02.06.2025Federal tax court issues rulings on profit allocation to permanent establishments based on income adjustment rule under Foreign Tax Act
Income adjustment rule may only be applied to profit attribution to permanent establishments under specific circumstances
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.
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.
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