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.
Judgment 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 the customer P. The taxable income was not included in the taxable income for the year 2013.”
“According to the principles generally applicable to vGA, it is decisive that the plaintiff sold the material to CB at its purchase prices and did not later receive it back through purchases from CB. The plaintiff thus made a loss, because it was not reimbursed for the expenses it incurred in procuring the material. In such cases, a correction is necessary in that a mark-up is applied to compensate for the plaintiff’s own costs and for a certain profit margin (cf. BFH ruling of 6 April 2005 I R 22/04, BStBl II 2007, 658 and Gosch § 8 KStG marginal no. 1145 “Price discount” and marginal no. 386 on the cost mark-up method).”
“A mark-up was also customary for third parties, as CB itself could not have purchased the material from third parties for the agreed purchase prices. Thus, the plaintiff expressly submitted that CB would not have been able to realise the purchasing advantages that it itself had with its suppliers.”
“In reviewing the transfer prices of the plaintiff’s (re)purchases, the FA was correct in applying the cost-plus method.”
“However, the Senate does not consider CB’s locational advantages to have been sufficiently taken into account. Since the plaintiff can only make profits by producing abroad, it is dependent on a foreign company cooperating with it. A foreign managing director of CB can claim this dependence of the plaintiff, because the plaintiff would have to look for another contracting partner of equal quality and cost, if necessary. The Senate therefore considers a profit mark-up rate of … % to be appropriate.”
(See the later decision of the BFH – I R 54/19)
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