In three separate decisions, the German Federal Tax Court has ruled that German tax authorities are prohibited from recharacterising intercompany charges on the mere basis that the transaction as such is not unrelated party behaviour. This new line of case law is particularly in favour of foreign investors with German subsidiaries.
We have reported in this Newsletter both on the Federal Tax Court ruling as of 11 October 2012 (I R 75/11) on the formalities of intercompany contracting and the ruling as of 17 December 2014 (I R 23/13) on the adjustment of book value depreciation for an unsecured loan. In both cases, the court argued that the Double Tax Treaty restricts transfer price adjustments.
Based on German domestic tax law, under certain conditions, the tax office is authorised to deem a taxable dividend paid by the subsidiary to its shareholder(s). For many a foreign investor, this meant double taxation as corresponding adjustments in the investor's country of residence or mutual agreement procedures usually failed.
Profound change in the ruling of the German Federal Tax Court
Under German domestic law, intra-group charges between a majority shareholder and a subsidiary are only accepted by the tax authorities if such affiliates agree on clear, legally effective and binding conditions before the transaction is carried out. Authorities recognise neither retro-active transfer price adjustments nor irregular executions of intra-group agreements. Thus, until recently, tax auditors had the means to refute a chosen transfer price structure on formal grounds.
In October 2012, the Federal Tax Court ruled that under Art. 9 of OECD Model Convention (here Double Tax Treaty Netherlands) tax administrations must focus on testing the impact of terms and conditions on prices, not on disqualifying a transaction as such. Only under exceptional circumstances are tax authorities allowed to recharacterise a transaction, namely if the related parties enter into a transaction agreement with the intention to achieve an economic result totally disconnected from its form (economic-substance-test). An example should be if a company pays its shareholder/managing director only by later pensions in order to record matching accruals in its accounts, thereby deferring Corporate tax payments. Another example might be an intercompany loan which aims at disguising a shareholder equity injection.
This ratio was confirmed in December 2014 when the court prohibited the adjustment of a fair value depreciation made by a German parent company on receivables from an unsecured loan granted to its US-subsidiary. The tax auditor claimed that unrelated parties would have never entered into an unsecured loan agreement and therefore dismissed the depreciation expenses altogether. The Federal Tax Court ruled that tax authorities, again, violated the arm's length standard laid out in Art. 9 of the OECD Model Convention. The authorities may only consider whether interest was understated under these particular conditions. The court again confirmed that the economic-substance-test should be applied. On 24 March 2015 (I B 103/13), the court confirmed his judgment in a similar case with a Russian subsidiary.
Comment and prospect
The court rulings are broadly in line with the – current – OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2010. According to no. 1.64, tax authorities should acknowledge transactions and conditions between related group companies as long as:
the economic substance of a transaction does not differ from its form (coherence); and
the otherwise coherent transaction is in its totality commercially rational and does not impede the tax administration from determining an appropriate transfer price.
Only in exceptional circumstances, tax administrations shall be allowed to recharacterise intra-group conditions. However, the OECD explicitly limits these cases to scenarios deemed as tax evasive (no. 1.64, 1.66).
The Federal Tax Court jurisprudence is in line with this approach and maybe a degree more pro-Revenue since it merely tests the coherence between economic substance and legal conditioning.
On the other hand, discussion drafts published by the OECD in its current BEPS project appear much more extreme in allowing fiscal re-characterizations and, thus, incompatible with standing German tax law.
Often, disconcerting adjustments emerge when tax officials substitute the economic rationale followed by real business people with their own understanding of unrelated party behavior.
Foreign investors, in particular, should welcome this new line of case law which affects all sorts of intra-group transactions (e.g., costs pooling agreements; retro-active price adjustments; start-up costs; agreements on the set off of benefits; etc.) and provides legal security for upcoming tax audits.