A large number of medium-sized German companies are internationally oriented and operating in many different countries around the world. Their foreign involvement ranges from basic representative offices to complete production units with their own responsibility for a particular market.
That being the case, it comes as no surprise that the tax authorities are paying more attention to cross-border transactions, increasingly making them a focal point of their field audits. Fiscal authorities have boosted capacity significantly at both the state and federal levels by expanding their use of tax examiners with expertise in international tax issues.
Experience shows that certain hot-button issues come up time and again during routine field audits:
When goods and services are traded globally among the various companies making up a corporate group, the prices charged for those goods and services must be appropriate. In order for the tax authorities to accept the transfer prices in the countries and territories concerned, the parties involved in a transaction must ensure and maintain documented proof that their transfer prices comply with the arm’s length standard. If, within a group of companies, for example, management-related tasks such as IT, financial and payroll accounting, controlling or staff development are handled centrally by one group company, the other group companies have to pay a recurring management fee for this. In order for the tax authorities to recognize the amount of this fee as valid, it must be equivalent to what independent, i.e. unrelated, parties would typically agree upon in similar circumstances.
For instance, if a German company simply passes on the costs it incurs to provide such goods and services, the German tax authorities will add an appropriate profit margin to the amount, which increases the parent company’s taxable earnings. Conversely, if the mark-up on the amount a German subsidiary is charged is more than the parent company would be able to charge a third party, the tax authorities will reduce the business expense deduction accordingly and treat the difference as an undisclosed profit distribution. The same principle applies when the cost basis to which the mark-up is applied is unreasonably high.
There is no automatic guarantee that a transfer price adjustment made in one country or territory will be accompanied by a comparable adjustment in the other country or territory concerned. For instance, although the one jurisdiction’s tax authorities may reduce the business expense deduction for the management fee, those in the other may treat the full fee as taxable income, the overall result being double taxation of the portion deemed to be in excess of the acceptable amount. In many cases, the only way, if any, to eliminate this double taxation is through a very lengthy mutual agreement procedure conducted between the two jurisdictions.
Allowing an affiliated company the use of intangible assets presents another interesting situation. Apart from compliance with the arm’s length standard when determining the amount to charge for this, companies also must be mindful of withholding taxes. This is because it is routine practice in the source country for taxes to be withheld from the amount paid insofar as an exemption from the withholding cannot be claimed, particularly on account of EU laws and regulations. If the amount of tax withheld is adjusted during a field audit, then the company paying to use the assets could be on the hook for any taxes it failed to withhold. Ultimately, it will be liable for these taxes if it cannot seek recourse against the company to which it paid the fees.
Another issue receiving greater attention during field audits is permanent establishments. The existence of a permanent establishment is regularly the deciding factor in determining whether a country has the right to tax the profit a foreign business generates in its territory. However, the issue of permanent establishments is also very important, because since 2013, the business a company’s headquarters transacts with its permanent establishments, like that which it transacts with its foreign subsidiaries, must comply with arm’s length requirements. Conflicts between German and foreign tax law regarding what constitutes a permanent establishment are not uncommon in this regard. For example, German tax law does not recognize services-related permanent establishments, while the tax authorities in the BRICS countries (Brazil, Russia, India, China and South Africa) do. In those jurisdictions a company can be deemed to have formed a permanent establishment merely by rendering services there for a certain period of time.
Not infrequently this prompts discussions during field audits about whether and, if so, how to allocate the company’s profit to the respective countries for tax purposes.
The illustrative examples provided here demonstrate the opportunity that cross-border intragroup transactions present for field auditors, in general, and tax examiners with expertise in international tax issues, in particular, to increase tax revenues. Globally active companies need to be proactive when it comes to structuring their intragroup transactions by seeking the comprehensive advice of experts and exercising the greatest of care.