Gap in German Tax Law Hinders OECD Profit Allocation Approach

Allocation of profits to permanent establishments has long been a challenging subject in transfer pricing. What should be an uncontroversial tax compliance process has often turned out to be anything but—due to the lack of proper legislative implementation.

Two recent interconnected rulings by Germany’s Federal Fiscal Court show the limitations that gaps in local legislation can create for the ability of taxpayers and tax authorities to properly attribute profits to permanent establishments using commonly accepted transfer pricing principles.

When doing business within the same group using legal entities, the resulting intercompany transactions should comply with the arm’s-length principle developed by the OECD over many decades and now adopted by most countries worldwide.

However, carrying out business in several countries using the same legal entity may partly end up with notional transactions—also called “dealings”—between a head office and its foreign country permanent establishment.

A permanent establishment represents a taxable presence for an enterprise operating in a foreign country, typically through a fixed place of business. Although dealings between a head office and its permanent establishment do not have any legal substance as they effectively take place within two parts of the same legal entity, they are instrumental in determining taxable income in each country and so need to be properly priced and documented for tax purposes.

For transfer pricing purposes, the head office and its permanent establishment should be regarded as if they were two independent companies dealing with one another on arm’s-length terms.

In the past, the wide-ranging permanent establishment profit allocation mechanisms that were adopted by countries often lacked transparency or consistency. This changed in 2010, when the Organization for Economic Cooperation and Development developed the so-called Authorized OECD Approach to permanent establishment profit allocation.

The cornerstone of the OECD authorized approach is logical and simple—carrying out business using legal entities or permanent establishments should ultimately be neutral, and both options should lead to the same arm’s-length outcome.

This approach has gradually been adopted by many countries, although the rate of adoption has been patchy at times. Based on available survey data, around two thirds of countries covered have fully or partly adopted the OECD authorized approach.

There are still hold-out countries such as India that would reserve the right to determine permanent establishment profit allocation solely using domestic tax regulations. The US follows the OECD authorized approach only for 7 out of its 64 double tax treaty partners.

Nevertheless, the majority of OECD member countries have followed the OECD approach for many years now. Or so they thought.

German Court’s Rulings

Two German rulings (I R 45/22 and I R 49/23 ) have shown how even a country that has acknowledged its acceptance of the OECD approach for many years can struggle in translating its principles into practice.

At stake in the decisions was a Hungarian company’s permanent establishment in Germany performing contract assembly work. The taxpayer viewed this permanent establishment as an autonomous entity transacting with third parties only. It didn’t engage in any explicit transactions or dealings with its head office or any other related parties in the group.

The German tax authorities saw things differently and concluded that the permanent establishment was merely an extended arm of the head office without much autonomy and should have been compensated by the latter on the basis of all its operating costs and a modest 5% profit margin.

The German tax authorities contended that this compensation would better reflect the permanent establishment’s value added—or, in transfer pricing parlance, its “functional and risk profile.” In the authorities’ view, this is how two independent parties would have structured their operations under the arm’s-length principle.

The taxpayer disagreed and won at a lower court level as well as at the Federal Fiscal Court on appeal.

However, the reason for the taxpayer’s win was not that the tax authorities were necessarily wrong in assessing what the appropriate profit potential of the permanent establishment should be.

The taxpayer won on a technicality: that the German tax law currently doesn’t enable tax authorities to construct a new notional dealing between a head office and a permanent establishment where none exists. It only allows the tax authorities to adjust an existing transaction that was already priced by the taxpayer, which is why the Fiscal Court dismissed the tax authorities’ challenge.

Key Takeaways

The gap in the German tax law that ultimately decided the two recent cases in the taxpayers’ favor highlights how difficult and arduous the implementation of the OECD authorized approach has been in practice, even in mature jurisdictions that have long subscribed to it.

The court ruled that tax authorities cannot create a new internal dealing between a head office and its permanent establishment unless the taxpayer engaged in such a dealing themselves. Tax authorities can’t invent new transactions that don’t exist.

Perhaps the lesson for multinationals is that, where business doesn’t see any preference in terms of doing business through a legal entity or a permanent establishment, sticking with the legal entity for now will just make everyone’s life easier, leading to a higher degree of certainty of arm’s-length outcomes.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

David Zarecky is a transfer pricing adviser and co-founder at Reptune, a boutique transfer pricing firm.

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