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SAC: toll manufacturing should not result in loss

The Supreme Administrative Court recently dealt with yet another transfer-pricing case. The dispute involved the entitlement of a toll manufacturer to report losses due to unfavourable developments in the target market.

The controlled entity manufactured cables using raw materials provided by the parent company and, according to the transfer-pricing documentation, operated as its detached manufacturing plant. The transfer price was set as the price per minute of manufacturing service and the transfer price was updated every six months. In 2008, the manufacturer incurred a loss due to a significant drop in the production volume.

The tax administrator levied additional tax onto the entity as a percentage of actually incurred costs, using the tax administration’s own Amadeus-based comparative analysis. The administrator did not acknowledge the drop in output as an argument, claiming that the manufacturer did not control the utilisation of its production capacity. Moreover, the documentation explicitly stated that the “detached manufacturing plants do not bear any other risks but those linked to their production function”.

The Supreme Administrative Court confirmed the legitimacy of the profit adjustment by the tax administrator (5 Afs 194/2015). According to underlying documentation submitted by the manufacturer during the tax inspection, the cost plus method should have been applied, taking into account all production costs. According to the court, it was appropriate to remunerate the total production activity.

What is positive about the tax administrator’s approach is that it compares the Czech manufacturer’s profitability against the lowest values of profitability for entities selected within a comparative analysis. Negative is that the tax administrators did not deal in much detail with the activities that were in fact carried out by the companies being benchmarked and relied solely on the provided code of classification of economic activities.

The decision is a confirmation of the tax administrator’s consistent long-term approach towards companies whose functions are significantly restricted, particularly when such a fact also emerges from the presented transfer-pricing documentation.

We expect that the decision will back tax administrators and that loss-making companies operating as contract manufacturers or toll manufacturers will continue being easy prey for the tax administrator in the future. Timely and diligent preparation for a transfer pricing inspection as well as consistent argumentation to support any losses is therefore highly recommendable.