International supply chains where more than one own company generates profits have to be considered tax differentiated. For this purpose, international transfer prices are determined. A number of different methods are used in this context. They are designed to provide realistic tax bases in certain constellations. On the one hand, the price comparison method is basically required. It applies if there is the possibility for an external comparison. If this is excluded, however, then there are some other alternatives. These include the resale method, the cost surcharge method, the transaction-related net margin method and, in various versions, the transaction-related profit allocation method.

If you run companies in several countries that work for and with each other, this logically often has an impact on their taxation in the respective countries. This is especially true when cross-border transactions are concerned with deliveries of goods. However, the provision of services may also fall under this heading. In this case, a businessman could, purely hypothetically, determine a very own approach to setting prices. This would make it possible to shift profit to those tax regimes that generate the least tax.

However, it should be clear to everyone that the large industrial nations in particular, with their relatively high tax rates, take a different position on this. This is why the OECD has drafted its own guidelines on this topic, namely the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. In any case, sensible cross-border taxation only makes sense if all the tax regimes involved agree on a common approach. Otherwise there would certainly be double taxation. And double taxation is in no one's interest. Otherwise, entrepreneurs would quickly settle in another country that offers more favorable conditions.

With a side view of taxation in other tax regimes, we now want to discuss the German view on international transfer prices. To do this, we first take a look at our own legal regulations, which are relevant for cross-border business relationships.

First of all, we should be interested in the tax code. Section 90 (3) AO codifies the notification obligations of taxpayers who come to the fore in tax contexts within the meaning of Section 1 (4) AStG. For our discussion, § 1 (4) sentence 1 number 2 AStG is particularly relevant. We have already established the next legal reference, namely to the External Tax Act. This is important because this legislation specifies precisely when a case arises that causes a company to charge international transfer prices.

All other provisions concerning the methods necessary for determining transfer prices are to be found in special regulations and decrees of the Federal Ministry of Finance. At the forefront is the BMF letter on administrative principles transfer pricing of 14.07.2021. In fact, it contains the current rules on the applicable transfer pricing methods. This is where we are focusing our attention.

Furthermore, § 8(3) KStG is also responsible for the treatment of inappropriate international transfer prices. Under this legislation, such a case is treated as a hidden distribution of profits.

Also important, albeit rather marginally, are the provisions concerning international transfer prices in the double taxation agreements (DTAs) concluded by Germany. In this context, the OECD Model Agreement (OECD-MA) may also have an influence, because it often forms the basis for the closed DBAs.

International transfer pricing is based on the arm's length principle. The determination of international transfer prices under this approach is known as the price comparison methodology. However, a direct external comparison is only given under particularly favorable circumstances. Alternative transfer pricing methods have also been developed. Other criteria are then decisive. In addition, these alternatives lead to an international transfer pricing approach that operates at premiums or discounts. Reference is made to the resale method and the surcharge method. Other, but often only complementary, methods used to determine international transfer prices are the transaction-based net margin method and the transaction-based profit allocation method. These are used when the aforementioned methods seem less useful than these alternatives.

Incidentally, the BMF letter on the administrative principles of transfer pricing explicitly indicates that the transfer pricing methods mentioned therein are by no means to be understood conclusively. Although it is pointed out that the OECD only recommends these five methods, from the perspective of the Federal Ministry of Finance, a combination of several methods may be suitable for quantifying international transfer prices as precisely as possible.

Since the price comparison method is mainly intended to determine international transfer prices, we dedicate a separate chapter to this method. However, we divide it because there are two different approaches.

In principle, this approach looks at what price another company competing with its own company charges for a comparable performance. This is the international transfer price used for a cross-border transaction with your own foreign company. This is called an external price comparison.

For example, if you have founded a company in the Canary Islands that produces straw hats there at a tax-deferred rate to sell them in Germany or elsewhere, then you can set aside EUR 10 per item for goods. A resale at EUR 11 would then only result in a taxable profit of EUR 1 in Germany. With production costs of EUR 2, a profit of EUR 8 would then remain, which could be taxed particularly favourably in the Canary Islands. However, there are also other manufacturers of comparable products who offer their goods for only EUR 5. Thus, when determining one’s own international transfer prices via the price comparison methodology, only EUR 5 can be used. In Germany, therefore, EUR 6 and in the case of the company in the Canary Islands EUR 3 would be taxable.

With a gross tax rate of about 30 % in Germany (15 % corporate tax and a business tax of about the same amount), this leads to a regular tax of EUR 1.80 per cap. If the Spanish company is a tax-advantaged ZEC company, in the Canary Islands the profit of EUR 3 is paid only 4 % in corporation tax. Ergo there are EUR 0.12 in taxes. The total tax is therefore EUR 1,92.

If, on the other hand, you were allowed to choose the own approach described at the beginning, then you would have a total tax of only EUR 0.62 per cap (EUR 0.30 in Germany and EUR 0.32 in Spain).

In contrast, there is also an intrinsic price comparison that allows one to use the price comparison methodology to determine international transfer prices.

In principle, one proceeds in the same way as in the external price comparison. The only difference here is that we compare our own prices. Because if our company in the Canary Islands mentioned in the previous example offers the same product, which should cost us EUR 10, to another buyer only for EUR 5, then you can only use EUR 5 for the international transfer price. In the end, however, you get the same tax amount.

If, however, a Group-owned company only works for its own group, then an internal price comparison is of course excluded. Equally unrealistic is an external price comparison, if the comparability of the purchased services is missing. An external price comparison could at best still be set if you could also commission the same service from a third-party provider. However, such proof is usually hardly directly comparable. Therefore, a different approach may be used to determine international transfer prices.

The first alternative we want to consider is the resale method. Here one considers the price one would demand for the service to third parties. From this you then deduct a reasonable margin to determine a fake purchase price. This is the international transfer price. If you deduct the manufacturing costs from this fictitious purchase price, you get the taxable profit.

On the other hand, you can also feign a cost surcharge on production costs, which includes a reasonable gross margin. Here, too, one tries to find an approach that is as realistic as possible, which comes close to an external comparison, at least in some aspects.

Another method for determining international transfer prices is the transaction-based net margin method. In this case, the net margins of the participating companies are compared with the net margins that other related companies would use in comparable circumstances. These ratios can then be used as an approach to international transfer prices.

A division of the total profit in relation to a transaction takes place here. However, this is based on the originally expected profits instead of those that actually occurred. Therefore, a number of factors play a role in the transaction-based profit allocation methodology. This requires a functional analysis of the companies involved.

5.4.1. the contribution method

On the one hand, the size of each company’s contribution to the overall economic performance is considered. This means the values of the services that the respective companies used to achieve the profit. Here one compares the values of these services with those which other companies would charge for similar services. This is why it is called the contribution method.

5.4.2. the residual profit method

Alternatively, one can also follow the approach that one can take as a contribution in terms of laying the foundations for the overall profit achieved. For example, the necessary expertise or the contribution made by research and development is important here. However, in order to take into account the profit-making intention of each of the participating companies, it is necessary to allocate a reasonable, realistic margin between the companies before the allocation. Therefore, this approach is also called the residual profit method.

5.4.3 Method of capital employed

Furthermore, it is also possible to examine how high the capital investment is. This is based on the assumption that all companies involved should count the same return on their invested capital. This method is known as the method of capital employed.

5.4.4. Method of comparable profit allocation

The fourth option is the method of comparable profit distribution. In this case, one considers comparatively how other companies under similar circumstances actually perform the profit distribution based on their functions and entrepreneurial risks.

The current regulations regarding international transfer prices and their role in the taxation of profits in Germany are under criticism. Because in the context of the application of double taxation agreements, the OECD-MA often comes into play. After all, this is the basis for the majority of DBAs, which Germany has also negotiated with other countries. However, the provisions of the OECD-MA, which contain provisions concerning international transfer pricing in Article 9, are less stringent than the German provisions.

For example, German law stipulates that agreements must always be documented at the time they are determined. Otherwise, a retroactive agreement may meet the event of a hidden distribution of profits. However, Article 9 OECD-MA allows such an ex post agreement. Thus, there is the risk that one adheres to the requirements of the corresponding DTA, but can still be confronted with double taxation. In this case, only a complex agreement procedure between the tax authorities of the taxing states can lead to a solution.

At first glance, you might think that the circumstances that lead to a violation of a DTA by German law are rare. But this is neither completely right nor relevant if you yourself are affected. In addition, there has been a tendency in the past that at least the German legislature has constantly tightened the regulations with regard to international transfer prices. This was most recently the case in the course of the adoption of the ATADUmsG 2021. It can therefore be assumed that further tightening will also make it more difficult to determine international transfer prices in the future.