The (simplified) case
A GmbH [German private limited company] allowed labour- and energy-intensive production stages to be performed by a Bosnian sister corporation. According to this corporation’s functional and risk profile, it basically acted as a contract manufacturer for the GmbH. In the course of this, the GmbH sold materials to the Bosnian company at cost price and the return delivery of semi-finished or finished products took place on the basis of analyses of the value added and ‘contribution margin calculations’. From the perspective of the German fiscal administration however, ultimately, too much profit remained with the Bosnian company. From 2013, the Bosnian company also sold to and supplied a previous customer of the GmbH because the latter was no longer able to offer this customer competitive prices.
Key statements by the BFH on transfer price formation
The arrangements described above gave the court an opportunity to adopt a position on many points. In this context, we would like to highlight the following four aspects:
Relationship between individual adjustment rules
First of all, the BFH clarified that the specific regulation for making adjustments for foreign transactions tax purposes (Section 1 Foreign Transactions Tax Act [Außensteuergesetz, AStG]) would generally be subordinated to other regulations for making adjustments to income (e.g. from a constructive dividend) and would only apply when and to the extent that the scope of the other regulation for making adjustments was smaller.
Please note: These statements by the BFH are thus, for example, important because different types of legal consequences are linked to the various regulations for making adjustments. For instance, a constructive dividend would possibly result in capital gains tax arising, however an adjustment in accordance with 1 AStG would not.
Aspects pertaining to contract manufacturing
The BFH took the view that it is possible to make an overall assessment of individual business transactions if their separation would not be appropriate for the economic content. The BFH thus, in economic terms, combined the sale of raw materials by the GmbH to the Bosnian company with the selling back by the latter of semi-finished/finished products to the GmbH into one business relationship of ‘contract manufacturing’.
Furthermore, the BFH confirmed that in the case of contract manufacturing it is appropriate to use the cost-plus method for the transfer pricing structure, preferably on the basis of planned costs, whereby the costs of the material that is supplied (economically by the ordering party), as non-value added costs, are not included in the cost base.
The BFH ultimately rejected an estimate of the profit mark-ups based on ‘general principles derived from experience’ or on ‘internet research’. Instead, the court stipulated that such estimates need to be based on companies with comparable functional and risk profiles or on comparable sectors.
Recommendation: While the BFH ruling basically does not contain any radical new insights with respect to the aforementioned details about contract manufacturing, nevertheless it does provide a reliable basis for argumentation and structuring. It should be particularly noted that, in its ruling, the BFH clearly rejected, among other things, the above-mentioned blanket estimates based on ‘general principles derived from experience’. Therefore, in practice, it is likely that the importance of database analyses will continue to increase for small and medium-sized centerprises, too. If and when such analyses have to be prepared please do not hesitate to contact your PKF consultants; they can of course arrange for qualified and experienced staff to support you.
Pure sale of materials
Insofar as, from 2013, the materials supplied by the GmbH were used by the foreign corporation not for the contract manufacturing but, instead, for its own production (i.e. for the purpose of the subsequent sale to the aforementioned third party customer) the BFH had no objection to the 5% mark-up rate on the cost price. However, from this it should not be deduced that a 5% mark-up on the cost price of materials purchased for the benefit of third parties is generally appropriate. Rather, the BFH pointed out that, in the case in question, the purchasing benefits generated by higher volumes had remained (almost) entirely with the GmbH.
Please note: It would therefore appear that the 5% mark-up was (only) accepted against this background, while otherwise, at any rate, higher mark-ups would likewise be possible or necessary.
Customer transfer potentially requires the payment of royalties
Moreover, the BFH considers it conceivable that the Bosnian company should have had to pay royalties to its sister company for the referral of the customer supplied from Bosnia-Herzegovina as of 2013. The BFH was however unable to decide this, instead, the case has been referred back to the Munich tax court in this respect.
More Information: Apart from the aspects mentioned above, the BFH ruling includes a variety of statements on, among other things, the topic of the transfer of functions. However, for reasons of simplicity, these points are not discussed here.
Please note: The ruling makes clear in different ways that in the case of cross-border business transactions, in particular when over time the circumstances undergo changes, greater vigilance is necessary with respect to the potential tax burdens associated with the changes. This would still apply even if – as argued by the GmbH in the case in question – continuing doing business from Germany would not have been economically viable.