Transfer pricing when processing raw materials: new case law
Recent case law provides a new perspective on the method of setting transfer prices in situations where a taxpayer formally owns raw materials but all risks associated with the ownership are borne by another party. The judgment may have implications for situations where companies have raw materials at their disposal but the risks associated with it are borne by the customer who ordered the work – i.e. cases of contract manufacturing and similar models.
Judgment No. 29 Af 56/2022-93 follows earlier decision No. 29 Af 91/2019-147, which concerned a Czech manufacturer in the electronics industry. The manufacturer carried out assembly according to its parent company’s instructions, while the parent company provided the raw materials. Although as per the accounting records, the manufacturer acquired the raw material into their ownership, their role was limited to assembly, without adding value to the material or assuming the risks associated with its ownership.
The taxpayer therefore argued that the most appropriate profitability indicator would be ROVAC (return on value-added costs), which only considers value-added costs. However, the tax administrator insisted on the ROTC (return on total costs) indicator, which works with a mark-up on all costs, including the value of the material, because of its formal ownership by the manufacturer.
In the first decision, the court agreed with the taxpayer and held that a mere formal ownership of the raw material does not mean that the taxpayer bears the related risks. According to the court, the tax administration had not considered the actual functional and risk profile of the manufacturer, and the choice of the ROTC indicator had therefore been insufficiently reasoned.
The tax administrator subsequently reconsidered their approach and carried out an additional analysis, using a scoring system to allocate functions and risks between the manufacturer and the customer, based on a value chain analysis submitted in the previous proceedings. The system assigned weights to each function and risk according to its importance. The tax administrator then multiplied the ascertained value generation percentage by the originally determined mark-up to, in their view, better match the manufacturer's profile.
In the second judgment, the regional court sided with the tax administrator, confirming that this modified approach was correct, and agreeing that the application of the ROTC indicator was suitable in such cases, provided that the limited role of the manufacturer is considered.
The case will continue with a cassation complaint before the Supreme Administrative Court. We recommend following its further development, especially for companies in a similar situation.
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