SAC: The parent company must compensate the contract manufacturer for losses

The Supreme Administrative Court (“SAC”) delivered a judgment in the area of transfer pricing confirming the opinion of the Financial Administration that fellow subsidiaries of multinational groups operating in the Czech Republic as contract manufacturers should not, basically, incur any losses from their routine activities. If they incur losses from their activities, regardless of whether from transactions with related or unrelated parties, the group, or rather the parent company should compensate them for the losses so that the fellow subsidiaries can record at least minimum operating profitability.

The tax administrator assessed additional income tax for a manufacturing company, which is part of a multinational group, since it concluded that the company, from the perspective of transfer pricing, operates as a contract manufacturer and thus should not incur any losses. Although the company supplied its products (automotive parts) directly to both related and unrelated parties (car manufacturers), it bore, according to the tax administrator, risks within its manufacturing activities that could not be influenced within its position as a contract manufacturer. For instance, the exchange rate risk of purchasing inputs for the production or the risk of determining the sale prices of its products was affected. The tax administrator stated that the company was selling its products for prices lower than operating costs, which the company was not able to reflect in final prices to the customers as the selling prices were negotiated by the parent company, or the other two sister companies. Such a setting resulted in loss-making operations that were not compensated in any way.

The tax administrator thus identified an intragroup transaction, “a hypothetical service consisting in loss-making production for the benefit of the group“, for which the independent undertaking would be sufficiently compensated, if performed. However, the taxable entity did not receive such compensation. The tax administrator quantified the compensation in a level so that the company could record aggregate operating profitability (from all, both related and non-related transactions) of 1.26% representing the minimum of arm’s length range achieved by comparable entities (in contrast to the negative profitability of -3.27% reported by the taxable entity). In its ruling No. 7 Afs 398/2019-49, the SAC confirmed the method and conclusions of the tax administrator and the regional court. The SAC also affirmed that the reported positive profitability of the taxable entity in the following taxable periods was not relevant for the conclusions on profitability achieved in the audited taxable period (2011 in this case).

At the same time, the SAC also admitted that it was not important which of the related persons (the parent company or sister subsidiaries) was supposed to compensate the company. The SAC concluded that in this case, the company should have claimed compensation from its parent company, which acts as a principal entity of the whole group.

The key points of this decision in connection with our experience with similar tax proceedings can be summarised as follows:

  • Proving the functional and risk profile within tax audit remains a substantial, though rather complicated and problematic area in practice. We often experience that the taxpayers have not formally documented the decision-making processes in the company and often do not have persuasive arguments confirming the declared facts. It should be mentioned that in this specific case, the company submitted transfer pricing documentation upon the initiation of the tax audit claiming the company is a contract manufacturer performing only limited functions. Subsequently, within the later stages of the audit, updated documentation was submitted declaring a more complex functional profile (of a licensed manufacturer) without providing credible evidence of changes in the functional profile.
  • It has been a long-standing opinion of the Czech Financial Administration that it is irrelevant whether a company supplies its products to related or unrelated parties if a limited functional and risk profile is proved. If the parent or other company within the group influences the decision-making processes that may have a material impact on a fellow subsidiary‘s risk materialisation, e.g. individually negotiates key input prices or selling prices to customers, the fellow subsidiary should, in such a case, insist on ensuring a minimum arm’s length profitability from the side of the parent or other company in the group.
  • The potential positive profitability of a taxable entity with a limited functional and risk profile in other periods (either prior or following) is not relevant. This approach complies with the long-term trend declared by the Czech Financial Administration, which does not accept (contrary to the OECD recommendations) the multiple-year approach where the average profitability of an entity is tested over several periods, usually three or five years.
  • Finally, it is necessary to mention that the SAC’s opinion that it is irrelevant which specific group entity should compensate the entity with a limited functional and risk profile for potential losses may complicate or disable a potential mutual agreement procedure (“MAP”) to avoid double taxation.

In conclusion, it must be noted that the judgment mentioned confirms that the incorrect transfer pricing set-up or lack of related supporting documentation or persuasive means of evidence may result not only in additional costs concerning the additionally assessed tax, related penalties, and late payment interest but also in significant necessary time commitment from the company to conduct the tax audit and subsequent proceedings (appeal proceedings, regional court proceedings or SAC proceedings) as well as related costs for advisory or legal assistance. In the specific case, the decision of the dispute was made more than 10 years after the end of the audited taxable period. As a similar set-up may be relevant for several taxable periods, the financial impact on the company and the whole group may be highly material.

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