Tax Alert: The defensibility of losses for entities with a limited functional profile from the point of view of current case law
We would like to draw your attention to an important decision of the Supreme Administrative Court (hereinafter “SAC”) in the field of transfer pricing, which may have extensive implications for several tax entities operating in the position of entities with a limited functional profile (e.g., contract manufacturers, buy-sell distributors, etc.).
This is the decision 7 Afs 398/2019 – 49, which deals with the case of an entity operating on the Czech market as a producer who supplies its products to related and unrelated customers. During the period under review, this entity realised a loss and the tax administrator thus increased its tax base on the basis of the difference between the achieved loss and the arm’s length profit margin for comparable independent entities.
This was done as the entity acted within the multinational group as a contract manufacturer with limited functions, and it could not influence from whom and for how much it would buy inputs or to whom and for how much it would sell products. Although the entity partially sold its products to unrelated entities, it was at prices determined by the group.
Based on this, the tax administrator concluded (and the SAC subsequently confirmed) that even transactions carried out by the entity with unrelated parties should be considered to be controlled transactions since they were affected by the group. The entity assumed the risks for the benefit of the group that it could not influence, and for this it is entitled to appropriate compensation. As stated by the SAC, the entity “should have been compensated for its hypothetical service consisting in the realization of loss-making production for the benefit of the multinational group.” According to the SAC, under given (limited) functional profile it is not necessary to examine individual transactions conducted by the entity; only the overall profitability of the entity is relevant.
The question is how serious the consequences of this decision will be and how it will be reflected in the practice of the tax authorities. However, it will evidently be necessary to face new challenges in the form of (i) the correct valuation of “hypothetical services” provided between members of the group and (ii) the defence of the arm´s length nature of profits (losses) achieved by related companies in relation to transactions with unrelated parties, if they were conducted on the basis of the so-called parent company order[1].
The whole topic is becoming more important in the context of the present time, when, due to the worsening economic conditions (whether due to the coronavirus pandemic or the war in Ukraine), the extent of losses achieved by Czech companies has been increasing significantly. It is necessary to thoroughly analyse and verify whether these losses will be justifiable before the tax administrator and to what extent.
If you are interested in any more information on the given topic, please do not hesitate to contact our leading transfer pricing experts.
[1] Decree of the Czech Financial Directorate D-34: Communication on the application of international standards in the taxation of transactions between associated enterprises – transfer prices. The parent company's order is generally meant to be any influencing of the independent transaction by the parent company (or by another related entity).
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