Transfer pricing (TP) controversy remains at the forefront of the issues faced by tax heads in multinational enterprises. There has been a marked growth in reported case numbers, even though the tax authority success rate, after reaching a peak in 2022, has declined in the past two years, according to tpcases.com.
This article discusses cases relating to some of the common disputes covered during TP audits and the resulting key considerations for taxpayers.
Use of range
In TP controversy, the arm’s-length nature of a taxpayer’s profitability is a common issue. It raises two questions:
What range of comparable profitability should be viewed as appropriate; and
What positioning in that range should be considered as arm’s length.
Articles 3.57 and 3.62 of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the OECD Guidelines) refer to the use of the interquartile range (IQR) and median when “comparability defects” remain and the potential use of the full range where it comprises results of relatively equal and high reliability; therefore, it could be argued that any point in the range would satisfy the arm’s-length principle.
However, in practice, we see a tacit reversal of the burden of proof, wherein the median is the point of reference, and the taxpayer bears the burden of proof if it wants to justify a different positioning. Slovakia has already implemented this in its law. It is likely that the TP laws of various European countries will soon follow the same path. In Asia, Indian and Malaysian regulations require use of the median with a smaller range of 35% to 65% and 37.5% to 62.5%, respectively.
While analysing the cases in this regard, it has been observed that on the first point, some judgments refer to the possibility of using the full range of comparable results. For instance, in a Swedish case involving an alcoholic drink maker, the court decided that the full range in a benchmark could be validly applied and, therefore, the tax authorities did not fulfil the burden of proof.
In a more recent case, concerning an electronic parts supplier, a Danish judge stated that the results of the company being outside the IQR was not sufficient to demonstrate a violation of the arm’s-length standard. Regarding the second point, in the decisions validating the use of the full range, this ruling clearly mentioned that any point in the range would be viewed as being at arm’s length.
Apart from these decisions, most of the other cases in Europe favour use of the IQR. In cases that have validated the IQR, the judgments either validate:
The full IQR (and, thus, consideration of a point that would benefit the taxpayer; i.e., in most cases, the lower quartile); or
The selection of a given point (namely, the median or the average).
For example, a Spanish judgment (involving a designer and seller of furniture, kitchen appliances, and home accessories) ruled that the use of the median was only valid in the event of comparability defects. Therefore, in the case at hand, the full IQR was accepted, and the company was reassessed to the lower quartile. Another case, concerning a distributor of luggage and travel accessories, validated the application of the lower quartile, due to the absence of demonstration of comparability defects in the set of comparables.
In the same way, a Swiss judgment involving a distributor of pharmaceuticals allowed the use of the lowest quartile. The ruling stated that, in principle, the taxpayer is free to set an operating target margin that is also tax deductible if the selected margin complies with the arm’s-length comparison.
On the contrary, France has taken a much stricter approach. The French jurisprudence started with a decision from a court of appeal (with regard to a seller of TV sets) that stated that every point of the IQR satisfies the arm’s-length standard. A slight evolution has been seen with a Supreme Court decision (involving a distributor of medical equipment) that ruled in essence that the use of the median was valid.
Since then, the French tax authorities have systematically targeted the median. And the judges have followed, establishing the median as the point of reference (including the Administrative Court of Appeal concerning a developer and distributor of plant protection products). An interesting case at the Administrative Court of Appeal, involving a fashion house specialising in luxury footwear and accessories, has also validated the use of the average rather than the median, stating that the OECD Guidelines do not specifically favour the median to the average.
Thus, in France, like most countries, if the taxpayer falls outside the range (i.e., the IQR), the adjustment will be made to a central point (the median or average), and the taxpayer needs to provide evidence to support any other positioning within the range.
Intragroup services
Globally, the tax authorities continue their challenge in auditing intragroup services (IGS) transactions. In all cases, the submission of a contract and an invoice for the services is not sufficient. The taxpayer needs to submit details of services received, including the utility of such services for the taxpayer’s business, and proof of the services being non-duplicative and not being shareholder activities in nature. Details of group cost allocation, including concerning cost pool and allocation keys applied, is also required. All these aspects are subject to detailed review during audit proceedings, as well as in courts. In all cases, the courts have put the burden of proof on the taxpayer.
In a decision in favour of the taxpayer that was a real estate company, the Supreme Administrative Court in the Czech Republic ruled that once the receipt of services, including satisfaction of the benefits test, is proven, the burden of proof is on the tax authorities to challenge the service fees determined by the taxpayer. However, in a case involving a manufacturer of bread and bakery products, the Czech court disallowed the use of the comparable uncontrolled price (CUP) method by the taxpayer as the CUP was applied based on bid prices and not an actual transaction price. The application of the CUP method for IGS transactions is generally difficult due to a lack of data (both external and internal); hence, the rejection of bid prices accentuates difficulties in applying the CUP method to IGS.
Interestingly, during advance pricing agreement discussions in India regarding IGS transactions, tax authorities have also looked at the impact of IGS fees on the operating profit of the recipient entity and have proposed an upper cap on IGS fees based on such analysis.
One more decision to highlight is an EU case involving year-end adjustments for transactions between Belgium and Romania, concerning a global crane rental group. The advocate general (AG) gave their opinion on whether the TP adjustments fall within the scope of VAT and that the tax authorities can require supporting documentation to justify the VAT deduction.
Though the AG did not give any principal view on the applicability of VAT, which needs to be looked at on a case-to-case basis, in this instance the AG opined that the amount invoiced by the principal entity to a group entity for the supply of services (as a year-end adjustment) constitutes a payment for services that falls within the scope of VAT.
In the second part, the AG opined that the taxpayer must provide objective evidence that goods or services were supplied, and that the tax authorities may require a taxpayer to provide documents other than the invoice within the principle of proportionality. Though the impact of VAT is not in favour of taxpayers, the concept of the principle of proportionality is important and should benefit taxpayers during audits.
Loss-making entities
Losses incurred by limited risk entities have a high likelihood of audit across countries. In China and India, losses are not acceptable to tax authorities for contract manufacturers or limited risk distributors. In India, taxpayers face increased scrutiny for economic adjustments such as capacity utilisation and depreciation, as well as for other risk-related factors in the event of losses or during a startup period.
While analysing court cases, the decisions favouring tax authorities relate, in principle, to instances where the limited risk entity is incurring losses and group entities are making profits. Accordingly, the Supreme Court in Costa Rica, in a case concerning a processor of agricultural products, opined that tax authorities could intervene in such circumstances and make necessary adjustments.
In the fashion house specialising in luxury footwear and accessories case mentioned earlier (again, in favour of the tax authorities), the local entity was a distributor of luxury shoes and clothes, and incurred losses. The taxpayer did not have any say in its purchase of luxury goods, which was decided by a group entity and the unsold inventory would be resold back to the group entity at a discount. Though not specified in the decision, the court of appeal took into consideration the concept of control over risks, as in a third-party scenario under the current arrangement, the entity purchasing goods would not assume the risks for unsold inventory. The court even allowed the tax authorities to scrutinise prior carried-forward losses even though the statute of limitation had passed.
In most countries, including France, persistent loss is a clear indicator of a potential TP mismatch and can be viewed as a valid argument for an assessment, unless the ‘entrepreneurial’ nature of the taxpayer is established.
Similarly, in a case involving a distributor of car accessories, a Spanish court rejected the taxpayer’s argument of applying the CUP method and justifying a loss position. The court analysed in detail the business model and pricing policy for the transactions and opined that a third-party entity would not systematically buy at a higher price and incur losses at a gross level.
In cases where the courts have ruled in favour of the taxpayer, the key step has been justifying the reasons for loss, such as the materialisation of risk, business/economic circumstances where control over such risk was with the taxpayer, or a decision with respect to the business/economic circumstances was taken by the taxpayer.
In France, there have been several rulings in favour of taxpayers. In a Supreme Court case involving a producer of dairy and plant-based products, the taxpayer was able to demonstrate that a subsidy paid by the French entity to a group entity in Turkey was for strategic business importance and future growth potential.
In another case in France, a local taxpayer involved in the manufacture of large custom bearings was incurring losses. The tax authorities characterised the entity as performing limited production functions and therefore should not incur losses in view of the risks associated with this role. The taxpayer was able to demonstrate that the local entity assumed a more important functional role and higher development and commercial risks, which materialised, leading to operating losses. Hence, risk control is a key feature in the majority of these TP cases.
In a case in Norway involving a global logistics group, the local entity was incurring losses and the tax authorities made a discretionary adjustment stating that the loss-making entity may not be receiving adequate compensation from the group entities. The tax authorities did not specify the transaction that it considered not to have been conducted at arm’s length. The court opined that without such details, the burden of proof was effectively on tax authorities and ruled in favour of the taxpayer.
Final thoughts on the burden of proof in TP
The analysis of recent court decisions in TP cases corroborates what is currently being observed in tax audits: tax authorities are strengthening the TP compliance burden (wider master file and local files, TP forms, country-by-country reporting, electronic invoicing, etc.) and are stricter in their interpretation of the OECD Guidelines (e.g., in terms of positioning within the IQR range, or with systematic challenges of loss-making entities and IGS transactions).
These elements induce some kind of reversal of the burden of proof. Indeed, increasingly, it is the taxpayer that needs to demonstrate that a challenge of its TP policy by a tax authority is inaccurate, rather than having the tax authorities demonstrating the inadequacy of the TP policy of the taxpayer. The jurisprudence shows that in many cases the courts are validating the view of the tax authorities. The taxpayers may benefit from relief at higher courts, but the prolonged litigation only adds to the woes of the tax heads.
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