purposes. Whoever refers to the fact that no uniform capitalization period is applicable to the enterprises concerned is obliged to prove the prerequisites for that. 2.6.2 Specifics for limited capitalization periods 113 If a limited capitalization period is assumed, at its end it must be examined in licensing cases whether the intangible assets concerned will be used in the future or on what basis the acquiring enterprise will continue its activity. If it is disposed of intangible assets in the course of a relocation of functions, § 1 (3) sent. 11 and 12 Foreign Tax Act may have to be applied where appropriate (recital 138 et seq.), e.g. if the set capitalization period deviates considerably from the actual life. In case the business activity of the acquiring enterprise continues after the termination of the capitalization period, it must be examined based on what this is done and whether a new relocation of functions applies. 2.7 Calculation of the range of mutual consent, § 7 Ordinance on the Relocation of Functions 114 In order to calculate the minimum price of the transferring enterprise and the maximum price of the acquiring enterprise for purposes of determining the range of mutual consent (§ 1 (3) sent. 6 Foreign Tax Act), the underlying profit expectations from the function relocated have to be realistic. It is essential for the calculation that the transfer prices for business relations possibly existing prior to the relocation of function (regarding the minimum price) and for business relations possibly existing after the relocation of functions (regarding the maximum price) comply with the arm’s length principle. 115 The transferring enterprise may derive a first indication for the profit potential that will break off from the results achieved with the function in the past. Regarding the minimum price of the transferring enterprise, it may also be significant whether at the time the relocation of functions occurred it was factually or legally in the position to exercise the concerned function itself unrestrictedly in the future (see example under recital 120 and recital 127). 2.7.1 Minimum price in cases of profits, § 7 (1) Ordinance on the Relocation of Functions 116 If the transferring enterprise had in the future expected profits from the function relocated, the calculation of the lower limit of the range of 329

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mutual consent, i.e. regarding the minimum price of that enterprise (marginal price), has to consider that an unaffiliated transferring enterprise would at least have requested a compensation for the profit potential that will either entirely or partially be lost and a reimbursement for closure costs it may possibly incur. From the perspective of the transferring enterprise it would economically not be reasonable to surrender the function without such an adjustment. The calculation of the minimum price (recital 87 et seq.) for the transferring enterprise will be performed unilaterally from the perspective of this enterprise (recital 13). 117 Realistically available and clearly more advantageous alternatives for action (recital 96, sec. 9.59, 9.64 OECD-Guidelines) that are based on the managerial discretion of disposition of the transferring enterprise have to be considered when determining prices as these have an impact on the minimum price of this enterprise. The threshold of this power to act is the transfer pricing determination seen from the perspective of two sound and prudent business managers as defined in § 1 (1) sent. 2 Foreign Tax Act who presumably have all information on all significant circumstances of the business relationship in order to determine the range of mutual consent and the result within which unaffiliated third parties would negotiate. 118 In order to calculate the minimum price of the transferring enterprise, its tax burden on the revenues from the disposition of elements of the transfer package of the relocated function has to be considered (see appendix, example 1). 119 In cases where a technically or economically outdated product is substituted (recital 23), no objections shall be raised if a minimum price of zero is assumed for the transferring enterprise under the following, cumulative existing prerequisites: – Due to a replacement product, it will not be distributed anymore in the previously primarily supplied markets. – The relocation was necessary in order to commence production of a direct replacement product with higher profit expectations in the domestic market. – The intangible assets including the process know-how that are necessary for the production transferred are not being disposed of but licensed. 2.7.2 Minimum price and liquidation value, § 7 (2) Ordinance on the Relocation of Functions 120 If it is in the future no longer economically attractive for the transferring enterprise to exercise the relocated function as it has done hitherto e.g. because a customer compulsory requests the transfer or due to the dis330

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tance to the market a direct delivery by the transferring enterprise does not seem reasonable in the future, the minimum price of the transferring enterprise equals in principle the liquidation value of the assets no longer required, see recital 121 et seq. regarding cases of losses. The closure costs have to be observed when determining the liquidation value as it may also be negative. Example: P maintains a printing plant and delivers the printed paper products manufactured in the domestic market to customers worldwide. Specific foreign customers threaten to cancel the contract because they regard the time between placing the order and delivery of the printed paper products as too long. P does not want to lose those customers and thus establishes a subsidiary (T) abroad that will independently become active in the foreign market. P closes down a domestic manufacturing plant, sells its printing machines to T, transfers the respective foreign customer base, renders services during the establishment of the printing plant, and relocates to T the necessary intangible assets. Although it is in the future no longer economically attractive for P to exercise the function “production and distribution for the respective foreign market” as customers threatened to terminate the agreement, a relocation of function took place. In this case, the minimum price (present value) equals the liquidation value.

2.7.3 Minimum price in cases of losses, § 7 (3) Ordinance on the Relocation of Functions 121 In cases of losses the lower limit of the transferring enterprise will either be restricted by the anticipated losses or by closure costs. An unaffiliated company would also have the option either to continue the function while sustaining permanent losses or to discontinue with it and to accept the closure costs. The amount that presents a smaller burden to the transferring enterprise shall be assumed as the lower limit of the scope of negotiation because an unaffiliated company would also base its action on the option that is economically less disadvantageous to it (sec. 9.59, 9.64 OECD-Guidelines). 122 Two results of a relocation of functions in cases of losses are quoted in § 7 (3) Ordinance on the Relocation of Functions, without constituting a final rule: – First, compensation may be negotiated that covers the arising closure costs only partially as the benefit of the acquiring enterprise is lower than the closure costs of the transferring enterprise. From the perspective of the transferring enterprise the compensation will at least partially compensate the closure costs. – Second, the transferring enterprise may waive compensation and in addition make a compensatory payment to the acquiring enterprise for assuming the source of loss to the extent that with the relocation of functions closure costs are avoided for the transferring enterprise that exceed the compensatory payment to the acquiring enterprise (sec. 9.96 et seq. OECD-Guidelines). 331

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123 The compensation agreed or the compensatory payment made by the transferring enterprise is economically reasonable from the perspective of the transferring enterprise and complies with the action taken by a sound and prudent business manager if the closing costs that were reduced by the compensation or increased by the compensatory payment are lower than the future losses anticipated from the relocated function. Example: By employing intangible assets it has developed itself, the domestic subsidiary (T) of a group (M) manufactures technical products and distributes these on its own account. Due to the high costs (e.g. wages, rents) it incurred high losses for years without expecting any improvement in the future. Thus, M decides to relocate the manufacture and distribution to another foreign group enterprise (U). U manufactures using lower production costs and in return expects profits. An unaffiliated third party being in the situation of T would try to reduce its losses through revenues that may be generated for the function even though it does not have a strong negotiating position. On the other hand, an unaffiliated third entrepreneur being in the position of M or U would be willing to pay compensation for the transfer package (machines, know-how, customer base, other intangible assets etc.) if he was in the position to generate profits at short notice. This only applies to the extent that payments for the transfer package do not exceed the costs for creating equally profitable, own intangible values (customer base, know-how etc.) and to the extent that a profit adequate to the function will remain for the entrepreneur.

2.7.4 Maximum price, § 7 (4) Ordinance on the Relocation of Functions 124 The profit potential for the function the transferring enterprise has calculated from its own perspective (recital 13) shall be the relevant criterion for its price calculations (recital 87 et seq.). On this basis, the upper limit of the range of mutual consent (maximum price) is determined from the perspective of a sound and prudent business manager. See recital 172 et seq. regarding the accounting for the acquiring enterprise. 125 In order to calculate the maximum price of the acquiring enterprise, the tax effects of the expenses spent on acquiring elements of the transfer package of the function relocated (depreciation on assets acquired) have to be considered (see appendix, example 1). 126 Realistically available and clearly more advantageous alternatives for action (recital 96, sec. 9.59 and 9.64 OECD-Guidelines) that the acquiring enterprise would have were it an unaffiliated third party and which would be based on its managerial discretion of disposition have to be considered as they may have an impact on the maximum price the enterprise would be willing to accept. The threshold of this power to act presents the transfer pricing determination seen from the perspective of two sound and prudent business managers as defined in § 1 (1) sent. 2 Foreign Tax Act who presumably have all information on all significant circumstances of the business relationship in order to determine the range of mutual consent within which unaffiliated third parties would negotiate.

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2.7.5 Transfer price in specific cases of § 7 (5) Ordinance on the Relocation of Functions 127 Remuneration may have to be cleared if the transferring enterprise relocates or restricts the function for reasons that are set forth in § 7 (2) and (3) Ordinance on the Relocation of Functions, e.g. because a capacity overload is imminent or an important customer urges the relocation of functions, and if the minimum price is at zero or below. In such situations an unaffiliated third party would also not be willing to make the transfer package available free of charge (cf. example in recital 120); it is referred to the special situations of the substitution of products (recital 119). On the other hand, as an acquiring enterprise an unaffiliated third party would be willing to pay such remuneration if it may tap a profit potential to which it would not have access otherwise. 2.7.6 Value within the range of mutual consent, mean value, § 1 (3) sent. 7 Foreign Tax Act 128 The transfer package shall be based on the value within the range of mutual consent that with highest probability complies with the arm’s length principle (sec. 3.61 et seq. OECD-Guidelines). The taxpayer needs to show this credibly by using transparent and feasible aspects (recital 40). When determining this value, the existing relationships under company law remains without consideration. In contrast, all circumstances of the case like the respective market positions, own business objectives the transferring enterprise has in the relocation, the dependency of the acquiring enterprise on the assets and benefits, the capital resources and the profit situation of the participating enterprises, the generation of synergy effects, the respective regional advantages, and the amount of the start-up costs saved by the acquiring enterprise have to be considered in principle. In particular, the alternatives for action both enterprises have (recital 96) need to be observed (sec. 1.34, 9.59 OECD-Guidelines). Example: An enterprise (P) relocates the production and distribution for specific products to a foreign subsidiary (T). The economically determined range of mutual consent that considers all tax benefits, regional advantages, and synergy effects lies between 100 (minimum present value) and 200 (maximum present value), from which results a mean value of 150. P shows credibly that the profit expectations of T (200) would only amount to 170 without employing the distribution concept developed by T itself. This concept may also be used in connection with other distributions. It is likely that an unaffiliated third party would not make benefits (distribution concepts) it developed itself and that are neither subject of the transaction nor may be used by it available for a disposal above that price. Hence, a transfer price of 135 may be accepted which presumes a deviating allocation of the range of mutual consent (100 – 30 = 70, thereof 1/2 = 35 + minimum present value 100 = 135).

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2.7.6.1 Mean value 129 In case the taxpayer is unable to show another credible value within the range of mutual consent (recital 40), pursuant to § 1 (3) sent. 7 second half sentence Foreign Tax Act the mean value of the range of mutual consent shall be used as basis. 2.7.6.2 Waiver of an adjustment 130 If the taxpayer bases his income determination on the mean value of an inappropriately calculated range of mutual consent, the transfer price must in principle be adjusted (§ 1 (3) sent. 8 Foreign Tax Act). It may be refrained from an adjustment if the transfer price employed by the taxpayer is within the appropriately determined range of mutual consent. It must e.g. be taken into account whether the deviation from the mean value within the appropriate range of mutual consent is significant or whether the taxpayer was aware or should have been aware that the determination of the range of mutual consent was incorrect (e.g. due to a respective objection during a previous audit). 2.8 Claims for damages, indemnity, and compensation, § 8 Ordinance on the Relocation of Functions 131 If relocations of functions are carried out by means of suspending or reducing a function, it is often claimed that unaffiliated third parties being the transferring enterprise would also not be eligible to reimbursement but at the most to a compulsory or contractual claim for damages or other indemnity and compensation claims (sec. 9.69, 9.100 et seq. OECDGuidelines). In such cases it shall regularly be examined whether (written) contracts are available (recital 151), whether these comply with the arm’s length principle, and whether the actions of the enterprises involved were in accordance with the contractual conditions (cf. recital 146). 132 Claims for damages, indemnity or compensation may include for instance: – Legal claims to compensation made by a sales representative, commission agent, agent, or authorized dealer as set forth in § 89 German Commercial Code or resulting from its analogical application; – Contractually agreed damages, e.g. for unamortized investments of an authorized dealer that were made at the instigation of the manufacturer; – Contractually agreed damages, e.g. for profits missed and for closure costs incurred (e.g. continuing rent) if the contract was cancelled prematurely; – Claims based on breaching a non-competition clause. 334

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133 In addition, any claims from a contractual or factual exclusion of existing alternatives for action for one of the enterprises involved may be possible – as between third parties independent from one another. In such cases a bilateral consideration is necessary (sec. 9.116 OECD-Guidelines). 134 The limitation to a claim for damages, indemnity or any other compensation shall be recognized for tax purposes if the taxpayer shows credibly (recital 40) that third parties unaffiliated to one another would only have asserted such claims under comparable circumstances and that in connection with the suspension or reduction of this function no essential intangible assets and benefits were relocated or provided for use unless the relocation or provision for use mandatorily results from contractual arm’s length behavior. Otherwise, remuneration for the relocation of functions shall be determined according to the general rules, i.e. principally the treatment as a transfer package with the determination of the range of mutual consent based on the respective profit potentials and, where applicable, application of the mean value. Example: A foreign controlling enterprise (K) concluded a contract processing agreement with its subsidiary (T) with which it guaranteed for a ten-year period the purchase of specific minimum quantities paying a cost-oriented remuneration. T has sufficiently considered the investment and personnel risks after the expiration of the minimum contractual period applying a cost plus. If the minimum quantity is not fulfilled, K is required to remunerate the profits lost therewith. After seven years have expired, the contract is prematurely cancelled. T is reimbursed the profits it lost for the remaining years as well as the costs incurred by the premature termination. The contractual conditions and the factually compensation paid comply with the dealing at arm’s length principle. Intangible assets or other benefits were not transferred. The agreed remuneration is thus at arm’s length and shall be accepted for tax purposes.

2.9 Adjustment provisions, § 1 (3) sent. 11 Foreign Tax Act, § 9 Ordinance on the Relocation of Functions 135 When carrying out a relocation of functions, sound and prudent business managers may conclude that the determination of the value for the transfer package is sufficiently reliable to determine the price irrevocably, without reserving the right to perform subsequent price adjustments (sec. 6.29 OECD-Guidelines). Such considerations shall be documented contemporaneously (§ 3 Ordinance on the Documentation of Income Attribution). Apart from that, sound and prudent business managers will agree on price adjustment provisions if the determination of the value for the transfer package involves considerable uncertainties at the time the contract is concluded (sec. 3.72 et seq., 9.88 OECD-Guidelines). 136 The provisions of § 1 (3) sent. 11 and 12 Foreign Tax Act that enable the tax authorities to make a subsequent adjustment in certain circumstances shall only be applied if the enterprises involved did not agree on any arm’s length adjustment provisions regarding the disposition of a 335

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transfer package (or an intangible asset included therein) at a fixed price (single payment or payment by installment). Only in such a case ten years were legally defined to perform one potential adjustment during this review period. In case an income or sales-related license or a combination of both is agreed, § 1 (3) sent. 11 and 12 is not applicable. 137 If a price adjustment provision is agreed, it shall be examined whether it complies with the arm’s length principle. If no comparable cases may be determined, an economically balanced reconciliation of interests will be the standard for the examination of such provision. If an appropriate price adjustment provision is agreed, the legal adjustment options pursuant to § 1 (3) sent. 11 and 12 Foreign Tax Act do not exist. Deadlines for price adjustment provisions that comply with the arm’s length principle may be recognized in individual cases if these comprise a period of less than ten years. 2.10 Substantial deviations from the profit trend in cases of disposition, § 1 (3) sent. 11 Foreign Tax Act, § 10 Ordinance on the Relocation of Functions 138 Within the scope of an adjustment pursuant to § 1 (1) sent. 1 Foreign Tax Act a deviation from the profit trend that is not in accordance with the original expectations of the acquiring enterprise from the function relocated is considered as “substantial” within the meaning of § 1 (3) sent. 11 Foreign Tax Act, if in cases of dispositions the applicable transfer price for the function under consideration of the actually arising profit trend is outside the originally presumed range of mutual consent. This may e.g. also exist if the actual utilization period deviates from the presumed capitalization period (recital 113). 139 The “new” range of mutual consent that considers the actual profit trend is determined as follows: – The original minimum price of the transferring enterprise will remain unchanged as in this context no changes may have occurred after the relocation of functions. – The maximum price of the acquiring enterprise shall be determined anew based on the profits actually achieved, as in this context substantial deviations have occurred. When calculating, the profit expectations of the acquiring enterprise regarding future years of the capitalization period shall be projected based on the profit trend of years already expired. 140 A “substantial” deviation also exists if the actual profit trend of the acquiring enterprise from the function assumed develops disadvantageous in such manner that no range of mutual consent can be determined any more. This applies if the original minimum price of the transferring enter-

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prise is higher than the “new” maximum price of the acquiring enterprise. 141 Under § 1 (3) sent. 11 Foreign Tax Act the taxpayer has the option to refute the assumption that third parties unaffiliated to one another would have agreed on a contractual adjustment provision due to existing uncertainties. He may for instance furnish evidence that due to steady results the transferring enterprise achieved from the function for many years, actually no essential uncertainties existed at the time of the relocation of the function or that the actual profit trend was influenced by unpredictable results that third parties unaffiliated to one another could not have predicted. 2.11 Appropriate adjustments, § 1 (3) sent. 12 Foreign Tax Act, § 11 Ordinance on the Relocation of Functions 142 In the case of § 10 (1) Ordinance on the Relocation of Functions, in light of the actual profit trend a correct “new” transfer price has to be determined for the relocation of functions in accordance with the general rules (new range of mutual consent; mean value if no other value is credibly shown). 143 In the case of § 10 (3) Ordinance on the Relocation of Functions, the mean value between the original minimum price of the transferring enterprise and the new maximum price of the acquiring enterprise has to be calculated. This value is lower than the original minimum price and higher than the new maximum price. 144 In both cases, the difference to the original transfer price shall be recorded as the adjustment amount in the business year following the business year in which the deviation occurred.

3. Additional remarks and individual questions 3.1 Managerial discretion of disposition; decisiveness of business transactions concluded 145 Enterprises can freely decide whether and to what extent they exercise functions, assume risks and chances of profit and which resources they employ for these purposes (managerial discretion of disposition; sec. 9.163 OECD-Guidelines). The managerial discretion of disposition also includes decisions about whether the enterprise exercises the functions itself, centralizes them at another (group) enterprise, divides them on several enterprises, or commissions a subcontractor therewith. The decision whether on the occasion of a relocation of functions assets are relocated or provided for use and services are rendered is also part of the managerial discretion of disposition, the exercise of which is derived from the contracts concluded (recital 97 and 151). On a regular basis, the tax autho337

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rities shall accept these decisions when applying the arm’s length principle within the meaning of § 1 Foreign Tax Act as they are usually economically justified (sec. 9.57 OECD-Guidelines). On the other hand, the managerial discretion of disposition does not prevent the tax authorities from drawing conclusions in accordance with the arm’s length principle that result from exercising this freedom (sec. 9.163 OECD-Guidelines). 146 As a rule, the income determination has to be based on the factually implemented facts whose evaluation is generally determined by the contracts concluded. If the contracts concluded are not in accordance with the actual dealings of the parties involved, the economic substance of the actual dealings shall be taken into account (sec. 1.48 OECD-Guidelines). The actual relations with their economic substance are relevant (sec. 2.1.2 Administrative Guidelines – Income Allocation; sec. 1.64 OECD-Guidelines). 147 The fact that transactions within a group that would be unusual between unaffiliated third parties or would actually not be existent, e.g. a relocation of entrepreneur functions (sec. 3.4.10.2 (b) Administrative Guidelines – Procedures) or the secondment of personnel (Administrative Guidelines – Personnel Secondment), does by itself not give rise to such business relations not being acknowledged. In contrast, in such cases it must also be decided on what remuneration unaffiliated third parties would have agreed (“hypothetical arm’s length test”, § 1 (3) sent. 5 to 8 Foreign Tax Act; sec. 3.4.12.6 (b) Administrative Guidelines – Procedures; sec. 2.4.6 Administrative Guidelines – Income Allocation; sec. 1.11, 9.19 and 9.52 OECD-Guidelines). 148 The tax authorities may in exceptional cases disregard the legal arrangement chosen by the taxpayer for his business relations under § 1 Foreign Tax Act if the economic substance differs from the agreed outer form or if form and substance are actually in accordance but the agreements reached differ from those that unaffiliated third parties would have agreed in an economic reasonable way, whereby the actually chosen arrangement factually limit the possibilities of the tax authorities to determine an appropriate transfer price (sec. 1.65, 9.168 et seq. OECD-Guidelines). 3.2 Transparency of information 149 Especially when carrying out the hypothetical arm’s length test that regularly shall be applied in connection with relocations of functions with essential intangible assets (recital 62 et seq.), a transparency of information has to be assumed (sec. 9.81, 9.85 OECD-Guidelines, “bilateral consideration”). Without the legal fiction set forth in § 1 (1) sent. 2 Foreign Tax Act the negotiating range resulting from the respective profit expectation could not be determined for numerous situations. The determination of the scope of negotiation reflects the special circumstances of business relations between affiliated companies (within a group), enables the deter338

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mination of economically appropriate transfer prices in accordance with the hypothetical arm’s length test, and thus altogether complies with the arm’s length principle. Its application requires that taxation is based on actions taken by the taxpayer and the affiliated person that corresponds with the actions of a sound and prudent business manager. Unaffiliated third parties view one another as independent business partners with each of them pursuing their own interests and exploiting the negotiating range provided to achieve the best results possible for their enterprise. The internationally acknowledged principle (sec. 5.4 OECD-Guidelines) that has been confirmed by the Federal Fiscal Court in its established case-law of the double sound and prudent business manager (e.g. decision of the Federal Fiscal Court of May 19, 1998 – Federal Tax Gazette 1998 II pg. 689) simulates the regularly absent contrast of the interests between affiliated persons. When determining the respective negotiating positions, the economic considerations of the group or the group enterprises also have to be considered (recital 11 et seq.). 3.3 Cooperation and documentation duties 150 As regards cross-border business transactions, i.e. including relocations of functions, the taxpayer is obliged to clarify the facts he implemented, to provide for necessary evidence, and to collect evidence in advance (§ 90 (2) General Fiscal Code) in addition to the general cooperation duties the parties involved have under § 90 (1) General Fiscal Code. 151 Furthermore, the taxpayer is required to prepare documentation on the nature and content of his cross-border business relations with affiliated persons within the meaning of § 1 Foreign Tax Act (§ 90 (3) General Fiscal Code). Nature, content, and scope of the documentation to be prepared are governed by the Ordinance on the Documentation of Income Attribution. The required documentation includes especially all (written) contracts involving the relocation of function (recital 97) as they are materially significant for the determination of transfer prices (sec. 9.57, 9.164 OECD-Guidelines). If such contracts cannot be provided, pursuant to general principles the taxpayer has an increased burden of proof regarding the fact whether on their merits agreements were concluded and with what specific content, § 90 (2) General Fiscal Code. In case of doubt, agreements are presumed that comply with the specific behavior of the enterprises involved (sec. 9.11 OECD-Guidelines). 152 See the Administrative Guidelines – Procedures explaining the documentation duties in detail (especially sec. 3). When implementing the cooperation and documentation duties, the principle of proportionality shall be observed (cf. sec. 5.28 OECD-Guidelines). Compare sec. 4 Administrative Guidelines – Procedures regarding the legal consequences for breaching the documentation requirements.

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153 See recital 198 et seq. regarding the legal consequences of § 162 (3) sent. 3 General Fiscal Code in cases where an affiliated person involved breaches his cooperation duties. 154 See recital 188 regarding the cooperation duties in cases of relocations of functions regarding assessment periods prior to 2008. 3.3.1 Documentation duties for relocations of functions (extraordinary business transactions) 155 A relocation of functions is usually carried out to transfer or to increase the profit within a group (sec. 9.6 OECD-Guidelines), e.g. by achieving synergy effects or exploiting local advantages in specific countries. Therefore, they are regularly related to a change in business strategies, i.e. to essential functional and risks changes regardless of whether they are caused by the transferring or acquiring enterprise or by the group. Accordingly, relocations of functions constitute extraordinary business transactions within the meaning of § 90 (3) sent. 3 General Fiscal Code in connection with § 3 (2) Ordinance on the Documentation of Income Attribution for which the taxpayer is obliged to prepare documentation contemporarily. 3.3.1.1 Date at which a relocation of functions “occurs” 156 A relocation of functions “occurs” in the business year (§ 3 (1) Ordinance on the Documentation of Income Attribution) in which the facts in accordance with § 1 (2) Regulation on the Relocation of Functions have been completely realized. This time is relevant for the determination of whether respective documentation has been prepared “contemporarily” within the meaning of § 3 (2) Ordinance on the Documentation of Income Attribution. This applies regardless of whether any additional business transactions that follow at a later time are economically part of the relocation of functions and thus have to be included in the treatment as a transfer package (recital 26 f.). 3.3.1.2 Information on documentation requirements 157 If relocations of functions are the subject of tax audits, respective documentation shall be required early in the process. Documentation required by § 90 (3) General Fiscal Code to be prepared for this purpose has to include especially: – Documentation on the facts implemented, especially changes in the operative group structure, the personnel structure, and the contracts underlying the business transactions with affiliated parties (§ 4 no. 1 (c) and no. 2 Ordinance on the Documentation of Income Attribution). It also comprises information on changes in business strategies (§ 5 sent. 2 no. 1 Ordinance on the Documentation of Income Attribution). 340

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An appropriate documentation shall consider the positions of the enterprises involved (§ 1 (1) sent. 2 Foreign Tax Act) and illustrate from the perspective of the group as well as the perspective of the affected enterprises the economic assessment bases and methods as well as the advantages and disadvantages, respectively, arising from the relocation of function on which the decision was based to carry out the relocation of function (§ 3 (2) sent. 2 Ordinance on the Relocation of Functions, see sec. 9.57 OECD-Guidelines). This also applies to relocations of functions for which it may be refrained from applying a treatment as a transfer package by applying an escape clause under § 1 (3) sent. 10 Foreign Tax Act and for which individual transfer prices for the affected individual assets and benefits have to be determined instead (recital 69 et seq.); see in addition also § 1 (1) Ordinance on the Documentation of Income Attribution and sec. 3.4.8.2 and sec. 3.4.12.6 Administrative Guidelines – Procedures. – A transfer pricing analysis (§ 4 no. 4 Ordinance on the Documentation of Income Attribution) from which results the appropriateness of the transfer price for the transfer package and for the concerned assets and benefits, respectively, from the perspective of the concerned enterprises based on their profit forecasts (cf. sec. 3.4.12.6 Administrative Guidelines – Procedures). – Documentation on the transfer pricing methods used (sec. 3.4.10 Administrative Guidelines – Procedures) regarding the ongoing delivery of goods and services prior to and after the relocation of functions that considers the amended functional distribution. – Documentation on research projects and research activities (§ 5 sent. 2 no. 6 Ordinance on the Documentation of Income Attribution); it may include indication that intangible assets are affected by a relocation of functions. 3.3.2 Other functional changes 158 Duplications of functions (recital 42 et seq.) and the new assimilation of functions (recital 57) may constitute as functional changes within the meaning of § 3 (2) Ordinance on the Documentation of Income Attribution extraordinary business transaction within the meaning of § 90 (3) sent. 3 General Fiscal Code. This applies in particular if essential intangible assets and other benefits are affected by a functional change. 3.4 Investigation options by the tax authority 3.4.1 Existence of a relocation of functions on its merits 159 The tax authority may derive indication for whether a relocation of functions took place in an enterprise during the audit period e.g. from the 341

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documentation that must be prepared contemporarily for extraordinary business transactions (recital 155). Based on this, additional findings may be obtained from a functional and risk analysis including several years (§ 4 no. 3 Ordinance on the Documentation of Income Attribution, sec. 3.4.11.4 Administrative Guidelines – Procedures) and from an analysis of the value-added process (sec. 3.4.11.5 Administrative Guidelines – Procedures). Besides, indication for a relocation of functions may often be derived from an analysis of personnel organizational charts and their changes and update over a period of several years. 160 Further indication may e.g. be derived from the following documents and circumstances: – Documents of foundation, annual financial statements, reports audited by accountancy firms, and subordinate status reports for affiliated companies; – Reduced turnover or profits; – Less labor expenses due to reduced staff numbers, social plans; accruals for social plans; – Reduced expenses regarding rent for offices or inventory, or disposition of premises of the enterprise; – Revenues from the transfer or provision for use of fixed assets (e.g. machines, patents) and current assets (raw materials, accounts receivable); – Increased expenses for using services; – Increased expenses for travelling to affiliated companies; – Documentation on research projects and the use of their results; – As regards credit institutions, submitted documents for the granting of loans. 3.4.2 Consequences for breaching cooperation and documentation duties 161 If the taxpayer breaches his cooperation duties under § 90 (1) to (3) General Fiscal Code, in particular the following consequences may result: – Reduction of the investigatory duties of the tax authority (§ 88 General Fiscal Code, sec. 4.3 Administrative Guidelines – Procedures). – Reduction of the standard of proof (sec. 4.4 Administrative Guidelines – Procedures).

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– Shift of the burden of proof to the detriment of the taxpayer (e.g. disputable assumption under § 162 (3) General Fiscal Code; sec. 4.6.1 Administrative Guidelines – Procedures). – Estimation of the assessment bases by the tax authority (§ 162 (1) to (3) General Fiscal Code; sec. 4.6.2 Administrative Guidelines – Procedures). If an estimation is performed pursuant to § 162 (3) General Fiscal Code because the taxpayer has breached his cooperation duties under § 90 (3) General Fiscal Code by e.g. not submitting documentation or by having provided essentially unusable documents and the income may only be determined within a certain scope (e.g. range of mutual consent), this scope may be exploited to the detriment of the taxpayer. – Determination of a surcharge (§ 162 (4) General Fiscal Code; sec. 4.6.3 Administrative Guidelines – Procedures). 3.4.3 Determination of value of the transfer package in cases of estimation 162 In cases of estimation, the determination of the value of the transfer package is generally also primarily made based on unrestrictedly or restrictedly comparable arm’s length data pursuant to § 1 (3) sent. 1 to 4 Foreign Tax Act. If such values cannot be determined, the value of the transfer package has to be determined by means of estimation in accordance with the hypothetical arm’s length test under § 1 (3) sent. 5 to 8 Foreign Tax Act. The necessary information on profit expectations, interest rates for capitalization, and capitalization periods are in cases of estimation also primarily derived from available documents on which the enterprise’s decision was based to relocate the function. 163 For estimation purposes, other values deviating from recitals 165 et seq. and recital 170 may be applied if the taxpayer can verify these other values or if they may be determined with reasonable effort. Differences in the financing structures (recital 94) remain out of consideration for simplification purposes. In order to simplify matters, the tax effects resulting from the consideration of the remuneration to be applied for the relocation of functions (recitals 33, 118, and 125) may be assessed at a lumpsum of always 15 % of the marginal prices, provided that the taxpayer does not submit any appropriate calculations. 3.4.3.1 Determination of present value 164 In order to estimate the value of the transfer package based on the arm’s length test, the range of mutual consent has to be determined first by means of estimation. The minimum price of the transferring and the maximum price of the acquiring enterprise may be determined for this purpose by applying the discounted cash-flow method usually used for business evaluations. Under § 1 (4) Ordinance on the Relocation of Func343

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tions, the anticipated net profits after tax have to be discounted at the reporting date. For this discounting, pursuant to § 5 Ordinance on the Relocation of Functions an appropriate interest rate for capitalization has to be used (recital 170) and in accordance with § 6 Ordinance on the Relocation of Functions an unlimited capitalization period has to be assumed (recital 171) if no reasons for a deviating capitalization period may be shown credibly or are evident (cf. appendix, example 2). 3.4.3.2 Determination of the profit potential of the relocated function 165 Each profit potential has to be determined in cases of estimation under consideration of all identifiable circumstances of the individual case based on a functional and risk analysis performed prior to and after the relocation of functions in relation to the affected function (direct method) (§ 3 (2) Ordinance on the Relocation of Functions). 166 Regarding the separation of the profits that are allocable to or anticipated for the relocated function, the following internal documents may provide for substantial indication: – Divisional/segmented accounts, cost and activity accounting, accounting area; – Profit center accounting, also to the extent they have been prepared for purposes of profit or sales-oriented remuneration systems; – Financing documents to be provided to credit institutions. 167 If no suitable documents regarding the separation of the profit potential of the transferring enterprise are available, the estimation of the profit expectations may be made based on the turnover achieved from the relocated function during the previous business years from which the costs of the function, possibly determined by means of estimation, have to be deducted. When applying data from the past, the profit expectations have to be adjusted, provided that circumstances that were only profitable in the past or presumably will be profitable in the future are evident or are presented. 168 For the acquiring enterprise, the profit potential resulting from the relocated function at the time of the relocation may be estimated in the amount of the actually generated net profit after taxes known at the time the audit was carried out. If this is no longer possible or seems inappropriate, the profit potential communicated by the transferring enterprise may be considered as initial value for the assessment of the profit potential of the acquiring enterprise. This initial value shall be adjusted to the special, profitable circumstances at the acquiring enterprise (e.g. local benefits and synergy effects). 169 In suitable cases, the assessment of the respective profit potential may be performed in accordance with the indirect method (recital 32) 344

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3.4.3.3 Interest rate for capitalization 170 The net profits after taxes underlying the estimation (recital 31) have to be discounted at the time of the relocation of functions. Whenever possible, the interest rate for capitalization shall equal the return from a comparable investment and be equivalent as regards term, risk, and taxation. Respective returns can be divided to a base rate and a risk premium for assuming the entrepreneurial risk. Deviating from recital 104 et seq. and under consideration of recital 63 the following applies: – Base rate The base rate reflects the return of a “quasi-risk free” money investment. In cases of estimation a return on public bonds with excellent credit rating that have an equivalent term may be taken into account for the interest rate of both enterprises (e.g. yield curve of the German Federal Bank). – Risk premium Under § 5 sent. 1 Ordinance on the Relocation of Functions, the functional risk of both enterprises has to be considered with a premium on the interest of a risk-free investment. In cases of estimation the premium may typically be assumed to be 50 % of the domestic base rate, yet at least at 3 %. This premium shall cover all risks (e.g. currency risks, growth risks). – Taxes The base rate plus the risk premium has to be reduced for both the transferring and the acquiring enterprise in the amount of the respective nominal tax rate on business profits (example for the domestic territory: base rate 5.0 % + premium 3.0 % (minimum risk premium); tax rate 30 %; applicable interest rate after taxes: 5.6 %). 3.4.3.4 Capitalization period 171 Deviating from recital 109 et seq., in cases of estimation an unlimited capitalization period shall be assumed, provided that there are no apparent reasons for a limited capitalization period that is indicated by the circumstances of performing the function. 3.5 German accounting tax law consequences from a relocation of functions 172 Where a transfer package is relocated, the taxpayer is obliged to inter alia assess for balance sheet purposes what individual tangible and intangible assets and other benefits have been relocated under the transfer package. At the level of the transferring enterprise the respective assets shown in the balance sheet have to be removed from the balance sheet and at the level of the acquiring enterprise the assets and other benefits have to be capitalized in the balance sheet. If agreements in accordance 345

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with the arm’s length principle are available, they disclose the values for the capitalization at the level of the acquiring enterprise regarding the affected assets and may also include those of self-created intangible fixed assets of the transferring enterprise that were not yet capitalized. The capitalization is determined by the law of the state where the acquiring enterprise has its registered seat. 173 To the extent that the arm’s length value (present value) of the transfer package cannot be attributed to individual assets or does not result in any business expenses (e.g. service remuneration, remuneration for the provision of use), where necessary the acquiring enterprise may be required to show an mathematical remaining amount as a goodwill if German accounting rules applicable for the acquiring enterprise permits this tax-wise (see decision of the Federal Fiscal Court of March 27, 2001 – Federal Tax Gazette 2001 II pg. 771 on the German tax accounting treatment). As a rule, it cannot be assumed that a remaining amount which would have to be shown as goodwill will regularly remain from the relocation of functions. 3.6 Deliveries of goods and services after the relocation of functions 174 The tax audit of a relocation of functions focuses both on the appropriateness of remuneration paid for the relocation itself and on the appropriateness of the remuneration of business transactions that may have taken place prior to or after the relocation of functions during the ordinary course of business. 175 In principle, the transfer prices for the delivery of goods and services after the relocation of functions will have to be determined under different principles than before as the changes resulting from the relocation of functions must be taken into account. The changes require documentation on the appropriateness of the agreed on prices prior to and after the relocation of functions that the taxpayer shall, where necessary, be obliged to prepare contemporarily under § 90 (3) sent. 2 General Fiscal Code, § 1 (1) and (3) Ordinance on the Documentation of Income Attribution and sec. 3.4.12 Administrative Guidelines – Procedures and to produce it. 3.7 Withholding tax, tax deduction for taxpayers subject to limited taxation, and value added tax 176 As regards business transactions that are part of a relocation of functions and to which under § 4 (1) Ordinance on the Relocation of Functions separate transfer prices are set, the general taxation provisions apply for withholding tax purposes (§§ 43 et seq. Income Tax Act), for withholding taxes as they relate to taxpayers subject to limited taxation (§ 50a Income Tax Act), and for value added tax purposes. These also apply if a uniform license is established for a transfer package.

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3.8 Notes on relocation of functions in case of business partnerships 177 A business partnership may constitute an affiliated person within the meaning of § 1 (2) Foreign Tax Act (cf. sec. 1.4.3 Introductory Act to Foreign Tax Act). The provisions of § 1 Foreign Tax Act and thus including the provisions on relocations of functions are consequently applicable to business partnerships, be it as transferring enterprise or acquiring enterprise, provided that the other prerequisites are fulfilled. A respective application of the arm’s length principle results from art. 7 and 9 OECDModel Tax Convention. 3.9 Notes on relocations of functions between permanent establishments 178 Under double taxation agreements concluded by Germany that follow in content art. 7 OECD-Model Tax Conventions, the arm’s length principle also applies to the profit attribution between permanent establishments. This principle is interpreted in international consent through the OECD-Report on the Attribution of Profits to Permanent Establishments without explicitly addressing relocations of functions (sec. 9.7 OECD-Guidelines). The OECD-Guidelines shall in principle apply correspondingly to the attribution of profits to permanent establishments (sec. 80 et seq. OECD-Report on the Attribution of Profits to Permanent Establishments). 179 If based on double taxation provisions that comply with art. 7 OECD-Model Tax Convention restrictions apply to German taxation, these must be followed. 3.10 Treatment of relocations of functions up to and including assessment period 2007 180 Pursuant to § 21 (16) Foreign Tax Act, the provisions of § 1 (1), (3), and (4) Foreign Tax Act apply in the version of the Corporate Tax Reform Act 2008 (art. 7 of the law of August 14, 2007 (Federal Law Gazette I pg. 1912, Federal Tax Gazette I pg. 630)) for the first time for the assessment period 2008. Accordingly, the following do not apply to previous years: – § 1 (1) sent. 2 Foreign Tax Act (transparency of information, i.e. the assumption “that independent third parties have knowledge of all essential circumstances of the business relation”); – § 1 (3) sent. 7 Foreign Tax Act (mean value in the range of mutual consent); – § 1 (3) sent. 9 Foreign Tax Act (regular calculation of the transfer package);

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– § 1 (3) sent. 11 and 12 Foreign Tax Act (legal fiction of a price adjustment clause). 181 According to the explanatory statement on art. 7 (§ 1 Foreign Tax Act) of the Corporate Tax Reform Act 2008 (publication no. 16/4841 pg. 84 of the German Parliament), the amendment of the law primarily has a clarifying and refining effect to the extent the new provisions (including relocations of functions) constitute a product of the always applicable arm’s length principle and merely an explicit regulation of this principle has been made. With regard to relocations of functions that were carried out in the assessment periods up to and including 2007, the comments made in recitals 182 to 200 shall be observed in this context. 3.10.1 Principle of the double sound and prudent business manager (§ 1 (1) sent. 2 Foreign Tax Act) 182 It complies with the arm’s length principle to include the situation of both enterprises (contractual partners) in order to determine the transfer prices using an objective standard (“principle of the double sound and prudent business manager”). Both participate (at least fictitiously) in the market that determines the conditions, in particular prices, that shall have to be used as basis. Solely under such conditions it is possible to derive transfer prices that are in line with market conditions and balanced for tax purposes. 183 The principle of the double sound and prudent business manager is common taxation practice and complies with established case-law (recital 149). To that extent, the law amendment merely serves clarification purposes. 3.10.2 Overall evaluation with focus on capitalized earnings value, § 1 (3) sent. 5 et seq. Foreign Tax Act 184 In order to apply the arm’s length principle in cases of a relocation of functions, it is required to determine the economic substance of the transaction. For price determination purposes, sound and prudent business managers evaluate – including assessment periods prior to 2008 – regularly as an economically consistent transaction and calculate remuneration both for the relocation of functions as a whole and for the individual assets and benefits based on the respective profit potentials (with respect to the package deal cf. sec. 3.9 et seq., 9.67 OECD-Guidelines; cf. recital 4 et seq. and recital 9 et seq.). To that extent it is appropriate to base the tax treatment of relocations of functions on an overall evaluation that focuses on the capitalized earnings value (treatment as a transfer package). 185 Accordingly, for the assessment periods prior to 2008, in such cases documents on which the enterprise based its decision regarding the relocation of functions have to be requested and submitted by the taxpayer as 348

XI. Relocation of Functions (2010)

they are an essential starting point for the tax treatment and evaluation of the procedure and the price determination of the individual business transactions of which the relocation of functions consists. The escape clauses provided for in § 1 (3) sent. 10 Foreign Tax Act (recital 69 et seq.) apply also to the assessment periods prior to 2008. 186 If an enterprise is unable to furnish documents on the profit expectations or their calculation in cases of a relocation of functions for assessment periods prior to 2008 despite having fulfilled its cooperation and documentation duties under § 90 General Fiscal Code, it is not objected if the price determination is based on the actual profit situation of the transferring enterprise prior to the relocation of functions and the actual profit situation of the acquiring enterprise after the relocation of functions, unless the taxpayer shows credibly that at the time it was decided upon a relocation of functions one or both enterprises had other profit expectations from the relocated function that deviated from the profits actually achieved. 187 The burden of proof with respect to an adjustment of the transfer price based on an overall evaluation of the transfer package with focus on capitalized earnings value is borne by the tax authority regarding assessment periods prior to 2008. 188 As regards the cooperation and documentation duties under § 90 General Fiscal Code that have to be observed for the assessment periods prior to 2008, it has to be considered that § 90 (3) General Fiscal Code applies for the first time to business years commencing after December 31, 2002 (art. 97 § 22 sent. 1 Introductory Act to General Fiscal Code). The Ordinance on the Documentation of Income Attribution was issued on November 13, 2003 taking effect on June 30, 2003. The cooperation and documentation duties are specified in detail in the Administrative Guidelines – Procedures. 3.10.3 Value in the range of mutual consent, mean value, § 1 (3) sent. 7 Foreign Tax Act 189 There are fundamental differences that in principle lead to different legal consequences between a range from actual comparable arm’s length data and a range of mutual consent under the application of the hypothetical arm’s length test that results from two calculations of marginal prices (no actual comparable arm’s length data). As an example, ranges under § 1 (3) sent. 3 Foreign Tax Act generally have to be narrowed (sec. 3.4.12.5 Administrative Guidelines – Procedures) whereas a range of mutual consent under § 1 (3) sent. 7 Foreign Tax Act requires the application of the mean value, where appropriate. Only for assessment periods from 2008 onwards, the explicit legal regulation is to be applied that in absence of credibly showing another value, the mean value of the range of mutual con-

349

D. Administrative Guidelines

sent shall be used as basis for the income determination may be based on, applies (recital 180). 190 As regards assessment periods prior to 2008, when applying the hypothetical arm’s length test to relocations of functions in order to determine the value in the range of mutual consent that complies best with the arm’s length principle and thus is material for the transfer prices, it shall be assumed from experience that unaffiliated third parties will agree on a mean value. This especially applies if both parties have a similarly high interest in accomplishing the business transaction and have similarly strong negotiating positions and if there is no particular indication for a specific value within the range of mutual consent (cf. decisions of the Federal Fiscal Court of January 19, 1994 – Federal Tax Gazette 1994 II pg. 725 and of February 28, 1990 – Federal Tax Gazette 1990 II pg. 649). In all other cases, the general provisions on the burden of proof and substantiation apply (cf. sec. 2.1 in connection with sec. 4 Administrative Guidelines – Procedures). 3.10.4 Price adjustment clauses 191 An agreed on arm’s length price adjustment clause of the enterprises involved shall in general be accepted both to the advantage and the disadvantage of the domestic enterprise. Where the taxpayer does not calculate his income in accordance with the agreed on price adjustment clause, a transfer pricing correction shall be carried out in the year in which the stipulated requirements have occurred. 192 The legal fiction of a price adjustment clause under § 1 (3) sent. 11 and (12) Foreign Tax Act applies for the first time to assessment periods as from 2008 (recital 180). 193 A transfer pricing correction has to be carried out for assessment periods prior to 2008 though, if unaffiliated third parties could successfully have referred to a breach of the contract basis under § 313 Civil Code or, to the extent it has not been agreed on the application of German law, to a comparable regulation of foreign civil law. If the application of foreign civil law has been agreed and it does not contain a standard comparable to § 313 Civil Code, it may be assumed that a sound and prudent business manager would explicitly have agreed on a price adjustment in case of a breach of the contract basis. 194 The legal concept of the “loss or breach of the contract basis” generally applicable under civil law and which is a product of good faith also applies within the arm’s length principle under § 1 Foreign Tax Act. The requirements for its application are fulfilled if the circumstances that formed the basis of the contract have changed profoundly and in good faith it is unreasonable for a contractual partner to adhere to the unchanged contract, in particular under consideration of the contractual or 350

XI. Relocation of Functions (2010)

legal sharing of risks. In mutual contracts, the concept of equality in services rendered and services received is always part of the contract basis. This also applies in cases where this concept has not been particularly addressed during the contractual negotiations. As a rule, an application of § 313 Civil Code cannot be considered in mutually contracts that have already been fulfilled in whole. As reasonability is decisive, by way of exception an adjustment may be considered for already completed contracts, e.g. if the implicit purpose of a contract had been absent from the beginning (decision of the Federal Fiscal Court of November 15, 2001 – New Juridical Weekly (NJW) 2001 pg. 1204) or if it is unreasonable to adhere to the previous contractual content despite mutual fulfillment (decisions of the Federal Fiscal Court of June 1, 1979 – Decisions of the Federal Supreme Court in Civil Cases (BGHZ) 74, 373 and of November 24, 1995 – Decisions of the Federal Supreme Court in Civil Cases (BGHZ) 131, 209). 195 Pursuant to civil-law jurisprudence and as provided by the individual case it has to be assessed when a profound interruption of the implicit purpose of the contract within the meaning of § 313 Civil Code or in good faith exists. If the projected profits deviate significantly from the actually realized profits, it must be assumed that unaffiliated third parties could have successfully referred to an interruption of the implicit purpose of the contract under § 313 Civil Code and actually would have referred to. 196 If such case exists, it must be differentiated: – If the false projection has negative effect on the German tax revenue, the tax authority will carry out an increase in profit in the year in which the sound and prudent business manager of an independent enterprise would have claimed an interruption of the implicit purpose of the contract (sec. 6.33 et seq. OECD-Guidelines). – If the false assessment has positive effect on the German tax revenue, an adjustment based on § 1 Foreign Transaction Tax Act is not feasible. Unless other adjustments are feasible under other legal norms, the taxpayer has the remaining option to file an application for the implementation of a mutual agreement procedure (§ 89 General Fiscal Code and Bulletin Regarding the International Mutual Agreement and Arbitration Procedures for Taxes on Income and Capital, Administrative Memorandum of July 13, 2006 – Federal Tax Gazette I pg. 461). 197 A transfer pricing adjustment on grounds of an interference with the basis of the transaction under § 313 Civil Code cannot be compared with a standardized adjustment based on the price adjustment clause of § 1 (1) sent. 11 and 12 Foreign Transaction Tax Act as regards the prerequisites and legal consequences.

351

D. Administrative Guidelines

3.10.5 Exhaustion of the range of estimation due to a breach of cooperation duties of a foreign affiliated person, § 162 (3) sent. 3 General Fiscal Code 198 If a party concerned claims that in cases of relocations of functions that regularly require a two-way consideration (sec. 9.81 and 9.85 OECDGuidelines) (in particular, if it affects essential intangible assets and benefits) it cannot give information or provide documentation because an affiliated party possesses these exclusively and refuses a release, the participant does not violate his cooperation requirements if he has neither the legal (e.g. under company law) nor the factual possibility to obtain the information or documents from the affiliate and furthermore, he was unable to collect evidence in advance or such was unreasonable (sec. 3.3.2 (b) Administrative Guidelines – Procedures). 199 In such cases § 162 (3) sent. 3 General Fiscal Code authorizes the tax authority to carry out estimations to that point within the resulting range of estimation that is least favorable to the taxpayer if the facts cannot be clarified sufficiently due to a breach of the cooperation duties under § 90 (2) General Fiscal Code or the obligation to furnish information under § 93 (1) General Fiscal Code by a foreign affiliated person. 200 § 162 (3) sent. 3 General Fiscal Code has been added by art. 6 no. 5 (b) of the Corporate Tax Reform Act 2008 taking effect on August 18, 2007. The extended estimation authorization under § 162 (3) sent. 3 General Fiscal Code shall apply to cases of relocations of functions that have “occurred” after December 31, 2007 within the meaning of recital 156.

4. Special aspects of specific relocations of functions 4.1 Relocation of production 4.1.1 Relocation of production to a manufacturer 201 The fact that the enterprise performs production functions (e.g. manufacture, product development, product selection, purchase, storage, research and development etc.) as well as marketing functions (e.g. advertising, distribution etc.) and makes decisions are indispensable features of a manufacturer. The manufacturer is regularly the owner of essential business basics (tangible and in particular intangible assets) and bears the opportunities and risks in connection with performing the functions (e.g. market risk, quality risk, distribution risk etc.). 202 If the transferring enterprise operates as a manufacturer and the production is – as a whole or parts thereof (recital 14 et seq.) – relocated in combination with the associated marketing functions to an acquiring enterprise, the acquiring enterprise regularly becomes active as a manufacturer.

352

XI. Relocation of Functions (2010)

4.1.2 Reorganization from production to toll manufacturer 203 If the transferring enterprise operates as manufacturer (recital 201) and the marketing functions and the production risks are transferred to an affiliated company, a relocation of functions exists under which the transferring enterprise becomes a toll manufacturer. In such cases the transfer package regularly includes the assets that the previous manufacturer does not use any longer independently, e.g. from its own market access, the customer base, the distribution organization, the product know-how, and other intangible assets and benefits. Together with the marketing function and the essential production risks (including research and development), the opportunities and risks connected therewith are transferred to the acquiring enterprise. 204 Typical features of a toll manufacturer are that on a contractual basis or in factual practice he – does not bear production risks (e.g. quality risk, capacity risk, distribution risk, inventory risk); – does not develop products by himself nor owns nor acquires intangible assets required for the production; – does not assume any marketing functions and bears no market risks; – does not have discretionary competence, and – receives the necessary raw materials, consumables and supplies, but also as a whole or in part the production facilities from the principal (provision). Example: The foreign beverage group (K) to which the domestic subsidiary (T) also belongs has grown considerably by acquiring several competitive enterprises. Until the end of 04, the group has been organized decentralized, i.e. all national enterprises (including T) have carried out research, production, management, distribution and marketing independently. In the year 05, the management of development, production, and distribution were centralized with K in order to save costs. The individual national enterprises merely become active as toll manufacturer and sales representative for K. This significantly decreases the profits of the national enterprises. A relocation of intangible asset to K is neither separately agreed nor remunerated. Nevertheless, the national enterprises reveal to K the recipe of the individual beverages and transfer to K also the trademark rights and brand names. A relocation of functions exists as the essential intangible assets (formula, trademark rights, brand names etc.) were transferred from T to K and the function of T has been restricted because T does no longer operate as separate manufacturer.

205 Apart from the basic models of the manufacturer and the toll manufacturer, subject to the contractual arrangement of the individual features several mixed models may exist. One of these mixed models constitutes for instance the contract manufacturer who differs from the toll manufacturer as he acquires the natural resources and material himself on his own 353

D. Administrative Guidelines

behalf and for his own account, without the risks assumed by the contract manufacturer being higher than they would be for the toll manufacturer. 4.1.3 Relocation of a production to a toll manufacturer 206 If an enterprise operating as a manufacturer (recital 201) relocates merely its production function as a whole or in part (e.g. for a specific product or product group, cf. recital 14 et seq.) to another affiliated company, the acquiring enterprise becomes active as toll manufacturer if the respective features (recital 204) have been met. 207 A relocation of functions also arises if the arm’s length transfer price of the acquiring enterprise (toll manufacturer) for the products manufactured is determined under the cost plus method or under a transactional net margin method based on costs. § 2 (2) Ordinance on the Relocation of Functions has to be observed, though (recital 66 et seq.). When applying the cost plus method in all other cases, the costs for natural resources and material supplied by the principal may not be included in the cost basis of the toll manufacturer. This applies also if the toll manufacturer obtains the ownership under civil law because to that extent he regularly does not make any contribution to the added value. 4.1.4 Reorganization from toll manufacturer to manufacturer 208 If an enterprise previously acting as a toll manufacturer becomes independently active in the market using intangible assets and benefits provided by the transferring, affiliated company (i.e. towards unaffiliated third parties but also towards other group enterprises) and applies prices that exceed the remuneration under the transfer pricing methods set forth in recital 66 et seq., an arm’s length remuneration has to be set-off for the previously provided assets at the time of first provision in the market (knowhow, machines etc.), because the enterprise previously acting as toll manufacturer now uses these assets for its own participation in the market (§ 2 (2) sent. 2 Ordinance on the Relocation of Functions and recital 68). 209 In cases of toll manufacturers it must be checked on an ongoing basis whether and, where applicable, as of when additional functions (first initial sale that is not rendered to the transferring enterprise) are performed in order to draw tax consequences in time. Example: A domestic automotive supplier (P) has distributed exhaust systems to several third party car manufacturers by engaging its foreign subsidiary (T) that acts as toll manufacturer on its behalf. The production know-how, the natural resources, and machines have previously been provided to T without compensation. After several years, T independently distributes at market prices to customers of P. As T employs the production know-how etc. of T for its own participation in the market, a relocation of functions arises upon commencement of the independent delivery to the customers of P by T at market prices (restriction of P’s distribution function).

354

XI. Relocation of Functions (2010)

4.2 Relocation of distribution 4.2.1 Relocation of distribution to a distributor (or authorized dealer) 210 An enterprise constitutes a typical distributor if it performs marketing functions (e.g. advertising, distribution etc.) and has the respective discretionary competencies, and the essential business substance (e.g. customer base) and the opportunities and risks (e.g. storage risk) are allocated to him for its activity as an independent distributor. 211 A relocation of functions arises where the distribution (as a whole or parts thereof, cf. recital 14 et seq.) is relocated to an acquiring enterprise. In such cases the acquiring enterprise regularly also becomes active as distributor. 212 When determining the minimum price of the transferring enterprise, it has to be taken into consideration that a third party distributor would be able to continue carrying out his distribution function independently from the production enterprise due to his own market position (inter alia customer base) (alternative course of action, recital 96) and may be serious competition (e.g. remuneration for a waiver of competition). 213 The same applies to authorized dealers. Among others, the assignment of a specific distribution area, the granting of a sole distribution right, reporting duty, restrictions for competition, and the involvement in price fixings and advertising measures of the manufacturer are features of an authorized dealer. It must be observed though, that unlike a full distributor an authorized dealer regularly does not dispose of his own customer base for distribution as he is included in the sales organization of his manufacturer. Nevertheless, an authorized dealer may have his own customer base to the extent that in addition to distribution he renders other services in the market, e.g. service and repairs. 4.2.2 Reorganization of a full distributor to commission agent or agent 214 If a full distributor is reorganized by way of change in functions to a commission agent, sales representative, or agent, it has to be examined whether assets and benefits are transferred or provided for use for which an unaffiliated third party would pay remuneration. In particular it must be examined who previously owned the customer base, whether and when and at what remuneration it has possibly been transferred or provided for use, and whether the ownership of the customer base has been taken into account correctly when determining the transfer prices. An arm’s length change in function that complies with the contract (e.g. expiration of the distribution contract, timely termination) and the reduction of opportunities and risks associated therewith for the concerned full distributor is as such by itself not treated as relocation of functions (recital 131 et seq.).

355

D. Administrative Guidelines Example: The full distributor (H) has distributed for years office machines in the domestic territory for its foreign parent group enterprise (K). Until now, no contractual agreement regarding the processing of the business has been made. H has established its own customer base over time. Customers are primarily governmental institutions and major enterprises with an excellent credit rating, so that previously no bad debts have been recorded. The appropriate average gross profit margin resulted in arm’s length profits amounted to 30 % during the last five years. As of January 1, 2006, K concludes a commission agent agreement with H. In its course, H will surrender its own accounts receivable department and stock keeping. H transfers the respective assets to K and cuts back on the affected personnel. In the agreement, a commission rate of 20 % of the turnover mediated is set. The lower margin is in particular justified with the fact that H as commission agent (in contrast to full distributor) will in future no longer bear any distribution risks, in particular bad debt and storage risk. A relocation of functions exists as H transfers assets even though H as independent third party would not have been forced to do this and is restricted in its business activity. Especially the legal implications of H’s previous customer base which H may have either transferred or provided for use have to be clarified. H must provide clarification in order for the necessary tax conclusions (purchase price, licensing, or appropriate consideration under the new commission rate) to be drawn. In case the profits of H shall in the future be derived from data bases, for comparability purposes it has to be considered who shall be entitled to the customer base. The use of the customer base does not allow any final conclusion. Modification (for differentiation): As of January 1, 2006, merely the transfer of the bad debt risk to K and the lowered commission rate have contractually been agreed. H will in all other aspects carry out its business activity unchanged. A relocation of functions does not arise because neither a business activity has been restricted nor have assets or benefits, in particular customer base, been transferred or provided for use. With regard to the customer structure and because based on past experiences no bad debts are expected in the future, the reasons given by H for decreasing the commission rate are not justified at least in this example. Hence, third parties independent of one another would not accept that their prospective profits would be reduced considerably based on an elimination of insignificant risks.

215 Under certain circumstances a commission agent or agent may constitute a permanent establishment for his principal (sec. 1.2.2 Administrative Guidelines – Permanent Establishments). The profit of a dependent agent permanent establishment (principal is subject to limited taxation) has to be determined independently from the profit of the agent by itself (cf. part 1 sec. 263 to 283 OECD Report on the Attribution of Profits to Permanent Establishments). Such cases are not the objective of this circular (corresponding to sec. 9.7 OECD-Guidelines). 4.3 Relocation of research and development 216 Research and development activities may be organized in different manners, e.g.: – The enterprise exclusively performs research for its own purposes (own research).

356

XI. Relocation of Functions (2010)

– The enterprise contracts another affiliated company to perform research and development (contract research). – The enterprise pursues several research projects simultaneously for its own purposes and as service for other enterprises. – The enterprise researches together with other enterprises within a pool (cost sharing agreement, cf. Administrative Guidelines – Cost Sharing Agreements). 217 A relocation of functions arises if the function “research and development” is relocated together with the respective assets and benefits to another affiliated company. Whether the acquiring enterprise renders its activity to the transferring enterprise as own researcher or contract researcher depends on the circumstances in the individual case. In case the acquiring enterprise becomes active as contract researcher, the applicability of § 2 (2) Ordinance on the Relocation of Functions has to be examined (recital 66 et seq.). As regards cases of relocation of research and development, it is in particular referred to § 5 no. 6 Ordinance on the Documentation of Income Attribution. Example: Parallel with the research department of P (domestic territory), a new subsidiary (T) is established as research enterprise abroad. The required personnel, especially the researchers, are transferred from P to T. The research activities of P are continuously reduced (staff reduction, no further funds, etc.) whereas T successfully carries out research and continues with it afterwards (patents). A relocation of functions exists. The transfer package includes e.g. the research knowhow and knowledge of ongoing research projects.

4.4 Relocation of services 218 A relocation of functions arises if the acquiring enterprise assumes a service function (e.g. bookkeeping, marketing, advertising) from the transferring enterprise (recital 19). 219 In case the transferring enterprise has previously performed the services on its own behalf only, it often constitutes a case set forth in § 2 (2) Ordinance on the Relocation of Functions after the relocation of functions (recital 66 et seq.) if the acquiring enterprise renders this service exclusively to the transferring enterprise. 220 The relocation of services often does not affect essential intangible assets and benefits, so that the opening clause under § 1 (3) sent. 10 first alternative Foreign Tax Act (recital 71) is applicable.

357

D. Administrative Guidelines

4.5 Relocation of purchasing department 221 The relocation of the purchasing department of an enterprise may for example take place in order to achieve all advantages from central purchasing (e.g. discounts) from which all participating enterprises that until then have made their purchases independently will benefit (sec. 9.154 et seq. OECD-Guidelines). If purchasing is rendered as an internal service, an appropriate cost markup has to be considered for the purchasing enterprise (recital 66 et seq.). Realized purchase advantages may also be forwarded under a pool to the enterprises that are a party thereof (cf. Administrative Guidelines – Cost Sharing Agreements). 222 The specific individual case may constitute a relocation of functions though, in which in principle the treatment as a transfer package under § 1 (3) sent. 9 Foreign Tax Act must apply (see opening clauses in § 1 (3) sent. 10 Foreign Tax Act though, recital 69 et seq.). This is the case if the transferring enterprise transfers or provides for use essential intangible assets and benefits (e.g. supplier contacts, knowledge of the market). This may e.g. be carried out by transferring the staff working in the purchasing department of the transferring enterprise (recital 56). Example 11

Appendix

On the valuation for relocations of functions: A domestic enterprise (parent company, a corporation – MG –) has relocated a transfer package to a newly established foreign subsidiary, a corporation (TG). The opening clauses of § 1 (3) sent. 10 Foreign Transaction Tax Act do not apply. The sustainably achieved annual net profit after tax (R) from the relocated function presumably amounts to 600,000 Euros (turnover 28 million Euros) from the perspective of the transferring MG. The acquiring TG anticipates a sustainable achievable net profit after tax amounting to 900,000 Euros (turnover 34 million Euros). The quasi riskfree interest (p) amounts for both enterprises to 4 %, the appropriate risk premium (z) on the interest rate amounts to 5 %. Accordingly, the interest (i) to be applied amounts to 9 %. The domestic tax burden amounts to 30 % and that abroad to 20 %. Individual income taxes remain without consideration in this example (recital 34 et seq.). A) It is furthermore assumed: the capitalization period is unlimited; the transfer package or the parts thereof cannot be depreciated in the foreign jurisdiction; the transferring enterprise has already depreciated all assets of the transfer package to nil. Solution: Assuming an annually constant net profit (R), the earnings value amounts to: Earnings value ðwithout tax on transfer package  step 1Þ ¼

R i

1 The calculations made in all examples are exactly; the results are stated in whole Euro amounts.

358

XI. Relocation of Functions (2010) Minimum price (step 1) 600,000 t 0.09 6,666,667 v

Maximum price (step 1) 900,000 t 0.09 10,000,000 v

The earnings value is calculated under consideration of taxation effects of the remuneration paid for the transfer package (recital 118 regarding the minimum price; recital 125 regarding the maximum price) as follows: Earnings value ðstep 2Þ ¼

Earnings value ðwithout tax on transfer packageÞ 1  Tax burden

Minimum price (step 2) 6,666,667 t 1 – 30 % 9,523,810 v

Maximum price (step 2) Unchanged, as no tax effect for want of depreciation 10,000,000 v

B) It is furthermore assumed: the capitalization period (t) is limited to five years. Tax wise, the transfer package may be depreciated in the foreign jurisdiction within five years. The book values of the assets of the transfer package amount to 1,372,818 Euros at the transferring enterprise. C) It is additionally assumed: the capitalization period (t) is limited to ten years. Tax wise, the transfer package may be depreciated in the foreign jurisdiction within seven years. The book values of the assets of the transfer package amount to 2,265,056 Euros at the transferring enterprise. Solution: Assuming an annually constant net profit (R), the earnings value amounts to: Earnings value ¼

T X t¼1

Rt ð1 þ iÞt

Earnings value = sum of all earnings during a particular period of the years 1 – T T

= calculation period

t

= index of the period

Rt

= net profit after tax of the year t, t = 1, 2, …, T

Under the capitalized earnings method, the minimum price (step 1) of the transferring MG amounts to: Case B Minimum price ðstep 1Þ ¼

T X t¼1

Minimum price ðstep 1Þ ¼

5 X t¼1

Minimum price (step 1)

Rt ð1 þ iÞt

600; 000 t ð1 þ 0:09Þt 2,333,791 v

Case C T X t¼1

10 X t¼1

Rt ð1 þ iÞt

600; 000 t ð1 þ 0:09Þt 3,850,595 v

359

D. Administrative Guidelines The earnings value with respect to the minimum price is calculated under consideration of taxation effects of the remuneration paid (minimum price step 2) for the transfer package (recital 118) as follows: Earnings value ðstep 2Þ ¼

Minimum price ðstep 1Þ  Tax rate  book value 1  Tax rate Case B

Minimum price ðstep 2Þ ¼

Case C

2; 333; 791 t  30%  1; 372; 818 t 3; 850; 595 t  30%  2; 265; 056 t 1  30% 1  30%

2,745,636 v

Minimum price (step 2) =

4,530,111 v

Under the capitalized earnings method, the maximum price (step 1) of the acquiring TG is calculated as follows: Case B Maximum price ðstep 1Þ ¼

T X t¼1

Maximum price ðstep 1Þ ¼

5 X t¼1

Maximum price (step 1)

Case C T X

Rt ð1 þ iÞt

Rt ð1 þ iÞt

t¼1

10 X

900; 000 t 1:09t

900; 000 t 1:09t

t¼1

3,500,686 v

5,775,892 v

The earnings value with respect to the maximum price is calculated under consideration of taxation effects of the remuneration paid (maximum price step 2) for the transfer package (recital 125) as follows: Case B

01

02

03

04

05

0.200

0.200

0.200

0.200

0.200

9%

9%

9%

9%

9%

Present value factor

0.917

0.842

0.772

0.708

0.650

Present value of the depreciation rate

0.183

0.168

0.154

0.142

0.130

Depreciation rate (20 %) Interest rate

Corporate tax (foreign jurisdiction)

20 %

20 %

20 %

20 %

20 %

Tax savings of depreciation

0.037

0.034

0.031

0.028

0.026

Tax savings (total)

0.1556

The tax savings (total) has to be converted as follows to a premium rate on the maximum price (step 1) in order to determine the maximum price (step 2): Premium rate

= = =

1/(1 – tax savings (total)) 1/(1 – 0.1556) 1.1843

Maximum price (step 1)

3,500,686 t

x Premium rate

x 1.1843

Maximum price (step 2)

4,145,699 v

360

XI. Relocation of Functions (2010) Case C

01

02

03

04

05

06

07

0.143

0.143

0.143

0.143

0.143

0.143

0.143

9%

9%

9%

9%

9%

9%

9%

Present value factor

0.917

0.842

0.772

0.708

0.650

0.596

0.547

Present value of the depreciation rate

0.131

0.120

0.110

0.101

0.093

0.085

0.078

Corporate tax (foreign jurisdiction)

20 %

20 %

20 %

20 %

20 %

20 %

20 %

Tax savings of depreciation

0.026

0.024

0.022

0.020

0.019

0.017

0.016

Depreciation rate (14.3 %) Interest rate

Tax savings (total)

0.1439

The tax savings (total) has to be converted as follows to a premium rate on the maximum price (step 1) in order to determine the maximum price (step 2): Premium rate

= = =

1/(1 – tax savings (total)) 1/(1 – 0.1439) 1.1681

Maximum price (step 1)

5,775,892 t

x Premium rate

x 1.1679

Maximum price (step 2)

6,745,951 v

For want of other indication, the mean value of the range of mutual consent shall be applied (recital 129). Minimum price (step 2) Maximum price (step 2) Mean value

= = =

Case A 9,523,810 t 10,000,000 t 9,761,905 v

Case B 2,745,636 t 4,145,699 t 3,445,688 v

Case C 4,530,111 t 6,745,951 t 5,638,031 v

I. Variation to Case A (Determination of the license rate, distribution pursuant to recital 98) The transfer package consists of three production facilities and four individual machines as well as of two intangible assets. The arm’s length market price for the production facilities and the individual machines indisputably amounts to 761,905 Euros. The tangible assets shall be relocated to the acquiring enterprise. The intangible assets however, are only provided for use. For purposes of simplification it is assumed for the calculation that the rate for capitalization of 9 % (both for the calculation of the range of mutual consent and the calculation of the license rate) correctly reflects the risk profile for the licensor and the licensee (recital 104 et seq.).

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D. Administrative Guidelines

In order to determine the license rate of the intangible assets, the arm’s length market prices for the production facilities and the individual machines at the time of the relocation of functions (761,905 Euros) must be deducted from the mean value determined in case A (9,761,905 Euros) as these were relocated. Accordingly, at the time of the relocation of functions a license payment that is be claimed annually in the amount of 810,000 Euros (present value of the license of 9,000,000 Euros × capitalization interest rate of 9 %) results. With reference to a turnover in the amount of 34 million Euros that is permanently anticipated (see facts), a license rate of rounded 2.4 % results thereof (810,000 Euros/34,000,000 Euros = 0.024).

II. Variation to case B (Price adjustment clause) During the audit of the years 01 to 05 the tax auditor determines that TG – deviating from the original planning documents – has achieved an actual net profit after tax annually amounting to 1,300,000 Euros. The parties (MG and TG) neither arranged for any price adjustment clause nor license agreement. The taxpayer was unable to disprove the statutory assumption (§ 1 (3) sent. 11 Foreign Transaction Tax Act) that at the time of the conclusion of the business transaction uncertainties with respect to the price agreement existed and that unaffiliated third parties would have agreed on an appropriate adjustment clause. Based on the actual profit development of TG, a new maximum price (step 2) in the amount of 5,988,232 Euros is derived (calculation in accordance with the illustration above regarding case B). The mean value of the new range of mutual consent (2,745,636 Euros to 5,988,232 Euros) amounts to 4,366,934 Euros and thus lies outside the original range of mutual consent (2,745,636 Euros to 4,145,699 Euros). Hence, a substantial deviation (recital 138 et seq.) is present.

Example 21 Valuation for relocations of functions in estimation cases The domestic enterprise (P) maintains two production sites in Germany, one for paper handkerchiefs and one for toilet paper. The products are distributed worldwide. In the course of the tax audit during the year 2005 (tax audit period 2002 to 2004) the tax auditor establishes that the production site that previously had produced paper handkerchiefs was closed down on December 31, 2003. As of January 1, 2004, the paper handkerchiefs are produced by the newly established foreign subsidiary (T), a corporation, and distributed worldwide. In 2004, the production and the distribution of toilet paper remained in the domestic territory. 362

XI. Relocation of Functions (2010)

As stated in the annual financial statements furnished to the tax auditor, the net profit after tax of P has developed as follows:

Net profit after tax

2001

2002

2003

2004

2,000,000 t

2,000,000 t

1,900,000 t

1,000,000 t

The net profit after tax (R) includes the closing costs (100,000 Euros in the year 2003). After the investigation made by the tax auditor, the net profit after tax of T is presented as follows: 2004 In national currency In Euro

12,500,000 1,250,000

P did not provide any further documents. As P is unable to furnish any sufficient calculations for the valuation despite recognizable efforts to cooperate and the submission of all available documents that altogether are usable, the tax auditor estimates the value of the relocation of functions as of January 1, 2004 under § 162 (2) General Fiscal Code. Based on the actual figures encountered, he makes the following observation: Minimum price of the transferring enterprise: Net profit after tax prior to relocation of functions, adjusted for closing costs

2,000,000 t

Net profit after tax after relocation of functions

1,000,000 t

Net profit of the function (R)

1,000,000 t

In absence of other information, the tax auditor assumes that the difference in the amount of 1,000,000 Euros which is due from the relocation of functions may be updated in this manner in the future. In estimation cases an unlimited capitalization period is assumed for want of other indication (recital 171). The risk-free basic interest rate (p) as of January 1, 2004 is derived by the tax auditor from the yield curve for zero bonds of the German Federal Bank (here: 3.14 %). In estimation cases, the risk premium (z) simplified complies with 50 % of the risk-free interest rate, yet at least 3 % (recital 170). 50 % of 3.14 % are 1.57 %; accordingly, the minimum risk premium of 3 % has to be applied. Thus, all risks including political risks, currency and inflation risks are covered. Based on the initial value (6.14 %), the domestic nominal tax rate of 30 % (recital 170) must be deducted so that an applicable interest rate (i) of 4.298 % is yielded.

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R

1,000,000 t

–––––––––

–––––––––

i

4.298 %

Minimum price without closing costs

=

23,266,636 t

Plus closing costs

+

100,000 t

Minimum price by incorporating closing costs

=

23,366,636 t

Minimum price without closing costs

As the transferring enterprise is obliged to include also in its maximum price consideration the tax burden of the remuneration for the transfer package (recital 118), the minimum price is increased by lump-sum 15 % (recital 163) because no respective evidence has been provided by the taxpayer. Accordingly, the minimum price under consideration of the tax burden of the remuneration for the transfer package amounts to 26,871,631 Euros (23,366,636 Euros plus 15 %). Maximum price of the acquiring enterprise: In order to determine the maximum price of T, the tax auditor may employ the domestic risk-free interest and the respective risk premium after having converted the foreign net profit to Euro (recital 170). At the time of the relocation of functions, ten units of the national currency shall comply with 1 Euro under the official exchange rate. This shall also correspond with the average exchange rate of the year 2004. The maximum price of the acquiring enterprise (T) is calculated as follows:

Maximum price

Maximum price

R

1,250,000 t

–––––––––

–––––––––

i

4.298 %

=

29,083,295 t

As the acquiring enterprise is also obliged to include in its maximum price consideration the tax benefits from the depreciation option of the remuneration for the transfer package (recital 125), the maximum price is increased by lump-sum 15 % (recital 163) because no further evidence has been furnished by the taxpayer to that extent. Accordingly, the maximum price under consideration of the tax burden of the remuneration for the transfer package amounts to 33,445,789 Euros (29,083,295 Euros plus 15 %).

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Range of mutual consent: Hence, a range of mutual consent ranging from 26,871,631 Euros (minimum price) to 33,445,789 Euros (maximum price) is derived. As no reasons for a specific value within the range of mutual consent can be shown credibly or are otherwise evident, the estimation shall be based on the mean value 30,158,710 Euros of the range of mutual consent. Variation (Estimation under § 162 (3) sent. 3 General Fiscal Code) Domestic P and foreign T each are a 100 % subsidiary of the foreign group (K). For the rest, the facts remain the same except for the fact that P does not furnish any documents of T regarding the net profit after tax. P declares that it is not provided with any documents by K, solely the net profit after tax amounting to 12,500,000 in national currency has been announced by telephone. The tax office unsuccessfully requests the cooperation of K (§ 93 (1) General Fiscal Code). The tax auditor determines (as above) the minimum price of P amounting to 26,871,631 Euros and the maximum price of T in the amount of 33,445.789 Euros. As K did not provide any documents for T, there is considerable doubt that the net profit after tax of T is correct. This is prompted by the fact that K has not complied with its cooperation duties under § 90 (2) General Fiscal Code (§ 162 (3) sent. 3 General Fiscal Code). Under § 162 (3) sent. 2 General Fiscal Code, the value of the transfer package shall be estimated at the maximum price within the range of mutual consent, i.e. in the amount of 33,445,789 Euros.

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XII. Intercompany Loans (2011) Administrative Circular on the Application of § 1 Foreign Tax Act to Cases of Write-Down to Going Concern Value and Other Depreciations on Loans to Affiliated Foreign Companies Published on March 29, 2011 (IV B 5 – S 1341/09/10004, 2011/0203248, Federal Tax Gazette 2011 I p. 277)

With regard to the results of the discussion with the highest tax authorities of the Federal States, the following is valid regarding the application of § 1 Foreign Tax Act to cases of write-downs to going concern value and other depreciations on loans to affiliated foreign companies: Content 1. Preface. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2. Impact of § 1 Foreign Tax Act where cross-border loans are granted . 3. Basic case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1 Granting of the loan, interest rate . . . . . . . . . . . . . . . . . . . . . . 3.2 Adjustment of a write-down to going concern value under § 1 Foreign Tax Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4. Modification I . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.1 Granting of the loan. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2 Adjustment of a write-down to going concern value under § 1 Foreign Tax Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5. Modification II . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.1 Adjustment on trade receivables . . . . . . . . . . . . . . . . . . . . . . . 5.2 Granting of a loan through receivables that “remain outstanding” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6. Granting of loans within the group under other circumstances . . . . . 6.1 Write-down to going concern value where a loan is granted to an uncontrolled enterprise . . . . . . . . . . . . . . . . . . . . . . . . . 6.2 Write-down to going concern value where an unsecured loan is granted to a controlling enterprise. . . . . . . . . . . . . . . . . . . . . . 6.3 Write-down to going concern value where an unsecured loan is granted to a fellow subsidiary . . . . . . . . . . . . . . . . . . . . . . . . . 7. Application provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . .

. . . .

366 368 369 369

. . 370 . . 371 . . 371 . . 371 . . 372 . . 372 . . 372 . . 373 . . 375 . . 375 . . 375 . . 377

1. Preface 1 In its decision dated January 14, 2009, I R 52/08 (Federal Tax Gazette II p. 674), the Federal Fiscal Court established that write-downs to going concern value on so-called loans substituting equity do not constitute any reduction in profit not to be considered within the meaning of § 8b (3) Corporate Income Tax Act 2002 (in the version prior to the amendment 366

XII. Intercompany Loans (2011)

by the Annual Tax Act 2008 of December 20, 2007, Federal Tax Gazette 2008 I p. 218). Consequently, § 8b (3) sent. 3 Corporate Income Tax Act 2002 no longer applies to write-downs to going concern value on loans substituting equity. According to the opinion of the Federal Fiscal Court, the provision exclusively refers to write-downs to going concern value relating to the substance of the respective share and not any expenses economically connected to the share. Loans substituting equity constitute independent contractual obligations to be differentiated from the actual participation irrespective of their inducement by the shareholding relationship. According to the opinion of the Federal Fiscal Court, the amendment of § 8b (3) Corporate Income Tax Act by sentences 4 to 7 under the Annual Tax Act 2008 has a constitutive effect. 2 The aforementioned decision of the Federal Fiscal Court related to a domestic issue and left the question unanswered whether in comparable cases the granting of a loan to an affiliated foreign company would require making an adjustment under § 1 Foreign Tax Act. This circular takes a stand on the question of how to apply the provision of § 1 Foreign Tax Act in comparable cases. 3 In general, the principles set forth below are valid when applying § 1 Foreign Tax Act: – Under § 1 (1) Foreign Tax Act, adjustments shall be made to the taxpayer’s income from a foreign business relationship with an affiliated person (§ 1 (2) Foreign Tax Act) in cases where the income of the taxpayer had been reduced because he had based his income determination on different conditions, in particular different prices (transfer prices), than such on which third parties would have agreed under same or similar conditions (arm’s length principle). As regards content, this complies with the phrasing of double taxation agreements concluded by Germany that in turn correspond with art. 9 (1) OECD Model Tax Convention. – Pursuant to § 1 (1) sent. 1 Foreign Tax Act, § 1 Foreign Tax Act applies irrespective of other provisions, e.g. on the hidden profit distribution or hidden capital contribution (§ 8 (3) Corporate Income Tax Act). This means that notwithstanding the fulfillment of the facts of § 1 (1) sent. 1 Foreign Tax Act, no adjustment shall be made under this provision if, based on other provisions, legal consequences arise that give rise to an arm’s length result within the meaning of § 1 Foreign Tax Act (see also § 1 (1) sent. 3 Foreign Tax Act regarding competition). – Under § 1 (1) sent. 3 Foreign Tax Act, the legal consequences of § 1 Foreign Tax Act shall take effect exceeding the legal consequences of the other provisions, to the extent § 1 Foreign Tax Act provides for further adjustments than the other provisions.

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D. Administrative Guidelines

– Under § 1 (5) Foreign Tax Act, any other contractual relationship that does not constitute a stipulation under the terms of a company agreement represents a “business relationship” to which the arm’s length principle applies. – In contrast to the legal consequences of other provisions, it is the legal consequence of § 1 Foreign Tax Act that the income of the taxpayer shall be determined in the amount that would have been generated had – in relation to the affiliated person – arm’s length conditions and prices been agreed and set, respectively. 4 The provisions of this circular also apply if a natural person or a business partnership grants a cross-border loan to an affiliated person within the meaning of § 1 (2) Foreign Tax Act. 5 The principles of the circular of the Federal Ministry of Finance of February 25, 2000 (Federal Tax Gazette I p. 372) as well as those of the circular of the Federal Ministry of Finance of March 26, 2009 (Federal Tax Gazette I p. 514) apply to the write-down to going concern value when determining profits for income purposes. Provisions on the permissibility of write-downs to going concern value for tax accounting purposes, the application of § 3c Income Tax Act1, hidden capital contributions or hidden profit distributions, and withdrawals and contributions are not the objective of this circular. It shall only be referred to such questions for differentiation purposes in relation to § 1 Foreign Tax Act.

2. Impact of § 1 Foreign Tax Act where cross-border loans are granted 6 Where the granting of a loan constitutes the objective of the cross-border business relationship, the arm’s length prerequisites do not only include the agreed interest rate (transfer price) but all circumstances relating to the granting of the loan that would also be material to third parties (sec. 4.2.2 of the Administrative Circular on the Guidelines for the Examination of the Income Allocation Between Internationally Affiliated Enterprises; circular of the Federal Ministry of Finance of February 23, 1983, Federal Tax Gazette I p. 218). Accordingly, the interest rate (transfer price) to be applied under § 1 (1) Foreign Tax Act must comply with the interest rate that third parties being in the situation of the affiliated person would have agreed under consideration of all material conditions to be determined. The respective conditions also include securities at arm’s length. 7 When it is already evident at the time the loan is granted that, based on the economic situation of the borrower, the distribution of the amount is not connected with an actual obligation for redemption despite the contractual description and the showing in the accounts as “loan”, i.e. the re1 As regards the application of § 3c (2) Income Tax Act to domestic issues, refer to circular of the Federal Ministry of Finance of November 8, 2010, Federal Tax Gazette I p. 1292.

368

XII. Intercompany Loans (2011)

demption by the borrower is a priori objectively impossible or may most likely be ruled out, this does not alter the fact that this constitutes a “business relationship” under § 1 (5) Foreign Tax Act to which the arm’s length principle shall apply even though the legal consequences of other provisions take precedence.

3. Basic case Granting of a loan by a domestic controlling partner to an affiliated foreign company with which no business relations exist exceeding the loan relationship 3.1 Granting of the loan, interest rate 8 The granting of a loan by a controlling shareholder (H 36 III “controlling shareholder” Corporate Income Tax Notes) to his corporation may be arranged as follows: a) The granting of the loan is made by agreeing on a factual security. The agreed interest rate takes such security into account. b) The granting of the loan is made without agreeing on a factual security. The absent security shall be taken into account through an appropriate risk premium on the interest rate. c) The granting of the loan is made without agreeing on a factual security. A risk premium on the interest rate considering the absent security shall not be made due to the support within the group. 9 Cases a) and b) of recital 8 regularly comply with the arm’s length principle if the agreed interest rate has been determined under consideration of the principles set forth in recital 6. 10 Pursuant to the decisions of the Federal Fiscal Court (decisions of December 21, 1994, I R 65/94, Magazine of the Federal Fiscal Court Decisions 176, 571, High Court Financial Decisions (HFR) 1995, p. 445 and of October 29, 1997, I R 24/97, Federal Tax Gazette 1998 II p. 573), under case c) of recital 8 – support within the group – it is compatible with the arm’s length principle that no securities are agreed when a loan is granted within the group as the group relationship (“support”), seen by itself, provides for sufficient security. According to the opinion of the Federal Fiscal Court, the lack of a factual security does not result in an adjustment of the interest rate, i.e. the support within the group shall be acknowledged as security at arm’s length when examining the interest rate. 11 It shall be assumed that support within the group exists, provided that the controlling partner actually guarantees the solvency of the subsidiary (borrower) towards third parties (in the external relationship) and provided that the subsidiary fulfills its obligations in the external relationship, respectively. As long as the support within the group actually 369

D. Administrative Guidelines

exists to that extent, it is in principle assumed that it is provided for sufficient security that justifies accepting an interest rate during the term as it is agreed for secured loans under consideration of the principles set forth in recital 6 (see recital 15 regarding exemptions). 3.2 Adjustment of a write-down to going concern value under § 1 Foreign Tax Act 12 In case the conditions of the granting of the loan under cases a) and b) of recital 8 comply with the arm’s length principle (recital 9), a writedown to going concern value potentially permissive for tax accounting purposes shall also be accepted for the application of § 1 Foreign Tax Act if, like an unaffiliated sound and prudent business manager, the lender has provided for all possibilities for securing his claims during the term. § 1 (1) sent. 2 Foreign Tax Act has to be observed as regards business years ending after January 1, 2008. 13 As regards the application of § 1 Foreign Tax Act (arm’s length conditions) in cases of c) of recital 8, the support within the group shall in principle be considered as a continuous security at arm’s length regardless of a write-down to going concern value potentially permissive for tax accounting purposes, provided that the borrower fulfills his economic obligations in the external relationship. If the support within the group actually continues as a recoverable security towards third parties, this shall apply also to the respective loan relationship within the group. In such a case, there is no scope available regarding a write-down to going concern value under § 6 (1) no. 2 sent. 2 Income Tax Act as the redemption claim (loan) shall not be regarded as jeopardized, provided that the support within the group exists. A write-down to going concern value that had been made notwithstanding must be reversed due to the absence of the prerequisites of § 6 (1) no. 2 sent. 2 Income Tax Act. To that extent, § 1 Foreign Tax Act ranks inferior to the legal consequences of § 6 (1) no. 2 sent. 2 Income Tax Act; reference is made to § 1 (1) sent. 1 Foreign Tax Act (see recital 3). 14 This applies also to an actual reduction in profit that originates under comparable circumstances from waiving a loan. 15 By arguing specific circumstances, the taxpayer is at liberty to refer to the fact that, at the time of the write-down to going concern value potentially permissive for tax accounting purposes, the support within the group can actually no longer be obtained. This is for instance the case if: – the controlling shareholder does not ensure that the borrower fulfills his external obligations towards third parties; – the controlling shareholder actually does not warrant the support within the group towards a third party that had, based on the support within the group, granted a loan without any factual security to an affiliated company; or 370

XII. Intercompany Loans (2011)

– from the economic situation of the controlling shareholder or the group altogether it may be recognized that based on the support within the group no payments would and could be made. Where, at the time of the write-down to going concern value, the support within the group in fact no longer exists yet originally had existed, it must be examined whether and, where applicable, when it would have been recognizable for a third party being in the situation of the lender that the support within the group was doubtful and whether at that time other security options would have been available to which a sound and prudent business manager could have referred. § 1 (1) sent. 2 Foreign Tax Act has to be observed regarding business years ending after January 1, 2008. 16 If the support within the group does in fact and verifiably not exist any more at the time of a write-down to going concern value potentially permissive under tax accounting regulations (e.g. insolvency of the borrower actually occurred in the external relationship, see recital 15), in the absence of securities the write-down to going concern value shall also be acknowledged under § 1 Foreign Tax Act if a third party would have had neither cause nor the option to take security measures between the granting of the loan and the write-down to going concern value.

4. Modification I Granting of a loan by a domestic controlling shareholder to an affiliated foreign company with which further business relations (exchange of goods and services) exist 4.1 Granting of the loan 17 The general provisions of recitals 8 to 11 apply. In order to examine the question whether the granting of the loan and the conditions for its approval comply with the arm’s length principle, it must as a rule be examined whether the further business relations have any impact on the arm’s length character of the agreed conditions of the loan contract or whether and in what manner the granting of the loan is economically related to the further business relations. Moreover, as regards the application of the arm’s length principle when examining the interest rate, the presence of the support within the group (recital 13) shall generally be assumed as a security at arm’s length when in comparable cases third parties would have agreed on a factual security. 4.2 Adjustment of a write-down to going concern value under § 1 Foreign Tax Act 18 If in the cases of Modification I that correspond to case c) of recital 8 the presence of the support within the group has to be assumed for the application of § 1 Foreign Tax Act because the borrower fulfills his obligations in the external relationship, a write-down to going concern value po371

D. Administrative Guidelines

tentially permissive under tax accounting regulations does not comply with the arm’s length principle (see recital 13). Pursuant to § 1 (1) Foreign Tax Act, it has to be adjusted outside the balance sheet unless the taxpayer refers to circumstances within the meaning of recital 15. 19 Where the taxpayer waives the loan and where third parties would also have waived the loan notwithstanding an agreement on a factual security, e.g. in order to safeguard the economic existence of the borrower and the factual deliveries of goods and services in which there is a predominant business interest, the waiver of the loan does not result in an adjustment under § 1 Foreign Tax Act, i.e. the waiver shall also be acknowledged under § 1 Foreign Tax Act.

5. Modification II Claims from ongoing business relations (trade receivables) of a domestic controlling shareholder to an affiliated, foreign company to the extent the claims are not redeemed according to the agreed on payment terms at arm’s length 20 At the time when deliveries or services are agreed, the conditions agreed on (e.g. payment terms, reservation of title) must be reviewed with respect to their compatibility with the arm’s length principle. Unless a crisis is foreseeable, a security exceeding the reservation of title is regularly not at arm’s length regarding ongoing business relations. 5.1 Adjustment on trade receivables 21 In principle, adjustments on trade receivables potentially permissive under tax accounting regulations comply with the arm’s length principle, provided that third parties being in the situation of the controlling shareholder would also have carried out an adjustment for want of any security (recital 20). In this context, it has to be considered that, in case the payment default occurs permanently, third parties would only continue with the business relation if at least the payment for future deliveries and services was safeguarded. Once the imminent payment default is distinguishable, recitals 22 to 25 apply. 5.2 Granting of a loan through receivables that “remain outstanding” 22 In case trade receivables “remain outstanding” after the due date and pursuant to the arm’s length principle the granting of a loan is to be assumed, e.g. because the domestic parent enterprise has waived a potential collection or other security measures and the business relationship is nevertheless continued unmodified, pursuant to recitals 8 to 11 the presence of the support within the group shall be assumed for the application of § 1 Foreign Tax Act as regards the examination of the interest rate, unless a factual security is established. 372

XII. Intercompany Loans (2011)

23 If the presence of the support within the group shall be assumed for the application of § 1 Foreign Tax Act because the borrower fulfills his obligations in the external relationship, a write-down to going concern value potentially permissive under tax accounting regulations shall be adjusted in accordance with recital 13 outside the balance sheet pursuant to § 1 (1) Foreign Tax Act, unless the taxpayer refers to circumstances within the meaning of recital 15. 24 Where the taxpayer waives the loan (the trade receivables that “remain outstanding”) and provided that third parties would have waived the receivables in spite of having agreed on a factual security (e.g. in order to safeguard the economic existence of the borrower and the factual deliveries of goods and services in which there is a predominant business interest), the waiver of the loan does not result in an adjustment pursuant to § 1 Foreign Tax Act, i.e. the waiver shall also be acknowledged under § 1 Foreign Tax Act. 25 If, notwithstanding the requirement to carry out an adjustment, in the cases of recital 21 the business relations are continued without any amendments of the agreements, considering the specific circumstances of the case it must in addition be examined whether the continued business relationship still complies with the arm’s length principle. Where this is not the case, adjustments under § 1 Foreign Tax Act have to be to the extent no adjustments must be made under any other provisions (recital 3).

6. Granting of loans within the group under other circumstances 26 The following basic cases may for instance be associated with the granting of loans within the group that are not made by the controlling shareholder to a subordinate affiliated foreign company: – Granting of a loan by a domestic corporation that does not assume a controlling shareholder position to an affiliated foreign company, recitals 28 and 29; – Granting of a loan by a domestic corporation to a foreign higher-ranking enterprise or a foreign shareholder, recital 30; – Granting of a loan by a domestic corporation to a foreign fellow subsidiary (triangular cases), recitals 31 and 32. 27 Pursuant to the case law of the Federal Fiscal Court (decision of March 14, 1990, I R 6/89, Federal Tax Gazette II p. 795), in the cases of recital 26 it is in general not in accordance with the arm’s length principle if the granting of the loan is made without a sufficient factual security. The principles of the decisions of the Federal Fiscal Court of December 21, 1994, I R 65/94 (Magazine of Federal Fiscal Court Decisions 176, 571, High Court Financial Decisions (HFR) 1995, p. 445) and of October 29, 1997, I R 24/97 (Federal Tax Gazette 1998 II p. 573) on sufficient security 373

D. Administrative Guidelines

based on a degree of influence (see recital 10) are not applicable to that extent under the case law of the Federal Fiscal Court (decision of October 8, 2008, I R 61/07, Federal Tax Gazette 2011 II p. 62). It shall be distinguished as follows: – In order to apply the arm’s length principle, in the cases of recital 26 an arm’s length interest rate that, where applicable, may include a risk premium must in principle be applied to take into account the absence of a factual security (see recital 6). – Where, in the cases of recital 26, an absent factual security cannot be compensated by an arm’s length risk premium because third parties would not have granted a comparable loan – not even at a higher interest rate – e.g. due to an insufficient solvency, the loan does not comply with the arm’s length principle. Yet, even if such granting of a loan is induced by the shareholding relationship, for want of a contractual agreement it mandatorily continues to constitute a business relationship for the application of § 1 Foreign Tax Act, so that arm’s length conditions have to be presumed. With respect to the determination of the interest rate at arm’s length, in such cases the presence of a security at arm’s length must be assumed for the entire term in order to justify the respective interest rate during the term. Example: The domestic corporation (K) holds 40 % of the shares in the foreign corporation (T); the remaining shares of T are held by four persons that are not affiliated with K within the meaning of § 1 (2) Foreign Tax Act. In the year 01, K grants to T a loan amounting to 1,000,000 Euros. The agreed on interest rate amounts to 5 % for a term of ten years. It is not agreed on a security at arm’s length. The tax audit undisputedly determines that under comparable circumstances third parties would only have agreed on a loan bearing an interest rate of 5 % had they simultaneously agreed on a recoverable security. Under the actually given circumstances, a comparable granting of a loan without any agreement on a security cannot be considered in the absent of a sufficient solvency of T. Accordingly, a risk premium at arm’s length on the stipulated interest rate cannot be determined for want of comparable facts. Solution: The conditions of the granting of the loan by K to T do not comply with the arm’s length principle under § 1 Foreign Tax Act. In addition, under the given circumstances sound and prudent business managers independent from one another would not have reached any loan agreement. In order to maintain the business relations without any changes to the greatest extent possible, the stipulated interest rate for secured loans (5 %) shall be acknowledged. Accordingly, the application of the arm’s length principle requires the presumption that a security at arm’s length has been granted. This shall be documented. A subsequent write-down to going concern value on the loan that may potentially be permissive under tax accounting regulations shall be adjusted under § 1 Foreign Tax Act as, in accordance with the arm’s length principle, a security that is both at arm’s length and recoverable has to be assumed.

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6.1 Write-down to going concern value where a loan is granted to an uncontrolled enterprise 28 Where the terms of a loan and the agreed on interest rate comply with the arm’s length principle (e.g. interest rate at arm’s length in cases of security at arm’s length; interest rate includes risk premium that takes into account an absent factual security) while notwithstanding a writedown to going concern value potentially permissive under tax accounting regulations has to be carried out, no adjustment under § 1 Foreign Tax Act is possible, especially if in a comparable situation a third party as the borrower would have had neither cause nor the option to take any security measures between the granting of the loan and the write-down to going concern value. § 1 (1) sent. 2 Foreign Tax Act has to be observed regarding business years ending after January 1, 2008. 29 If a factual security was not agreed and its absence may not be compensated by a risk premium at arm’s length on the interest rate, the loan does not comply with the arm’s length principle. The need for depreciation would not have arisen if arm’s length conditions had been stipulated (see recital 6). Accordingly, a write-down to going concern value potentially permissive under tax accounting regulations shall be adjusted under § 1 (1) Foreign Tax Act (see recital 27). 6.2 Write-down to going concern value where an unsecured loan is granted to a controlling enterprise 30 Where a write-down to going concern value potentially permissive under tax accounting regulations is carried out on a loan on behalf of the subsidiary that has granted the loan to a controlling enterprise, pursuant to the case law of the Federal Fiscal Court this represents a hidden profit distribution in the amount of the write-down to going concern value under § 8 (3) Corporate Income Tax Act to the controlling enterprise (decisions of the Federal Fiscal Court of March 14, 1990, I R 6/89, Federal Tax Gazette II p. 795 and of July 14, 2004, I R 16/03, Federal Tax Gazette II p. 1010) because the loan has only been granted without any security based on the shareholding relationship. To that extent, § 1 Foreign Tax Act ranks inferior to the legal consequences of the hidden profit distribution. 6.3 Write-down to going concern value where an unsecured loan is granted to a fellow subsidiary 31 If an unsecured loan is granted by a domestic corporation to an affiliated foreign fellow subsidiary (triangular case), the write-down to going concern value on the loan receivable that may potentially be permissive under tax accounting regulations results in assuming a hidden profit distribution in the amount of the depreciation at the level of the borrower. In this case, the legal consequences of § 1 Foreign Tax Act rank inferior to 375

D. Administrative Guidelines

those of § 8 (3) Corporate Income Tax Act (§ 1 (1) sent. 1 Foreign Tax Act) because pursuant to the arm’s length principle, the hidden profit distribution results in an adjustment in the same amount. The shareholder shall receive the hidden profit distribution in the amount of the nominal value of the loan receivable when the borrower has waived the loan receivable. A hidden capital contribution at the level of the borrower shall also take place in the amount of the nominal value of the loan receivable. The principles of the decision of the Great Senate on the waiver of debts in the decision of the Federal Fiscal Court of June 9, 1997, Great Senate 1/94, Federal Tax Gazette 1998 II p. 307 (i.e. the inflow of the loan and the hidden capital contribution in the amount of the recoverable part) cannot be applied as the claim on which the waiver of the loan is based is itself already induced by the shareholding relationship. Example: In the year 01, a domestic enterprise (TG 1) grants a loan (100) to a domestic fellow subsidiary (TG 2) together with a mutual domestic shareholder (MG, each holding 100 %) without giving any security, i.e. not at arm’s length within the meaning of recital 27. In the year 05, TG 1 performs a full write-down to going concern value in the amount of 100; in the year 07, TG 1 waives the loan permanently. Solution: a) Adjustment under § 8 (3) sent. 2 Corporate Income Tax Act at the level of TG 1 Due to the absent actual reduction of assets, the granting of the loan in 01 does not result in any hidden profit distribution at the level of TG 1. The redemption of the loan by TG 2 is objectively possible at the time the loan is distributed. As the granting of the loan in the triangular case presented is made by TG 1 to its foreign fellow subsidiary TG 2 and not directly by the parent enterprise to its subsidiary, the principles of the case law of the Federal Fiscal Court on the support within the group (decision of the Federal Fiscal Court dated October 29, 1997, I R 24/97, Federal Tax Gazette 1998 II p. 573) cannot be applied (decision of the Federal Fiscal Court of March 14, 1990, I R 6/89, Federal Tax Gazette II p. 795). For it does not comply with the arm’s length principle that, based on the support within the group, no securities had been agreed in the course of the intra-group granting of that particular loan. Based on the absent loan security, the granting of the loan in 01 is already induced by the shareholding relationship; however, a hidden profit distribution under § 8 (3) sent. 2 Corporate Income Tax Act does not exist as not all elements have been fulfilled. As a result of a write-down to going concern value permissive under tax accounting regulations and the actual reduction of assets that thus occurred in 05, under § 8 (3) sent. 2 Corporate Income Tax Act a hidden profit distribution and an income adjustment at the level of TG 1 will take place in the same year. b) Inflow at the levels of MG and acquisition costs of the shares held in TG 2 At the time the loan is waived in 07, an inflow of the hidden profit distribution in the amount of 100 will occur. The inclusion shall be made at the full loan amount (100). A lower inclusion only in the amount of the part that is still recoverable is inapplicable as the nominal value has actually been received by TG 2. The acquisition costs on the shares held in TG 2 will increase in the same amount. To the extent a write-down to going concern value on the increased acquisition costs has to be made, due to § 8b (3) sent. 3 Corporate Income Tax Act it shall not take effect for tax purposes.

376

XII. Intercompany Loans (2011) c) Hidden capital contribution at the level of TG 2 In addition, in 07 a hidden capital contribution is made in the amount of the nominal value of the loan receivable (=100). Corresponding to the statements made under b), the inclusion shall also be made at the nominal value of the loan receivable as the nominal value has actually been received by TG 2. The principles of the decision of the Great Senate on the remission of debts in the decision of the Federal Fiscal Court of June 9, 1997, Great Senate 1/94, Federal Tax Gazette 1998 II p. 307 (i.e. the inflow of the loan and the hidden capital contribution in the amount of the recoverable part) cannot be applied, as the claim on which the waiver of the loan is based is itself already induced by the shareholding relationship.

32 When it is already evident at the time the loan is granted that, based on the economic situation of the borrower, the distribution of the amount is not connected with an actual obligation for redemption despite the contractual description and the showing in the accounts as “loan” (see recital 7), the distribution of the amount to the fellow subsidiary already represents a hidden profit distribution to the mutual parent company. This also applies if the redemption is a priori objectively impossible or may most likely be excluded (decisions of the Federal Fiscal Court of December 12, 2000, VIII R 62/93, Federal Tax Gazette 2001 II p. 234 and of November 7, 2006, IX R 4/06, Federal Tax Gazette 2007 II p. 372). In such cases, the legal consequences of § 1 Foreign Tax Act rank inferior to those of § 8 (3) Corporate Income Tax Act (§ 1 (1) sent. 1 Foreign Tax Act) because pursuant to the arm’s length principle, the hidden profit distribution results in an adjustment in the same amount.

7. Application provisions 33 To assessment periods prior to 2003, i.e. prior to the adoption of the revised version of § 1 (4) Foreign Tax Act in the version of the Tax Benefit Reduction Act (now: § 1 (5) Foreign Tax Act in the version of the Corporate Tax Reform Act 2008), applies that loans substituting equity that either bear no interest or low interest granted by the controlling enterprise to its foreign subsidiary do not constitute a business relationship within the meaning of § 1 (1) Foreign Tax Act (circular of the Federal Ministry of Finance of January 12, 2010, Federal Tax Gazette I p. 34); to that extent, § 1 Foreign Tax Act does not apply. However, the respective circular of the Federal Ministry of Finance does apply to assessment periods prior to 2003 if the granting of the loan represent a business relationship within the meaning of § 1 (1) Foreign Tax Act in conjunction with § 1 (4) Foreign Tax Act in the version of the Tax Reform Act 1992. 34 This circular shall also apply to assessment periods as of 2003 when the loan had been granted prior to 2003, yet the loan continues to exist as of the assessment period 2003.

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D. Administrative Guidelines

35 As regards assessment periods as of 2008, for corporations the application of § 8b (3) Corporate Income Tax Act in the version of the Annual Tax Act 2008 takes precedence over § 1 Foreign Tax Act to the extent § 1 Foreign Tax Act does not require any further legal consequences.

378

Index accounting tax law 345 accounts receivable 85 adjustment 10, 23 f., 31, 50, 134, 158, 160, 214, 223 ff. administrative bulletin 234, 263 administrative circular 27, 52, 129, 140, 151, 162, 232, 234, 263, 293, 366 administrative guideline 27 ff. advance mutual agreement procedure 234 ff. advance pricing agreement 263 ff. advertising cost 42 advisory commission 256, 258 affiliated parties 30 ff., 181, 190, affiliated person 351 agent 64 aggregation of business transactions 208, 304 allocation key 134 allocation of assets 71 APA 263 ff. application deadline 204, 249 application requirement 269 appropriate adjustment 337 arbitration procedure 227 ff., 234 ff. arm’s length data 168, 195 arm’s length documentation 194 ff. arm’s length prices 47, 50 arm’s length principle 300 arm’s length test 33, 143, 145, 315 assessment notice 245 assessment period 347 assigning enterprise 144 bagatelle arrangement 310 base rate 326 Berry ratio 289 binding effect 279 ff. building site 57, 64, 92 ff., 112 burden of proof 218 business expenses 79 business income 18, 56

business partnership 61, 65, 73, 75, 346 business property 68, 81 business relationship 32 f., 181, 190 business revenues 79 capital allocation method 153 f., 159 capitalization period 327 ff., 345 capitalized earnings value 348 causation principle 143 checklist 168 claims for damages, reimbursement and compensation 334 co-entrepreneurship 181 commercial business partnership 61, 355 commercial service 39, 41 commission agent 205 f., 355 commodities 39 comparability 205 f. comparable profit method 189 comparable uncontrolled price method 41 compensation 24, 334 competent authorities 257 f. competent federal state tax authority 279 compliance report 279 consortium 94 construction material 97 construction project 96 contemporaneous documentation 182 continuing obligation 183 f. contract research 47 f. control and coordination office 98 f. cooperation duties 59 ff., 106, 160, 170 ff., 217 f., 351 coordination office 98 f. cost plus method 41 cost sharing agreement 50, 129 ff., 272 379

Index

creation of a permanent establishment 80 critical assumption 273, 280 f. cross-border relocations of functions 20 ff., 293 ff. currency conversion 76 f. database 196 deadline 185, 240, 249, 264 ff. debt financing 323 delivery of goods and commodities 39 dependent agent 64 determining factor 39 direct method 70 disclosure obligation 176 disposal of a participation 226 dissolution of a permanent establishment 80 f. distribution 30, 224, 354 f. documentation 59 ff. documentation duties 59 ff. domestic adjustment 230 domestic tax law 28, 56, 220 dotation capital 72, 86 double taxation agreement 29, 62, 66 ff., 104, 226, 237 f., 264, 299 duplication of functions 21, 308 f. duties of the tax authorities 166, 218 duty to collect evidence in advance 175 earnings value 348 EEA 152, 157 effective date 182 employer 142 endowment 157 ff. enterprise 61, 101, 106, 123, 127, 144, 284, 303, 316, 328, 375 escape clause 317 ff. estimation 219, 221, 343, 351 EU Arbitration Convention 227 ff., 234 ff. evidence 107, 149, 173, 279 exchange of information 247 extension of the APA 283 380

external comparison 145 extraordinary business transaction 182, 184, 339 Federal Central Tax Office 260, 264 federal state authorities 277, 279 fellow subsidiary 375 financing costs 97 fixed place of business 57, 63 foreign adjustment 230 foreign language 171, 211 Foreign Tax Act 10 ff. foreign tax 226 full distributor 355 functions 191, 293 ff. general administrative expenses 84 General Fiscal Code 3 ff. going concern value 370 ff. goods 39, 346 guarantee 46 head office 73 ff., 96 hidden capital contribution 30 hidden profit distribution 30, 224 hypothetical arm’s length test 145, 315 income adjustment 31 income allocation 28, 30, 33, 50, 143, 148 f. income attribution 13 ff., 189 ff. increased cooperation duties 107, 172 independent agent 64 indirect method 71 installation project 64, 92, 94, 112 installation work 97 insurance companies 89 ff. Insurance Supervisory Authority 90 f. intercompany charge 48 intercompany loan 368 ff. interest 83 interest rate 44, 326, 344, 369

Index

internal business planning 202 internal comparison 245 internal transfer pricing guidelines 208 international exchange of information 247 investigation option 341 investigatory duties 218 joint venture 94 limited taxation 62, 346 liquidation 226 liquidation value 330 loan 368 ff. long-term relationship 183 loss 15, 17 f., 23 f., 96, 331 low tax area 33 management expenses 84 managerial discretion of disposition 337 manufacturer 352 ff. margin share 85 market condition 191 market development 82 f. market penetration costs 42 maximum price 332 mean value 333, 349 medium-sized enterprise 284 members of the pool 130 minimum capital endowment method 155, 159 minimum price 329 ff. multi-year analyses 208 mutual agreement 162 ff. mutual agreement procedure 234 ff. negative apportionment 311 net profit after tax 306 non-compliance 223 non-pool member 132 non-usability of documentation 213

OECD-Model Tax Convention 108, 299 off-balance-sheet adjustment 224 official investigation 166 participation 61, 65, 226 parties subject to cooperation 170 partner 79 permanent establishment 52 ff. permanent representative 58 personnel secondment 140 ff. planning forecast 202 pool member 130 preliminary proceeding 248 preliminary talks (prefiling) 268 premature withdrawal 135 present value 320, 326, 343 price adjustment 207 price adjustment clause 350 procedural principle 243, 252, 257, 276, 282 procedure 50, 106, 227 ff., 234 ff., 259, 268, 276 production 104, 352 ff. profit attribution method 69 profit determination 77, 79 profit forecast 202 profit mark-up 133 profit potential 306 f., 321, 343 profit share 61 f. profit split method 176, 189, 194, 289 profit trend 336 purchasing 357 questionnaire 168 range of mutual consent 329, 333, 349 regional advantage 323 rejection 270, 275 relief 212 relocation of functions 20 ff., 293 ff. repatriation 74

381

Index

repeal 51, 108, 139, 231 reporting 279 request for information, documents, and records 167 resale price method 10, 36, 41 f., 176, 187, 288 research and development 356 restriction of a function 310 retention of documentation 178 retention of records 171 revenue surplus method 76, 79 reversion clause 67 revision of tax return 172 revocation 281 right to appeal 278 right to be heard 228 risks 153, 191 roll back of the APA 282 rotation procedure 146 routine enterprise 316 routine function 186 ff., 316 secondment of personnel 140 ff. services 39, 48, 81, 131, 137, 312, 346, 357 set-off of benefits 36, 148 shipping enterprise 101 simplification provision 157, 159 simplified procedure 284 sound and prudent business manager 348 special document 177 special remuneration 65 standard method 35, 41, 315 start-up costs 43 statute of limitation 245 statutory assumption 220 statutory bases 28 statutory ordinance 13 ff., 20 ff. strategy 324 subcontractor 94 subject-to-tax clause 67 f.

382

submission duties 177, 179 subsequent compensation 226 subsequent pricing 207 supply of goods and services 39 surcharge 221 synergy effect 323 tax audit 246 tax authorities 166, 218, 228, 243, 279 f., 341 tax credit 74 f. tax treatment 148, 223 temporary relocation 304 toll manufacturer 82, 352 ff. trade receivable 372 transactional net margin method 187 f., 289 transfer of assets 73, 79 transfer of know-how 148 transfer package 305, 315, 320 transfer pricing method 185 ff., 270 transitional provision 51, 160 translation of document 171 transparency of information 338 treaty benefit 245 uniform allocation scheme 147 unlimited taxation 61 unsecured loan 375 valuation 79, 95 valuation method 322 valuation of the transfer package 320 value added tax 346 value chain 193 waiver 246 waiver of an adjustment 333 withdrawal 135, 225, 282 withholding tax 136, 346