C. spółka z o.o. is part of a larger group and mainly (95%) sells products (boxes, metal enclosures, etc.) and related services to related parties. According to its transfer pricing documentation the “cost-plus” method had been used to determine the prices of products sold to related parties. The company was audited for FY 2016. According to the tax authorities, the company did not provide enough evidence to support the cost-plus method. The tax authority instead used the transactional net profit method to estimate the company’s income for the year 2016, taking into account factors such as characteristics of goods or services, functional analysis, contractual conditions, economic conditions, and economic strategy by comparing the company’s performance with similar companies over a 3 year period by using EBIT margin. As a result, the authority adjusted the company’s loss and established income based on a EBIT margin of 3.66%, resulting in additional taxable income of PLN 1,803,592.08. C. spółka filed an appeal with the Administrative Court. The Administrative Court predominantly dismissed the appeal and found in favor of the tax authorities. However, the tax authorities have wrongly determined the income of the complainant, by referencing to its entire activity, despite the fact that 5% of the transactions are not subject to regulation under the arm’s length provision. Because of this, the court repealed the decision of the first-instance authority and stated that when re-examining the case, the authority should take into account the position expressed. An appeal was then filed by C. spółka with the Supreme Administrative Court. Judgement of the Supreme Administrative Court The Court dismissed the appeal and upheld the decision of the Administrative Court. Excerpts “The company completely ignores in the cassation complaint that the tax documentation of the transaction submitted by it did not confirm its use of the “cost-plus” method of calculating the sales price to related parties with a mark-up of 30% on the direct costs constituting the cost base (depreciation, value of materials and energy used, third-party services, salaries and wages with mark-ups). The submitted tax documentation shows that in the Company, the valuation of the value of the products sold to related customers should follow the reasonable margin “cost-plus” method. In addition, the Company, in describing the method and manner of calculating income and determining the price of the subject of the transaction, explained, among other things, that in 2016, in transactions to related parties (i.e. to: C. GmbH,. P.GmbH, R. mbH), the price was the sales value of individual finished products, determined each time on invoices issued by the Applicant. The price for the individual products was determined on the basis of pre-agreed price lists or on the basis of ongoing arrangements and negotiations, taking into account changing market conditions. This was to be the method provided for in Article 11(2) of the A.p.d.o.p., consisting in setting the price for the sale of goods and rights and the provision of services in transactions with a related party at the level of the sum of the cost base and profit mark-up, comparable to the cost base and profit mark-up established between independent parties, which take into account comparable functions, risks incurred and assets involved. In the explanations submitted during the tax proceedings, the Company additionally stated that it calculated the selling prices of finished goods taking into account the following elements: – material costs; – third-party service costs; – labour costs; – a mark-up of 30%. It further explained that the 30% mark-up applied by it was established in 2005 and was not updated, and was applied in transactions carried out for related parties and independent parties under individual orders and orders. At the same time, it did not submit any documents related to the calculation of the sales prices of finished goods applied to related parties. It should also be emphasised that the Appellant, when preparing the profit and loss account in the comparative variant, did not separate in it such an item as management costs within the meaning of the Accounting Act, the determination of which is necessary in the event of a reliable application of the “cost-plus” method to transfer pricing settlements. The tax authority was therefore correct in concluding that the sales prices to related parties were not correctly calculated based on market standards. At the same time, it must be emphasised that the Company did not have any long-term contracts with customers, and production and sales were based on current orders from customers, including related and independent entities. In the business relationship concerning the production and sale of products to the related party C. GmbH (as parent company), the Applicant acted as a subcontractor, and these processes were planned on the basis of long-term contracts concluded by C. GmbH with its customers. The company did not in any way contractually secure its own turnover volume or even the planning of the supply of its products and services in the medium term. Most importantly, however, it is apparent from the evidence gathered, including the documentation obtained from the Applicant, that sales were made at amounts that did not take into account all costs incurred and that there was no rational reason for such sales prices. According to the tax authority’s calculations, the revenues obtained by the Company according to the reasonable “cost-plus” margin method indicated by itself should have been higher by approximately PLN 4.5 million. Meanwhile, the margin realised by the Applicant was negative and actually amounted to -6.80%. This indicates that the Company’s method of pricing to related parties, contrary to its position, did not assume the achievement of an adequate profit, and the tax documentation submitted for the Complainant’s transactions with related parties did not assume a mark-up of 30%, which would have translated into a profit for 2016 rather than a loss. Therefore, it is not possible to agree with the Company’s position that only objective factors influenced the negative financial result and were the only reason for the application of Article 11(1) of the A.T.C. Properly ...

In other instances, taxpayers might test the actual outcome of their controlled transactions to demonstrate that the conditions of these transactions were consistent with the arm’s length principle, i.e. on an ex post basis (hereinafter “the arm’s length outcome-testing” approach). Such test typically takes place as part of the process for establishing the tax return at year-end ...

In some cases, taxpayers establish transfer pricing documentation to demonstrate that they have made reasonable efforts to comply with the arm’s length principle at the time their intra-group transactions were undertaken, i.e. on an ex ante basis (hereinafter “the arm’s length price-setting” approach), based on information that was reasonably available to them at that point. Such information includes not only information on comparable transactions from previous years, but also information on economic and market changes that may have occurred between those previous years and the year of the controlled transaction. In effect, independent parties in comparable circumstances would not base their pricing decision on historical data alone ...

A contractual assumption of risk constitutes an ex ante agreement to bear some or all of the potential costs associated with the ex post materialisation of downside outcomes of risk in return for some or all of the potential benefit associated with the ex post materialisation of positive outcomes. Importantly, ex ante contractual assumption of risk should provide clear evidence of a commitment to assume risk prior to the materialisation of risk outcomes. Such evidence is a very important part of the tax administration’s transfer pricing analysis of risks in commercial or financial relations, since, in practice, an audit performed by the tax administration may occur years after the making of such up-front decisions by the associated enterprises and when outcomes are known. The purported assumption of risk by associated enterprises when risk outcomes are certain is by definition not an assumption of risk, since there is no longer any risk. Similarly, ex post reallocations of risk by a tax administration when risk outcomes are certain may, unless based on the guidance elsewhere in these Guidelines and in particular Section D.1.2.1, be inappropriate ...

In certain cases, the arm’s length principle may result in an administrative burden for both the taxpayer and the tax administrations of evaluating significant numbers and types of cross-border transactions. Although associated enterprises normally establish the conditions for a transaction at the time it is undertaken, at some point the enterprises may be required to demonstrate that these are consistent with the arm’s length principle. (See discussion of timing and compliance issues at Sections B and C of Chapter III and at Chapter V on Documentation). The tax administration may also have to engage in this verification process perhaps some years after the transactions have taken place. The tax administration would review any supporting documentation prepared by the taxpayer to show that its transactions are consistent with the arm’s length principle, and may also need to gather information about comparable uncontrolled transactions, the market conditions at the time the transactions took place, etc., for numerous and varied transactions. Such an undertaking usually becomes more difficult with the passage of time ...

One potential solution to the uncertainty caused by the COVID-19 pandemic would be to allow for the inclusion of price adjustment mechanisms in controlled transactions. This may provide for flexibility while maintaining an arm’s length outcome. In particular, this approach to the extent permissible by domestic law would allow the adjustment of prices relevant for FY2020 through adjusted invoicing or intercompany payments effectuated in a later period (likely FY2021), when more accurate information to establish the arm’s length transfer price becomes available. In jurisdictions that use the outcome-testing approach, price adjustment mechanisms to reflect updated information relevant to determining an arm’s length price are often used. A jurisdiction that temporarily allows the outcome-testing approach could also temporarily allow the use of price adjustment mechanisms for that purpose and the taxpayer would be expected to describe the application of the price adjustment mechanism in its transfer pricing documentation. Such price adjustment mechanisms (provided that they are consistent with the arm’s length principle in the particular facts and circumstances) would address the issue of the lack of contemporaneous information on comparables or other direct evidence of arm’s length behaviour in response to the pandemic. This would give flexibility to taxpayers and tax administrations while also ensuring ultimate compliance with the arm’s length principle; however, given the scope of the potential adjustments, care would need to be taken with their appropriate characterisation, any effects that the payment may have on the comparability analysis for FY2021, and their potential resultant VAT/GST and customs duty implications (which are not the subject of this chapter or guidance) ...

Where possible, and on a temporary basis during the pandemic, tax authorities that otherwise use the price-setting approach could consider allowing taxpayers, for those controlled transactions affected by the pandemic, to take into account information that becomes available after the close of the taxable year in filing their returns (where legally permissible and properly described in the transfer pricing documentation). Tax administrations could provide flexibility to allow amendments to FY 2020 tax returns such that transfer prices are set on an arm’s length basis and using available information. Also given the potential for double taxation that may arise as a result of unilateral adjustments, consideration may be given by tax administrations to: Provide for flexibility in the allowance of “compensating adjustments” to be made before the tax return is filed, where it is legally permissible, in order to allow for any available contemporaneous information to be better evaluated by taxpayers and tax administrations such that arm’s length prices can be reliably established12; or Ensure access to the MAP, or to some alternative applicable procedure, where the issue could be addressed between the respective tax administrations and early certainty could be obtained, to avoid double taxation, noting that through MAP or alternative procedures tax administrations can address issues in a non-adversarial proceeding, often achieving a negotiated settlement in the interests of all parties. 12 Paragraphs 4.38 and 4.39 of Chapter IV of the OECD TPG ...

The OECD TPG describe two approaches to identify and collect data required to undertake a transfer pricing analysis. The first is a “price-setting,” i.e. an ex-ante approach, which uses historical data updated to reflect any change in economic conditions through the date of the contract. The second is an “outcome-testing” approach, which may incorporate information that becomes available after the close of the taxable year to determine arm’s length conditions and report results on the taxable year to determine arm’s length conditions and report results on the tax return. According to the OECD TPG, both approaches, or a combination of these approaches, are found among OECD member countries.11 11 Paragraph 3.71 of Chapter III of the OECD TPG ...

In other instances, taxpayers might test the actual outcome of their controlled transactions to demonstrate that the conditions of these transactions were consistent with the arm’s length principle, i.e. on an ex post basis (hereinafter “the arm’s length outcome-testing” approach). Such test typically takes place as part of the process for establishing the tax return at year-end ...

In some cases, taxpayers establish transfer pricing documentation to demonstrate that they have made reasonable efforts to comply with the arm’s length principle at the time their intra-group transactions were undertaken, i.e. on an ex ante basis (hereinafter “the arm’s length price-setting” approach), based on information that was reasonably available to them at that point. Such information includes not only information on comparable transactions from previous years, but also information on economic and market changes that may have occurred between those previous years and the year of the controlled transaction. In effect, independent parties in comparable circumstances would not base their pricing decision on historical data alone ...

The decision is about a German distribution company of international groups, which is in a continual overall loss position. This case established an important principle that: ‘… an orderly and diligent manager will, for the corporation managed by him, introduce to the market and distribute a new product only if he can expect, based on a prudent and pre-prepared economic forecast, a reasonable overall profit within a foreseeable period of time with due consideration to the predictable market development’. This decision covered the market introduction of a new product by an already established company and stated that typically a market introduction phase, losses should not be accepted for longer than three years. A later Bundesfinanzhof decision from 15 May 2002 stated that a start-up loss phase can be substantially longer than 3 years based on facts and circumstances. Click here for English translation Click here for other translation ...