Due to the economic situation of automotive suppliers in Germany in 2006, “Cutting Tech GMBH” established a subsidiary (CB) in Bosnien-Herzegovina which going forward functioned as a contract manufacturer. CB did not develop the products itself, but manufactured them according to specifications provided by “Cutting Tech GMBH”. The majority of “Cutting Tech GMBH”‘s sales articles were subject to multi-stage production, which could include various combinations of production processes. In particular, “Cutting Tech GMBH” was no longer competitive in the labour-intensive manufacturing processes (cut-off grinding, turning, milling) due to the high wage level in Germany. Good contribution margins from the high-tech processes (adiabatic cutting, double face grinding) increasingly had to subsidise the losses of the labour-intensive processes. Individual production stages, however, could not be outsourced to external producers for reasons of certification and secrecy. In addition, if the production had been outsourced, there would have been a great danger that a third company would have siphoned off “Cutting Tech GMBH”‘s know-how and then taken over the business with “Cutting Tech GMBH”‘s customer. This could have led to large losses in turnover for “Cutting Tech GMBH”. Furthermore, some of the labour-intensive work also had to cover one or more finishing stages of the high-tech processes, so that this business was also at risk if it was outsourced. For these reasons, the decision was made to outsource the labour-intensive production processes to Bosnia-Herzegovina in order to become profitable again and to remain competitive in the future. There, there were German-speaking staff with the necessary expertise, low customs duties and a low exchange rate risk. CB functioned as a contract manufacturer with the processes of production, quality assurance and a small administrative unit. Cost advantages existed not only in personnel costs, but also in electricity costs. CB prevented the plaintiff’s good earnings from the high-tech processes in Germany from having to continue to be used to subsidise the low-tech processes. “Cutting Tech GMBH” supplied CB with the material needed for production. The deliveries were processed as sales of materials. “Cutting Tech GMBH” received as purchase prices its cost prices without offsetting profit mark-ups or handling fees/commissions. The material was purchased and supplied to CB by “Cutting Tech GMBH”, which was able to obtain more favourable purchase prices than CB due to the quantities it purchased. The work commissioned by “Cutting Tech GMBH” was carried out by CB with the purchased material and its personnel. CB then sold the products to “Cutting Tech GMBH”. In part, they were delivered directly by CB to the end customers, in part the products were further processed by “Cutting Tech GMBH” or by third-party companies. “Cutting Tech GMBH” determined the transfer prices for the products it purchased using a “contribution margin calculation”. Until 2012, “Cutting Tech GMBH” purchased all products manufactured by CB in Bosnia and Herzegovina. From 2013 onwards, CB generated its own sales with the external company P. This was a former customer of “Cutting Tech GMBH”. Since “Cutting Tech GMBH” could not offer competitive prices to the customer P in the case of production in Germany, CB took over the latter’s orders and supplied P with the products it manufactured in accordance with the contracts concluded. CB did not have its own distribution in the years in dispute. The tax audit of FY 2011 – 2013 The auditor assumed that the transfer of functions and risks to CB in 2007/2008 basically fulfilled the facts of a transfer of functions. However, since only a routine function had been transferred, “Cutting Tech GMBH” had rightly carried out the transfer of functions without paying any special remuneration. Due to CB’s limited exposure to risks, the auditor considered that the cost-plus method should be used for transfer pricing. In adjusting the transfer prices, the auditor assumed a mark-up rate of 12%. The material invoiced by “Cutting Tech GMBH” and the scrap proceeds was not included in the cost basis used in the assessment. For 2013, the auditor took into account that the customer P had agreed contracts exclusively with CB and reduced the costs by the costs of the products sold to P. Furthermore, the auditor took the legal view that the entire audit period should be considered uniformly. Therefore, it was appropriate to deduct an amount of €64,897 in 2011, which had been calculated in favour of “Cutting Tech GMBH” in 2010 and not taken into account in the tax assessment notices, in order to correct the error. The auditor did not consider it justified to determine the transfer prices for “Cutting Tech GMBH”‘s purchases of goods by means of a so-called contribution margin calculation. Based on the functional and risk analysis, the auditor concluded that CB was a contract manufacturer. On the grounds that this profit of CB was remuneration for a routine function, the auditor refrained from recognising a vGA because of the transfer of client P from the applicant to CB. However, he stated that according to arm’s length royalty rates, values between 1% and 3% could be recognised as royalty “according to general practical experience.” “Cutting Tech GMBH” filed an appeal against the assessment in 2015 and in November 2019 the Tax Court parcially allowed the appeal of “Cutting Tech GMBH” and adjusted the assessment issued by the tax authorities. An appeal and cross appeal against the decision of the Tax Court was then filed with the Federal Tax Court (BFH). Judgement of the BFH The Federal Tax Court overturned the decision of the Tax Court and referred the case back to the Tax Court for another hearing and decision. “The appeals of the plaintiff and the FA are well-founded. They lead to the previous decision being set aside and the matter being referred back to the Fiscal Court for a different hearing and decision (§ 126 Para. 3 Sentence 1 No. 2 FGO). The arm’s length comparison carried out by the lower court to determine the transfer prices for the acquisition of processed products from C by the Plaintiff is not free of legal ...

In determining which party(ies) should be attributed the location savings at arm’s length, it will be important to consider the functions, risks and assets of the parties, as well as the options realistically available to each of them. In this example, assume that there is a high demand for the type of engineering services that the company in Country X sells. Assume also that the subsidiary in Country Y is the only company operating in a lower-cost location that is able to provide such services with the required quality standard, and Company Y is able to withstand competitive pricing pressures because the technical know-how it has established acts as a barrier to competition. Furthermore, the company in Country X does not have the option of engaging qualified engineers in Country X to provide these services, as the cost of their wages would be too high compared to the hourly rate charged to clients. Considering this, the enterprise in Country X does not have many other options available to it than to use this service provider. The remuneration payable by Company X to Company Y should take into account the location savings created by Company Y, in addition to the value of its services including any intangibles used in providing those services. In some instances, the nature of the contributions made by the enterprise in Country X and its subsidiary in Country Y may meet the criteria for the use of a transactional profit split method ...

As another example, assume now that an enterprise in Country X provides highly specialised and quality engineering services to independent clients. It charges a fee to its independent clients based on a fixed hourly rate that compares with the hourly rate charged by competitors for similar services in the same market. Suppose that the wages for qualified engineers in Country X are high. The enterprise subsequently subcontracts a large part of its engineering work to a new subsidiary in Country Y. The subsidiary in Country Y hires equally qualified engineers to those in Country X for substantially lower wages, thus deriving significant location savings for the group formed by the enterprise and its subsidiary Clients continue to deal directly with the enterprise in Country X and are not necessarily aware of the sub-contracting arrangement. For some period of time, the well-known enterprise in Country X can continue to charge its services at the original hourly rate despite the significantly reduced engineer costs. After a certain period of time, however, it is forced due to competitive pressures to decrease its hourly rate (at an amount that would not allow the company in Country X to cover the wages for qualified engineers in Country X, but that would still yield a benefit if those services are provided by qualified engineers in Country Y). Part of the location savings are passed on to its clients. In this case also, the question arises of which party(ies) within the MNE group should, at arm’s length, be attributed the part of the location savings not passed on to the clients: the subsidiary in Country Y, the enterprise in Country X, or both (and if so in what proportions) ...

Take the example of an enterprise that designs, manufactures and sells brand name clothes. Assume that the manufacturing process is basic and that the brand name is famous and represents a highly valuable intangible. Assume that the enterprise is established in Country A where the labour costs are high and that it decides to close down its manufacturing activities in Country A and to relocate them in an affiliate company in Country B where labour costs are significantly lower. The enterprise in Country A retains the rights on the brand name and continues designing the clothes. Further to this restructuring, the clothes will be manufactured by the affiliate in Country B under a contract manufacturing arrangement. The arrangement does not involve the use of any significant intangible owned by or licensed to the affiliate or the assumption of any significant risks by the affiliate in Country B. Once manufactured by the affiliate in Country B, the clothes will be sold to the enterprise in Country A which will on-sell them to third party customers. Assume that this restructuring makes it possible for the group formed by the enterprise in Country A and its affiliate in Country B to derive significant location savings. The question arises whether the location savings should be attributed to the enterprise in Country A, or its affiliate in Country B, or both (and if so in what proportions) ...

Where significant location savings are derived further to a business restructuring, the question arises of whether and if so how the location savings should be shared among the parties. In addressing this matter, the guidance in Section D.6 of Chapter I is relevant ...

Where the functional analysis shows that location savings exist that are not passed on to customers or suppliers, and where comparable entities and transactions in the local market can be identified, those local market comparables will provide the most reliable indication regarding how the net location savings should be allocated amongst two or more associated enterprises. Thus, where reliable local market comparables are available and can be used to identify arm’s length prices, specific comparability adjustments for location savings should not be required ...

Pursuant to the guidance in paragraphs 9.126 – 9.131, in determining how location savings are to be shared between two or more associated enterprises, it is necessary to consider (i) whether location savings exist; (ii) the amount of any location savings; (iii) the extent to which location savings are either retained by a member or members of the MNE group or are passed on to independent customers or suppliers; and (iv) where location savings are not fully passed on to independent customers or suppliers, the manner in which independent enterprises operating under similar circumstances would allocate any retained net location savings ...

Due to the economic situation of automotive suppliers in Germany in 2006, “Cutting Tech GMBH” established a subsidiary (CB) in Bosnien-Herzegovina which going forward functioned as a contract manufacturer. CB did not develop the products itself, but manufactured them according to specifications provided by “Cutting Tech GMBH”. The majority of “Cutting Tech GMBH”‘s sales articles were subject to multi-stage production, which could include various combinations of production processes. In particular, “Cutting Tech GMBH” was no longer competitive in the labour-intensive manufacturing processes (cut-off grinding, turning, milling) due to the high wage level in Germany. Good contribution margins from the high-tech processes (adiabatic cutting, double face grinding) increasingly had to subsidise the losses of the labour-intensive processes. Individual production stages, however, could not be outsourced to external producers for reasons of certification and secrecy. In addition, if the production had been outsourced, there would have been a great danger that a third company would have siphoned off “Cutting Tech GMBH”‘s know-how and then taken over the business with “Cutting Tech GMBH”‘s customer. This could have led to large losses in turnover for “Cutting Tech GMBH”. Furthermore, some of the labour-intensive work also had to cover one or more finishing stages of the high-tech processes, so that this business was also at risk if it was outsourced. For these reasons, the decision was made to outsource the labour-intensive production processes to Bosnia-Herzegovina in order to become profitable again and to remain competitive in the future. There, there were German-speaking staff with the necessary expertise, low customs duties and a low exchange rate risk. CB functioned as a contract manufacturer with the processes of production, quality assurance and a small administrative unit. Cost advantages existed not only in personnel costs, but also in electricity costs. CB prevented the plaintiff’s good earnings from the high-tech processes in Germany from having to continue to be used to subsidise the low-tech processes. “Cutting Tech GMBH” supplied CB with the material needed for production. The deliveries were processed as sales of materials. “Cutting Tech GMBH” received as purchase prices its cost prices without offsetting profit mark-ups or handling fees/commissions. The material was purchased and supplied to CB by “Cutting Tech GMBH”, which was able to obtain more favourable purchase prices than CB due to the quantities it purchased. The work commissioned by “Cutting Tech GMBH” was carried out by CB with the purchased material and its personnel. CB then sold the products to “Cutting Tech GMBH”. In part, they were delivered directly by CB to the end customers, in part the products were further processed by “Cutting Tech GMBH” or by third-party companies. “Cutting Tech GMBH” determined the transfer prices for the products it purchased using a “contribution margin calculation”. Until 2012, “Cutting Tech GMBH” purchased all products manufactured by CB in Bosnia and Herzegovina. From 2013 onwards, CB generated its own sales with the external company P. This was a former customer of “Cutting Tech GMBH”. Since “Cutting Tech GMBH” could not offer competitive prices to the customer P in the case of production in Germany, CB took over the latter’s orders and supplied P with the products it manufactured in accordance with the contracts concluded. CB did not have its own distribution in the years in dispute. The tax audit of FY 2011 – 2013 The auditor assumed that the transfer of functions and risks to the CB in 2007/2008 basically fulfilled the facts of a transfer of functions. However, since only a routine function had been transferred, “Cutting Tech GMBH” had rightly carried out the transfer of functions without paying any special remuneration. Due to CB’s limited exposure to risks, the auditor considered that the cost-plus method should be used for transfer pricing. In adjusting the transfer prices, the auditor assumed a mark-up rate of 12%. The material invoiced by “Cutting Tech GMBH” and the scrap proceeds was not included in the cost basis used in the assessment. For 2013, the auditor took into account that the customer P had agreed contracts exclusively with CB and reduced the costs by the costs of the products sold to P. Furthermore, the auditor took the legal view that the entire audit period should be considered uniformly. Therefore, it was appropriate to deduct an amount of €64,897 in 2011, which had been calculated in favour of “Cutting Tech GMBH” in 2010 and not taken into account in the tax assessment notices, in order to correct the error. The auditor did not consider it justified to determine the transfer prices for “Cutting Tech GMBH”‘s purchases of goods by means of a so-called contribution margin calculation. Based on the functional and risk analysis, the auditor concluded that CB was a contract manufacturer. On the grounds that this profit of CB was remuneration for a routine function, the auditor refrained from recognising a vGA because of the transfer of client P from the applicant to CB. However, he stated that according to arm’s length royalty rates, values between 1% and 3% could be recognised as royalty “according to general practical experience.” “Cutting Tech GMBH” filed an appeal against the assessment in 2015. Judgement of the Fiscal Court The Fiscal Court adjusted the assessment issued by the tax authorities and thus parcially allowed the appeal of “Cutting Tech GMBH”. Excerpts “In the case at issue, the decisive cause for the plaintiff losing the customer P is not to be seen in the transfer of business to CB. The applicant lost the customer because it could not offer him competitive prices. The takeover of the business with P by CB is thus not the cause of the loss of the customer. The plaintiff’s factual submission is undisputed in this respect and is confirmed by the small profit that CB made from the business according to the calculations of the foreign auditor.” “The FA was correct to add € … to the taxable income in the year 2013 due to the supply of materials to CB for the processing of its business with ...

In determining which party(ies) should be attributed the location savings at arm’s length, it will be important to consider the functions, risks and assets of the parties, as well as the options realistically available to each of them. In this example, assume that there is a high demand for the type of engineering services that the company in Country X sells. Assume also that the subsidiary in Country Y is the only company operating in a lower-cost location that is able to provide such services with the required quality standard, and Company Y is able to withstand competitive pricing pressures because the technical know-how it has established acts as a barrier to competition. Furthermore, the company in Country X does not have the option of engaging qualified engineers in Country X to provide these services, as the cost of their wages would be too high compared to the hourly rate charged to clients. Considering this, the enterprise in Country X does not have many other options available to it than to use this service provider. The remuneration payable by Company X to Company Y should take into account the location savings created by Company Y, in addition to the value of its services including any intangibles used in providing those services. In some instances, the nature of the contributions made by the enterprise in Country X and its subsidiary in Country Y may meet the criteria for the use of a transactional profit split method ...

As another example, assume now that an enterprise in Country X provides highly specialised and quality engineering services to independent clients. It charges a fee to its independent clients based on a fixed hourly rate that compares with the hourly rate charged by competitors for similar services in the same market. Suppose that the wages for qualified engineers in Country X are high. The enterprise subsequently subcontracts a large part of its engineering work to a new subsidiary in Country Y. The subsidiary in Country Y hires equally qualified engineers to those in Country X for substantially lower wages, thus deriving significant location savings for the group formed by the enterprise and its subsidiary Clients continue to deal directly with the enterprise in Country X and are not necessarily aware of the sub-contracting arrangement. For some period of time, the well-known enterprise in Country X can continue to charge its services at the original hourly rate despite the significantly reduced engineer costs. After a certain period of time, however, it is forced due to competitive pressures to decrease its hourly rate (at an amount that would not allow the company in Country X to cover the wages for qualified engineers in Country X, but that would still yield a benefit if those services are provided by qualified engineers in Country Y). Part of the location savings are passed on to its clients. In this case also, the question arises of which party(ies) within the MNE group should, at arm’s length, be attributed the part of the location savings not passed on to the clients: the subsidiary in Country Y, the enterprise in Country X, or both (and if so in what proportions) ...

Take the example of an enterprise that designs, manufactures and sells brand name clothes. Assume that the manufacturing process is basic and that the brand name is famous and represents a highly valuable intangible. Assume that the enterprise is established in Country A where the labour costs are high and that it decides to close down its manufacturing activities in Country A and to relocate them in an affiliate company in Country B where labour costs are significantly lower. The enterprise in Country A retains the rights on the brand name and continues designing the clothes. Further to this restructuring, the clothes will be manufactured by the affiliate in Country B under a contract manufacturing arrangement. The arrangement does not involve the use of any significant intangible owned by or licensed to the affiliate or the assumption of any significant risks by the affiliate in Country B. Once manufactured by the affiliate in Country B, the clothes will be sold to the enterprise in Country A which will on-sell them to third party customers. Assume that this restructuring makes it possible for the group formed by the enterprise in Country A and its affiliate in Country B to derive significant location savings. The question arises whether the location savings should be attributed to the enterprise in Country A, or its affiliate in Country B, or both (and if so in what proportions) ...

Where significant location savings are derived further to a business restructuring, the question arises of whether and if so how the location savings should be shared among the parties. In addressing this matter, the guidance in Section D.6 of Chapter I is relevant ...

Where the functional analysis shows that location savings exist that are not passed on to customers or suppliers, and where comparable entities and transactions in the local market can be identified, those local market comparables will provide the most reliable indication regarding how the net location savings should be allocated amongst two or more associated enterprises. Thus, where reliable local market comparables are available and can be used to identify arm’s length prices, specific comparability adjustments for location savings should not be required ...

Pursuant to the guidance in paragraphs 9.126 – 9.131, in determining how location savings are to be shared between two or more associated enterprises, it is necessary to consider (i) whether location savings exist; (ii) the amount of any location savings; (iii) the extent to which location savings are either retained by a member or members of the MNE group or are passed on to independent customers or suppliers; and (iv) where location savings are not fully passed on to independent customers or suppliers, the manner in which independent enterprises operating under similar circumstances would allocate any retained net location savings ...