Correct transfer pricing between related persons may represent considerable problems in many cases. Yet the time and efforts spent on the setup is rewarded in maintainable business and a smoother and cheaper course of tax audits. It often happens in practice that the perspective of the tax administrator may differ in many ways from the expectations of the management, especially if the company did not focus on the setup of transfer pricing or did not bring the setup to a successful conclusion. In this article we would like to focus on a decision of the Plzeň regional court, which decided about the correctness of the procedures of the tax administrator in the matter of transfer pricing between related persons. The tax administrator had lowered tax losses for a Czech company and subsequently assessed additional tax, due to incorrectly set up transfer pricing.

What was this decision about? It was basically the case of a Czech company, which was a subsidiary of a German company and provided the production of products for it, according to its requirements and instructions.

In the course of a tax audit, the Czech company stated that it had prepared special documentation for the purpose of correct determination of transfer pricing with the parent company and related issues. The documentation stated that transfer pricing should be set up so as to cover the costs with an add-on profit margin. The documentation did not contain the profit margin, though. In the year 2008, the set prices were not sufficient for covering these costs, though, and the Czech company therefore posted losses for this period. It mainly argued that a significant decrease in production occurred in this year as a result of the worldwide economic crisis, and the revenues from this production therefore did not cover the costs incurred. That is that the losses were due to external factors and not due to incorrectly set up price policy. The tax administrator did not agree with this assertion of the Czech company.

First, the tax administrator dealt with the functional profile of the company. The tax administrator concluded that with regard to the division of functions and risks between the subsidiary and the parent company, when the subsidiary only has a producing function, the latter only bears the risk related to production activity. Losses of the complainant could thus only occur if the company posted low efficiency of labour. In the course of the tax audit, the subsidiary provided no evidence of not having fulfilled its duties ensuing from the contracted amount and quality of supplies, and there was therefore no reason for it to post losses.

Subsequently also following the presented documentation, the tax administrator identified with the method of transfer pricing setup mentioned in the documentation itself, that is that transfer pricing should be set so as to cover the cost with an add-on profit margin. And yet, despite this claim, it did not happen and the company posted losses.

And finally, the tax administrator also dealt with the height of the profit margin. In order to be able to prove better that the Czech company did not have correctly set up transfer pricing, the tax administrator tried to find companies of the same size with the same or similar orientation as that mentioned by the Czech company, and based on an analysis of the profit margin in these companies, it determined a minimum profit margin in this sector between unrelated parties. To find such companies, the tax administrator used the European databases AMADEUS and ALBERTINA. The profit margin was thus logically higher in all thus selected companies than in the examined Czech company, and the tax administrator therefore presumed that transfer pricing is not set up correctly and adjusted the tax base.

The court examined these facts an upon consideration of all presented aspects it ruled in favour of the tax administrator, confirming his decision, that is a lowering of tax losses and an additionally assessed tax.

Are you a producing company? Is there any similarity here to your situation? Come to us for advice. We recommend focusing in greater detail on transfer pricing.

Štěpán Osička

Zbyněk Švejcar