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Courts settle TP cases despite COVID-19

Justice set aside?

Courts in India, Denmark, and the US issued precedent-setting judgments in three transfer pricing (TP) cases concerning Samsung, Adecco and Whirlpool, respectively, which tax professionals need to consider when assessing their TP arrangements.

There have been several landmark court decisions in 2020 since COVID-19 changes the business landscape. ITR has covered the Apple state aid case and the Cameco TP case in extensive detail, yet there are other important cases that have implications for multinationals.

Large companies with complex arrangements are vulnerable to TP disputes, even if they take proper precautions. This puts some taxpayers in a difficult position.

“Transfer pricing alignment with business strategies is even more essential,” said Jonathan Schwarz, barrister at Temple Tax Chambers. “Opportunistic behaviour is unlikely to be tolerated and resisting opportunistic behaviour by tax administrations depends on it.”

The COVID-19 pandemic may have increased the propensity for audits and disputes. Although the COVID-19 crisis shutdown economies, the pandemic did not stop some court cases from reaching their long-awaited conclusions. The law waits for no one – not even a virus.

Samsung wins India PE case over project office

The Supreme Court of India ruled in favour of the taxpayer in the case of Samsung Heavy Industries on July 22. The case concerned the specific activity exemption to the permanent establishment (PE) rule for preparatory and auxiliary activities.

Samsung Heavy Industries argued that its Mumbai project office did not constitute a fixed place PE and relied on the tax treaty between India and South Korea as the basis of its defence. The manufacturing company set up the Mumbai office to serve as an intermediary with the Oil and Natural Gas Corporation, a state-owned enterprise in India, over its work in the country.

The case dates back to 2006 when the Oil and Natural Gas Corporation awarded a contract to a consortium including Samsung Heavy Industries. This contract included work on facilities under the Vasai East Development Project.

Although the Mumbai Project Office was an important channel for the company to communicate with the Indian state enterprise, the office was secondary to a lot of the work. For example, engineering and procurement were handled abroad.

Yet this was the basis of the dispute. Samsung Heavy Industries declared a tax loss on its activities in India, but the Indian tax authority argued that 25% of the company’s profits should be attributed to the office because of its role.

Neither the Tax Tribunal nor the High Court issued a decisive ruling in the case, resulting in the Indian Tax Department appealing to the Supreme Court. Ultimately, the Supreme Court found that the project office carried out preparatory and auxiliary activities and therefore could not be a PE. This precedent may make it easier for foreign companies to do business in India.

Adecco wins Danish TP case over royalties

The Supreme Court of Denmark ruled in favour of human resources agency Adecco and its Swiss parent company on June 25 in a crushing blow to the Danish tax authority. The case concerned the deductibility of royalty payments made between 2006 and 2009.

Although Adecco had reported losses in Denmark for several years, the Danish unit of the agency paid DKK 84 million ($12.6 million) to its Swiss parent company in exchange for the use of the Adecco trademark, know-how and access to the corporate network.

Originally, Adecco DK paid a royalty of 1.5% on net sales to the parent company under the license agreement but this rate was increased to 2% in 2006. The license included intangible assets such as know-how and the company’s network.

The company applied royalty rates established using the comparable uncontrolled price (CUP) method. However, no comparable license agreements had been identified and a number of franchise deals had been used for benchmarks.

The Norwegian and Swedish tax authorities accepted the rate of 2% in a joint audit, while the Danish Tax Agency rejected this rate on three grounds:

1.       The royalty payments were fundamentally not deductible business expenses under Danish tax law;

2.       The payments were not made in accordance with the arm’s-length principle; and

3.       The payments should be offset against deemed remuneration from the Swiss parent company to the Danish unit, essentially cutting expenses to zero.

When the case went to Denmark’s Eastern High Court, the court accepted these arguments and ruled in favour of the Tax Agency. Adecco decided to fight on and appealed to the Supreme Court.

The Supreme Court rejected the earlier decision and found that the payments were made for the right to use the trademark and counted as operational costs deductible for tax purposes.

The Adecco case is just one of many defeats for the Tax Agency. The Danish Ministry of Taxation has suffered a string of defeats since the TP regime was put in place in 1998. Nevertheless, the ministry has said it will continue to scrutinise the taxation of multinationals, meaning more cases like Adecco in the future are inevitable.

Whirlpool learns a lesson about maquiladora structures

The US Tax Court ruled in favour of the Internal Revenue Service (IRS) on May 5 against home appliance company Whirlpool over its use of a Mexican low-tax structure. The decision increased the company’s tax burden by $50 million.

The figure may be small for a large multinational corporation, but the case is a lesson in what kind of structures to avoid. The case goes back when Whirlpool restructured its Mexican manufacturing operations between 2007 and 2009 to take advantage of existing tax incentives.

The Mexican government created the maquiladora regime to grant foreign companies tax incentives in exchange for setting up manufacturing plants in the country. The regime reduced the headline corporate tax burden of foreign companies from 28% to 17%. However, if the company met certain TP standards it could then be exempt from tax.

Whirlpool operated in Mexico through its local subsidiary via a controlled foreign corporation (CFC) based in Luxembourg. Under the Mexico-Luxembourg tax treaty, the CFC’s income was exempt from tax in Luxembourg. The Luxembourg CFC had no employees of its own, except for a part-time administrator, yet it contracted manufacturing services to the Mexican subsidiary.

The extra twist was that the Mexican subsidiary leased the factory plants and seconded the employees from another local Whirlpool sub-subsidiary of the same network. These arrangements allowed Whirlpool to slash its tax burden in Mexico, Luxembourg and the US.

The IRS challenged Whirlpool on its TP arrangements that took advantage of treaty benefits. The US revenue service argued that the income the Luxembourg CFC earned through the Mexican subsidiary constituted foreign base company sales income (FBCSI) and, therefore, the income falls under the sub-part F branch rules of the US Tax Code.

The US Tax Court found that Whirlpool’s arrangements via Mexico and Luxembourg counted as FBCSI because the result of the scheme was that the sales income went untaxed in either jurisdiction.

Each of these cases demonstrate the risks of TP policy, as well as how best to mitigate those risks. Companies will have to rely on documentation more and more as part of risk management, but most importantly TP decisions will have to be informed by business strategy.

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