35. The facts in this example are the same as in Example 9, except that Company S now enters into a three-year royalty-free agreement to market and distribute the watches in the country Y market, with no option to renew. At the end of the three-year period, Company S does not enter into a new contract with Primair. 36. Assume that it is demonstrated that independent enterprises do enter into short-term distribution agreements where they incur marketing and distribution expenses, but only where they stand to earn a reward commensurate with the functions performed, the assets used, and the risks assumed within the time period of the contract. Evidence derived from comparable independent enterprises shows that they do not invest large sums of money in developing marketing and distribution infrastructure where they obtain only a short-term marketing and distribution agreement, with the attendant risk of non-renewal without compensation. The potential short-term nature of the marketing and distribution agreement is such that Company S could not, or may not be able to, benefit from the marketing and distribution expenditure it incurs at its own risk. The same factors mean that Company S’s efforts may well benefit Primair in the future. 37. The risks assumed by Company S are substantially higher than in Example 9 and Company S has not been compensated on an arm’s length basis for bearing these additional risks. In this case, Company S has undertaken market development activities and borne marketing expenditures beyond what comparable independent enterprises with similar rights incur for their own benefit, resulting in significantly lower profit margins for Company S than are made by comparable enterprises. The short term nature of the contract makes it unreasonable to expect that Company S has the opportunity of obtaining appropriate benefits under the contract within the limited term of the agreement with Primair. Under these circumstances, Company S is entitled to compensation for its at risk contribution to the value of the R trademark and trade name during the term of its arrangement with Primair. 38. Such compensation could take the form of direct compensation from Primair to Company S for the anticipated value created through the marketing expenditures and market development functions it has undertaken. Alternatively, such an adjustment could take the form of a reduction in the price paid by Company S to Primair for R watches during Years 1 through 3 ...

Consider for example, a manufacturer, whose functional currency is US dollars, that sells goods to an associated distributor in another country, whose functional currency is euros, and the written contract states that the distributor assumes all exchange rate risks in relation to this controlled transaction. If, however, the price for the goods is charged by the manufacturer to the distributor over an extended period of time in euros, the currency of the distributor, then aspects of the written contractual terms do not reflect the actual commercial or financial relations between the parties. The assumption of risk in the transaction should be determined by the actual conduct of the parties in the context of the contractual terms, rather than by aspects of written contractual terms which are not in practice applied. The principle can be further illustrated by Example 7 in the Annex to Chapter VI, where there is an inconsistency between the contractual assumption of risk and the conduct of the parties as evidenced by the bearing of costs relating to the downside outcome of that risk ...

Consider for example, a manufacturer, whose functional currency is US dollars, that sells goods to an associated distributor in another country, whose functional currency is euros, and the written contract states that the distributor assumes all exchange rate risks in relation to this controlled transaction. If, however, the price for the goods is charged by the manufacturer to the distributor over an extended period of time in euros, the currency of the distributor, then aspects of the written contractual terms do not reflect the actual commercial or financial relations between the parties. The assumption of risk in the transaction should be determined by the actual conduct of the parties in the context of the contractual terms, rather than by aspects of written contractual terms which are not in practice applied. The principle can be further illustrated by Example 7 in the Annex to Chapter VI, where there is an inconsistency between the contractual assumption of risk and the conduct of the parties as evidenced by the bearing of costs relating to the downside outcome of that risk ...

Lender S.A had granted a loan to a related entity but had not collected the agreed interest payments and not added the interest to its taxable income. The tax authorities stated that granting an interest-bearing loan to a related entity but not collecting the interest still results in taxable revenue. The reason Lender S.A. did not collect interest on the loan was due to the group relationship. Lender S.A. filed an appeal where it argued that since the interest was not received, it could not be taxed. Judgement of the Court The Supreme Administrative Court stated that the arm’s length principle applies to agreements concluded on arm’s length terms, where these are not implemented in accordance with there wording. Hence, the arm’s length standard also applies when the parties do not follow the agreement. Click here for English translation Click here for other translation ...

The Duke of Westminster’s gardener was paid weekly, but to reduce tax, his solicitors drew up a deed in which it was said that the earnings were not really wages, but were an annual payment payable by weekly instalments. The tax authorities held that for tax purposes the true relationship and the true nature of these payments were decisive – substance over form. Judgment of the House of Lords The House of Lords decided in favor of the Duke of Westminster and set aside the assessment. LORD TOMLIN. “… Apart, however, from the question of contract with which I have dealt, it is said that in revenue cases there is a doctrine that the Court may ignore the legal position and regard what is called “the substance of the matter,” and that here the substance of the matter is that the annuitant was serving the Duke for something equal to his former salary or wages, and that therefore, while he is so serving, the annuity must be treated as salary or wages. This supposed doctrine (upon which the Commissioners apparently acted) seems to rest for its support upon a misunderstanding of language used in some earlier cases. The sooner this misunderstanding is dispelled, and the supposed doctrine given its quietus, the better it will be for all concerned, for the doctrine seems to involve substituting “the incertain and crooked cord of discretion” for “the golden and streight metwand of the law.” 4 Inst 41 Every man is entitled if he can to order his affairs so as that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax. This so-called doctrine of “the substance” seems to me to be nothing more than an attempt to make a man pay notwithstanding that he has so ordered his affairs that the amount of tax sought from him is not legally claimable. The principal passages relied upon are from opinions of Lord Herschell and Lord Halsbury in your Lordships’ House. Lord Herschell L.C. in Helby v. Matthews [1895] AC 471, 475 observed: “It is said that the substance of the transaction evidenced by the agreement must be looked at, and not its mere words. I quite agree;” but he went on to explain that the substance must be ascertained by a consideration of the rights and obligations of the parties to be derived from a consideration of the whole of the agreement. In short Lord Herschell was saying that the substance of a transaction embodied in a written instrument is to be found by construing the document as a whole. Support has also been sought by the appellants from the language of Lord Halsbury L.C. in Secretary of State in Council of India v. Scoble. [1903] AC 299, 302 There Lord Halsbury said: “Still, looking at the whole nature and substance of the transaction (and it is agreed on all sides that we must look at the nature of the transaction and not be bound by the mere use of the words), this is not the case of a purchase of an annuity.” Here again Lord Halsbury is only giving utterance to the indisputable rule that the surrounding circumstances must be regarded in construing a document. Neither of these passages in my opinion affords the appellants any support or has any application to the present case. The matter was put accurately by my noble and learned friend Lord Warrington of Clyffe when as Warrington L.J. in In re Hinckes, Dashwood v. Hinckes [1921] 1 Ch 475, 489 he used these words: “It is said we must go behind the form and look at the substance …. but, in order to ascertain the substance, I must look at the legal effect of the bargain which the parties have entered into.” So here the substance is that which results from the legal rights and obligations of the parties ascertained upon ordinary legal principles, and, having regard to what I have already said, the conclusion must be that each annuitant is entitled to an annuity which as between himself and the payer is liable to deduction of income tax by the payer and which the payer is entitled to treat as a deduction from his total income for surtax purposes. There may, of course, be cases where documents are not bona fide nor intended to be acted upon, but are only used as a cloak to conceal a different transaction. No such case is made or even suggested here. The deeds of covenant are admittedly bona fide and have been given their proper legal operation. They cannot be ignored or treated as operating in some different way because as a result less duty is payable than would have been the case if some other arrangement (called for the purpose of the appellants’ argument “the substance”) had been made. I find myself, therefore, in regard to the annuities other than that of Blow, unable to take the same view as the noble and learned Lord upon the Woolsack. In my opinion in regard to all the annuities the appeal fails and ought to be dismissed with costs.” This “Duke of Westminster-doctrine” was later set aside in the Ramsay case where a substance over form-doctrine was endorsed by the House of Lords. The “Ramsay principle” has since been applied in other cases involving tax avoidance schemes in the UK, where transactions have been constructed purely for tax purposes. UK vs DUKE OF WESTMINSTER 1935 ...