German Transfer Pricing Rulings Can Be a Win for Multinationals

Germany’s Federal Fiscal Court has significantly restricted the conditions in which German tax authorities can allocate profits to permanent establishments of foreign companies in Germany.

This marks a clear shift in how multinational enterprises operating in Germany through PEs—especially in service-heavy, low-margin industries—may be taxed. The court has affirmed that taxation must be grounded in actual business outcomes, not assumptions about functional roles or routine service profiles.

The rulings (I R 45/22 and I R 49/23) clarify that section 1, paragraph 5 of the German Foreign Tax Act isn’t a standalone profit attribution rule but a corrective provision limited to addressing transfer pricing mismatches in actual cross-border transactions.

For many multinational enterprises with low-margin, labor-intensive German PEs, these decisions may bring welcome relief. They confirm that well-documented losses won’t automatically trigger taxable adjustments based on routine-function characterizations or administrative presumptions.

Case History

The cases concerned two Hungarian corporations operating in Germany through separate PEs. One provided meat-processing services, the other performed mechanical assembly work. Both PEs carried out all economic activity locally in Germany, using their own personnel and incurring their own operating expenses.

Each PE independently generated revenue through services to unrelated third-party clients. Despite that, both PEs recorded net losses under standard German accounting principles.

The losses reported by the German PEs weren’t accepted at face value. The German tax authorities reclassified the German PEs’ operations as “routine functions” and invoked section 1, paragraph 5 of the Foreign Tax Act, in conjunction with sections 16 and 32 of the German Regulation on the Attribution and Documentation of Profits to Permanent Establishments (Betriebsstättengewinnaufzeichnungsverordnung).

Applying a cost-plus method, the tax authorities imputed hypothetical profits to the German PEs, essentially taxing them on assumed returns regardless of their actual financial results.

The German tax authorities’ reasoning was straightforward: Even if the PEs reported losses, they performed “routine services” and under the regulation’s presumed arm’s-length pricing rules, those services should have generated a return.

The court disagreed—decisively.

The court’s interpretation of section 1, paragraph 5 of the Foreign Tax Act is unambiguous. It is a corrective rule, not a constitutive one. It can’t, on its own, serve as a basis for determining PE profits in the absence of actual “intercompany dealings.” Its purpose is to address income distortions where related parties deviate from the arm’s-length, not to create fictional income based on hypothetical pricing.

Since such “intercompany dealings” as existed between the Hungarian headquarters and the German PEs were minor and unremunerated the court found no basis for applying section 1, paragraph 5 of the Act. The PEs’ own profit and loss calculations, based on actual revenue and expenses, were deemed reliable and sufficient for tax purposes.

Legal Ramifications

The implications for the regulation governing PE profit determination are considerable. The regulation’s core presumption—that certain types of PEs, such as those involved in construction or assembly, should automatically earn a cost-plus return—was directly undermined.

According to the court, such assumptions cannot override the legal requirement that any income adjustment must be tied to a demonstrable deviation from arm’s-length pricing.

The decisions suggest that Germany’s attempt to implement elements of the Organization for Economic Cooperation and Development’s authorized OECD approach through such a regulation, rather than anchoring them in tax legislation itself, may have reached its limits.

The court pointedly noted that if Germany intended to adopt a standalone regime for PE profit attribution in line with the authorized OECD approach, it should have done so explicitly in the Income Tax Act, not indirectly through the Foreign Tax Act or secondary regulations.

The judgments support the principle that taxation must reflect economic reality, not theoretical returns or assumed functional profiles.

However, the court rulings also raise new questions—especially in the international context. Germany’s rejection of “intercompany dealings” or presumed functional returns stands somewhat apart from OECD guidance and the authorized OECD approach as applied in other jurisdictions.

That divergence increases the risk of double taxation, particularly when foreign tax authorities expect Germany to attribute more profit to PEs using cost-based or formulaic methods.

It also complicates the treaty landscape. If Germany now refuses to attribute profits to PEs in the absence of actual “intercompany dealings,” but its treaty partners do so based on deemed dealings, mismatches will emerge. Diverging approaches could result in more cases being brought into mutual agreement procedures to avoid double taxation.

Potential for Reform

These decisions may prompt legislative reform. The German Ministry of Finance could seek to revise domestic law to explicitly codify its approach to profit attribution, aligning it more closely with international standards.

Alternatively, it may need to reframe its administrative guidance, reducing reliance on the PE profit determination regulation in favour of case-by-case economic analysis.

For now, multinational enterprises should review their German PE structures and documentation practices. If they are relying on direct, economically coherent loss calculations—without cross-border service flows—they may now have a stronger legal basis to resist adjustments under section 1, paragraph 5 of the Foreign Tax Act.

This suggests that PEs generating third-party revenue and incurring their own costs, without receiving services or support from the head office, can argue that their losses reflect genuine business activity and shouldn’t be replaced by notional arm’s-length profits based on assumed routine functions.

For multinational enterprises, this shifts the burden of proof: Rather than defending losses as deviations from the norm, they can position them as the natural outcome of standalone, economically substantiated operations—provided the factual and functional separation from the head office is clearly documented.

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

Philipp Redeker is an attorney, tax adviser, and partner at Freshfields Bruckhaus Deringer.

Viktoria von Abel is an economist, tax adviser, and principal associate at Freshfields Bruckhaus Deringer.

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