The conditions of transactions between related parties may differ from those agreed on by non-related parties. They are lacking a conflict of interests, which will ensure “fair” conditions for both parties to the transaction. There is, on the other hand, a common interest of the ultimate owner in them. This may result in reduction of tax liability in the Czech Republic (CR), which our tax administrator has been eminently interested in, lately. The options the tax administration has in terms of transfer pricing will be covered by this article.

The topic of transfer pricing will also be discussed at 3rd year of the TAX FORUM 2016 conference, which takes place on November 25, 2015 in Prague and which we are co-organising. In case you are interested in attending the conference, please contact Anna Bergová at anna.bergova@fucik.cz or register directly at http://www.epravo.cz/eshop/tax-forum-2016-iii-rocnik-9.html. We will be happy to meet you at the conference and to discuss specific problems in this area.

The principle of market detachment

The income tax act adjusts transfer prices in section 23 paragraph 7. Specifically, it sets the rule that prices charged by related parties must reflect prices set between unrelated parties in common business relations under the same or similar conditions. A sophisticated methodology exists for pricing. Those, who are interested and have the time, can begin by reading for example the OECD joint transfer pricing guidelines – see http://www.oecd-ilibrary.org/taxation/oecd-transfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations-2010_tpg-2010-en. The Financial Administration of the Czech Republic refers to this methodology. There is more literature, though.

The tax administrator exacts data

Since 2014, the tax administrator has been collecting information from selected taxpayers about their transactions with related parties. It requires them for a risk analysis, if it should launch a transfer pricing audit. The tax administrator demands data for transactions with each related party individually. It means, for example, the total volume of sales and purchases of long-term immovable, moveable and financial assets, goods, services, royalties, interests or other transactions with related parties.

The tax authority does not demand this information from everyone, however. Only from “interesting” tax subjects – that is those, which fulfil at least one of the criteria for and audit: (a) assets totalling more than CZK 40m, (b) net turnover of more than CZK 80m or (c) an average number of employees in full-time equivalent units reaching more than 50 – and further only in situations, when erosion of the Czech tax base may occur (transactions with foreign related parties, a taxpayer posting losses or using investment incentives and having transactions with related parties in general).

The supplement gives the tax administrator a relatively good overview in terms of the significance of transactions with related parties within the management of the tax subject and it suggests where there might be a problem. It also focuses on disputable or exploited transactions in optimising schemes. This is exactly what is expected from a supplement. The tax administrator will find out the height of licensing fees from it and will know, to whom and to what country they are being paid. The tax administrator can consequently find out, if any special tax regimes are being used in that country or what the level of taxation is there. The tax administrator has the information about sales or purchases of immovable assets, services and goods. The tax return also includes financial statements and notes to the final accounts. It is thus possible to assess the information in the supplement in the light of relevant financial indicators about the performance of the company, too, (for example profitability, revenues or expenditure, ...) in relation to competitors.

Transfer pricing audit

Transfer prices are most frequently examined within a tax audit. Their inspection may begin within a procedure to dismiss doubts, though, too. More than the procedure itself, though, the allocation of the burden of proof is significant. It is not standard as in the case of usual inspection, for example when proving a right to deduction. The taxpayer has a somewhat better position in the realm of transfer prices. It depends on the taxpayer alone, how he is able to use it. A professional should know how to move about here.

Did a transaction take place and does the tax subject benefit from it?

First of all, if the tax administrator is inspecting a certain transaction with a related party, the taxpayer has the burden of proof regarding two facts: (i) if and how the transaction took place and (ii) if the transaction had the corresponding economic benefit for the recipient, which increases or maintains its business position. In practice, these two facts are examined by the tax administrator mainly in the case of transactions with an effect on expenditure. This is because the tax administrator wants to assess if the transaction really represents expenditure eligible for tax purposes. It is logical, if the taxpayer does not withstand its burden, the tax administrator excludes the expenditure from the tax base in a vast majority of the cases.

You are surely interested in what the burden of proof regarding these two facts means in particular. I will try to demonstrate it to you on the example of managerial services received from a parent company. What could the tax administrator want? In an audit, the tax administrator may, for example, demand an answer to the following questions (the taxpayer should also submit evidence to support his claims):

• what services were performed on the part of the parent company
• including a requirement of submitting possible contracts and accounting
• in what way these services were received
• including possible evidence about their provision
• how these services were used for the economic activity of the recipient and what their economic benefit for the recipient consisted in

The tax administrator will also examine, if the service represents a true economic benefit for the recipient, that is if an independent subject would pay for such a service or perform the activities himself (in-house).

It is necessary to realise one important thing. The tax administrator does not have a duty to prove that a service did not take place or the subject had no economic benefit from the service. The taxpayer has that duty. He has to prove that, which he claims in the tax return, that the applied expenditure is eligible for tax purposes. The tax administrator only expresses doubts regarding the assertions of the taxpayer. The tax administrator has a very easy position. It is perhaps needless to say that of the taxpayer is not cooperating sufficiently in this stage, then he has a problem. He has a problem, too, though, if what he is saying and proving is unconvincing or even contradictory. The doubts of the tax administrator should be rational, however.

Was the principle of market detachment respected?

If the taxpayer the able to sustain his burden of proof regarding both above-mentioned facts, then it comes to the burden of proof regarding the observation of the principle of market detachment (prices generally accepted), that is if the price negotiated with a related person corresponds to a price, which would have been agreed on between unrelated parties under the same or similar conditions. Here, though, the setup is more in favour of the taxpayer. It is governed by stipulations of section 23 paragraph 7 of the act on income taxes.

At the beginning, the burden of proof always begins on the side of the tax administrator. He has to prove that a transaction took place (i) with a related party (ii) for prices that differ from prices, which would have been agreed on between unrelated parties under the same or similar conditions. The tax administrator should have no greater problems with the first condition. He can use the data in our or in foreign trade register or even cooperation with foreign tax administrations. The second condition is not as easy, however. The tax administrator needs to present a rational and reasoned analysis, from which the difference between the regular price and the negotiated price is clear. The tax administrator should deal with material factors, which may have an influence on the price, especially (i) the characteristic qualities of the object of the transaction, (ii) the conditions of the transaction, (iii) a functional analysis of the transaction, (iv) economic circumstances and (v) the business strategy of the parties involved in the transaction. Bearing these factors in mind, he should seek sufficiently comparable independent transactions. If a fully comparable transaction cannot be found, he should at least argue for a sufficiently reliable adjustment of the price, which would amend the irregularities. The above-mentioned can be summarised into stating that the tax administrator needs to “do a good job”. He certainly will not be able to sustain the burden of proof by referring to several invoices to non-related parties for the same product or service. He has to take interest in the inner side of transactions. The theory regarding transfer pricing is more than rich. A professional is important here, who can be an equivalent opponent and attend to the rights of the taxpayer.

If the tax administrator sustains his burden of proof, especially by proving the difference between regular prices and the price negotiated by the taxpayer, then the burden of proof is passed on to the taxpayer. The taxpayer is obliged to satisfactorily substantiate this difference. In effect, he should understand the analysis of the tax administrator and come up with further facts, which the tax administrator did not take into account and which have an influence on the price (such as for example quality variations in products, which influence better or worse usability for the recipient, a non-standardised product, which has different parameters from the regular products on the market). The question is, though, how the tax administrator will accept the arguments of the taxpayer. There is, of course, always the option of appealing against the decision of the tax administrator, and in case the appeal fails, there is also the option of administrative courts.

This brings us to the topic of documentation or some other analysis of the taxpayers, which documents compliance with the principle of market detachment. Is it not too late to present it at this moment? Do you suppose the tax administrator will willingly throw away his work, on which he spent many productive hours? Preparing a quality analysis requires processing a great amount of information, especially about the group, the taxpayer, the transaction, and their analysis, search for comparable transactions, their conditions, or consideration of the relevant conditions, and eventually the preparation of a final financial analysis. Do you think that after such an analysis, the tax administrator will simply assent to the arguments of the taxpayer? It often happens in practice that the tax administrator finds it hard to change his view. As the audit protracts, the expenditure of the taxpayer increases, unfortunately. This has happened to me several times in practice already, when I tried to convince the tax administrator about the point of view of the taxpayer for a long time and proved erroneous assumptions and procedures of the tax administrator (an audit even took me two and a half years). This is because transfer pricing auditing is not straightforward and simple. It mostly requires work with a number of data, their analyses, explanations and substantiation. In practice, it may also happen that with regard to growing expenditure related to the tax audit, the taxpayer accedes to a “certain” compromise and agrees with a not quite correct adjustment of transfer pricing. The question remains, though, how to proceed in future, or even in the still open years, which were not subject to an audit. Besides, transfer pricing is mostly a systemic matter. And also, will a foreign tax administration accept this compromise?

The above-described distribution of the burden of proof regarding compliance with the principle of market detachment does not always apply. It is important to keep this in mind, because in situations, when this standard distribution does not apply, the taxpayer is in a far more disadvantageous position (the distribution of the burden of proof is actually as described in the introduction to this part of the article on tax audit). These are situations, when the taxpayer files a supplementary tax return due to adjustment of transfer prices or when he is a recipient of investment incentives (burden of proof according to section 35a article 2 letter. d) of the income tax act). Both situations have also been confirmed in the judicature of the Supreme Administrative Court. In these two situations, the taxpayer has the burden of proof regarding correctness of the applied transfer pricing. The tax payer needs to present plausible evidence to the tax administrator, proving that transfer pricing complies with the principle of market detachment, ideally a documentation of the way, in which transfer pricing was set. The tax administrator has the option of expressing doubts regarding this evidence.

Did the tax audit end with a back tax?

Several practical things relate to a back tax.

• First, it needs to be said that the taxpayer of course has the right to appeal and to also use procedural means of administrative justice in case of failure.
• Adjustment of transfer pricing also relates to the question of how to proceed in the next years. To file a supplementary tax return or wait for an audit? Transfer pricing is usually a systemic matter for a taxpayer.
• Also, the regular price represents an interval of figures in a vast majority of the cases and the tax administrator should assess a back tax up to the, for the taxpayer most advantageous, limit price. It is the application of the principle “in dubio mitius” when, if several options for applying the law exist, public law subjects should, according to article 4 of the Charter of Fundamental Rights, apply an alternative, which respects the essence and meaning of fundamental rights of the taxpayer, and in case of doubts, to proceed more leniently.
• Tax transactions also relate to a back tax. The tax administrator will assess a penalty from the back tax (20 %, if the tax is increased and 1 % if tax losses are decreased) and interest from delayed payment (an annual rate is set as the REPO rate set by the Czech National Bank plus 14 %).
• The topic of Avoidance of double taxation also relates to the back tax. By raising the tax based, double taxation of the same economic value occurs. First at the related party (taxation of profit on the side of the partner of the transaction) and then, as a consequence of ta audit, also for the taxpayer (an increase of the tax base). A group of related persons should then deal with the question of whether or not economic double taxation can be prevented, that is if the state, in which the related party (partner of the transaction) resides, will return a tax corresponding to the increase in the tax base in the Czech Republic (in the theory, this is called subsequent adjustment of double taxation). It is not an easy matter, though. It is necessary to assess the view of the local law in the country of the related party regarding this issue. It cannot automatically be said that there is no option for return here. Treaties on avoidance of double taxation and Arbitration Conventions offer certain procedures (in case of a related party in a country that has joined this convention – these are mostly other countries of the European Union).
• Impact on other duties, such as for example VAT or customs, also relate to the back tax, because in certain cases they work with the regular price. In addition, adjustment of the tax base, that is the detected difference between the negotiated price and the price regular on the market (section 23 paragraph 7 of the income tax act), is considered a share in the profits in the sense of section 22 paragraph 1 letter g) point 3 of the income tax and as such is subject to the withholding tax. This reclassification as share in the profits sis not applied towards a resident of another member state of the European Union or the tax resident of Norway, Iceland or the Swiss Confederation. Despite this, even when reclassification is applied, the situation needs to be assessed from the perspective of treaties for avoidance of double taxation as well, however.

Transfer pricing documentation

Here we are getting to the topic of documentation of transfer pricing creation. This documentation is not obligatory in the Czech Republic yet. It is only recommended by the tax administrator. The recommended content of the documentation is stated in Instruction D – 334 of a Notice of the finance ministry on the scope of documentation for creation of prices between related parties.

The decision about preparing documentation is thus solely up to the income tax payer. Yet, should he prepare it? Small as well as medium companies currently prepare documentation. This is because the documentation brings them transparency and a method for setting transfer pricing. Despite this, many companies postpone the preparation of documentation in practice, due to its demands on time and financial means. As most decision, it has its “pros” and “cons”. During the preparation of the documentation, it is possible to detect a wrong setup of transfer pricing within the group. It is better to detect this problem in time, and not during a tax audit (the uncertainty, if the result of the audit will be a “correct” price or a certain compromise; a back tax for all the years opened so far; related sanctions). Preparing documentation only just before a tax audit brings higher expenditure and stress. An absence of documentation in a tax audit arouses mistrust of the tax administrator regarding the setup of transfer pricing by the taxpayer. In addition, the taxpayer is risking that the tax administrator will carry out his own analysis, with a result that will be not acceptable for the taxpayer, and it will consequently be difficult for him to change the tax administrator’s view.

Conclusion

Transfer pricing has lately been an increasingly more important topic not only in our country but in the surrounding countries as well. From the year 2016, for example, regulation concerning transfer pricing will become stricter in Poland. In the “Base Erosion and Profit Shifting” project of the OECD, four action points out of the total fifteen are dedicated to it. Some of the current interpretations are being revised – see action points 8 – 10 (for example specific directions for detecting the content of a transaction, risk allocation, synergic effects). Action point 13 for documentation to the way of transfer pricing creation states quite clearly that tax administrators often do not have sufficient information to carry out a transfer pricing audit and recommends obligatory documentation of transfer pricing. We will see, if the changes around us are reflected in an adjustment of our regulation as well. After years, though, the tax administrator has woken up and begun to be active in terms of transfer pricing.     

Does this problem concern you and you would like to know more? We will be glad to help you and you can turn to us for possible consultations.