The Supreme Administrative Court (SAC) issued a judgment annulling the decision of the Regional Court (RC) confirming the tax assessment on grounds of insufficient margin of the tax entity – a contract manufacturer, which was made on the basis of a reference price analysis prepared by the tax administrator that, however, in the view of the SAC was incorrect and unreviewable.

The judgment is quite brief and contains several interesting paragraphs. As is often the case, brief statements may be misleading and we have therefore, because of our detailed knowledge of the case, considered very carefully what the SAC is saying in the light of all the circumstances. Of course, as counsel for the client, we cannot comment on all the specific circumstances, and many of the arguments are a reaffirmation of the boundaries that the SAC has long been defining in its case law, but some seemingly clear statements are not clear in context. In general, the judgment clearly emphasises the requirement of proof even in areas of transfer pricing analysis that were generally considered dogmatically given. In our practice, when defending the interests of our clients, we always focus on stable and long-term trends, which the SAC emphasizes in its judgment.

Disproving the taxpayer’s evidence

Tax administrators are generally accustomed to their exclusive power to arbitrarily determine when evidence is already sufficiently persuasive and when it is not. In common practice, apart from transfer prices, the tax administrator has almost unlimited scope to find that the evidence presented is not convincing. The existing case law of the Supreme Administrative Court (SAC) generally puts up a barrier against complete arbitrariness and reminds that the tax administrator may only require a degree of persuasiveness of evidence that is proportionate to the circumstances. However, the infinite variety of economic relations makes it difficult to translate this generally understandable principle into a standard rule.

In the case of transfer pricing, the situation is different. A mere rejection of the taxpayer’s evidence is not sufficient to adjust the tax base and the tax administrator must always bear the burden of proof. This is while the provision of the Code of Tax Procedure is quite clear. The tax administrator assesses each piece of evidence individually and all the pieces of evidence in their mutual context, taking into account everything that has come to light during the administration of taxes. Therefore, the tax administrator cannot first assess the evidence submitted by the taxpayer, deem it insufficient and then put it off ad acta. This evidence remains what came to light in the tax proceedings.

However, this creates a completely unambiguous benchmark for each specific situation to determine when the evidence submitted by the tax administrator is sufficient. Or vice versa, where the evidence provided by the taxpayer cannot be declared insufficient. In particular, the tax administrator cannot reject the taxpayer’s evidence as insufficient and then use its own, burdened with the same deficiencies.

The Supreme Administrative Court reaffirms this connection in paragraph [25] “The Supreme Administrative Court also upheld the complainant’s objection that the tax administrator and the defendant did not bear the burden of proof in the tax proceedings, as they did not sufficiently prove that the price at which the complainant sold the goods to related persons (...) differed from the price that would have been agreed between unrelated persons in normal relations under similar or comparable conditions.” The SAC here clearly concludes that disproving the taxpayer’s evidence falls within the burden of proof of the tax authority in the same way as the construction of the reference price itself by the tax authority.

Non-reviewability and qualitative requirements for transfer pricing analysis

The SAC has repeatedly pointed out the need for reviewability of the tax administrator’s reasoning. As a reason for annulling the judgment of the Supreme Administrative Court, for example, stated that the Regional Court did not deal with the complainant’s objection that the sample of comparable companies compiled by the tax administrator was not sufficient for the conclusions of its analysis to be properly representative. The SAC repeatedly mentions this defect even separately.

In general, the tax administrator very often relies on extremely small data samples. It is then, of course, necessary to consider all the more carefully, and in the position of the tax administrator bearing the burden of proof, to justify in detail why such a small sample is sufficient for such a serious interference with the constitutional right to the protection of property, which additional tax assessment represents. Although the SAC could have based the annulment of the judgment of the RC on this single material fact alone, it also comments on other defects leading to unreviewability.

The SAC also refutes the tax administrator’s reasoning, which was adopted and confirmed by the RC without further discussion, and concludes that the tax administrator’s conclusion that based on the functional risk profile of the tax entity, which was to perform the function of a mere contract manufacturer, it can be concluded that the tax entity should always make a reasonable profit, or not achieve a negative margin, is pure speculation. According to the SAC, such conclusions must be supported by an adequate analysis.

Another manifestation of evidentiary arbitrariness in transfer pricing control is the lack of justification for the steps taken by the tax administrator to establish the reference price. Very often we encounter a three-point procedure of the tax administrator:

1. The tax administrator assesses the taxpayer’s argumentation, finds some specific flaws in this argumentation and rejects the price used by the taxpayer as unproven.
2. The tax administrator then takes what the taxpayer has created, taking no account of the declared defects, and adds other elements to the basis created by the taxpayer to create a reference price. On this basis, it then declares the reference price to be proven, since what it has taken over from the taxpayer cannot be doubted, since the taxpayer originally claimed it himself.
3. At best, it will then limit the demonstration to some details of the elements it has added. In many cases, such as this one, it will not even do that.

As can be seen from the judgment, the tax administrator proceeded in this way here, too. The absence of reflection on the additional steps taken by the tax administrator in modifying the taxpayer’s original data also leads to unreviewability. Specifically, there is a lack of reasoning as to why the transactional net margin method is chosen in the analysis, why a specific reference period is chosen, why an interquartile range is chosen, etc.

Specifically, in paragraph [30], the SAC adds “The tax administrator did not even provide any reasoning as to why the resulting set of average operating margins of individual companies should be “trimmed” at all, i.e. why, for example, outliers identified in one way or another could not be acceptable with regard to the nature of the entity or the market sector, in which the entity operates.”

It can be said that in the individual paragraphs of the case law, the SAC raises a number of rhetorical questions that call into question the conclusions of the tax administrator and to which the contested decision does not provide answers precisely because it is unreviewable. It must be said that there are indications of this lack of reasoning in earlier decisions of the SAC.

This judgment thus shows the direction that can be taken in increasing the certainty of a taxpayer, who sets his prices with a related party, and it also shows areas, where the tax authority must proceed very carefully, if it is to bear its burden of proof.

Conclusion

The judgment also contains other interesting conclusions, but these must be considered with caution in view of the fact that this is a specific decision in a specific situation. Considering the complexity as well as the uncertainties in some areas of the entire issue and the related potential penalties, we have no choice but to recommend that you do not wait for the tax audit, but preferably turn to erudite consultants at the time of setting the transfer prices and set the prices with their help. We are of course ready to assist you in this area as much as possible, so please do not hesitate to contact us.

Author Jiří Jakoubek, Zuzana Kalincová