Determining the profits of permanent establishments

Challenge: Determining the permanent establishment profit

The correct tax treatment of permanent establishments is always a major challenge for international tax law advisors. In particular, the determination and allocation of tax bases between the parent company and the permanent establishment regularly leads to discussions with the domestic and foreign tax authorities during tax audits. With regard to the application of Section 1 (5) sentence 1 of the Foreign Tax Act (AStG) as an independent regulation for determining permanent establishment profits, the Federal Fiscal Court has recently provided more clarity.

Methodological approach of the OECD

Various concepts for the allocation of income and expenses were discussed in the OECD's permanent establishment reports in 2008 and 2010. Ultimately, the Functionally Separate Entity Approach (also known as the "Authorised OECD Approach" / AOA) prevailed. According to this approach, permanent establishments are treated as independent companies for tax purposes. The methodology follows three steps: First, the functions and risks performed by a parent company and its permanent establishment must be analysed on the basis of the personnel working there in each case. Based on the personnel functions performed in the permanent establishment, the assets and endowment capital required to perform these functions are then allocated to the permanent establishment. Finally, the notional service relationships (dealings) existing between the permanent establishment and the parent company must be valued for the purposes of determining the permanent establishment's earnings. The OECD transfer pricing guidelines with their various transfer pricing methods are applied here.

AOA in German law

In Germany, the AOA was implemented in Section 1 (5) AStG from 2013. The regulation is modelled on Article 7 OECD Model Tax Convention 2010. Previously, only limited independence of the permanent establishment was assumed in Germany. As Section 1 AStG is originally an income correction standard for existing business relationships with related parties abroad, there were already doubts in the literature when the law was introduced as to whether Section 1 AStG was the right place to establish a profit calculation method for permanent establishment income or whether the AOA would not be better "saved" in the Income Tax Act (e.g. Section 4 EStG).

Judges confirm: Section 1 (5) AStG only income correction standard

In two identical judgements dated 18 December 2024, the Federal Fiscal Court ruled that Section 1 (5) AStG is not an independent regulation for determining permanent establishment profits, but merely an income correction standard: In the cases in dispute, a Hungarian corporation determined the income attributable to its domestic construction and assembly permanent establishment on the basis of the taxable income. The tax office rejected the income calculations in each case without carrying out further checks and recalculated the permanent establishment profits by applying the cost-plus method to the personnel costs incurred in the permanent establishment. In doing so, it referred to section 1 para. 5 sentence 1 AStG in conjunction with section 32 para. 1 sentence 2 of the Betriebsstättengewinnaufteilungsverordnung (BsGaV). 

The Federal Fiscal Court has opposed this approach: Section 1 para. 5 AStG is not a sufficient legal basis for completely rejecting an assessment of profits based on taxable events. This follows in particular from the wording of Section 1 para. 5 AStG and in particular its sentence 3, from which it cannot be inferred that, outside the scope of application of Section 1 para. 1 AStG, an assessment of causation should be carried out solely on the basis of the personnel functions exercised in the respective parts of the company. Furthermore, according to Section 1 para. 5 sentence 1 AStG, the reduction in income must arise as a causal condition "through" the agreement of conditions that are not arm's length, in particular transfer prices. Such causality is neither fictitious through the mere existence of business relationships within the meaning of Section 1 para. 4 sentence 1 no. 2 AStG nor through another provision (here: Section 32 BsGaV). There is also no provision in the Income Tax Act that stipulates the determination of profits exclusively on the basis of personnel functions and transfer prices.

Practical tips and outlook

The judgements are to be welcomed in principle, as permanent establishment profit calculations that do not or do not fully follow the AOA approach should not be rejected across the board. Nevertheless, it is extremely doubtful whether the clarification now provided by the Federal Fiscal Court will reduce discussions with the tax authorities on issues relating to the allocation of permanent establishment profits. In addition, international agreement on the taxation of the "correct" permanent establishment profit and the avoidance of double taxation will be made more difficult. In this respect, it will be interesting to see how the tax authorities react to the decisions. In our opinion, the legislator is also called upon to make improvements and to systematically and correctly implement the AOA into national law, which has not yet been fully realised.