SAC’s view on parent company orders
Any influencing of an uncontrolled transaction by a related party, usually a parent company, is regarded by the tax authorities as a parent company’s orders. This may be, e.g., a parent company ordering a subsidiary to sell goods to that subsidiary’s customers at prices lower than arm’s-length. In our experience, the tax administrators’ interpretation is rather extensive. The Supreme Administrative Court (SAC) has currently ruled on two cassation complaints, further clarifying the issue.
The first judgment (7 Afs 358/2021-34) concerned a taxpayer producing and supplying timber to related parties and to unrelated customers. The tax authorities applied the taxpayer’s arm’s length prices also to supplies to unrelated parties (additional assessment as a percentage of costs). The regional court refused to deal with the case, arguing that the tax authority had impermissibly extended the definition of a related party transaction beyond the scope of the Income Tax Act to unrelated parties.
However, in further proceedings, the SAC reversed the regional court’s judgement favouring the taxpayer and sided with the tax administrator. According to the SAC, the taxpayer's parent company was the main controlling element: it provided direction, coordination, and management and by the set business model made it impossible for the subsidiary to negotiate contractual terms with their customers. Therefore, the taxpayer did not have full control over their transactions and, although they entered into transactions with unrelated parties, they did so upon the parent company’s orders. The parent company should therefore compensate them for the services provided, or damage incurred. The case was thus returned for further proceedings to the regional court, which is bound by the SAC’s opinion.
It can therefore be concluded that the mere fact that the taxpayer supplies to and invoices unrelated parties and has no formal relationship with the parent company does not in itself preclude the application of the arm’s-length price rule.
In the second judgment (10 Afs 162/2021-50), the SAC dealt with whether a parent company's decision to discontinue an unprofitable production of knitting machines and dispose of the raw material inventories can be subsumed under the provisions on arm’s-length prices in the Income Tax Act and the Double Taxation Treaty. The court examined whether the parent company was obliged to compensate the subsidiary for the related damage.
The tax administrator viewed the loss on the disposal of the raw materials carried out following the order to discontinue production as a transaction between related parties that was not carried out at arm's length. According to the tax administrator, in common contractual relations, the person who gave an order to dispose of inventories would compensate the other party for the damage incurred. The company argued that they had decided to discontinue the production themselves, and that the parent company had merely consented to exiting the markets; had the parent company not given the consent, the company would have gone bankrupt and dissolved.
The regional court and then the SAC concluded that this was not a transaction between related parties that would be subject to the transfer pricing provision as the provision applies to contractual obligations. In the present case, however, it was the parent company’s decision made as a part of the business management of the subsidiary. The management of a company does not in itself result in the origination, change, or termination of a contractual obligation. Nor did the parent company receive any direct undue profit in this respect.
The decision to discontinue an unprofitable production and dispose of inventories was thus the result of a perfectly legitimate business decision. It is thus not possible to generalise that any loss from any transaction should be compensated.