Denmark

October 08 2002

A special report by Martin Nielsen, KPMG, Copenhagen

Since 1998, when new transfer pricing regulations were introduced, the Danish tax authorities have increased focus on transfer pricing. Denmark is a member of the OECD and has adopted the OECD Transfer Pricing Guidelines. However, a general arm's-length principle has been considered to be part of Danish tax law since 1903, with rules determining which income was taxable for a specific taxable person and which was not. In 1998 specific rules setting the arm's-length principle as a standard were incorporated and contemporaneous documentation requirements were introduced, including information requirement in the tax return.

The arm's-length principle

According to the arm's-length rule as incorporated in Danish tax law, any taxpayer who:

is controlled by an individual or legal person;
controls an individual or a legal person;
is affiliated with a legal person;
has a permanent establishment outside of Denmark; or
is a non-Danish individual or legal person with a permanent establishment in Denmark

must, when calculating their taxable income, assure that prices and terms for trading and economic transactions with the above-mentioned individuals or legal persons, correspond to those prices and terms that would have applied, had the transactions taken place between non-affiliated parties.

Control is defined as direct or indirect ownership or control of more than 50% of the share capital or voting power of a legal entity.

Application of the OECD guidelines

Denmark fully adopts the OECD guidelines. The accepted methodologies for evaluating transfers of tangible property, intangible property and services are the same as those outlined in the OECD guidelines. Since Danish transfer pricing legislation does not specify any preferred methods for determining arm's-length prices, the implication is that methods described in the OECD guidelines should be followed.

The OECD has given priority to the traditional transaction-based methods. In accordance with this, the Danish guidelines recognize the following transfer pricing methods (listed in order of priority):

comparable uncontrolled price (CUP) method;
resale price method;
cost plus method;
profit split method; and
transactional net margin method.

According to the Danish guidelines, the profit-based methods should be used only as a last resort.

Documentation requirements

Current legislation relating to documentation stipulates that companies must provide information in their tax returns as to the nature and extent of cross-border intra-group transactions. A standard form has been issued by the tax authorities and must be filed with the tax return each year. Furthermore, companies with such cross-border transactions must prepare and maintain written documentation of how prices and terms for inter-company trade have been determined. The documentation must be made available to the tax authorities upon request.

The tax authorities may adjust the taxable income if:

no documentation has been prepared;
the written documentation is insufficient; or
the tax authorities disagree with the pricing.

All adjustments must be based on the OECD guidelines, and the tax authorities must justify the basis and the method applied in the adjustment of the taxable income.

The transfer pricing legislation does not contain precise guidance as to how taxpayers should meet the documentation requirements. However, the documentation must be sufficient for the tax authorities to evaluate the transfer pricing and to assess whether prices are consistent with the arm's-length principle.

Generally it is assumed that depending on the nature and extent of transactions, the company should at least be able to provide the tax authorities with the following information:

a description of the organization, ownership structure and the profits of the companies involved in intra-group transactions;
the nature and scope of the intra-group transactions;
the type of activities of each company, for example manufacturing, advertising, distribution, procurement, (functions and risks);
comparable transactions with independent parties, if any;
price and cost calculations, including specific circumstances affecting prices, and business strategies, including information on whether the transaction is part of other agreements; and
method(s) used in determining intra-group prices. The methods used should comply with the OECD guidelines.

Furthermore, companies should consider supplementing the above with information on the financial position of the companies, changes in intra-group trading agreements, the foreign company's transactions with other group companies, and a list of comparable companies, if any.

The central custom and tax authorities have also indicated that external comparable searches (database analysis) may be an integral part of defensible transfer pricing-documentation where no internal CUPs are available.

Penalties

There are no penalties for non-compliance with the documentation requirements. Nonetheless, the information on intra-group cross-border transactions is considered part of the tax return. Penalties may apply, if not filed properly.

A transfer pricing adjustment will not usually result in penalties. Interest will be charged on additional tax payments arising from transfer pricing adjustments.

Rulings and APAs

Although recent transfer pricing audits have had no particular industry focus, the audits have concentrated on management fee, intra-group services and interest on inter-company loans. Rulings are still reasonably few.

The Danish transfer pricing legislation does not include specific rules for advanced pricing agreements (APAs). Regardless, the Danish tax authorities have entered into APA negotiations, in accordance with applicable tax treaties.

Thin capitalization

According to Danish rules on thin capitalization, the deductibility of interest expense by a Danish company relating to loans from a foreign group company (controlled loans) is restricted, if the Danish subsidiary has a debt-to-equity ratio of more than 4:1 at the end of the tax year.

Controlled loans are considered to be loans from any group company that directly or indirectly controls 50% or more of the share capital or voting rights in the Danish company, is related to the company, or is controlled by the Danish company.

Also, guaranteed loans from third parties such as banks, which have been guaranteed by a group company, will be regarded as controlled loans. Even a letter of intent or letter of comfort will be regarded as a guarantee in this sense. The same applies to back-to-back loans where a group company is involved.

The deduction of interest expense will only be affected, if the debt-to-equity ratio exceeds 4:1 at the end of the income year. It is of no consequence if the ratio exceeds these limits during the course of the income year. Each year a new evaluation is made to determine the deductions possible for the particular year. The debt taken into consideration is all debt in the company.

The effect of the thin capitalization rules is that a deduction is denied for interest expenses and capital losses on such part of the controlled debt that exceeds a 4:1 debt-to-equity ratio.

The equity and debt must be calculated on a consolidated basis for all Danish group companies based on actual market value, including goodwill and other intangible assets. If the assets are increased by a capital contribution, the assets must remain in the Danish company for at least two years in order to be taken consideration when computing the 4:1 debt-to-equity ratio.

If the company wishes to finance more than 80% of its capital with inter-company loans, documentation proving that similar loans could have been obtained from external sources will have to be presented. This is done by a concrete evaluation of the company and its finances. One indication that similar financing would have been available from a third party is the existence of a loan offer on similar terms from a third party.

New case law - use of comparable searches

In recent years there has only been a limited number of court cases involving transfer pricing issues.

On February 28 2002 the Danish High Court issued an important court decision on the use of comparable searches. This decision is the first ruling from the Danish courts where comparable searches have been used, and it is expected that it will set precedence in future transfer pricing cases, even though the ruling concerns tax years before the current Danish transfer pricing legislation came into force

The tax authorities argued that:

a distribution-bonus agreement between a manufacturing and a sales company was not commercially motivated;
the division of profits did not reflect the functions performed and the risks assumed by the group companies involved; and
similar agreements would not have been entered into between independent parties.

The High Court ruled that as it had not been proven that the sales company had earned profit margins that were considerably higher than normal for the industry, there was no reason to adjust the taxable income. At High Court the taxpayer referred to operating margins earned by four independent distributors, which all had higher margins than the sales company.

The ruling shows that the tax authorities may have to present valid external comparables to challenge the taxpayer's transfer prices if the taxpayer has prepared transfer pricing documentation.

Status on the transfer pricing cases

In connection with the introduction of the new transfer pricing legislation in 1998, a central office for international corporate taxation was established, normally referred to as the transfer pricing office. The role of the transfer pricing office is to handle the official approval procedure in transfer pricing cases proceeded by the local tax authorities, coordinate the transfer pricing efforts and negotiate mutual agreement proceedings with foreign tax authorities in transfer pricing cases. The latest information about cases from the transfer pricing office since its establishment in 1998 until the end of 2001 shows that the Danish transfer pricing office has been involved in:

193 transfer pricing cases; and
20 mutual agreement cases.

Of the 193 cases, 104 have been concluded and 11 of the 20 mutual agreement cases have been concluded. As shown in the figure below, the cases proceeded by the Danish tax authorities are primarily focused on intra-group service agreements and partly on transfer of goods, whereas the mutual agreement cases (primarily proceeded by the foreign tax authorities) are centred on transfer of goods.

Transfer pricing cases
	Percentage
Service agreements	41
Goods	19
Financial services	12
Intangible assets	11
Tangible assets and company shares	4
Others/ not specified	13