With two rulings dated December 18, 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 a norm for income correction and not an independent regulation for determining the profits of a permanent establishment. Consequently, the profit determination of a domestic dependent permanent establishment cannot be rejected solely based on this norm, nor can a reallocation of profits be undertaken.
Background: Authorised OECD Approach
With Section 1 (5) AStG, the content of the OECD Permanent Establishment Report published in July 2008 (also known as the Authorised OECD Approach, or "AOA") and its subsequent revision in the OECD Model Tax Convention and its commentary were intended to be implemented into domestic law. The norm of Section 1 (5) AStG is further specified by the Permanent Establishment Profit Allocation Ordinance (BsGaV).
According to the regulation, the arm's length principle is fundamentally applicable to cross-border business relationships between the head office and the permanent establishment. Additionally, the AOA is based on the idea of treating permanent establishments essentially as separate and independent entities (known as the Functionally Separate Entity Approach).
The AOA is divided into two essential steps:
- Allocation of people functions, assets, risks, as well as an appropriate equity (attribution of free capital) to the permanent establishment.
- Determination of the nature of business relationships or dealings between the head office and the permanent establishment and the transfer pricing for these dealings.
The integration of permanent establishment profit recording and determination into the income correction norm of Section 1 AStG has led to numerous challenges in practice since its introduction. These include implementation issues, as well as questions regarding deadlines and sanctions for non-compliance. This often results, as seen in cases assessed by the Federal Fiscal Court (BFH), in disputes between taxpayers (and their advisors) and the tax authorities.
BFH; Ruling of December 18, 2024 (I R 45/22)
In the dispute, a Hungarian corporation (head office) maintained a permanent establishment in Germany, which performed contract work in the field of assembly. The tax authority responsible did not accept the declared profit of the permanent establishment for the year in dispute. Instead, it assumed that the permanent establishment only carried out routine activities and posited a contractual relationship between the permanent establishment and the head office (known as "dealing"). The tax authority determined the profit of the permanent establishment by applying the German specified regulations for profit allocation in construction and assembly permanent establishments using the cost-plus method with a (fictitious) cost markup. However, the lower court found no evidence for the existence of a "dealing" and therefore rejected the application of fictitious markup rates (Tax Court Nürnberg, ruling of September 27, 2022, 1 K 1595/20).
The BFH has now confirmed the decision of the Tax Court Nürnberg. The deciding senate held the view that the wording of the law and the integration of the norm into the Foreign Tax Act already indicate that Section 1 (5) AStG is a norm for income correction and not an independent profit determination regulation systematically assignable to the regulatory area of Section 4 ff. EStG. In this respect, the provision is contingent upon a preceding reduction of income. Section 1 (5) AStG thus does not have any effect outside its corresponding scope of application, allowing for a causation-based profit determination for permanent establishments according to Sections 4 ff. EStG. Furthermore, the BFH emphasizes that an off-balance correction by Section 1 (5) AStG can only be made if non-arm's length prices were agreed upon, and as a causal condition, the permanent establishment's income was reduced.
Due to the fact that the BFH does not assume a violation of documentation obligations, it can be concluded that it does not consider the existence of assumed contractual relationships between the permanent establishment and the head office. Since no (non-arm's length remunerated) service relationships could be established in the case, Section 1 (5) AStG should therefore not be applied. According to the BFH, there is a lack of relevance for transfer pricing.
The BFH also confirmed these principles in a second decision, dated the same day (ruling of December 18, 2024, I R 49/23 (NV)).
Conclusion and Practical Implications
The BFH has confirmed its previous jurisprudence with the rulings, stating that Section 1 of the Foreign Tax Act (AStG) is purely a correction provision for income. It does not permit the simple rejection of an existing, event-based profit determination, as is often prescribed or occurs abroad, without further examination.
An income correction for permanent establishments under Section 1 (5) AStG is only possible if there is a causal connection between non-arm's length transfer prices and a resulting reduction in income. This must be assessed based on the facts of the case using the following evaluation steps:
- Were non-arm's length prices agreed upon between the permanent establishment and the head office for assumed contractual relationships (Dealings)?
- Did these non-arm's length prices reduce the domestic permanent establishment's income?
At the same time, the rulings highlight the weaknesses in the legislative implementation of the Authorised OECD Approach (AOA) within the income correction norm of Section 1 AStG, which were already addressed initially.
This leads to the following practical question: Is the application of the AOA and the preparation of the required auxiliary and supplementary calculations mandatory for (limited) taxpayers with permanent establishments in Germany?
Even if the rulings argue against an obligation, the tax authority is internally required to examine according to instructions and guidelines and to apply this standard. Therefore, from an advisory practice perspective, it is advisable to consider an appropriate profit determination logic for implementation to avoid potential disputes.
Even though we welcome the recent rulings, in our opinion, they do not resolve the dilemma. Therefore, the further development of the law remains to be seen with anticipation. Currently, another case concerning similar issues is pending at the BFH under case number I R 38/23, with a decision expected next year.
Our KPMG transfer pricing experts are happy to assist you with any questions regarding permanent establishments.
Publication Date:
29 August 2025