General Remarks/Introduction
Looking up the definition for a “business” or “enterprise” one regularly finds that a key characteristic is the intention to generate profits, i. e. to produce goods, services, or intangibles for a market that generates a revenue that is greater than the cost of the underlying professional activity.
However, even though businesses intend to make profits, they will not always be able to achieve that goal. It is evident that in order to establish a business, it first needs to invest in a market to make itself and its product known to potential customers and to create sufficient demand. One of the best-known examples for this is Amazon that due to its expansion strategy needed nearly ten years from its foundation in 1994 to the first full year of profit in 2003. Other reasons for losses may be changing market conditions or internal mismanagement. As a result, businesses in general need to become profitable (or at least have the prospect of becoming profitable in the foreseeable future) in order to stay in the market, as otherwise they will sooner or later become insolvent and go out of business.
Transfer Pricing Perspective
However, when looking at a group of companies, it is possible that an individual group company is kept in business by support in form of capital injections or guarantees by its shareholders even though the company does not generate any profits over a longer period of time. This might be done for example to promote a brand in one market that has positive spill-over effects into other markets which means that the group as a whole benefits while the individual group company in question is making losses. However, from a transfer pricing perspective, such an approach appears inconsistent as it violates the arm’s length principle: No independent company would incur losses in order to allow another (unrelated) company to generate additional profits without compensation. This is also acknowledged in Section 3.64 of the 2022 OECD-Guidelines.
As a result, tax authorities often regard ongoing losses of a local company as a red flag for non-arm’s length transfer prices and start conducting an audit, which is in line with the recommendations of the 2022 OECD Guidelines (see Section 3.65). Tax authorities may consider transfer pricing adjustments if there is no credible evidence that independent third parties would have accepted similar losses for the period under audit. Such an argumentation will have to explain the market and/or local organizational reasons for the losses and usually also requires an explanation of how the company is expected to become profitable (again) by budget data that withstands a critical review by the tax authorities.
Approach taken by German tax authorities
According to the German transfer pricing rules and guidelines, the following aspects need to be considered with regards to ongoing losses:
- According to Section 4 (2) No. 5 of the German decree on transfer pricing documentation1, “records of the causes of losses and of measures taken by the taxpayer or related parties to eliminate the loss situation if the taxpayer has reported a tax loss from business relations for more than three consecutive financial years from business relationships” have to be provided as part of the company’s transfer price documentation.
- This requirement is further specified in the German transfer pricing guidelines2 that contain a full section on the audit of loss situations (chapter C5). The main statements are summarized below:
- In cases where ongoing losses (on a pre-tax level) are tolerated (or even encouraged) by the group, the company needs to be remunerated by the benefiting companies and thus compensated for the losses.
- The review of a loss situation should be based on the company’s specific and individual organization of operational processes but not only look at functions performed, risks assumed and assets employed, but also the cause of losses (e. g. strategic decisions, local mismanagement).
- If a company has neither the relevant decision-making authority to take or reduce risks nor the financial capacity to assume risks that are determined to be the cause of a loss situation, the resulting expenses should not be allocated to this company for tax purposes. Hence a routine entity should normally not be in a loss position for a prolonged period of time, i. e. it should generally be able to show a total profit after at least five years. However, that period may be longer or shorter depending on the underlying market conditions and circumstances.
- In an ongoing loss situation, non-arm’s length transfer prices may be manifested by:
- Inappropriate transfer prices for goods and services exchanged,
- The non-identification (and pricing) of additional transactions, or
- The incurrence of expenses caused by the interest of other group entities.
- It is not sufficient to demonstrate the arm’s length nature of transfer prices by referring to an internal CUP for the same products and services if other business conditions regarding the allegedly comparable uncontrolled transaction differ as also laid out by the five comparability criteria defined by the OECD Guidelines (e. g. market conditions, turnover or cost situation or contractual relationships, such as the obligation to purchase the entire product range).
- Capital injections or capital-replacing measures (e. g. debt waiver, letter of comfort) by other companies belonging to the group can be regarded as an indication that the business activities of a loss-making group company are in the (co-)interest of the group as a whole.
In that respect, it needs to be pointed out that ongoing losses may not only be relevant if they occur on a company level. Instead, it might already suffice that a certain product group incurs losses over a longer period of time for the German transfer pricing rules to become effective.
The rule of thumb applied by the German transfer pricing rules and guidelines is that (start-up) losses of a distribution entity should normally not exceed three years, and the company should show a total profit after five years. This stems from decisions by the highest German Fiscal Court3 that determined these periods as being acceptable under normal arm’s length considerations for a distribution business.
Conclusion
In the event of losses over a longer a period of time, it is necessary to determine not only the functions actually performed, the risks assumed and the assets used, but also the causes of the losses. If a company has neither the relevant decision-making powers to take or reduce risks nor the financial capacity to assume such risks, a tax allocation of risks and the resulting expenses to this company is likely to be challenged.
In order to be prepared for such a discussion with the German tax authorities it is recommendable to enhance the local file by including a section that explains the reasons for the loss situation and describes the measures taken to improve on the situation.
1 Verordnung zu Art, Inhalt und Umfang von Aufzeichnungen im Sinne des § 90 Absatz 3 der Abgabenordnung (Gewinnabgrenzungsaufzeichnungs-Verordnung - GAufzV) dated 12 July 2017 (BGBl. I S. 2367)
2 Verwaltungsgrundsätze – Verrechnungspreise 2024 dated 12 December 2024 (IV B 3 - S 1341/19/10017 :004)
3 Bundesfinanzhof Decisions dated 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)
Publication Date:
29 August 2025