SAC on investments made based on parent company’s decision

In connection with a change in its production portfolio, a taxpayer (a company in a group) reported a loss that was not compensated by the parent company. In subsequent years, it supplied its production to other customers within the group. The company then became subject to a separate tax inspection resulting in an assessment of additional operating profit and additional tax, which the company did not contest.

According to the SAC, there was no dispute between the parties to the proceedings that the taxpayer was a contract manufacturer. It was also proven that, based on a strategic decision by the parent company, the taxpayer had spent funds on building new production facilities, for which the parent company did not compensate it in any way.

The regional court ruled in favour of the taxpayer in the first instance, arguing that this was a matter of the common business management, referring to the Mayer & Cie. CZ case law (10 Afs 162/2021-50). In that particular case, the court did not identify a change of the production portfolio as a controlled transaction; however, the case involved a company that, thanks to a shareholder's decision to change the production portfolio and subsequently dispose of inventories, avoided bankruptcy. The Appellate Financial Directorate filed a cassation complaint against the court's decision.

The SAC rejected the regional court’s argument, stating that while the Mayer & Cie. CZ case involved a rational and economic procedure for a subsidiary without any profit for the parent company, in the case under review, the parent company or group profited from its decision regarding the investment.
 

How the financial administration thinks about transfer pricing

This example illustrates the Appellate Financial Directorate's position on transfer pricing, which is evident in particular from the following: "...internationally recognised rules governing relations between related entities must be understood independently of the rules of corporate law" and "...the assessment of commercial and financial relations between related entities does not serve to prevent tax evasion but rather to distribute the jointly generated profits of the group in the same way as they would have been achieved under comparable conditions in independent transactions of a business entity."

This clearly shows the approach taken by the financial administration with respect to transfer pricing: it does not always accept a formalised contractual arrangement as evidence and tends to simplify matters, often disregarding the legal requirement for comparability of transactions, contractual relationships, and price fairness, and instead focusing on the simple requirement of allocating profits to the Czech taxpayers.

In the given case, the SAC then defined the subject matter of the particular contractual relationship as "the establishment of automotive component production for the group", while in the SAC’s view, consideration for this (or rather the coverage of costs incurred in this respect) was missing. The SAC then suggested several possible solutions by referring to Article 2.91 of the OECD Guidelines.

We recommend that companies in the position of contract manufacturers consider this court decision when planning their investments and making related transfer pricing arrangements. In view of the frequent argument by the tax authorities that a loss-making company is subject to a ‘parent company’s order’, with the parent company then bearing the consequences of the negative situation, we generally recommend that even full-fledged companies pay increased attention to documenting the economic justification for any significant investments they make.

You can read about the Supreme Administrative Court’s previous rulings concerning parent company orders (7 Afs 358/2021-34, 10 Afs 162/2021-50) here.