Transfer pricing issues for permanent losses

A company is characterised by the fact that it is founded and operated with the intention of making a profit - i.e. providing products, services or rights to the market whose revenues exceed the costs of doing business.

However, even if companies are fundamentally geared towards making a profit, they do not always succeed in actually achieving this goal. It is obvious that a company must first invest in a market in order to establish itself, make its product known to potential customers and create sufficient demand. One of the best-known examples of this is Amazon, which took almost ten years from its foundation in 1994 to its first full-year profit in 2003 due to its expansion strategy. Other reasons for losses can include changing market conditions or internal mismanagement. Consequently, companies generally need to become profitable (or at least have the prospect of becoming profitable in the foreseeable future) in order to survive in the market. Unprofitable companies are at risk of being forced out of the market due to over-indebtedness or insolvency.

In the case of groups of companies, however, it is possible that an individual company in the group is kept alive by capital injections or guarantees from its shareholders, even though this company itself does not generate any profits over a longer period of time. This could be done, for example, to promote a brand in a market from a group perspective that has positive spillover effects on other markets, meaning that the group as a whole benefits while the company in question makes losses. From a transfer pricing perspective, however, such an approach seems incomprehensible as it violates the arm's length principle: No independent company would permanently accept losses in order to allow another (unrelated) company to make additional profits without compensation. This is also stated in section 3.64 of the OECD Guidelines 2022.

As a result, tax authorities often consider ongoing losses of a local company as an indication of non-arm's length transfer pricing and start a closer scrutiny in line with the recommendations of the 2022 OECD Guidelines (see section 3.65). Tax authorities could consider transfer pricing adjustments if it cannot be credibly argued that independent third parties would have accepted similar losses for the audited period. Such reasoning must take into account the market-related and/or local organisational reasons for the losses. This usually also requires an explanation of how the company plans to become profitable (again) - based on budgeted data that can withstand critical scrutiny by the tax authorities.

According to the German transfer pricing rules and guidelines, the following aspects must be taken into account for current losses:

• According to §. 4 para. 2 no. 5 of the German Profit Deferral Recording Ordinance1 , the transfer pricing documentation must contain records of the causes of losses and of arrangements made by the taxpayer or related parties to eliminate the loss situation if the taxpayer reports a tax loss from business relationships for more than three consecutive financial years.
• This requirement is further specified in the German administrative principles on transfer pricing2. They contain a complete section on the audit of loss situations (Chapter C5). The most important statements are summarised below:
  • In cases where ongoing losses (before tax) are tolerated (or even encouraged) by the group, the company must be compensated by the benefiting companies.
  • The review of a loss situation should be based on the specific and individual organisation of the operational processes - but should not only consider the functions performed, the risks taken and the assets used, but also the causes of losses (e.g. strategic decisions, local mismanagement).
  • If a company has neither the decision-making authority to take or reduce risks nor the financial capacity to take risks that have been determined to be the cause of a loss situation, the resulting expenses should not be attributed to that company for tax purposes. A routine business should therefore not normally be in a loss-making situation for an extended period of time, i.e. it should generally be able to report an overall profit after at least five years. However, this period may be longer or shorter depending on the underlying market conditions and circumstances.
  • In a situation with ongoing losses, non-arm's length transfer pricing can manifest itself as follows:
    • Inappropriate transfer prices for exchanged goods and services,
    • the failure to identify (and price) additional transactions, or
    • the incurrence of costs caused by the interest of other companies in the group.
  • It is not sufficient to demonstrate the arm's length nature of transfer prices by reference to an internal price comparison for the same products and services if the business relationships used for comparison differ, as discussed in the five comparability criteria of the OECD Guidelines (e.g. market conditions, sales or cost situation or contractual relationships, such as the obligation to purchase the entire product range).
  • Capital injections or capital substitution measures (e.g. debt waiver, letter of comfort) by other companies belonging to the group can be seen as an indication that the business activities of a loss-making group company are in the (co-)interest of the group.

In this context, it should be noted that current losses may not only be relevant if they are incurred at company level. Rather, it may be sufficient for a certain product group to generate losses over a longer period of time for the German transfer pricing rules to apply.

The rule of thumb applied in the German transfer pricing rules and guidelines that the (start-up) losses of a distribution company should generally not exceed three years and that the company should show an overall profit after five years is based on court decisions of the Federal Fiscal Court3, which considered these periods to be acceptable for a distribution business under normal arm's length considerations.

In the case of permanent losses, not only the functions actually performed, the risks assumed and the assets utilised must be documented, but also the causes of the losses. If a company has neither the appropriate decision-making powers to take or reduce risks nor the financial capacity to assume the costs potentially associated with such risks, the allocation of risks and the resulting expenses to this company for tax purposes is generally not permitted and is likely to lead to transfer pricing adjustments by the German tax authorities.

In order to be prepared for such a discussion with the German tax authorities, it is advisable to add a section to the country-specific documentation (local file) in which the reasons for the loss situation are explained and the measures to improve the situation are described.

1. Ordinance on the type, content and scope of records within the meaning of Section 90 (3) of the German Fiscal Code (Gewinnabgrenzungsaufzeichnungs-Verordnung - GAufzV) of 12 July 2017 (BGBl. I p. 2367)
2. Administrative principles - transfer prices 2024 of 12 December 2024 (IV B 3 - S 1341/19/10017 :004)
3. Federal Fiscal Court judgements of 17 October 2001 (I R 103/00, BStBl II 2004 p. 171) and 17 February 1993 (I R 3/92 BStBl 1993 II p. 457)