The tax authorities had issued a notice of assessment which, among other adjustments, disallowed a bad debt loss and certain costs as tax deductible. In addition, royalties paid to the parent company were adjusted on the basis of the arm’s length principle. N…S.A. appealed to the Administrative Court, which partially annulled the assessment. Both the tax authorities and N…S.A. then appealed to the Administrative Court of Appeal. Judgement of the Court The Administrative Court of Appeal partially upheld the assessment of the tax authorities, but dismissed the appeal in respect of the royalty payments. According to the Court, a transfer pricing adjustment requires a reference to the terms of the comparable transaction between independent entities and a justification of the comparability factors. Extracts from the judgement related to the controlled royalty payment. “2.2.2.2 Regarding the correction for ‘transfer pricing’, the applicant submits that the Judgment erred in annulling the correction in question since the defendant calculated the royalty payable to the mother company in a manner that deviated from similar transactions between independent entities. It censures the fact that the rappel discount was not included in the computation of net sales for the purposes of computing the royalty under review. “[S]ince rappel is a discount resulting from the permanent nature of the contractual relationship between the supplier and the customer, (in the case of the Defendant, set at one year) constituting a reduction in the customer’s pecuniary benefit structurally linked to the volume of goods purchased, it can hardly be argued that it has a temporary nature, in the sense of ‘momentary’ or of ‘short duration'”; “(…) by excluding the rappel of rebates deductible from the gross value of sales, for the purposes of determining the net value of sales pursuant to Clause 32 of the Licence Agreement, the Tribunal a quo erred in fact”; “[that] on the transfer pricing regime, the AT demonstrated, by the reasoning of fact and law contained in the final inspection report that the existence of special relations between the Defendant and SPN led to the establishment of different contractual conditions, in the calculation of the royalties payable, had they been established, between independent persons”. In this regard, it was written in the contested judgment as follows: “(…) // In fact, the exceptions provided for in clause 32 of the Licence Agreement, which have a broad content, allow the framing of the so-called rappel situations, contracted by the Impugnant with its clients for a determined period of time and subject to periodic review, given their temporary nature. // Which means that, as to the form of calculation of the tax basis of the royalties payable to SPN, no violation of the provisions of the Licence Agreement has occurred. // For this reason, one cannot accept the conclusion of the Tax Authority in the inspection report, that such discounts do not fall within the group of those which, as they have a limited timeframe for their validity, should not be considered as a negative component of the sales for the purposes of calculation of the royalties, in accordance with the contract entered into between the Impugnant and SPN. // In addition, the Tax Authority failed to demonstrate in the inspection report to what extent the conditions practiced in the calculation of the royalties payable by the Impugnant to SPN diverge from the conditions that would be practiced by independent entities, not having been observed the provisions of article 77, no. 3, of the General Tax Law (LGT)”. Assessment. The grounds for the correction under examination appear in item “III.1.1.6 Transfer prices: € 780,318.77” of the Inspection Report. The relevant regulatory framework is as follows: i) “In commercial transactions, including, namely, transactions or series of transactions on goods, rights or services, as well as in financial transactions, carried out between a taxable person and any other entity, subject to IRC or not, with which it is in a situation of special relations, substantially identical terms or conditions must be contracted, accepted and practiced to those that would normally be contracted, accepted and practiced between independent entities in comparable transactions”(12). (ii) ‘When the Directorate-General for Taxation makes corrections necessary for the determination of the taxable profit by virtue of special relations with another taxpayer subject to corporation tax or personal income tax, in the determination of the taxable profit of the latter the appropriate adjustments reflecting the corrections made in the determination of the taxable profit of the former shall be made’.) (iii) “The taxable person shall, in determining the terms and conditions that would normally be agreed, accepted or carried out between independent entities, adopt the method or methods that would ensure the highest degree of comparability between his transactions or series of transactions and other transactions that are substantially the same under normal market conditions or in the absence of special relations…”.) (iv) “The most appropriate method for each transaction or series of transactions is that which is capable of providing the best and most reliable estimate of the terms and conditions that would normally be agreed, accepted or practised at arm’s length, the method which is the most appropriate to achieve the highest degree of comparability between the tied and untied transactions and between the entities selected for the comparison, which has the highest quality and the most extensive amount of information available to justify its adequate justification and application, and which involves the smallest number of adjustments to eliminate differences between comparable facts and situations”. (v) ‘Two transactions meet the conditions for comparable transactions if they are substantially the same, meaning that their relevant economic and financial characteristics are identical or sufficiently similar, so that the differences between the transactions or between the undertakings involved in them are not such as to significantly affect the terms and conditions which would prevail in a normal market situation, or, if they do, so that the necessary adjustments can be made to eliminate the material effects of the differences found’ (16). (vi) “In the case of operations ...

Both tax administrations and taxpayers often have difficulty in obtaining adequate information to apply the arm’s length principle. Because the arm’s length principle usually requires taxpayers and tax administrations to evaluate uncontrolled transactions and the business activities of independent enterprises, and to compare these with the transactions and activities of associated enterprises, it can demand a substantial amount of data. The information that is accessible may be incomplete and difficult to interpret; other information, if it exists, may be difficult to obtain for reasons of its geographical location or that of the parties from whom it may have to be acquired. In addition, it may not be possible to obtain information from independent enterprises because of confidentiality concerns. In other cases information about an independent enterprise which could be relevant may simply not exist, or there may be no comparable independent enterprises, e.g. if that industry has reached a high level of vertical integration. It is important not to lose sight of the objective to find a reasonable estimate of an arm’s length outcome based on reliable information. It should also be recalled at this point that transfer pricing is not an exact science but does require the exercise of judgment on the part of both the tax administration and taxpayer ...

SONY Music Entertainment Colombia S.A. had filed transfer pricing information and documentation, on the basis of which the Colombian tax authorities concluded that payments for administrative services provided by a related party in the US had not been at arm’s length. SONY Colombia then filed new transfer pricing information and documentation covering the same years, but where the tested party had been changed to the US company. Under this new approach, the remuneration of the US service provider was determined to be within the arm’s length range. The tax authorities upheld the assessment issued based on the original documentation. A complaint was filed by SONY and later an appeal. Judgement of the Administrative Court The court allowed the appeal and issued a decision in favor of SONY. Excerpts “The legal problem is to determine, for the tax return of the taxable period 2007 of the plaintiff: (i) Whether it is appropriate to take into account the correction of the transfer pricing information return submitted by the plaintiff and its supporting documentation, and whether the information submitted is sufficient to determine compliance with the arm’s length principle. … In the present case, the DIAN [tax authorities], by means of the contested acts, disregards operating expenses of $1,963,235,000 of the plaintiff’s income tax return for the taxable period 2007, because it considered that the administrative expenses that the plaintiff paid to its related party in the United States of America (United States) were not adjusted to market prices, which had been agreed with other suppliers. In order to justify the disregard of the aforementioned expenses, the DIAN took as reference the individual informative declaration of transfer prices (DIIPT) and the supporting documentation initially submitted by the plaintiff, in which it was determined that it was outside the market range. Furthermore, it stated that if the corrections to the DIIPT and the supporting documentation are taken into account, there is no reason to justify that the analysis of administrative expenses should be carried out for the company located abroad. For its part, the plaintiff considers that the DIIPT and the initial supporting documentation should not have been taken into account, due to the fact that the correction was made in which it is demonstrated that the expenditure operation was carried out at market values, since the related company in the United States should be analysed, and not the company in Colombia as was done in the original declaration. … From the cited provisions it is clear that there is room to impose a sanction in the case of the correction of the individual informative declaration or of the supporting documentation, in the event of errors or inconsistencies in these documents. On previous occasions, this Court has recognised that it is appropriate to correct the information return and supporting documentation. However, regardless of whether the correction of the return or of the supporting documentation is punishable, such corrections should be examined by the Administration, in order to determine whether the transactions recorded by the taxpayer with his economic partners were in accordance with the arm’s length principle. …. In addition, the documentation clarifies that the reason for the study from the company abroad was an administrative services contract that had been in place since 2005, for which the company abroad was paid $3,569,194,000, a payment that was corroborated by the DIAN in the audit process by means of the withholdings made, transactions carried out and items paid. This contract was submitted to the file and shows that Sony Colombia and Sony United States agreed that “The Services provided by SBME will be invoiced to the Company at a rate calculated at cost plus an increase of 8%. The Services will be billed periodically, but in no case will they be billed for periods longer than one year”, a clarification together with the global situation of the music industry that justifies the Markup analysed, and the comparable companies in the supporting documentation. … Consequently, it is reiterated that the change of the tested party was supported and it is clarified that such change only affects the information of the administrative services transaction, since the transfer pricing methods apply to individual transactions, as determined by article 260-2 of the Tax Statute. … In this context, the plaintiff could correct its DIIPT and its supporting documentation, the information submitted in its corrections should have been taken into account, the plaintiff was free to choose to carry out its analysis of the foreign company, and it complied with the requirements of its supporting information together with the arm’s length principle. Consequently, the contested measures should be annulled, and the other pleas in law are dismissed as the main plea is well founded.” Click here for English translation Click here for other translation ...

Both tax administrations and taxpayers often have difficulty in obtaining adequate information to apply the arm’s length principle. Because the arm’s length principle usually requires taxpayers and tax administrations to evaluate uncontrolled transactions and the business activities of independent enterprises, and to compare these with the transactions and activities of associated enterprises, it can demand a substantial amount of data. The information that is accessible may be incomplete and difficult to interpret; other information, if it exists, may be difficult to obtain for reasons of its geographical location or that of the parties from whom it may have to be acquired. In addition, it may not be possible to obtain information from independent enterprises because of confidentiality concerns. In other cases information about an independent enterprise which could be relevant may simply not exist, or there may be no comparable independent enterprises, e.g. if that industry has reached a high level of vertical integration. It is important not to lose sight of the objective to find a reasonable estimate of an arm’s length outcome based on reliable information. It should also be recalled at this point that transfer pricing is not an exact science but does require the exercise of judgment on the part of both the tax administration and taxpayer ...