RKS, whose business consists of the manufacture of very large custom bearings for the civil and military industries, is controlled by the Swedish SKF group through (SAS) SKF Holding France. RKS was subject to a tax audit for FY 2009 and 2010, at the end of which the tax authorities took the view that the results reported by SAS RKS (losses since 2005) had not been determined in accordance with the arm’s length principle. It therefore increased SAS RKS’s results from 2006 to 2010 to the median net margin observed in a benchmark of eight comparable companies, equal to 4.17% in 2006, 4.32% in 2007, 3.38% in 2008, 2.33% in 2009 and 2.62% in 2010. SAS SKF France Holding applied to the Administrative Court for a discharge, and in judgment no. 1608939 of April 23, 2018, the Montreuil Administrative Court upheld the claim. In ruling no. 18VE02849 of June 22, 2020, the Versailles Administrative Court of Appeal upheld the appeal lodged by the the authorities against this ruling. By decision no. 443133 of October 4, 2021, the Conseil d’Etat, hearing an appeal lodged by SAS SKF France Holding, set aside the decision of the Versailles Administrative Court of Appeal and referred the case back to it. Judgement of the Administrative Court of Appeal In accordance with the guidance provided in the decision of the Conseil d’Etat, the Administrative Court of Appeal ruled in favor of SKF Holding and annulled the assessment of the additional taxable income. Excerpts in English “6. In addition, as mentioned above, the tax authorities have found that SAS RKS has had a negative net margin since 2005, with the exception of 2008. It then carried out a functional analysis of SAS RKS’s intra-group relations, taking the view that SAS RKS performed only limited production functions, and that it was therefore not likely to receive negative remuneration in view of the risks associated with this role. Lastly, it applied a “transactional net margin method” (MTMN), comparing SAS RKS’s ratio of net margin to sales for the operations in question with that of eight companies operating at arm’s length in similar fields. In doing so, it noted that the company’s net margin ratio was -19.32% in 2006, -6.44% in 2007, 1.41% in 2008, -10.46% in 2009 and -21.87% in 2010, compared with 4.17% in 2006, 4.32% in 2007, 3.38% in 2008, 2.33% in 2009 and 2.62% in 2010 for the median of the companies compared. In view of these factors, and as stated in the Conseil d’Etat’s decision of October 4, 2021, in the absence of any criticism of the comparables used by the tax authorities, the latter have established a presumption of profit transfer for the transactions in question, up to the difference between the amount of revenue recorded and that which would have resulted from the application of the average net margin rate of the panel of comparable companies. 7. However, SKF Holding France maintains that its subsidiary SAS RKS in fact assumes a more important functional role than that of a simple production unit within the SKF group, which meant that it had to assume higher development and commercial risks, which materialized in 2009 and 2010 and led to significant operating losses. 8. It is clear from the investigation that SAS RKS, founded in 1932 and acquired by the SKF group in 1965, has long-standing technical expertise and manufactures very specific products, often made-to-measure, for civil and military engineering, whose clientele, made up exclusively of professionals, is in fact limited to around fifteen companies, thus requiring no sales prospecting expenditure on the part of the distributing companies. In addition, SAS RKS owns all the tangible assets required for production, bears the risks associated with production, such as product quality defects, organizes the transport and logistics of its products at its own expense, and bears the inventory risk, as recognized by the French tax authorities when they accepted the principle of a provision for inventory depreciation during the audit. While it is common ground that the intangible assets, including patents, required for this production are held by AB SKF in Sweden, it is nevertheless clear from the investigation that SAS RKS carried out research and development work during the period under review, that it participated, through its parent company SKF Holding France, in an agreement to share research and development costs organized at group level, and that it therefore benefited free of charge from all the intangible assets thus held by the Swedish parent company. Furthermore, while it is common ground that the Swedish parent company periodically sends SAS RKS a schedule of margins to be applied to production costs, depending on the country of invoicing. This schedule is intended to guarantee a margin of 3% for the distribution companies, it is clear from the investigation that SAS RKS is free to determine its own production costs, known as “standard production costs”, which serve as the basis for negotiations with the end customer, carried out jointly with the distribution companies. It also emerges from the investigation, and in particular from the results of computer processing carried out by the tax authorities, that this scale, while applied in the majority of intra-group transactions, is not systematically applied. Furthermore, the company, which bears the exchange rate risk, maintains, without being contradicted, that it can freely refuse to contract with a customer if the final price negotiated does not suit it. On the other hand, it appears from the investigation that the distributing companies are limited to managing sales in practical terms, for example by drawing up contracts and invoices, and to assisting end customers in their negotiations with SAS RKS. As a result, SAS RKS enjoys relative autonomy within the Group, and assumes a high level of risk due to its production activities. Furthermore, it is clear from the investigation that the standard production cost defined by SAS RKS, which serves as the basis for the final price agreed with the customer, is determined at a very early ...

An operating profit represents a return for the investment of resources and assumption of risks. Therefore, although all of the factors described in § 1.482-1(d)(3) must be considered, comparability under this method is particularly dependent on resources employed and risks assumed. Moreover, because resources and risks usually are directly related to functions performed, it is also important to consider functions performed in determining the degree of comparability between the tested party and an uncontrolled taxpayer. The degree of functional comparability required to obtain a reliable result under the comparable profits method, however, is generally less than that required under the resale price or cost plus methods. For example, because differences in functions performed often are reflected in operating expenses, taxpayers performing different functions may have very different gross profit margins but earn similar levels of operating profit ...

The facts are the same as in paragraph 2.42. However, the amount of the warranty expenses incurred by Distributor A proves impossible to ascertain so that it is not possible to reliably adjust the gross profit of A to make the gross profit margin properly comparable with that of B. However, if there are no other material functional differences between A and B and the net profit of A relative to its sales is known, it might be possible to apply the transactional net margin method to B by comparing the margin relative to A’s sales to net profits with the margin calculated on the same basis for B ...

A similar approach may be required when there are differences in functions performed by the parties being compared. Assume that the facts are the same as in the example at paragraph 2.44 except that it is the comparable independent enterprises that perform the additional function of technical support and not the associated enterprise, and that these costs are reported in the cost of goods sold but cannot be separately identified. Because of product and market differences it may not be possible to find a CUP, and a resale price method would be unreliable since the gross margin of the independent enterprises would need to be higher than that of the associated enterprise in order to reflect the additional function and to cover the unknown additional costs. In this example, it may be more reliable to examine net margins in order to assess the difference in the transfer price that would reflect the difference in function. The use of net margins in such a case needs to take account of comparability and may not be reliable if there would be a material effect on net margin as a result of the additional function or as a result of market differences ...

One strength of the transactional net margin method is that net profit indicators (e.g. return on assets, operating income to sales, and possibly other measures of net profit) are less affected by transactional differences than is the case with price, as used in the CUP method. Net profit indicators also may be more tolerant to some functional differences between the controlled and uncontrolled transactions than gross profit margins. Differences in the functions performed between enterprises are often reflected in variations in operating expenses. Consequently, this may lead to a wide range of gross profit margins but still broadly similar levels of net operating profit indicators. In addition, in some countries the lack of clarity in the public data with respect to the classification of expenses in the gross or operating profits may make it difficult to evaluate the comparability of gross margins, while the use of net profit indicators may avoid the problem. (An example illustrating the sensitivity of gross and net profit margin indicators is found in Annex I to Chapter II.) ...

For this purpose, it is particularly important to consider differences in the level and types of expenses – operating expenses and non- operating expenses including financing expenditures – associated with functions performed and risks assumed by the parties or transactions being compared. Consideration of these differences may indicate the following: a) If expenses reflect a functional difference (taking into account assets used and risks assumed) which has not been taken into account in applying the method, an adjustment to the cost plus mark up may be required. b) If the expenses reflect additional functions that are distinct from the activities tested by the method, separate compensation for those functions may need to be determined. Such functions may for example amount to the provision of services for which an appropriate reward may be determined. Similarly, expenses that are the result of capital structures reflecting non-arm’s length arrangements may require separate adjustment. c) If differences in the expenses of the parties being compared merely reflect efficiencies or inefficiencies of the enterprises, as would normally be the case for supervisory, general, and administrative expenses, then no adjustment to the gross margin may be appropriate. In any of the above circumstances it may be appropriate to supplement the cost plus and resale price methods by considering the results obtained from applying other methods (see paragraph 2.12) ...

It should be expected that the amount of the resale price margin will be influenced by the level of activities performed by the reseller. This level of activities can range widely from the case where the reseller performs only minimal services as a forwarding agent to the case where the reseller takes on the full risk of ownership together with the full responsibility for and the risks involved in advertising, marketing, distributing and guaranteeing the goods, financing stocks, and other connected services. If the reseller in the controlled transaction does not carry on a substantial commercial activity but only transfers the goods to a third party, the resale price margin could, in light of the functions performed, be a small one. The resale price margin could be higher where it can be demonstrated that the reseller has some special expertise in the marketing of such goods, in effect bears special risks, or contributes substantially to the creation or maintenance of intangible property associated with the product. However, the level of activity performed by the reseller, whether minimal or substantial, would need to be well supported by relevant evidence. This would include justification for marketing expenditures that might be considered unreasonably high; for example, when part or most of the promotional expenditure was clearly incurred as a service performed in favour of the legal owner of the trademark. In such a case the cost plus method may well supplement the resale price method ...

The resale price method also depends on comparability of functions performed (taking into account assets used and risks assumed). It may become less reliable when there are differences between the controlled and uncontrolled transactions and the parties to the transactions, and those differences have a material effect on the attribute being used to measure arm’s length conditions, in this case the resale price margin realised. Where there are material differences that affect the gross margins earned in the controlled and uncontrolled transactions (e.g. in the nature of the functions performed by the parties to the transactions), adjustments should be made to account for such differences. The extent and reliability of those adjustments will affect the relative reliability of the analysis under the resale price method in any particular case ...

RKS, whose business consists of the manufacture of very large custom bearings for the civil and military industries, is controlled by the Swedish group SKF through  (SAS) SKF Holding France. RKS was subject to a tax audit for FY 2009 and 2010, at the end of which the tax authorities adjusted the prices at which it had invoiced its products to the SKF group’s distribution companies abroad. According to the tax authorities, RKS was a simple manufacturing company that did not have control over strategic and operational risks, at therefore should not have losses resulting from such risks. As a result of the adjustment, SKF Holding France (the immediate parent of RKS) was subject to additional corporate income taxes amounting to EUR 5,385,325, including penalties. In a 2018 judgment the Montreuil Administrative Court discharged the additional taxes. However, this decision was set aside by the Versailles Administrative Court of Appeal in a judgment of 22 June 2020 in which the appeal of the tax authorities was granted. This judgement was then appealed by SKF to the Supreme Court. Judgement of the Supreme Court The Supreme Court decided in favor of SKF Holding and annulled the decision of the Versailles Administrative Court of Appeal. Excerpts from the Judgement “It is clear from the documents in the file submitted to the court that the administration applied a “transactional net margin method” (TNMM) during the audit of RKS, which consisted of comparing the ratio of net margin to turnover of this company for the transactions in question with that of eight companies operating at arm’s length and in similar fields of activity. In doing so, it found that the company’s net margin ratio was -10.46% in 2009 and -21.87% in 2010, whereas it was 2.33% in 2009 and 2.62% in 2010 for the average of the companies compared. Consequently, the administrative court of appeal was able to hold, without any error of law, that the service, at the end of this comparison, of which it noted that no criticism was addressed to it, had established a presumption of transfer of profits for the transactions in question, up to the difference between the amount of revenue recorded and that which would have resulted from the application of the average net margin rate of the panel of comparable companies. However, SKF Holding France argued before the court, in order to justify this difference, that RKS had a more important functional role than that of a simple production unit within the SKF group, which meant that it had to assume a development risk and a commercial risk and that this risk had affected its operating profit for the years in dispute. Firstly, as recommended by the OECD Transfer Pricing Guidelines, in order for it to be considered established that a company belonging to a group is in fact intended to assume an economic risk which the group’s transfer pricing policy leads it to bear, and that this policy is therefore consistent with the arm’s length principle, it is necessary for that company to have effective control and mitigation functions over that risk, as well as the financial capacity to assume it. In holding that RKS was not liable for economic losses related to the operation of its business on the sole ground that it did not have the status of ‘main contractor’ within the SKF group, without investigating whether its functional position within the SKF group was such that it could not be held liable, without investigating whether its functional position within the group gave it the right to bear the specific risks it invoked, namely, on the one hand, strategic risks linked to the choice to develop new products, and, on the other hand, operational risks linked to the efficiency of the production processes, the court vitiated its judgment with an error of law. Secondly, in holding that the negative margin rate of the company RKS was not the result of the realisation of a risk that it was intended to assume, the Administrative Court of Appeal noted that the consolidated result of the SKF group, all activities taken together, was at the same time between 6 and 14%, that the company’s purchases of raw materials had been stable and that its sales had not suffered any decrease in volume except for wind turbines. In so doing, it did not respond to the argument that SKF Holding France raised to justify the drop in RKS’s margin over the two financial years in question, according to which this company had suffered the consequences of a strategic risk linked to its choice to reorient its sole activity towards the wind power sector. It therefore vitiated its judgment by failing to state adequate reasons.” Click here for English translation Click here for other translation France vs SKF 041021 Conseil d'Etat Case no 443133 ...

RKS, whose business consists of the manufacture of very large custom bearings for the civil and military industries, is controlled by the Swedish group SKF through (SAS) SKF Holding France. RKS was subject to a tax audit for FY 2009 and 2010, at the end of which the tax authorities adjusted the prices at which it had invoiced its products to the SKF group’s distribution companies abroad. According to the tax authorities, RKS was a simple manufacturing company that did not have control over strategic and operational risks, at therefore should not have losses resulting from such risks. In a 2018 judgment the Montreuil Administrative Court discharged the additional taxes. However, this decision was set aside by the Versailles Administrative Court of Appeal in a judgment of 22 June 2020 in which the appeal of the tax authorities was granted. This judgement was then appealed by SKF to the Supreme Court. Judgement of the Supreme Administrative Court The court decided in favor of SKF Holding and annulled the decision of the Versailles Administrative Court of Appeal. Excerpt “It is clear from the documents in the file submitted to the court that the administration applied a “transactional net margin method” (TNMM) during the audit of RKS, which consisted of comparing the ratio of net margin to turnover of this company for the transactions in question with that of eight companies operating at arm’s length and in similar fields of activity. In doing so, it found that the company’s net margin ratio was -10.46% in 2009 and -21.87% in 2010, whereas it was 2.33% in 2009 and 2.62% in 2010 for the average of the companies compared. Consequently, the administrative court of appeal was able to hold, without any error of law, that the service, at the end of this comparison, of which it noted that no criticism was addressed to it, had established a presumption of transfer of profits for the transactions in question, up to the difference between the amount of revenue recorded and that which would have resulted from the application of the average net margin rate of the panel of comparable companies. However, RKS argued before the court, in order to justify this difference, that it had a more important functional role than that of a simple production unit within the SKF group, which meant that it had to assume a development and commercial risk and that this risk had affected its operating profit for the years in dispute. Firstly, as recommended by the OECD Transfer Pricing Guidelines, in order for it to be considered established that a company belonging to a group is in fact intended to assume an economic risk which the group’s transfer pricing policy leads it to bear, and that this policy is therefore in accordance with the arm’s length principle, it is necessary for that company to have effective control and mitigation functions over that risk, as well as the financial capacity to assume it. In holding that RKS was not liable for economic losses related to the operation of its business on the sole ground that it did not have the status of ‘main contractor’ within the SKF group, without investigating whether its functional position within the SKF group was such that it could not be held liable, without investigating whether its functional position within the group gave it the right to bear the specific risks it invoked, namely, on the one hand, strategic risks linked to the choice to develop new products, and, on the other hand, operational risks linked to the efficiency of the production processes, the court vitiated its judgment with an error of law. Secondly, in holding that the negative margin rate of the company RKS was not the result of the realisation of a risk that it was intended to assume, the Administrative Court of Appeal noted that the consolidated result of the SKF group, all activities taken together, was at the same time between 6 and 14%, that the company’s purchases of raw materials had been stable and that its sales had not suffered a drop in volume except for wind turbines. In so doing, it did not respond to the argument that the company raised to justify the drop in margin over the two financial years in question, according to which it had suffered the consequences of a strategic risk linked to its choice to reorient its sole activity towards the wind power sector. It therefore vitiated its judgment by failing to state adequate reasons.” Click here for English translation Click here for other translation France vs RKS October 2021 Conseil d'État, 8ème - 3ème chambres réunies, 04_10_2021, 443130 ...

The facts are the same as in paragraph 2.42. However, the amount of the warranty expenses incurred by Distributor A proves impossible to ascertain so that it is not possible to reliably adjust the gross profit of A to make the gross profit margin properly comparable with that of B. However, if there are no other material functional differences between A and B and the net profit of A relative to its sales is known, it might be possible to apply the transactional net margin method to B by comparing the margin relative to A’s sales to net profits with the margin calculated on the same basis for B ...

A similar approach may be required when there are differences in functions performed by the parties being compared. Assume that the facts are the same as in the example at paragraph 2.44 except that it is the comparable independent enterprises that perform the additional function of technical support and not the associated enterprise, and that these costs are reported in the cost of goods sold but cannot be separately identified. Because of product and market differences it may not be possible to find a CUP, and a resale price method would be unreliable since the gross margin of the independent enterprises would need to be higher than that of the associated enterprise in order to reflect the additional function and to cover the unknown additional costs. In this example, it may be more reliable to examine net margins in order to assess the difference in the transfer price that would reflect the difference in function. The use of net margins in such a case needs to take account of comparability and may not be reliable if there would be a material effect on net margin as a result of the additional function or as a result of market differences ...

One strength of the transactional net margin method is that net profit indicators (e.g. return on assets, operating income to sales, and possibly other measures of net profit) are less affected by transactional differences than is the case with price, as used in the CUP method. Net profit indicators also may be more tolerant to some functional differences between the controlled and uncontrolled transactions than gross profit margins. Differences in the functions performed between enterprises are often reflected in variations in operating expenses. Consequently, this may lead to a wide range of gross profit margins but still broadly similar levels of net operating profit indicators. In addition, in some countries the lack of clarity in the public data with respect to the classification of expenses in the gross or operating profits may make it difficult to evaluate the comparability of gross margins, while the use of net profit indicators may avoid the problem. (An example illustrating the sensitivity of gross and net profit margin indicators is found in Annex I to Chapter II.) ...

For this purpose, it is particularly important to consider differences in the level and types of expenses – operating expenses and non- operating expenses including financing expenditures – associated with functions performed and risks assumed by the parties or transactions being compared. Consideration of these differences may indicate the following: a) If expenses reflect a functional difference (taking into account assets used and risks assumed) which has not been taken into account in applying the method, an adjustment to the cost plus mark up may be required. b) If the expenses reflect additional functions that are distinct from the activities tested by the method, separate compensation for those functions may need to be determined. Such functions may for example amount to the provision of services for which an appropriate reward may be determined. Similarly, expenses that are the result of capital structures reflecting non-arm’s length arrangements may require separate adjustment. c) If differences in the expenses of the parties being compared merely reflect efficiencies or inefficiencies of the enterprises, as would normally be the case for supervisory, general, and administrative expenses, then no adjustment to the gross margin may be appropriate. In any of the above circumstances it may be appropriate to supplement the cost plus and resale price methods by considering the results obtained from applying other methods (see paragraph 2.12) ...

It should be expected that the amount of the resale price margin will be influenced by the level of activities performed by the reseller. This level of activities can range widely from the case where the reseller performs only minimal services as a forwarding agent to the case where the reseller takes on the full risk of ownership together with the full responsibility for and the risks involved in advertising, marketing, distributing and guaranteeing the goods, financing stocks, and other connected services. If the reseller in the controlled transaction does not carry on a substantial commercial activity but only transfers the goods to a third party, the resale price margin could, in light of the functions performed, be a small one. The resale price margin could be higher where it can be demonstrated that the reseller has some special expertise in the marketing of such goods, in effect bears special risks, or contributes substantially to the creation or maintenance of intangible property associated with the product. However, the level of activity performed by the reseller, whether minimal or substantial, would need to be well supported by relevant evidence. This would include justification for marketing expenditures that might be considered unreasonably high; for example, when part or most of the promotional expenditure was clearly incurred as a service performed in favour of the legal owner of the trademark. In such a case the cost plus method may well supplement the resale price method ...

The resale price method also depends on comparability of functions performed (taking into account assets used and risks assumed). It may become less reliable when there are differences between the controlled and uncontrolled transactions and the parties to the transactions, and those differences have a material effect on the attribute being used to measure arm’s length conditions, in this case the resale price margin realised. Where there are material differences that affect the gross margins earned in the controlled and uncontrolled transactions (e.g. in the nature of the functions performed by the parties to the transactions), adjustments should be made to account for such differences. The extent and reliability of those adjustments will affect the relative reliability of the analysis under the resale price method in any particular case ...