SAC paves way for assessment of additional tax on transactions with unrelated parties
The Supreme Administrative Court has opened transfer pricing’s Pandora's box by allowing tax administrators to assess additional tax based on overall profitability not just for related-party transactions, but also for transactions with unrelated parties. If the conclusions of this judgment 7 Afs 398/2019 - 49 hold up in the light of future case law, we can expect the financial administration to be more active in assessing additional tax for taxpayers operating within a corporate group.
The Income Tax Act, which regulates transfer pricing, stipulates that the tax administrator shall adjust the taxpayer's tax base if there is an unsubstantiated difference between the prices agreed with related parties and the prices that would be agreed with unrelated parties in normal business relations under the same or similar conditions.
As we can see from the wording of this provision, an adjustment of the tax base should only be considered once the tax administrator identifies transactions with related parties that differ from standard market conditions. Up until now, this was confirmed by both case law and the financial administration’s approach.
In the present case, the SAC concluded that even transactions with an unrelated party may be regarded as controlled transactions: if they had been influenced by a related party. In particular, where the parent company determines the distribution of functions and risks, it should compensate the manufacturer for the risks borne by them that they, in their position of a contract manufacturer, cannot control. The same conclusion was previously formulated by the regional court, which stated that the taxpayer should have received compensation from the parent company for the loss incurred. This means that once the financial administration authorities deduce that a taxpayer’s transactions with an unrelated party were influenced by a related party, according to the SAC, the transactions with the unrelated party do not have to be examined on an individual basis, but all these transactions en bloc shall be subject to an adjustment of the tax base.
The court therefore confirmed the tax administrator’s and subsequently the regional court’s suggestion that if transactions with unrelated parties that cannot be considered at arm’s-length are identified, the taxpayer should be compensated for their ‘hypothetical service’ (in this case, the loss-making production). In the court’s opinion, it is not relevant which of the related persons specifically benefited from the hypothetical service; however, the court admitted that usually the parent company will be the liable person.
The SAC has thus opened transfer pricing’s Pandora's box: its judgment has allowed the financial administration authorities to assess tax based on overall profitability, i.e., not only for transactions with related parties, but also on those with unrelated parties, even though the taxpayer had negotiated the conditions (prices) with them at arm’s length. This considerably widens the burden of proof on the taxpayer’s part: they will now have to prove the absence of a ‘service to the group’ (or not being influenced by another company in the group) for transactions with unrelated parties as well.
Given the significant departure from the current judicial decision-making practice in the context of transfer-pricing, the question remains whether this decision will also hold up in the light of other SAC case law.