Amortisation of valuation differences arising on company transformations part of cost base for transfer pricing purposes

In the case at hand, the taxpayer had not included the amortisation of the valuation difference arising from a demerger by spin-off with the creation of a new company in the cost base when calculating the transfer price, or the achieved profitability, to verify that such a price falls within the established margin. The method used was the net profit margin method (TNMM). 

Neither the transfer pricing method used (cost plus a mark-up) nor the functional and risk profile of the taxpayer was contested in the dispute. It was 'only' the failure to include the amortisation of the valuation difference in the cost base that was contentious. However, given the amount of the amortisation expense, this was a significant item. Simply put, the tax authorities believed the taxpayer had artificially reduced the price of their products and consequently their tax base by excluding this item. The Supreme Administrative Court sided with the tax administrators who based their reasoning essentially on the fact that the valuation difference was related to the taxpayer's production activities. According to the tax administrator and the SAC, there was no objective reason for excluding the amortisation from the cost base when calculating the profitability of operating costs, as it was an integral part of production costs.

The SAC also emphasised that the tax deductibility of the accounting item in question is not relevant in determining the price of the transaction for transfer pricing purposes. What is relevant is the economic link between the cost in question and the controlled transaction, and not its tax deductibility.

In our opinion, the SAC’s conclusion is questionable from a methodological point of view. Firstly, we draw attention to the OECD Guidelines, according to which it is necessary to exclude any items that are not of an operational nature and affect comparability with independent (uncontrolled) transactions. From a transfer pricing perspective, the cost of amortising the valuation difference is not related to a company’s operating activities but is essentially an extraordinary accounting item (this is different from recognition in accounting). Secondly, it is important to note that the valuation difference arising on transformations is not and never will be a real expense, but it is 'only' an accounting item that in most cases reflects the future expected profit potential of the spun-off part of a business establishment.

We also believe that the SAC’s decision ignores some essential circumstances. For example, while the valuation difference on transformations is accounted for under the Czech accounting regulations and is amortised to expenses over 15 years, under international accounting standards the valuation difference is not recognised and therefore not amortised. Thus, under the SAC’s interpretation, applying different accounting standards would thus lead to different results (i.e., a different unit price per product).

The published judgment may also present an interesting paradox in the context of an amendment to the Income Tax Act and the new Accounting Act currently under discussion, as these will allow certain taxpayers to determine their tax base based on accounting records kept in compliance with international accounting regulations.

Another statement of the SAC is also worth noting: in its view, taxpayers cannot bear the consequences of decisions (on mergers) taken by another company in the group and have their profit achieved reduced by the items resulting from such decisions.

Consequences of the judgment

How to read the judgment in question? First of all, it should serve as a caveat of the need to review the transfer pricing calculation setup where a company records goodwill or a valuation difference in its accounts, especially where these accounting items arise from the sale of a business or its part and represent a real expense for the buyer, while the arguments set out above cannot be applied to them. Consideration should also be given to situations where the transfer price excludes certain items that are not taxable/tax deductible. The fact that an expense or revenue is not tax deductible or taxable does not in itself guarantee that the item need not be included in the transfer pricing calculation where cost-based transfer pricing methods are used.