Regional court: tax administrator erred in applying transfer pricing rules to transactions between unrelated parties
The Regional Court in Hradec Králové sided with the taxpayer against a tax administrator who, without any basis in law, treated a part of a company's transactions with independent entities as controlled transactions. The tax administrator then wrongfully assessed additional tax and a penalty by applying to these uncontrolled transactions rules used to assess prices between related parties.
A large Czech timber company defended itself in court against the tax administrator's approach, and the Regional Court in Hradec Králové stood up for them. The Income Tax Act stipulates that, if prices agreed between related parties differ from prices that would have been agreed between unrelated parties in common business relations under the same or similar conditions, the tax administrator shall adjust the taxpayer's tax base by the ascertained difference. This provision should therefore apply only to related parties, strictly defined by law. However, the tax administrator applied it also to the company's transactions with unrelated parties (independent entities) and assessed additional income tax and penalties.
According to the Regional Court in Hradec Králové, however, the tax administrator erred in extending the exact definition of related parties in the Income Tax Act to cases that do not fall within that definition. The tax administrator assessed the function and risk profile of the company as a limited function and risk manufacturer, while the company considered itself a full-fledged manufacturer. In the dispute, the company argued that the tax administrator did not examine the actual state of the individual decision-making processes within the group to which the company belonged. At the same time, according to the company, the tax administrator erred in carrying out a comparability (market) analysis. The Regional Court upheld the company’s objection that the tax administrator could only analyse transactions between related parties, and that the tax administrator should first prove that there was indeed a relationship between related parties.
The Appellate Financial Directorate has lodged a cassation complaint against the court’s decision, and we will have to wait for the final assessment. Even so, the court’s ruling is quite crucial for many taxpayers, as it gives them new arguments for possible disputes with the tax administrator. At the same time, it has been once again confirmed that an incorrectly assessed function and risk profile within the group business model can cause considerable complications for companies.
Well-prepared transfer pricing documentation, including a comparative market analysis covering related-party transactions, can be very effective in preventing similar situations. We will be happy to assist you with the preparation of your company’s transfer pricing documentation.