Published: April 01, 2009
For decades, Germany has been a country with a highly developed, high-cost, economy. The opportunities - but also the risks - of a German investment are therefore numerous, real and calculable. On the positive side, Germany offers the foreign investor exciting national and international marketing and business perspectives. These are inextricably linked to the long-standing commitment to European integration and to the traditionally strong business and cultural ties to most other European countries. The cultured, highly trained and educated working population provides the medium for turning these perspectives to practical advantage.
The downside to this is that costs - and especially employment costs - when measured in terms of wage rates, social security and other charges levied on employers - are comparatively high. Investment success in Germany is thus dependent on a carefully planned, sophisticated operation. In this sense, Germany is very much an “up-market” country.
The German investment climate, both inward and outward, is both open and complex. Over the past few years, much has been done to encourage further investment, and more is planned. However, the complexity remains, so any encouragement measures benefit mostly those with a carefully considered investment structure. The article below has been adapted from our business guide “Doing Business and Investing in Germany” which gives those planning investments, in or from Germany, the necessary insight to determine their own specific areas of interest. The guide can be found at www.pwc.de. Any reader who would like a more detailed discussion of any of the subjects dealt with herein is cordially invited to contact a partner in any of our German offices.
Prof. Dr. Dieter Endres
Service line leader Tax
Taxes, rates and total burden, accounting principles on which taxable income is based, variations for trade tax, losses, tax groups, transfer pricing and related and third party finance, special features of branches and anti-abuse provisions
German business profits are subject to two taxes, trade tax and then to income or corporation tax. The income or corporation tax is subject to a surcharge, the so-called “solidarity surcharge”, of 5.5% of the amount due.
All businesses are subject to trade tax regardless of their legal form. The basis of assessment is the taxable income derived from the before tax accounting profit under rules applicable throughout Germany. This basis is determined centrally by the tax office responsible for the company’s German taxation (the place of German management). The tax office then allocates this to the various local authorities where the company has business establishments, generally in proportion to the total wages paid to the employees in each. Special rules apply to German permanent establishments without employees, such as pipelines passing through Germany, but operated and controlled from abroad. Each local authority then issues its own notice of assessment to the taxpayer, that is, it charges its share of the overall basis of assessment to trade tax at its own local rate. The local authorities are also responsible for collection of trade tax.
Foreign corporations may freely repatriate their German branch profits, other forms of permanent establishment income, or profit shares from their partnership holdings without further taxation.
Trade tax rates of larger towns generally fall within the range of 14.5-17%. Those of smaller towns and country districts are usually between 12% and 16%, although there are a few isolated instances of local authorities with rates of lower than 12%. The legal minimum rate is 7%. Tax-rate competition between town and country tends to be overshadowed by the other distinctions between the two (rents and other costs are often more expensive in the towns, although communications are frequently better). However, there may well be a noticeable trade tax advantage in locating a factory, warehouse or similar facility immediately beyond the city limits rather than just inside them.
A company’s profit is then subject to corporation tax. Profits earned by individuals are charged to income tax. Partnerships pay trade tax in their own right but then allocate the taxable income to their partners in a profit-sharing ratio. The partners are then subject to corporation or income tax on their profit shares as their own trading income.
Corporation tax is levied at 15% on both domestic and foreign corporations. Thus, there is no difference in the rate of corporation tax levied on the profits of a German GmbH and that levied on those of the German branch (or partnership share) of a foreign corporation.
Foreign corporations may freely repatriate their German branch profits, other forms of permanent establishment income, or profit shares from their partnership holdings without further taxation. There is no form of “branch profits tax” or other substitute for a dividend withholding tax. Dividends repatriated by companies are subject to a dividend withholding tax, which will be a final burden from the German point of view, unless the recipient of the dividend is a German tax-resident corporation or natural person.
The domestic rate of dividend withholding tax is 20% plus the solidarity surcharge. Almost all the German tax treaties reduce this to 5%, 10% or 15% on dividends paid to foreign corporate shareholders with at least a 25% holding in the German company. The Swiss and - for holdings of at least 80% - US treaties waive it altogether. Treaty provisions not withstanding, the EU Parent/Subsidiary Directive exempts dividends paid by a German corporation to a shareholder incorporated in another EU country holding at least 10% for an uninterrupted period of at least 12 months. This period does not have to be completed before the dividend is paid; any withholding tax initially levied will be refunded, once the minimum period has expired. [[[PAGE]]]
The total German income tax burden from investing in Germany therefore depends on the location of the German operation, and on the home country of the investor if the German investment is incorporated locally. The ultimate burden worldwide will, of course, depend upon the foreign tax relief mechanisms available to the investor in his home country. Trade tax at 17%, corporation tax at 15% and the 5.5% solidarity surcharge imply a total burden of 32.8%. This is the burden borne in respect of a German subsidiary of an EU corporation, or of the German branch of any foreign corporation, conducting its operations in a trade tax-expensive town. If the profits are subject to a 5% withholding tax (for example, holdings below 80% under the U.S. treaty), the burden rises to 36%. If the trade tax is only 15%, the respective burdens are 30.8% and 34.3%; if the trade tax rate is only 12%, the burdens fall to 27.8% and 31.4%. These burdens are to be seen as illustrative only; their accuracy depends on identity of basis of assessment to trade and corporation taxes - a rare occurrence.
Profits earned by German-resident corporations up to 2000 were charged to corporation tax under a different, imputation system. This old system made the corporation tax payable by the company dependent on its distribution policy and also gave a credit against a resident shareholder’s own income or corporation tax in the amount of the equivalent corporation tax previously borne by the company. Under the changeover provisions, companies with retained earnings taxed under the old system established their remaining imputation tax credit at one-sixth of the old taxed retained earnings still undistributed on December 31, 2006. This credit is then to be paid out in ten equal annual instalments from 2008 to 2017. A corresponding provision applies to retrospectively tax the distribution element of any remaining old system untaxed retained earnings of domestic source on December 31, 2006; the total burden is taken at 3% of the nominal amount, to be paid in 10 equal annual instalments from 2008 to 2017. September 30 is the due date for both credit and additional levy. Neither bears interest, though there is a provision for voluntary early payment of the remaining levy instalments at a discount of 5.5% for each remaining year outstanding.
Taxable income is derived from the statutory accounts drawn up in accordance with the provisions of the Commercial Code. In principle, all income is taxable except for dividends and capital gains on the sale of shares. In both cases, the exemption applies regardless of the amount of the investment or of the length of time for which the shares were held and it also applies equally to German and foreign investments. The non-deductible directly related costs of earning this tax-free income is irrefutably presumed to be 5% of the dividend received or capital gain realised. Banks are subject to special rules on their trading portfolios.
Specific provision must be made for anticipated bad debts.
German law describes the statutory financial statements as being “decisive” for the determination of taxable income. This does not mean that the tax authorities are obliged to base the corporation and trade tax assessments on the profit before taxation as shown in the financial statements, but rather that no expense, even if otherwise allowable, may be deducted from taxable income, unless it has also been taken up in the financial statements. Thus, for example, depreciation of fixed assets taken on the books in excess of that amount allowable under the relevant provisions of the Income Tax Act will be added back in the tax returns, while a company showing depreciation expense in its profit and loss account of less than that which could have been claimed under the tax rules, will have to base its taxable income on the lesser amount of the expense actually shown.
Companies accounting under IFRS are required to adjust their financial statements to reflect German accounting principles as the basis for their tax returns. The same adjusted statements are also the basis for the dividend resolution.
Intangible fixed assets are amortised straight-line over their useful lives. Often these can be objectively determined, such as in the case of patents and trademarks with a specific expiry date. Goodwill is amortised over 15 years. Investments may be neither written down nor regularly amortised with tax effect. Land is also not subject to regular amortisation, although it may, in rather unusual circumstances, be written down to a lower fair market value. Buildings constructed under planning permission applied for on or after April 1, 1985 are amortised at 3%, although different rules apply to older buildings. Movable fixed assets are depreciated, in theory, over their estimated useful lives. The Ministry of Finance publishes guidelines, the so-called depreciation tables, listing their estimates of the useful lives of movable fixed assets of different types as used in different industries. These tables are for guidance only and it is open to a taxpayer to argue that his actual or intended use of the assets concerned justified a shorter depreciation period. The tables are for straight-line depreciation. Reducing-balance depreciation is not permitted for assets acquired in 2008, although it can be continued with for assets acquired earlier. It has been reintroduced as an option for moveable fixed assets acquired in 2009 and 2010. The rates are 2 ? times the straight-line rate but may in no case exceed 25%. Depreciation on the reducing-balance method may change to straight-line, but not the reverse. The method option is exercised by individual asset.
Items purchased or commissioned during an accounting period are depreciated at one-twelth of the annual amount for each month of use.
Fixed assets, movable or otherwise, may be written down any time a permanent loss in value becomes apparent. There is, however, a write-back requirement should the value subsequently appreciate above the level that would have been reached had only ordinary, regular depreciation been deducted. [[[PAGE]]]
Inventories must be shown at the lower of cost or market. LIFO is expressly permitted by the Income Tax Act if it is also applied when drawing up the statutory financial statements. However, once LIFO has been applied, it must be continued with in subsequent years, unless the tax office agrees otherwise. Losses in value must be deducted from the original cost if they can be specifically determined. General provisions for technical obsolescence or reduced marketability on account of age or further developments are permitted in principle, although the attitude of the tax authorities has hardened in recent years. Those making generalised calculations or global provisions must now expect to be asked to justify the deduction by reference to specific facts and circumstances and/or to the past history of the business.
Accounts receivable should be shown at their original value. If the repayment value is higher (e.g. a zero-bond) the appreciation should be taken progressively until the repayment date. Accounts receivable in foreign currencies should be translated into euros at the rate of exchange on the day of the original transaction, unless the foreign currency has weakened by the balance sheet date. In that case, the receivable is taken up at the lower, year-end rate with the result that unrealised losses are taken up, but gains are deferred until actual realisation. Hedged accounts are the exception; exchange rate gains and losses are netted with the results of the relevant hedge and only the net loss is taken to expense. Specific provision must be made for anticipated bad debts. As with provisions for loss in value of inventories, the tax authorities now look more carefully than they once did at the provisions actually taken. Specific provisions must be justified specifically; general provisions must reflect the past experience of the business and even so will not be accepted without further explanation and investigation if they exceed 1% of all amounts outstanding.
There is no deduction for the bad debt expense of a shareholder with an interest of more than 25% in the debtor.
Liabilities are to be taken up in a manner corresponding to the treatment of accounts receivable. However, liabilities with a remaining term of 12 months or more at balance sheet date must be discounted at an annual rate of 5.5%, unless they are either interest-bearing (at any rate!) or result from payments in advance, or on account of services rendered.
Pension provisions must be computed actuarially under specific and detailed rules. In most cases, an underprovision in any one year cannot be recovered by simply recalculating the provision in future years, but, rather, must be carried forward mentally until the employee’s pension falls due. The funding of pension promises or the vesting of pension rights does not, as such, affect the calculations of the tax-deductible provisions. Prior or past service cost is spread over the period in which the provision accumulates to its balance on retirement date. No provision may be taken up for employees under 28.
Provisions for future costs must be calculated net of anticipated future benefits; thus a provision for future rental costs of a building no longer required should be made for the remainder of the lease net of the likely subrental income. Provisions for obligations other than payment and/or for obligations of uncertain incidence or extent - such as is the case with warranty provisions - should assume the actual incidence as being in accordance with past experience and should be based upon the anticipated direct costs together with an uplift for the indirect costs. Newly formed businesses or those without an adequate cost accounting system will therefore have difficulty showing that their warranty provisions conform to the tax rules.
Gains from the sale of land and buildings and freshwater shipping need not be taken to income immediately, but may be deducted from the cost of purchasing replacement assets in the same or in the previous year. Alternatively, the gain may be carried forward and be deducted from the purchase price of replacements acquired during the following four years or from the construction costs of a building erected during the following six. This reserve may be released back to taxable income at any time, but the release triggers additional taxable income of 6% of the amount released, for each year in which the reserve was carried. The release and uplift to taxable income are compulsory at the end of the fourth year, unless construction on a new building has already started. The effect of this rollover relief provision is to defer the taxation of a gain on sale by deducting it from the acquisition costs of replacement assets and thereby reducing their amortisation basis. The reserve is often referred as a “6b reserve” after the section in the Income Tax Act governing its creation.
The taxable income for trade tax is calculated on the same lines as for corporation tax. However, there are important differences, particularly in the area of interest and other financing costs.
The first €100,000 of interest expense is allowed in full. One-quarter of the annual interest cost over this amount is disallowed. Interest includes not only that paid under loan agreements or charged as such on overdrawn bank accounts and similar, but also the implicit interest in rentals, leasing fees and royalty payments. The implicit interest is seen as 20% of the amounts paid for moveable assets, 25% of the royalties for the use of rights (unless the only use made of them is to grant sub-licences) and 65% of property rentals. The term of the agreement is irrelevant.
For trade tax only, there is a lump-sum deduction of 1.2% of the taxable value of all real estate owned by the taxpayer. This deduction partially compensates the charge to land tax, an annual tax levied by the local authorities on the taxable value of real estate. The trade tax deduction therefore serves the purpose of relieving business from some of the burden of land tax. [[[PAGE]]]
For corporation tax , but not trade tax, taxpayers may claim a loss carryback of up to €511,500 to the previous year. This is an option and not a requirement. Amounts not carried back may be carried forward and utilised against future profits without time limit. The relief claimable in each year from losses brought forward is limited to €1m plus 60% of the current taxable income exceeding that amount. Companies with annual profits of more than €1m thus face current taxation on 40% of the excess. This is referred to in Germany as “minimum taxation”. However, the loss relief claimed in any one year from a loss brought forward does not reduce that subsequently claimable in retrospect against the remaining profit of the same year from a loss brought back.
The carry-forward and its offset rules apply to both trade and corporation taxes.
Legally, each Germany company is an independent legal entity and is therefore required to file its own tax returns.
Under a provision designed to hinder the purchase and sale of tax losses, the right to carry a loss forward is lost where more than 50% of the shares in a company are acquired by a new or existing shareholder within a five-year period. If the holding acquired is more than 25% but not more than 50%, the loss carry forward will be anulled in proportion to the amount acquired. Acquisitions of up to 25% do not lead to forfeiture of loss carry forwards. Acquisitions can be direct or indirect, and there is also an extension referring to related parties. This rule has been temporarily suspended to allow government sponsored rescue operations for banks during the present crisis. Legislation is pending to further extend it to other companies.
Losses still awaiting relief as of January 1, 2008, but potentially at risk under old rules because of a share acquisition of more than 50% of the issued share capital during the previous five years, are forfeited if the company resumes or continues its business within the five years following the share transfer with a contribution of substantially new assets. There is some dispute as to what constitutes a contribution of substantially new assets; the courts have held it to be more than the previously existing level of asset ownership, to be based on quantity rather than value, and to include current assets where there is also a change in trade. On the other hand, the share transfer must be direct under these rules.
Losses are no longer transfered on merger or other corporate reorganisation.
Legally, each German company is an independent legal entity and is therefore required to file its own tax returns. There is no concept of filing a consolidated return as such, although if two or more entities are so closely inter-linked that they can be seen as being effectively a single business, they combine their results for tax purposes, that is, they pool profits and losses. However, they do not eliminate intercompany profits. This type of group is referred to in Germany as an Organschaft.
An Organschaft parent may be any German business entity, including an actively trading partnership or locally managed German branch of a foreign company. The subsidiary must be a German tax-resident company. Two or more entities form an Organschaft if the parent directly or indirectly controls more than 50% of the voting rights over the subsidiary and they conclude a profit pooling agreement to run for not less than five years. This profit pooling agreement must be entered in the trade register of the subsidiary and must be followed in practice. Its effect is that the subsidiary surrenders its entire annual profit after recovery of any loss brought forward to the parent as of the end of each business year, while the parent enters into a corresponding obligation to assume any loss. The subsidiary’s financial statements will therefore always show an annual result of exactly nil (certain specific but unusual exceptions apart) and its balance sheet will carry an amount payable to or receivable from the parent equivalent to the profit surrendered or the loss subsidised. This balance must be settled once the amounts have been finally determined in the following year if accusations of non-fulfilment of the profit pooling agreement are to be avoided.
A profit pooling agreement may be cancelled during its five-year term for good cause. A typical example of a good cause is the divestment of the subsidiary outside the group. If the agreement is cancelled other than for good cause during the first five years, or is simply not implemented for any one of those years, it will be retroactively voided. The tax assessments will then be reissued as though the Organschaft had never existed and the subvention payments to the subsidiary will be seen as additional capital contributions by the parent, while the profit surrenders will be recast as dividend distributions. Cancellation following the first five years merely means that the agreement will lose its validity as of the year of cancellation; failure to implement it during any one year following the initial period suspends it for that year.
One of the effects of an Organschaft is that the profits of the subsidiary can be offset against the losses brought forward by the parent. However, the converse is not true; the losses brought forward will be frozen within the subsidiary until the Organschaft comes to an end.
There are no longer any differences of definition of Organschaft between trade and corporation taxes. From 2004 the effects are also the same for both taxes.
Under a provision in the Corporation Tax Act, the losses of an Organschaft parent may not be offset against present or future German income, if they can be offset abroad. Caution is therefore advised, both for dual resident companies and for those seen as part of another entity under foreign law (such as under the US “check-the-box” rules).
It should be emphasised that an Organschaft is usually necessary for German groups or sub-groups with centralised financing arrangements. Interest charged within the Organschaft is ignored. Outside interest as well as the trading profits are concentrated on the parent for the purposes of calculating the interest limitation. [[[PAGE]]]
Germany has extensive related party transfer pricing rules. Indeed, transfer pricing issues are almost always one of the most important components of tax audits of German subsidiaries of multinational concerns. The German transfer pricing rules are substantially in accordance with the OECD reports and recommendations on the subject, although they are more detailed and more specific. They are based on the premise that the German subsidiary should trade at arm’s length with its parent, fellow subsidiaries and other related parties as though each unit involved were an independent entity. To demonstrate this, it is necessary that all important overall relationships and each charge for services (anything other than the delivery of goods) be covered by a prior written agreement. A prior verbal agreement will fail this test.
Charges for specific transactions or series of transactions may be based on the comparable uncontrolled price, the resale price, or the cost-plus method. The German entity must document for itself the method used as the most appropriate in the circumstances and must be prepared to defend its choice accordingly. However, the tax auditors will usually accept the method chosen unless it is manifestly unreasonable, although they are not bound by the subsidiary’s determination of an appropriate profit margin, uplift rate or other matter of accounting estimate.
Many formalities must be observed, particularly in respect of agreements governing continuing relationships, such as the appointment of the German subsidiary as a commissionaire, or pooled research and development or similar activities. Under the statute, the substance, rather than the form, of trading at arm’s length is to be respected. However, the authorities (and also to a large extent the courts) tend to see failure to observe forms as an indication that the substance as depicted by the taxpayer is not necessarily the true substance to which he agreed in advance. Thus, the rule in practice in Germany is not “substance over form”, but “substance and form” as two distinct tests.
A recent change in the law has introduced enhanced duties of documentation.
A recent change in the law has introduced enhanced duties of documentation. Arm’s length documentation is no longer sufficient; a German taxpayer must now fully document all aspects of its trading and other relations with foreign related parties. This extends to the internal reasons for the decisions taken and pricing policies followed and includes records of third-party comparisons as w ell as any adjustments thereto in reflection of differing circumstances. Two Finance Ministry decrees set out the official expectations in detail. Failure to document adequately or, for unusual transactions, promptly will lead to serious penalties. If weak documentation means that the tax auditors can determine taxable income only within a range, they may base their finding on the end of the range least favourable to the taxpayer. Any doubts go to his detriment. This will almost guarantee a negative audit finding, opening the way to a fine of between 5% and 10% of the income adjustment.
A further change in the law has established a legal basis for the growing expectation of taxpayers to justify their transfer pricing by reference to a range drawn from publicly or semi-publicly available comparisons. If the price under review falls anywhere within the range, it is to be accepted. If it does not, adjustment is to the median of the range. If no comparables are available, the taxpayer can be asked to show that the price in question lies at the most appropriate point on the range between the highest price a buyer would be willing to pay and the lowest at which a seller would still be willing to sell.
Another amendment has institutionalised the transfer pricing relevance of a transfer of functions together with their related risks and opportunities from Germany to a related party or to a permanent establishment abroad. The transfer is to be at market value based on the profit expectations of the parties at the time of transfer. There is a rebuttable presumption that - in cases of uncertainty - independent third parties would have agreed on a retrospective adjustment to actual, should their expectations later turn out to have been misplaced. At all events, the taxpayer is required to identify the intangibles attaching to the function. [[[PAGE]]]
All borrowings to and from related parties must be at arm’s length. They must be governed by a prior written agreement which must be certain as to amount, repayment term (although this can be at will, or until further notice), currency and interest rate. Failure to conclude a written agreement in advance means that the interest expense is disallowable for the German borrower; it gives the tax office every opportunity of imputing its own concept of a fair market rate of interest to the income of the German lender.
Unusual circumstances apart, there is no requirement for a related-party loan to be secured. Rather, any need for security is deemed to be fulfilled by the German transfer pricing concept of “support within a group,” which means that a German company can neither bear any costs of securing or guaranteeing a related-party debt, nor can it incur with tax effect any form of bad debt write-off on any finance given to related parties. The few exceptions to these general rules all relate to unusual circumstances, such as when a company becomes a related party during the term of a loan.
The arm’s-length interest rate is that relevant to the currency of the loan. The currency chosen must be reasonably plausible in the circumstances, but the choice is not otherwise limited by any hard and fast rules. The corollary is, of course, that exchange gains and losses when measured against the Euro also fall to the German company. Interestingly, there is no need for strict consistency, as long as the German company is seen to enjoy an equal chance of gain or loss.
The transfer pricing rules state that the interest rate should always be based on bank lending rates, i.e., on the rate at which the German company could have borrowed the funds on otherwise the same terms and in the same currency from a German or foreign bank. This applies regardless of whether the German company is the borrower or the lender on the theory that the German company is not a bank and is therefore not entitled to mirror banking practices. On the other hand, the Supreme Tax Court has held that simply because a German company is not a bank it does not need to cover the costs of running a banking business, and its interest received should therefore be based on a rate lying somewhere between bank borrowing and lending rates. The Court declined to define what it meant by “somewhere between”, so the case does not necessarily give legal authority to take the arithmetical mean, even though this is often done in practice.
No withholding tax is levied on loan interest paid abroad. However, if the loan is secured by a mortgage on German real estate or on a German ship, the foreign lender is seen as having earned income from leasing or rentals rather than from interest on a loan. This renders him liable to German trade and corporation taxes on the income net of all relevant expenses (and he is therefore required to file tax returns as a non-resident), but the tax actually levied (including the solidarity levy) may not exceed the maximum rate of withholding tax on interest laid down in the relevant treaty. Similarly, interest on convertible bonds or on profit sharing loans is subject to a dividend withholding tax under domestic law and is therefore only not taxed by withholding where the treaty recognises it as interest chargeable at a nil rate.
Thin capital rules are no longer in force. Their substitute is an “interest limitation” restricting the deductibility of the negative interest margin (surplus of interest expense over the interest income) to 30% of the total net earnings before interest, taxes on income, depreciation and amortisation (EBITDA). This limitation does not apply where the negative interest margin for the year is no more than €1m, or where the interest paid to any one shareholder of more than 25% is not more than 10% of the negative interest margin. If the company is part of a group, this latter concession is dependent upon the demonstration that the equity to gross assets ratio of the company is no more than one percentage point below that of the group. This demonstration is to be based on financial statements under IFRS consistently applied. The accounting principles of any member state of the EU, or - as a last resort - US GAAP may be taken in place of IFRS if more relevant in the circumstances.
The interest limitation rules extend to related parties of shareholders and to third party lenders with rights of recourse to a shareholder or his related party. Back-to-back financing, is a particular target of these caveats.
Interest expense disallowed under the limitation in any one year can be carried forward for future offset without time limit. Future offset starts in the first year the limitation is not met by adding the amount brought forward to the interest margin for that year. Interest carry forwards are subject to the same curtailment of loss carry forwards that ensue on a change of shareholders. Acquisition of over 50% of the capital of the company by a single shareholder (and his related parties) destroys the carry forward entirely; acquisition of between 25% and 50% curtails it in proportion to the level acquired; acquisition of 25% or less is harmless.
The income of branches or of permanent establishments is subject to trade and corporation taxes at the same rates as those levied on subsidiaries. On the other hand, there is no withholding or other form of taxation levied on profit remittances abroad by branches or permanent establishments. The “branch/subsidiary rate comparison” is thus entirely dependent upon the rate of withholding tax, if any, to which the dividend distributed by the subsidiary would be subject.
By contrast, the taxable income reported by a subsidiary may be very different from that of a branch. This depends on the nature and extent of the ties to other business units of the parent corporation. Under the German transfer pricing rules, a subsidiary must act in every respect as though it were trading at arm’s length, that is, it must be seen to be dealing with its related parties as though they were unrelated entities. This means that all charges in and out are subject to value-for-money and also to market-value tests on the premise that an “orderly and conscientious business manager” would neither pay for a service he did not need, nor would he pay more for that service than its price on the open market. The converse applies to revenue earned by the German subsidiary from its related-party services rendered. It is therefore reasonable for service charges to include a mark-up for profit, unless they are costs allocated from within a pool. On the other hand, the branch, not being a separate legal entity, is unable to contract with its own head office. Consequently, it cannot pay a royalty to its own head office for its German use of technology, but can share in the head office costs of the related research or purchase even if the project fails. A branch cannot charge or bear a profit mark-up on its dealings with its own head office, but does not have to meet a value-for-money test.
By the same token, a branch cannot borrow from its own head office but can do so from another legal entity within the same group. Interest costs of the head office are deductible in the tax returns for the branch if the finance was taken out for the German operation. In either case, the amount deducted by the branch is subject to the interest limitation, though, as yet, no detailed guidance has been given as to how this might be calculated in respect of outside borrowings by the foreign head office.
Germany has a number of anti-abuse provisions designed to prevent the misuse of legal forms, the use of tax havens, treaty-shopping or the use of proxies. Partly, these provisions give the tax authorities the right to ignore artificial circumstances and relationships seen as abusive, and partly they make the tax deductibility of expenditure dependent on full and complete disclosure of the identity of the other business partner. Relationships with foreign entities subject to “low-tax regimes” are subject to a special act altogether, the Foreign Tax Relations Act, which not only charges a supplementary tax on the indirect German owners of income accumulated abroad, but puts German taxpayers purchasing goods and services from tax haven countries under an almost impossible burden of proof. Taxpayers are under an extended duty to cooperate with the tax authorities in respect of all business relationships with partners outside German jurisdiction and therefore beyond the reach of the German tax auditors. Essentially, the German taxpayer must proffer all documentation, information and explanations from or on the foreign party that would have been available had the taxpayer insisted in advance on access rights to the relevant records.
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