Following an audit the tax authorities issued an assessment of additional income resulting from an adjustment of the tax deductions related to marketing expenses. According to the tax authorities the price agreed between the related parties for advertising space was excessive and not determined in accordance with the arm’s length principle. ANITA B s.r.o. filed an appeal against the assessment. The Regional Court dismissed the appeal as unfounded by judgment of 26 October 2021, No. 62 Af 70/2019-48. The Court concluded that the tax authorities had established that the price agreed between ANITA B s.r.o. and its supplier (ELAPROMO) differed from the price that would have been agreed between unrelated parties. The Court upheld the method chosen by the tax authorities and concluded that ANITA B s.r.o. had failed to prove that the advertising costs claimed were justified in full. An appeal was then filed with the Supreme Administrative Court Judgement of the Supreme Administrative Court The court decided in favour of the tax authorities and upheld the decision from the Regional Court. Excerpt “[40] In its judgment of 26 March 2014, no. 9 Afs 87/2012-50, the Supreme Administrative Court explained that “[t]he purpose of the provision in question is to prevent the unwanted shifting of part of the income tax base between individual income taxpayers and to enable the sanctioning of abusive price speculation in business relations. It also concerns the so-called “profit shifting” between persons with different tax burdens, which usually occurs when such persons charge each other prices lower or higher than the prices used between independent persons in normal business relations, and the result of such transactions is an increase in costs or a decrease in sales for the company with the higher tax burden and a siphoning off of part of the profits to the company with the lower or zero income tax rate. It further summarised that ‘a material difference from normal prices occurs when sales are made too cheaply or purchases are made too expensively; in such cases, such a difference must always be satisfactorily documented’. [41] In that connection, the complainant pointed out that TOP Reklama was the exclusive purchaser of the advertising space, which significantly affected its subsequent bargaining position. However, that argument cannot be accepted. The Regional Court dealt with it in paragraph 29 of the judgment under appeal and the Supreme Administrative Court fully agrees with its view. That argument certainly cannot be regarded in the present case as satisfactory evidence of a price difference within the meaning of Article 23(7) of the ITA. As regards the argument concerning the importance and fame of the sports grounds in question, it cannot be accepted either, since any exclusivity is already included in the price at which SK Vodova Brno and FC Zbrojovka Brno lease the advertising space to TOP Reklama. The Supreme Administrative Court therefore has no other explanation than that the price was overestimated in order to obtain a tax advantage. [42] Furthermore, the complainant has repeatedly stated that it is an entrepreneur in the field of development, production and trade in sewing machines and cannot be required to have knowledge of the advertising market. However, this and subsequent arguments are again unhelpful as they do not explain the substantial difference from normal prices. At the same time, the Supreme Administrative Court reiterates at this point that it is irrelevant to the case whether the complainant was knowingly involved in the chain of connected persons. [43] In view of the foregoing, the tax administrator proved that the case involved related persons within the meaning of section 23(7)(b)(5) of the ITA, that the prices agreed between those persons differed from the prices that would have been agreed between independent persons in normal business relations under the same or similar conditions, and that the complainant did not specifically explain and document the difference between the agreed price and the normal price. In such a situation, the tax administrator was entitled to adjust the tax base by the difference between the above-mentioned prices in accordance with Article 23(7) of the ITA. [44] It can therefore be summarised that the Regional Court assessed the relevant legal issues correctly and based itself on the facts of the case duly established by the tax administration authorities. The grounds of appeal set out in Article 103(1)(a) and (b) of the Code of Civil Procedure were therefore not met.” Click here for English Translation Click here for other translation ...

The initial step in applying the simplified approach to low value-adding intra-group services is for the MNE group to calculate, on an annual basis, a pool of all costs incurred by all members of the group in performing each category of low value-adding intra-group services. The costs to be pooled are the direct and indirect costs of rendering the service as well as, where relevant, the appropriate part of operating expenses (e.g. supervisory, general and administrative). The costs should be pooled according to category of services, and should identify the accounting cost centres used in creating the pool. Pass-through costs in the cost pool should be identified for the purposes of applying paragraph 7.61. The cost pool should exclude costs that are attributable to an in-house activity that benefits solely the company performing the activity (including shareholder activities performed by the shareholding company) ...

When an associated enterprise is acting only as an agent or intermediary in the provision of services, it is important in applying a cost based method that the return or mark-up is appropriate for the performance of an agency function rather than for the performance of the services themselves. In such a case, it may not be appropriate to determine arm’s length pricing as a mark-up on the cost of the services but rather on the costs of the agency function itself. For example, an associated enterprise may incur the costs of renting advertising space on behalf of group members, costs that the group members would have incurred directly had they been independent. In such a case, it may well be appropriate to pass on these costs to the group recipients without a mark-up, and to apply a mark-up only to the costs incurred by the intermediary in performing its agency function ...

The selection of the appropriate financial indicator depends on the facts and circumstances of the case, see paragraph 2.82. Concerns have been expressed that Berry ratios are sometimes used in cases where they are not appropriate without the caution that is necessary in the selection and determination of any transfer pricing method and financial indicator. See paragraph 2.98 in relation to the use of cost-based indicators in general. One common difficulty in the determination of Berry ratios is that they are very sensitive to classification of costs as operating expenses or not, and therefore can pose comparability issues. In addition, the issues raised at paragraphs 2.99-2.100 above in relation to pass-through costs equally arise in the application of Berry ratios. In order for a Berry ratio to be appropriate to test the remuneration of a controlled transaction (e.g. consisting in the distribution of products), it is necessary that: The value of the functions performed in the controlled transaction (taking account of assets used and risks assumed) is proportional to the operating expenses, The value of the functions performed in the controlled transaction (taking account of assets used and risks assumed) is not materially affected by the value of the products distributed, i.e. it is not proportional to sales, and The taxpayer does not perform, in the controlled transactions, any other significant function (e.g. manufacturing function) that should be remunerated using another method or financial indicator ...

Where treating costs as pass-through costs is found to be arm’s length, a second question arises as to the consequences on comparability and on the determination of the arm’s length range. Because it is necessary to compare like with like, if pass-through costs are excluded from the denominator of the taxpayer’s net profit indicator, comparable costs should also be excluded from the denominator of the comparable net profit indicator. Comparability issues may arise in practice where limited information is available on the breakdown of the costs of the comparables ...

In applying a cost-based transactional net margin method, fully loaded costs are often used, including all the direct and indirect costs attributable to the activity or transaction, together with an appropriate allocation in respect of the overheads of the business. The question can arise whether and to what extent it is acceptable at arm’s length to treat a significant portion of the taxpayer’s costs as pass-through costs to which no profit element is attributed (i.e. as costs which are potentially excludable from the denominator of the net profit indicator). This depends on the extent to which an independent party in comparable circumstances would agree not to earn a mark-up on part of the costs it incurs. The response should not be based on the classification of costs as “internal” or “external” costs, but rather on a comparability (including functional) analysis. See paragraph 7.34 ...

“A Infrastructure S.A.” had granted loans related parties B and C. The average interest rate borne by A S.A. on its bank loans was lower than the one applied to loans passed on to B and C, but following an audit, the tax authorities observed that other financial expenses (bank commissions and stamp duty) had been deducted by A S.A as financial costs on its bank loans, but not recorded as financial income on the intra-group loans. On that basis an assessment was issued where deductions for these financial costs not passed on to B and C had been disallowed in the ratio of “loans granted to B and C” over “A S.A’s external bank loans”. A appeal was filed by A S.A. with the Administrative Tribunal (CAAD). Judgement of the CAAD The Tribunal granted the appeal and declared the annulment of the income tax assessment. Excerpt “The Court is not unaware that the application of rules, such as those on transfer pricing, which are essentially anti-avoidance and whose application is very much based on the concept of “comparability” of transactions – sometimes complex to put into practice – may give rise to some reluctance to use them as grounds for tax corrections. However, the law exists to be used in the situations to which it should apply. And, as it is true that the concept of comparability is sometimes difficult to apply, the same is true of the use of the concept of “indispensability” in Article 23 of the CIRC. The latter (Article 23 of the CIRC) should not be applied systematically as an anti-abuse clause; it contains, above all, a general condition to be respected for the deductibility of expenses. If there are anti-abuse rules that are adapted to certain situations, they must first be the control tools used by the AT. Within this framework, the contested assessment suffers from an error of law and factual assumptions, due to the erroneous interpretation and application of the provisions of Article 23(1)(c) of the IRC Code, which constitutes a breach of law, for which reason they must be declared illegal and, consequently, annulled.” Click here for English translation Click here for other translation ...

Samsung Electronics Baltic Ltd, is a subsidiary of Samsung Electronics Co. Ltd, which was established at the end of 2007. On 1 January 2008, Samsung Electronics Baltic and Samsung Electronics Co. Ltd entered into Distribution Agreement, under which Samsung Electronics Baltic was appointed as the distributor in the Baltic States of the products manufactured by Samsung Electronics Co. Ltd and its subsidiaries (‘the Distribution Agreement’). In 2008 and 2009, Samsung Electronics Baltic carried out business activities in the territory of Latvia, Lithuania and Estonia distributing the goods received from Samsung Electronics Co. Ltd under the Distribution Agreement. Samsung Electronics Baltic also provided warranty services for the goods sold by engaging service providers for that purpose, namely merchants who carried out repairs of the goods (‘Repair Services’). On 2 January 2008, Samsung Electronics Baltic concluded a Warranty Assumption Agreement (‘the Warranty Assumption Agreement’) with its sister company, Samsung Electronics Overseas B.V. (‘Dutch Samsung’), which was the distributor of Samsung Electronics Co. Ltd’s products in the Baltic States before the Applicant. Under the agreement, Samsung Electronics Baltic undertook to provide product warranty services for products sold by Dutch Samsung in the Baltic markets in 2005, 2006 and 2007, and Dutch Samsung undertook to pay Samsung Electronics Baltic a lump sum of USD 4 369 550 to fulfil the assumed warranty obligations. In order to fulfil its obligations under this contract, Samsung Electronics Baltic engaged the services of Repair Service Providers. Pursuant to the Distribution Agreement and the Marketing Fund Agreement (‘the Marketing Fund Agreement’) concluded on 1 January 2008 between Samsung Electronics Baltic and Samsung Electronics Co. Ltd, Samsung Electronics Baltic also performed marketing functions for the Samsung Group in 2008. In particular, Samsung Electronics Baltic engaged marketing agencies as marketing service providers in accordance with the marketing strategy set out by Samsung Electronics Co. Ltd. Samsung Electronics Baltic paid the service fees indicated in the invoices issued by these agencies and subsequently invoiced Samsung Electronics Co. Ltd (or other related companies) for the same amount. The State Revenue Service (hereinafter – the Service) audited Samsung Electronics Baltic for value added tax for the period from January 2008 to October 2009 and for corporate income tax for 2008. The administrative procedure before the authority was concluded by the decision of the Revenue Service of 15 February 2011 (hereinafter – the appealed decision), by which the value added tax, the related penalty and late payment fines were calculated for additional payment to the budget, the value added tax to be refunded from the budget and the related penalty were reduced, and the corporate income tax and the related late payment fines and penalties were calculated for additional payment to the budget by the applicant. As regards value added tax, the contested decision states that in 2008 and 2009 Samsung Electronics Baltic deducted as input tax in its value added tax returns the amounts of tax indicated in the invoices issued to Samsung Electronics Baltic by the Repair Service. According to the Authority, Samsung Electronics Baltic was not entitled to do so, since the transactions in question were not aimed at the pursuit of Samsung Electronics Baltic’s economic activity (transactions subject to value added tax). The Revenue Service considers that Samsung Electronics Baltic used the transactions in question to secure its warranty service obligations towards Samsung Electronics Co. Ltd and Samsung Netherlands, whereas, in the Revenue Service’s view, these relationships are not to be regarded as transactions subject to value added tax but as cost compensation transactions which are not subject to value added tax. As regards corporation tax, the contested decision states that Samsung Electronics Baltic, in performing the group’s marketing functions, has acted as an intermediary which undertakes to provide the related companies with the services of subcontractors (marketing agencies). The Authority found that since Samsung Electronics Baltic passed on the services received from the unrelated parties – the marketing agencies – to Samsung Electronics Co. Ltd and other related undertakings without a mark-up, it follows that Samsung Electronics Baltic provided services to the related undertakings below the market price, since an unrelated undertaking would have added a mark-up to such intermediation services in order to make a profit. Consequently, there are grounds for adjusting Samsung Electronics Baltic’s corporation taxable income by the difference between the value of the services reported by Samsung Electronics Baltic and the market value of the services as calculated by the Revenue Service. The method of adding up costs should be used to determine the market value of the services provided. Taking into account the information available in the Amadeus database, it is estimated that the operating cost or profit margin for unrelated undertakings ranges between 1,7 % and 4,05 %. Consequently, the market value of the services provided by Samsung Electronics Baltic to its affiliates was determined by applying the profit margin of 1,7 % to the sum of the value of the services received from the marketing agencies and Samsung Electronics Baltic’s agency costs as determined in the audit. In follows from the judgement that – If the arm’s length price is not applied and the goods or services are sold at a price below the arm’s length price, the taxable income for corporation tax purposes must be revised upwards by that part of the difference. The legislator has accepted that the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, which summarise the best practices in transfer pricing of OECD Member States, complement the explanation of the market price methods in the legislation and provide guidance to help calculate the market price as accurately as possible. Consequently, the application of market price methodologies should take into account and use, to the extent possible, the guidance provided in those guidelines. Determining the nature of the service provided is a prerequisite for application of the cost markup method. The essence of the cost markup method is the application of a mark-up to the costs incurred by the service provider in providing the service which is ...

The initial step in applying the simplified approach to low value-adding intra-group services is for the MNE group to calculate, on an annual basis, a pool of all costs incurred by all members of the group in performing each category of low value-adding intra-group services. The costs to be pooled are the direct and indirect costs of rendering the service as well as, where relevant, the appropriate part of operating expenses (e.g. supervisory, general and administrative). The costs should be pooled according to category of services, and should identify the accounting cost centres used in creating the pool. Pass-through costs in the cost pool should be identified for the purposes of applying paragraph 7.61. The cost pool should exclude costs that are attributable to an in-house activity that benefits solely the company performing the activity (including shareholder activities performed by the shareholding company) ...

When an associated enterprise is acting only as an agent or intermediary in the provision of services, it is important in applying a cost based method that the return or mark-up is appropriate for the performance of an agency function rather than for the performance of the services themselves. In such a case, it may not be appropriate to determine arm’s length pricing as a mark-up on the cost of the services but rather on the costs of the agency function itself. For example, an associated enterprise may incur the costs of renting advertising space on behalf of group members, costs that the group members would have incurred directly had they been independent. In such a case, it may well be appropriate to pass on these costs to the group recipients without a mark-up, and to apply a mark-up only to the costs incurred by the intermediary in performing its agency function ...

The selection of the appropriate financial indicator depends on the facts and circumstances of the case, see paragraph 2.82. Concerns have been expressed that Berry ratios are sometimes used in cases where they are not appropriate without the caution that is necessary in the selection and determination of any transfer pricing method and financial indicator. See paragraph 2.98 in relation to the use of cost-based indicators in general. One common difficulty in the determination of Berry ratios is that they are very sensitive to classification of costs as operating expenses or not, and therefore can pose comparability issues. In addition, the issues raised at paragraphs 2.99-2.100 above in relation to pass-through costs equally arise in the application of Berry ratios. In order for a Berry ratio to be appropriate to test the remuneration of a controlled transaction (e.g. consisting in the distribution of products), it is necessary that: The value of the functions performed in the controlled transaction (taking account of assets used and risks assumed) is proportional to the operating expenses, The value of the functions performed in the controlled transaction (taking account of assets used and risks assumed) is not materially affected by the value of the products distributed, i.e. it is not proportional to sales, and The taxpayer does not perform, in the controlled transactions, any other significant function (e.g. manufacturing function) that should be remunerated using another method or financial indicator ...

Where treating costs as pass-through costs is found to be arm’s length, a second question arises as to the consequences on comparability and on the determination of the arm’s length range. Because it is necessary to compare like with like, if pass-through costs are excluded from the denominator of the taxpayer’s net profit indicator, comparable costs should also be excluded from the denominator of the comparable net profit indicator. Comparability issues may arise in practice where limited information is available on the breakdown of the costs of the comparables ...

In applying a cost-based transactional net margin method, fully loaded costs are often used, including all the direct and indirect costs attributable to the activity or transaction, together with an appropriate allocation in respect of the overheads of the business. The question can arise whether and to what extent it is acceptable at arm’s length to treat a significant portion of the taxpayer’s costs as pass-through costs to which no profit element is attributed (i.e. as costs which are potentially excludable from the denominator of the net profit indicator). This depends on the extent to which an independent party in comparable circumstances would agree not to earn a mark-up on part of the costs it incurs. The response should not be based on the classification of costs as “internal” or “external” costs, but rather on a comparability (including functional) analysis. See paragraph 7.34 ...

Cheil Communications India Pvt. Ltd. is a subsidiary of a Korean based advertising agency, Cheil Communications. The Indian affiliate had excluded pass-through costs from its cost base when determining the arm’s length remuneration for its activities. The tax authority included the the pass-through costs in the cost base and issued an assessment for FY 2005-06 where these costs were also marked up. Judgement of the Tribunal The Tribunal annulled the assessment and ruled in favor of Cheil Communications India. Excerpt “(…)For performing the functions for and on behalf of associated enterprises, the assessee is remunerated by its associated enterprises on the basis of a fixed commission/charges based on expenses or cost incurred by the assessee for release of a particular advertisement. It is also to be noted that advertising space (be it media, print or outdoor), has been let out by third party vendors in the name of ultimate customers and beneficiary of advertisement. We have gone through the invoices and purchase orders from third party vendors and find that they contain customers’ name, and all the terms of advertisement are finalized after taking the approval from the customers. The assessee simply acts as an intermediary between the ultimate customer and the third party vendor in order to facilitate placement of the advertisement. The payment made by the assessee to vendors is recovered from the respective customers or associate enterprises. In the event customer fails to pay any such amount to the advertisement agency, the bad debt risk is borne by the third party vendor and not by the advertising agency i.e. the assessee. It is, thus, clear that the assessee has not assumed any risk on account of non-payment by its customers or associated enterprises. At this stage a useful reference may be made to ITS 2009 Transfer Pricing Guidelines accepted by the OECD where it is laid down that when an associate enterprises is acting only as an agent or intermediary in the provision of service, it is important in applying the cost plus method that the return or mark-up is appropriate for the performance of an agency function rather than for the performance of the services themselves, and, in such a case, it may be not appropriate to determine arm’s length price as a mark-up on the cost of services but rather on the cost of agency function itself, or alternatively, depending on the type of comparable data being used, the mark-up on the cost of services should be lower than would be appropriate for the performance of the services themselves. In this type of cases, it will be appropriate to pass on the cost of rendering advertising space, to the credit recipient without a mark up and to apply a mark-up only to the costs incurred by the intermediary in performing its agency function. These guidelines are as under:- 3.41 In applying the transactional net margin method, various considerations should influence the choice of margin used. For example, these considerations would include how well the value of assets employed in the calculations is measured (e.g. to shat extent there is intangible property the value of which is not captured on the books of the enterprise) and the factors affecting whether specific costs should be passed through, marked up, or excluded entirely from the calculation. 41. In the proposed revision of Chapter I-III of the Transfer Pricing Guidelines issue don 9th September, 2009 – 9th January, 2010 by OECD, it has been provided in Para 2.134 as under:- “2.134 In applying a cost-based transactional net margin method, fully loaded costs are often used, including all the direct and indirect costs attributable to the activity or transaction, together with an appropriate allocation in respect of the overheads of the business. The question can arise whether and to what extent it is acceptable at arm’s length to treat a significant portion of the taxpayer’s costs as pass- through costs to which no profit element is attributed (i.e. as costs which are potentially excludable from the denominator of the net profit margin indicator). This depends on the extent to which an independent party at arm’s length would accept not to be remunerated on part of the expenses it incurs. The response should not be based on the classification of costs as “internal” or “external” costs, but rather on a comparability (including functional) analysis, and in particular on a determination of the value added by the tested party in relation to those costs.” 42. Further, OECD in ITS 2009 Transfer Pricing Guidelines has laid down as under:- “7.36 When an associated enterprise is acting only as an agent or intermediary in the provision of services, it is important in applying the cost plus method that the return or mark-up is appropriate for the performance of an agency function rather than for the performance of the services themselves. In such a case, it may not be appropriate to determine arm’s length pricing as a mark-up on the cost of the services but rather on the costs of the agency function itself, or alternatively, depending on the type of comparable data being used, the mark-up on the cost of services should be lower than would be appropriate for the performance of the services themselves. For example, an associated enterprise may incur the costs of rending advertising space on behalf of group members, costs that the group members would have incurred directly had they been independent. In such a case, it may well be appropriate to pass on these costs to the group recipients without a mark-up, and to apply a mark-up only to the costs incurred by the intermediary in performing its agency function.” 43. In the light of these guidelines, it would be, therefore, clear that a mark-up is to be applied to the cost incurred by the assessee company in performing its agency function and not to the cost of rendering advertising space on behalf of its associate enterprises. We further find that the method adopted by the assessee while submitting ...