Legislation on transfer prices is comparatively rare. However, when it occurs, it frequently concerns fundamental legal matters. A current decision of the European Court of Justice could cause a central standard of German foreign transaction tax law to alter.
Essence
In transactions with foreign related parties, companies must observe the arm’s length principle. If companies within an international group do not conduct themselves in harmony with the arm’s length principle because the agreed prices (transfer prices) deviate from what independent third parties would have agreed, the incomes of the companies resident in Germany are to be corrected (increased) accordingly. The central standard for this is Section 1 of the Foreign Tax Act (FTA) and applies exclusively to cross-border transactions. Whether the regulation infringes upon European law has long been a hotly disputed topic. A current decision of the European Court of Justice (ECJ) is likely to intensify this debate further.
Facts of the case
German-based Hornbach-Baumarkt AG had an indirect, 100% participation in two Dutch corporations. The two foreign companies had negative equity and were dependent on bank loans for the continuation of their business operations and for the funding of intended investments. The financing bank had made the granting of the loans dependent on factors including the issue of a letter of comfort by the AG. Subsequently, the AG issued these letters of comfort, without demanding remuneration for this from its subsidiaries. The tax office assumed that unrelated third parties would have agreed liability compensation under the same circumstances and therefore increased the income of the AG pursuant to Section 1 FTA by the amount of the assumed liability compensation. After an unsuccessful appeal, the AG instituted legal proceedings. The Finance Court of Rheinland-Pfalz has doubts about the compatibility of Section 1 FTA with European freedom of establishment and therefore presented the matter to the ECJ.
Decision
The ECJ considers Section 1 FTA to be, in principle, compatible with European law. According to the court, although the rule intervenes in freedom of establishment, as it treats cross-border transactions differently (more strictly) than purely domestic processes, such a distinction is objectively justified, as it ensures a balanced distribution of taxation authority between the member states. The ECJ had already made a similar decision on a comparable regulation in Belgian tax law in 2010 (SGI case).
However, the current decision contains a significant limitation: in the opinion of the ECJ, it is necessary that the tax-paying entity be granted the opportunity to demonstrate business (non-tax) reasons for concluding the specific transaction. Otherwise, according to the court, this standard would infringe upon the principle of proportionality. Whether such a demonstration of business reasons is possible in the present case must be examined by the Finance Court in the next step.
Consequence
The statements of the ECJ regarding the business reasons are particularly noteworthy. According to the court, such business reasons that result from the AG’s shareholder status in relation to the subsidiaries – for example, its own interest in the business success of the companies and thus the prospect of future profit distributions or the financing responsibility as shareholder – are also to be permitted. So far, the German financial authorities have always rejected this consideration, precisely because it does not correspond to the arm’s length principle. Therefore, it remains to be seen, with interest, how the Finance Court (and, as a consequence, possibly also the Federal Fiscal Court) will utilise this template.