Transfer Pricing Adjustments and the Treatment of Compensatory Payments

Transfer pricing adjustments under Section 1 of the German Foreign Tax Act (AStG) serve, without prejudice to other provisions, to determine the correct amount of domestic income of taxpayers that maintain business relationships with related parties. The applicable benchmark is the arm’s length principle, according to which the conditions agreed between associated enterprises, in particular prices (transfer pricing), must correspond to those that would apply to comparable business transactions between independent third parties.

In transfer pricing and tax audit practice, the question often arises following an income adjustment as to how intragroup compensatory payments should be treated for tax purposes when the entities involved seek to restore, also from an economic perspective, an arm’s length result. This issue is particularly relevant because the off‑balance sheet income adjustment under Section 1 AStG does not in itself trigger a corresponding payment movement.

The BMF (i.e. German Federal Ministry of Finance) letter of 12 December 2024, IV B 3 – S 1341/19/10017 :004, German Administrative Principles Transfer Pricing 2024 (“AP‑TP 2024”), contains in para. 4.3 lit. d) an easement provision explicitly related to adjustments under Section 1 AStG. Under certain conditions, this provision allows an off‑balance sheet offsetting of compensatory payments against the surcharge levied as part of the income adjustment under Section 1 AStG.

The rule thus constitutes an important link between the tax‑technical correction and the economic allocation of results. What also makes this provision particularly interesting for the transfer pricing practitioner is that, under certain circumstances, it can serve as an efficient means of avoiding economic double taxation—without necessarily having to resort to international dispute resolution mechanisms such as a mutual agreement procedure.

If, in the course of a tax audit, it is determined that the conditions agreed between related parties do not comply with the arm’s length principle, the resulting income must be adjusted in accordance with Section 1 AStG, without prejudice to other provisions. The adjustment is carried out by an off‑balance sheet addition of the determined adjustment amount to the taxable result of the affected domestic taxpayer.

Although this form of income adjustment leads to a formal modification of the tax base, it does not affect the economic allocation of results within the group. From a group perspective, there may therefore be an interest in restoring an arm’s length outcome not only for tax purposes but also economically. This typically occurs through intragroup compensatory payments between the entities involved.

The tax‑relevant question in this context is whether such a compensatory payment can neutralize the previously imposed income adjustment, or whether it, viewed in isolation, gives rise to further tax consequences.

Para. 4.3 of the AP‑TP 2024 expressly differentiates the treatment of compensatory payments depending on the legal basis of the underlying income adjustment; i.e., it distinguishes between hidden profit distributions, hidden capital contributions, withdrawals/contributions and adjustments under Section 1 AStG.

For adjustments based on Section 1 AStG, lit. d) establishes an autonomous easement provision. According to this, it is permissible, on grounds of equity, to offset compensatory payments outside the balance sheet against the surcharge applied as part of the income adjustment, provided that certain cumulative conditions are met. Experience suggests that these conditions are to be interpreted restrictively and relate in particular to:

• the actual execution of the compensatory payment,
• the payment being made within one year after notification of the amended tax assessment, and
• the consistent off‑balance sheet treatment of the offset.

If these requirements are met, the previously imposed surcharge is, as a result, neutralized for tax purposes outside the balance sheet. The provision thereby acknowledges that Section 1 AStG adjustments are economically aimed at achieving an arm’s length result and not at imposing an additional burden on the taxpayer beyond that.

The easement provision set out in the AP‑TP 2024 is consistent with the case law of the German Federal Fiscal Court (Bundesfinanzhof, BFH ruling of 30 May 1990, I R 97/88, Bundessteuerblatt II 1990, p. 875).

The adjustment within the meaning of Section 1 AStG is limited to an off-balance sheet correction of the taxpayer’s income. The existing profit determination remains unaffected by the adjustment. If, in transfer pricing cases, the parties compensate for an income adjustment made by the German tax authorities by making compensatory payments to establish the situation that would have arisen had the arm’s length principle been observed, the risk of double taxation arises.

However, Section 1 AStG is not intended to result in double taxation. Therefore, a tax relief through easement measures within the meaning of Section 163 of the German Fiscal Code (Abgabenordnung, AO) is required. Paragraph 4.3 letter d) of the AP TP 2024 meets this requirement.

A domestic group company, D, generates a commercial profit of 1.0 million euros from the distribution of products of its foreign parent company, M, in the assessment period. In the course of a tax audit, the German tax authorities conclude that, based on the arm’s length principle, an appropriate profit for D would have been 1.4 million euros.

D’s taxable income is therefore increased off-balance sheet by 0.4 million euros in accordance with Section 1 AStG. From a group perspective, the economic allocation of results within the group is to be aligned with this tax-driven income adjustment. For this reason, M makes a compensatory payment of 0.4 million euros to the domestic company D; for example, in the form of a credit note on the product prices for goods purchased by D.

If this payment is made within one year after notification of the amended tax assessment implementing the off-balance sheet income adjustment, it must, under para. 4.3 lit. d) AP‑TP 2024, be offset off‑balance sheet against the imposed surcharge. The tax effect of the income adjustment is thereby neutralized domestically to that extent.

In practice, it is particularly important that, beyond the domestic easement solution under para. 4.3 lit. d) AP‑TP 2024, double taxation may—in suitable cases—already be avoided in an international context if, and to the extent that, the intragroup compensatory payment is recognized for tax purposes as a deductible business expense at the level of the paying entity in the other contracting state. In such a constellation, the profit increased in Germany as a result of the Section 1 AStG income adjustment is economically and fiscally offset by a corresponding reduction in taxable profit in the other state.

From a treaty perspective, this corresponds to the regulatory content of Art. 9(1) OECD MC, which requires profits to be adjusted so that they reflect the amounts that independent enterprises would have earned under comparable conditions. If the adjustments such as in the present case—is not made through a formal corresponding adjustment under Art. 9(2) OECD MC, but instead through the recognition of the compensatory payment as an arm’s length expense, the treaty‑mandated result is nevertheless achieved in substance.

This does, however, require that the foreign tax authority understands and accepts both the arm’s length nature of the payment and its underlying economic rationale. In such cases, the profit correlation required under the treaty is effectively realized without the need to initiate a mutual agreement procedure under Art. 25 OECD MC.

The application of the easement provision under domestic law does not automatically ensure international symmetry in taxation in the domestic and foreign jurisdiction. If the foreign state does not recognize the compensatory payment, or recognizes it only in part, as a deductible business expense, the risk of economic double taxation remains.

In such situations, the initiation of a mutual agreement procedure under Art. 25 OECD MC becomes particularly important. This often constitutes an effective instrument for achieving a treaty‑compliant allocation of profits within the group and for avoiding double taxation.

The treatment of compensatory payments discussed here—through para. 4.3 lit. d) AP‑TP 2024 in combination with a corresponding deduction of business expenses in the foreign state—therefore remains especially relevant and must always be examined where an (efficient) prevention of economic double taxation via a mutual agreement procedure under Art. 25 OECD MC cannot be expected. This particularly includes cases in which no double taxation treaty exists, an existing treaty does not contain an arbitration clause within the meaning of Art. 25(5) OECD MC, or where the German tax authorities make the waiver of a mutual agreement procedure a condition for reaching a “factual agreement” (tatsächliche Verständigung) on a certain Section 1 AStG adjustment.

The easement provision in para. 4.3 lit. d) AP‑TP 2024 constitutes a key instrument for preventing double taxation of domestic income arising as a consequence of an adjustment under Section 1 AStG and a corresponding compensatory payment between the parties involved.

Moreover, if the compensatory payment is correspondingly recognized as a deductible business expense abroad, the provision may, in practice, offer a means of avoiding treaty‑inconsistent double taxation even without initiating a mutual agreement procedure.

Taxpayers should therefore consider applying the easement provision in para. 4.3 lit. d) AP‑TP 2024 whenever a corresponding deduction for the compensatory payment appears feasible abroad and, at the same time, an (efficient) prevention of economic double taxation through a mutual agreement procedure under Art. 25 OECD MC is not to be expected.

Our KPMG specialists will be pleased to assist you with any questions or to exchange experience regarding the treatment of compensatory payments.