Transfer pricing: judgment on the including the depreciation of valuation difference in the cost base

The Regional Court in Hradec Králové issued judgment No. 31 Af 21/2022-99 on transfer pricing, where it confirmed the tax administrator’s view that when a valuation difference arises in an intra-group restructuring, the depreciation of this valuation difference should be included in the cost base for calculating the profitability of the contract manufacturer. This is the case even if the depreciation is a non-tax deductible expense for the company. According to the Court, the decisive factor is the economic link of the spun-off assets to future (taxable) income; the tax treatment of the depreciation of the valuation difference is not relevant to transfer pricing.

The tax administrator assessed income tax on a manufacturing company that is a member of a multinational group because the company did not achieve profitability in intercompany transactions at the level of lower quartile according to the submitted benchmarking analysis of independent contract manufacturers. The manufacturing company was formed due to a demerger by spin-off where a portion of the assets related to the manufacturing business was spun off into the company. In accordance with Act No. 125/2008 Coll., on Conversions of Commercial Companies and Cooperatives (“AoC”), a valuation of the spun-off part was carried out (using the discounted cash flow method and the net income capitalisation method for the valuation of non-operating assets) taking into account the future profit potential of the manufacturing company. As a result of this valuation, a valuation difference of CZK 1 billion was recognised in the opening balance sheet of the new company, which is being depreciated over 15 years in accordance with Czech accounting regulations. According to Act No. 586/1992 Coll., on Income Taxes, as amended (the “ITA”), the valuation difference, which arose otherwise than through the purchase, is considered a non-tax deductible expense and therefore its depreciation is also a non-tax deductible expense for the company.

It was not disputed that the new company could be characterised as a contract manufacturer (performing limited functions and bearing limited risks). Nor the tax administrator disputed the method used to determine the company’s profitability based on targeting the net profit mark-up on operating costs. At the heart of the dispute was the methodological issue of including the depreciation of the valuation difference in the cost base for calculating profitability. By not including the depreciation in the cost base, the company did not achieve (accounting) profitability at the level of lower quartile of the presented benchmarking analysis. The results of the benchmarking analysis were not disputed by the tax administrator.

The Regional Court agreed with the tax administrator

In its judgment 31 Af 21/2022-99, the Regional Court agreed with the tax administrator’s view that the valuation difference is related to assets connected with contract manufacturing, which is the company’s main activity, and therefore there was no objective reason to exclude this depreciation from the cost base when calculating the profitability level indicator.

The company did not incur any actual expense for either the valuation difference or the assets themselves. It merely took over the assets from its predecessor and the depreciation of the remaining assets included in the calculation of its profitability, so that the company obtained assets for which it would have to pay the purchase price in case of purchase. According to the Court, there is no doubt that these assets generate revenue for the company and, if sold, the residual value will be an expense and the sale itself will generate revenue. Accordingly, the Court cannot accept the company’s argument that the depreciation of the valuation difference does not constitute an actual expense incurred in the transaction under review and is an extraordinary item caused by the restructuring, which should be excluded from the cost base.

The Regional Court states that the crucial factor is the economic link of the expense to the controlled transaction of contract manufacturing, while the tax deductibility of the specific expense entering the cost base is not relevant to transfer pricing.

The Court has not found relevant the company’s arguments that such approach at the company leads to an economically irrational result and is contrary to the principle of tax neutrality of restructuring arising from the ITA, as based on the logic applied by the tax administrator due to the restructuring the cost base is increased, which would otherwise (without the implementation of the restructuring resulting in the valuation difference) not occur.

After the additional income tax assessment, the company claimed, with reference to Section 23(4)(e) of the ITA, the exclusion of the related income corresponding to the depreciation of the valuation difference included in the cost base. Respectively, the company requested that the expense in the form of the depreciation of the valuation difference be treated as tax deductible according to Section 24(2)(zc) of the ITA. The Regional Court, however, considered this claim to be unjustified and agreed with the tax administrator’s view that, although the depreciation of the valuation difference could be regarded as a non-tax deductible expense, it could not be automatically assumed that certain amount of the expense incurred generates identical amount of income for the company and, therefore, the provision under Section 23(4)(e) of the ITA could not be applied. Thus, according to the Regional Court, in this case, there cannot be inferred a direct link between the non-tax deductible expenses and the potential income arising from the calculation of the profit margin or from a direct “re-invoicing” of those expenses.

The tax administrator assessed the additional income tax at the lower quartile of the arm’s length range resulted from the presented benchmarking analysis and did not consider the minimum of the arm’s length range, even though the company’s profitability after including the depreciation of the valuation difference in the cost base is higher than the minimum. The Regional Court agreed with the tax administrator, which, in order to eliminate extreme values and inaccuracies and to ensure the maximum possible degree of comparability of the sample of 56 comparable entities, accepted the statistical methods used in the analysis presented, which took into account the medium trend, while respecting the principle of the most favourable treatment of taxpayers. The tax administrator did not accept the company’s subsequent argumentation regarding the use of a full range and the Court agreed with its view.

Further implications of this decision:

  • The judgment states, without further explanation, that under international (and e.g. US) accounting standards, the valuation difference is not depreciated and, thus, does not influence the profit or loss. In practice, it is possible to find cases when the tax administrator accepts the profitability calculation based on international (IFRS) or US accounting standards, if, for example, a Czech company follows the group transfer pricing methodology set up in this way. It would be interesting to see how the tax administrator would assess a similar case if the taxpayer had followed this possible alternative method (under which the targeted profitability would not be influenced by the valuation difference) from the beginning.
  • According to the recent case law of the Supreme Administrative Court, the interquartile range is not the only one correct if the use of statistical methods calculating the profitability range are sufficiently justified. It is not entirely clear from the case how the use of statistical methods was justified in the benchmarking analysis originally submitted by the company. However, what is clear is that additional justifications or extensions of the originally presented arm’s length results may not be possible, or more precisely, may not be accepted by the tax administrator or the Court, as they were not in this case.
  • The transfer pricing is not an exact science, but the proper application of different possible alternative methods should not lead to completely different conclusions or economically irrational results with a significant impact on the amount of tax assessed. The principle of correct determination and assessment of tax applies in tax proceedings, and the tax administrator is still obliged to determine the correct amount of tax.
  • Since the company has filed an appeal, further guidance on the procedures required from taxpayers will be provided by the Supreme Administrative Court. However, this case already demonstrates that the application of commonly accepted approaches in practice requires more detailed consideration than may appear at first sight. Companies should exercise great caution in the area of transfer pricing, even within the seemingly trivial steps of the procedures used. It has been repeatedly proven that providing additional explanations of the procedures used in the subsequent stages of the proceedings is very difficult.

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