GERMAN RULING ON FOREIGN TAX INCOME ADJUSTMENTS
Deloitte Tax hand reports (May 21, 2025)
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BFH clarifies Foreign Tax Act income adjustment rule for permanent establishments
In two decisions both dated 18 December 2024 (and published on 8 May 2025), Germany’s federal tax court (BFH) clarified that section 1(5) of the Foreign Tax Act (AStG) is an income adjustment rule and not an independent standard for determining profits.
The BFH ruled that the German tax authorities could not reject the profits declared by German permanent establishments of foreign head offices based on section 1(5) AStG, without thorough examination and further reasoning.
Background
Both cases involve Hungarian companies (headquartered in Hungary) with permanent establishments in Germany that provide assembly work (I R 45/22) and meat cutting work (I R 49/23).
In the respective tax audits, the German tax authorities rejected the profits declared by the permanent establishments, arguing that the profits were derived from only routine activities. Using the cost-plus method, the tax authorities issued revised corporate and trade tax assessments. The companies successfully challenged the assessments in the state tax courts, prompting the tax authorities to appeal to the BFH.
BFH decisions
The BFH dismissed the appeals, emphasizing certain key aspects below.
The BFH clarified that section 1(5) AStG is an income adjustment rule, not an independent standard to determine profits, and applies when transfer prices between a permanent establishment and its foreign head office deviate from the arm's length principle (i.e., prices independent third parties would have agreed to under comparable circumstances) and result in reduced domestic income.
The BFH noted that section 1(5) AStG implements the authorized OECD approach (AOA) based on article 7 of the OECD model tax convention into German law, which aims to ensure consistent cross-border taxation rules for all entities, including corporations, partnerships, and permanent establishments.
The BFH ruled that the declared profits cannot be rejected without a thorough examination and further reasoning, whereas income adjustments under section 1(5) AStG require an objective link between non-arm's length transfer prices and reduced domestic income.
The BFH also found no violations of documentation obligations under section 90(3) of the Fiscal Code (AO) and rejected the need for auxiliary calculations as required by the permanent establishment profit allocation regulation (BsGaV). This implies that no relevant dealings between the permanent establishments and their foreign head offices took place in the cases at hand although not explicitly stated in the fact patterns.
Income adjustments can only be made if the prices agreed between the permanent establishment and its foreign head office deviate from what independent third parties would have agreed under comparable circumstances. Additionally, these deviations must result in reduced domestic income.
Comments
The BFH reinforced its view that section 1(5) AStG is to be strictly regarded as an income adjustment rule and may not be used to reject profit determinations without thorough examination and further reasoning. Income adjustments under section 1(5) AStG are only permissible if there is a clear objective link between non-arm's length transfer prices and domestic income reduction.
Generally, profit determinations for permanent establishments are based on general accounting rules (see section 4 of the Income Tax Act, EStG).
The BFH’s decisions highlight the importance of adhering to the arm's length principle and proper documentation for cross-border transactions. Nevertheless, the practical implementation of the AOA in Germany remains challenging.
There are wider implications of the BFH ruling for permanent establishments around the world, where tax authorities seek to use discretion to make profit adjustments.