223. Transfer Pricing: Tax Court Upholds Document Production Order

The Münster Tax Court has upheld fines assessed by the tax authorities to compel taxpayer production of cost accounting documents for transfer pricing audit purposes (judgement of 22 August 2000 - 6 K 2712/00 - EFG 2001, 4). The judgement was not appealed and is now final.

The tax authorities requested the corporation under audit to produce its charts of cost centre accounts (Kostenstellenpläne) for two of the company's 60 departments for use in verifying the appropriateness of transfer prices paid. The charts of cost centre accounts (chart of functional accounts) would reveal the architecture of the company's cost accounting system since all journal expense entries in the financial accounting system were coded to specific cost centres. The tax authorities reserved the right, after examination of the charts of cost centre accounts, to require production of the cost accounting for the departments in question. Foreign affiliates of the corporation under audit carried on businesses of the same nature as the departments for which cost accounting documentation was requested.

Since the taxpayer failed to produce the requested documents, the tax authorities gave notice of intent to assess fines pursuant to §§ 332 AO (in conjunction with §§ 328, 329 AO) in an amount of DM 15,000 for each of the two document requests. When compliance was still not forthcoming by the deadline specified in the notice, the threatened fines were levied.

The taxpayer appealed the assessment on the following grounds:

• that the tax authorities were not entitled to documents prepared voluntarily, i.e. without legal obligation, and hence not subject to retention under § 147 (1) AO;
• that requiring the production of documents prepared voluntarily would unconstitutionally disadvantage the company as compared with other taxpayers who limited their documentation to the statutory minimum;
• that the document request was overbroad, part of a "fishing expedition," and impermissible because the tax authorities lacked the required "well-founded reason" (begründeter Anlaß) to doubt the accuracy of the company's transfer prices;
• that the documents sought were irrelevant to the stated purpose; and
• that the company had already provided the tax authorities with all documentation which it was legally required to generate and maintain, that this documentation was an adequate basis for transfer price auditing, hence that the production of additional internal management documents was unnecessary.

The Tax Court determined that the tax authorities were in principle entitled to require production of the chart of cost centre accounts (functional accounts) under § 97 (1) and § 200 (1) AO. At the time of the audit, these statutes read as follows in pertinent part:

§ 97 (1) AO

The tax authorities can require the parties and other persons to produce books, records, business papers, and other documents for inspection and review.

§ 200 (1) AO

The taxpayer shall cooperate in the determination of the matters that may have relevance for tax purposes. It shall in particular provide [requested] information, produce records, books, business papers, and other documents for inspection and review, and provide the explanations needed to understand these records.

Citing a 1968 ruling by a combined chamber (Großer Senat) of the Federal Tax Court (Gr. S. 5/67 of 13 February 1968 - BStBl II 1968, 365), the Münster Tax Court held that the tax authorities' right to production of documents was not limited to the books and records that taxpayers are required to keep under the Tax Procedure Act and the Commercial Code (above all, financial accounting records and business correspondence). The right to production of documents instead extended to all documents that existed in fact and possessed evidentiary value with respect to a legally relevant issue.

The court had little trouble affirming the evidentiary value of the cost centre planning for transfer price audit purposes. The court also rejected arguments by the taxpayer that information from outside the financial accounting realm was privileged as management information. A corporation had no privileged private sphere, the court stated.

The tax authorities therefore had authority to request the documents in question. The decision to use such authority in a specific case was discretionary and reviewable only for abuse of discretion.

The court stated that the tax authorities had discretion to require the production of documents only where such was "necessary, proportionate, feasible, and not unduly burdensome." However, the court affirmed that all these requirements were met.

The court noted that cost centre planning was sought for only 2 out of a total of 60 departments in the firm. For Department A, the documents sought would aid in verifying the carrying values of allocable inventory. For Department B, the documents sought would permit verification whether all costs allocable to services provided to an Irish affiliate company had been invoiced. The court furthermore gave weight to the tax authorities' contention that innumerable individual journal entries would have to be traced and analysed in order to glean comparable information from the financial accounts alone. Finally, the court stressed that the taxpayer was not being required to generate new documents, but merely to hand over records already in its hands.

The taxpayer contended that its document production obligations under §§ 91 (1), 200 (1) AO could never apply to documents the retention of which was not required by § 147 (1) AO.

§ 147 (1) AO reads as follows:

The following documents must be retained in a systematic manner:

1. books and records, inventory lists, year-end financial statements, management reports, [and] the opening balance sheet, together with the job instructions and other organisational documents necessary to their comprehension;
2. commercial and business letters received
3. reproductions of commercial and business letters sent
4. bookkeeping vouchers
5. other documents, to the extent having tax significance.

The court ruled against the taxpayer without specifically commenting on § 147 (1) AO. Logically, the court's reading of the law must be as follows:

• that document retention under § 147 (1) AO extends to documents having tax significance even if prepared by the taxpayer without legal obligation for internal management purposes, or
• that the documentation production obligations under §§ 97 (1), 200 (1) AO extend beyond the document retention obligations created by § 147 (1) AO, or
• both of the above.

The judgement of the Münster Tax Court stands for the proposition that the tax authorities are entitled to require the production of all tax relevant documents which the taxpayer possesses in fact, whether or not the taxpayer was legally required to create or retain such documents. In considering whether the tax authorities abused their discretion in seeking production of documents, the court appears to have weighed the following factors:

• whether compliance with the request would cause the taxpayer to incur significant expense or otherwise constitute a significant burden
• whether the documents sought were likely to have considerable probative value for transfer pricing purposes
• whether the production request was global or narrowly focussed (here limited to 2 out of 60 company departments)
• whether the same information could be derived from the financial accounts, and if so, whether the required effort would be significantly greater.

The case does not elucidate the limits of the taxpayer's obligation to provide information to the tax authorities on request, for instance to respond to written interrogatories. Nor does the case raise the issues involved in the interlocutory ruling by the Federal Tax Court (FTC) reported on in article no. 221 (10 May 2001 - I S 3/01). In this ruling, the FTC held that the taxpayer did not breach duties of cooperation by reason of non-production of documents it neither had nor was required to have. The Münster Tax Court found the taxpayer at fault for failing to produce documents which it indisputably did have, regardless of whether it was required to have them. Furthermore, in the FTC case the tax authorities sought to derive expanded authority to assess tax on an estimated basis under § 162 AO from the taxpayer's non-performance of alleged documentation obligations. In the case before the Münster Tax Court, the tax authorities sought to compel performance by assessing fines, not to assess tax on an estimated basis.

Given the large number of important document retention and production issues raised by the decision here reported on, it is regrettable that no appeal to the Federal Tax Court was taken. The decision indicates that at least the lower courts are willing to interpret tax procedure law liberally in favour of the tax authorities when it comes to document production in a transfer pricing context.