In two judgements dated 18 December 2024 (case numbers I R 45/22 and I R 49/23), the Federal Fiscal Court (BFH) clarified that Section 1 (5) of the Foreign Tax Act (AStG) is an income correction standard and not an independent regulation for determining permanent establishment profits. The determination of profits of a domestic dependent permanent establishment can therefore not be rejected solely on the basis of this standard and a reallocation of profits cannot be carried out.

Section 1(5) AStG was intended to transpose the content of the OECD permanent establishment report (also known as the Authorised OECD Approach, or "AOA" for short) published in July 2008 and the subsequent revision of the OECD Model Tax Convention and its new commentary into national law. The provisions of Section 1 (5) AStG are concretised by the Ordinance on the Apportionment of Permanent Establishment Profits (BsGaV).

According to this regulation, the arm's length principle applies to cross-border business relationships between the parent company and the permanent establishment. In addition, the AOA is based on the idea of treating permanent establishments as separate and independent companies (so-called functionally separate entity approach).

The AOA is divided into two main steps:

1. Allocation of personnel functions, assets, opportunities and risks as well as appropriate equity (endowment capital) to the permanent establishment.
2. Determination of the type of business relationships between the parent company and the permanent establishment and the transfer prices for these business relationships.

The incorporation of permanent establishment profit recording and profit determination in the income correction standard of Section 1 AStG has led to numerous challenges in practice since its introduction. These include implementation issues, but also questions relating to deadlines and sanctions in the event of non-compliance. This often leads to disputes between taxpayers (their advisors) and the tax authorities, as in the cases to be assessed by the BFH.

In the case in dispute, a Hungarian corporation (parent company) maintained a permanent establishment in Germany, which carried out contract work in the area of assembly. The competent tax office did not accept the permanent establishment profit declared in the year in dispute. Instead, it assumed that the permanent establishment only carried out routine activities and assumed a contractual relationship between the permanent establishment and the parent company (so-called "dealing"). The tax office determined the profit of the permanent establishment by applying the specific German regulations on profit allocation for construction and assembly permanent establishments using the cost-plus method with a (fictitious) cost mark-up. However, the lower court saw no evidence of dealing and therefore rejected the use of notional mark-up rates (Nuremberg tax court, judgement of 27 September 2022, 1 K 1595/20).

The BFH has now confirmed the decision of the Nuremberg tax court. The deciding senate was of the opinion that it is already clear from the wording of the law and the integration of the provision into the Foreign Tax Act that Section 1 (5) AStG is an income correction provision and not an independent profit determination provision that can be systematically assigned to the regulatory area of Sections 4 et seq. of the Income Tax Act (EStG). In this respect, the provision is linked to a previous reduction in income. § Section 1 para. 5 AStG therefore has no spill-over effect outside the corresponding area of application, meaning that an assessment of profits based on the taxable event in accordance with sections 4 et seq. EStG is also permissible for permanent establishments. In addition, the BFH emphasises that an off-balance sheet adjustment can only be made under Section 1 (5) AStG if non-arm's length prices have been agreed and, as a causal condition, the permanent establishment income has been reduced as a result.

Due to the fact that the BFH does not assume a breach of the documentation obligations, it can be concluded that it does not assume the existence of a relationship under the law of obligations between the permanent establishment and the parent company. As no service relationships (remunerated at arm's length) could be established in the facts of the judgement, Section 1 (5) AStG may therefore not be applied. In the opinion of the BFH, there is therefore no transfer pricing relevance.

The BFH also confirmed these principles in a second decision dated the same day (judgement of 18 December 2024, I R 49/23 (NV)).

With these judgements, the BFH has confirmed its previous case law, according to which Section 1 AStG is purely a correction provision for income. It does not allow an existing, event-related determination of profits, as is often the case abroad, to be simply discarded without further examination.

An income adjustment for permanent establishments in accordance with Section 1 (5) AStG is only possible if there is a causal link between transfer prices that are not at arm's length and the resulting reduction in income. This must be assessed based on the facts of the case using the following test steps:

1. Were non-arm's length prices agreed between the permanent establishment and the parent company for presumable contractual relationships (dealings)?
2. Did these arm's length prices reduce the domestic permanent establishment income?

At the same time, the judgements highlight the weaknesses in the legislative implementation of the AOA within the framework of the income correction standard of Section 1 AStG, which were already addressed at the beginning.

This results in the following practical question: Is the application of the AOA and the preparation of the required auxiliary and ancillary calculation mandatory for (limited) taxpayers with permanent establishments in Germany?

Even if the judgements speak against an obligation, the tax office is nevertheless subject to internal instructions and guidelines and must apply this standard accordingly. From a consultancy perspective, it is therefore advisable to consider a corresponding profit calculation logic in the essay in order to avoid corresponding disputes.

Even if the latest judgements are to be welcomed in our opinion, they do not solve the dilemma. Further legal developments therefore remain to be seen. A further case on similar issues is currently pending before the BFH under case number I R 38/23 and a decision is expected next year.

Our KPMG transfer pricing experts will be happy to answer any questions you may have about permanent establishments.