In its recent decision, the Czech Supreme Administrative Court (“SAC”) ruled on the acceptability of loss realized by a toll manufacturer.
The underlying situation concerned a Czech toller which provided services of manufacturing cables to its German principal. The toller used a CP Method for which it had corresponding Transfer Pricing Documentation. The toller’s services were charged based on a budget, with no year-end true-up in place. Since the toller’s capacity utilization was unexpectedly low in 2008 with the onset of the financial crisis, the toller could not absorb its fixed costs in the price of its services and realized a loss.
The Tax Authorities challenged the loss, performing their own benchmark to establish the arm’s length range of Cost Plus Mark-ups and subsequently restating the taxpayer’s taxable income to the minimum value in the range.
The taxpayer argued that the loss was a result of objective market conditions and as such should be regarded as arm’s length. However, the taxpayer’s appeal was ultimately struck down by SAC. First, SAC ruled that the use of the CP Method is justified for a low risk toller. SAC then sided with the Tax Authorities in ruling that a toller whose functions only concern routine manufacturing should not bear the capacity utilization risk and this risk should be for the account of the principal. Therefore, implicitly, the only situation in which a toller could justifiably end up in a loss position would be in case extra costs resulted from its own manufacturing inefficiencies. SAC also upheld the benchmark performed by the Tax Authorities in commercial databases (including Amadeus).
In our view, the case showcases the quickly increasing sophistication of the Czech Tax Authorities as well as courts in transfer pricing matters. Our main takeaways are as follows:
- In case there is no reliable basis for the use of the CUP Method, the use of other (margin-based) methods is justified. SAC has repeatedly ruled in this manner, using basic economic principles without referencing OECD Transfer Pricing Guidelines;
- TP adjustment should afford the most favorable result to the taxpayer i.e. in case of an upward adjustment to the lowest point in the range. This is a very taxpayer-friendly approach that not many other countries would follow (the more common practice is to adjust to the median);
- Targeting margins based on budget without subsequent true-up is not acceptable in case the risks incurred by the tested party as a result of budget-to-actual variance are not commensurate with its functions;
- SAC consistently follows the substance-over-form principle, dwelling less on formal legal arrangements and putting emphasis on the underlying economic substance of the related party transactions.
Source: SAC website at www.nssoud.cz, court case no. 5 Afs 194/2015 – 34
Author: David Zářecký