Tax administrations have expressed concerns about cases they have observed in practice where an entity voluntarily terminates a contract that provided benefits to it, in order to allow a foreign associated enterprise to enter into a similar contract and benefit from the profit potential attached to it. For instance, assume that company A has valuable long-term contracts with independent customers that carry significant profit potential for A. Assume that at a certain point in time, A voluntarily terminates its contracts with its customers under circumstances where the latter are legally or commercially obligated to enter into similar arrangements with company B, a foreign entity that belongs to the same MNE group as A. As a consequence, the contractual rights and attached profit potential that used to lie with A now lie with B. If the factual situation is that B could only enter into the contracts with the customers subject to A’s surrendering its own contractual rights to its benefit, and that A only terminated its contracts with its customers knowing that the latter were legally or commercially obligated to conclude similar arrangements with B, this in substance would consist in a tri-partite transaction and it may amount to a transfer of valuable contractual rights from A to B that may have to be remunerated at arm’s length, depending on the value of the rights surrendered by A from the perspectives of both A and B ...

B Restructuring LDA was a distributor within the E group. During FY 2014-2016 a number of manufacturing entities within the group terminated distribution agreements with B Restructuring LDA and subsequently entered into new Distribution Agreements, under similar terms, with another company of the group C. These events were directed by the Group’s parent company, E. The tax authorities was of the opinion, that if these transaction had been carried out in a free market, B would have received compensation for the loss of intangible assets – the customer portfolio and the business and market knowledge (know-how) inherent to the functions performed by B. In other words, these assets had been transferred from B to C. The tax authorities performed a valuation of the intangibles and issued an assessment of additional taxable income resulting from the transaction. E Group disagreed with the assessment as, according to the group, there had been no transaktion between the B and C. Furthermore the group held that there was no transaction or disposal of intangibles, as B could not sell what did not belong to it, namely the client portfolio, which had been, almost in its entirety, raised by the Group, prior to its use by B. Result reached in the arbitration tribunal The Tribunal set aside the assessment of additional income in respect of transfer of intangibles. Excerpts “…The Tax Authorities, anchored in the positions of the OECD, states in the RIT that: “From this perspective, the acceptance by B… of a distribution contract, on which the entirety of its activity depends, containing clauses that (i) harm its individual interest (Clause 11, which provides that the parties waive the right to claim damages in connection with the execution or termination of the contract) […] is a decision that differs from the rationality of pursuing self-interest that would exist in an independent company ” Indeed, the position that independent entities, when transacting with each other, would require consideration for the transfer of assets is understandable. However, it is also true that § 6.13 of the OECD Guidelines underlines that within a Group there are special relationships, with rules specific to the Group, which should not be automatically called into question for failure to respect the arm’s length principle, particularly in transactions involving intangibles. In this context, the RIT is totally silent, and should not be, on the value of the Group’s contribution to B… customers, as based on the evidence, in particular in the logic of application of the excess earnings method (and respective elements contributing to the assets under appraisal). In a transaction between independent parties, the selling party, having previously obtained such a right or intangible asset, certainly through the payment of a consideration, what it would gain is the value arising from its specific contribution, and not the total value of the asset, since a substantial part of it was not developed by it . In the present case, the profit of B… would have to be deducted the value contributed by the group for the portfolio of clients reallocated to C… . If a compensation for the reallocation of B…’s intangibles was accepted, it would also have to be analysed how it would be shared among the Group’s entities that contributed to the generation of the reallocated intangibles. In light of all the foregoing, it can be concluded that the tax acts of assessment of the CIT and the compensatory interest inherent thereto are vitiated by an error in the assumptions and can therefore be annulled on the grounds of substantive defects, by virtue of the AT’s failure to observe the legal criteria of the method for determining the comparable market price (PCM) or other alternative method. Specifically: a. The allegedly comparable price was obtained by the AT from the data of a controlled transaction, and not from a transaction between independent parties – which is not admissible under Article 63 of the IRC Code, Ministerial Order 1446-C/2001 and the OECD Guidelines that enshrine the guidelines to be followed for this purpose; b. The evaluation method used was the discounted cash-flow method, which has as general postulate that the value of an asset (or company) is based on the cash flows that it will release, updated (present value) to the moment when the transaction of that asset (or company) takes place. However, inconsistently, despite invoking that method, the AT did not rely on a projection of cash flows for a multi-year period, basing itself on the profits (and not, as stated, cash flows) of a given year – 2014 (and not, as stated, on a multi-year basis); c. Relevant comparability factors were not taken into account, such as, in the present case, the fact that the “profit” of B… should be deducted the value contributed by the Group for the portfolio of clients reallocated to C…”. Also with regard to the choice of method, in the words of the TCA Sul, in its Judgment of 25 January 2018, rendered in Case No. 06660/13 (available in http://www.dgsi.pt): “Transfer prices, as we have already stated, must be determined in accordance with the arm’s length principle (Pursuant to article 2 of Ordinance no. 1446-C/2001, the arm’s length principle is applicable (i) to controlled transactions between an IRS or IRC taxpayer and a non-resident entity; (ii) to transactions carried out between a non-resident entity and its permanent establishment, including those carried out between a permanent establishment in Portuguese territory and other permanent establishments of the same entity located outside this territory; (iii) controlled transactions carried out between entities resident in Portuguese territory subject to IRS or IRC. And by virtue of Article 58(10) of the CIRC and Article 23 of the above-mentioned Ministerial Order, the arm’s length principle is also applicable to the situations provided for therein. Maybe for this reason, the legislator consecrated an open clause regarding the methods to be adopted to determine the transfer prices (see the wording of paragraph b) of article 4 of Ministerial Order no. 1446-C/2001, of 21st March) ...

According to Colgate Palmolive, following a restructuring, the local group company in Spain was changed from being a “fully fledged distributor” responsible for all areas of the distribution process to being a “limited risk distributor” (it only performs certain functions). A newly established Swiss company, Colgate Palmolive Europe, instead became the principal entrepreneur in Europe. The changed TP setup had a significant impact on the earnings in the Spanish group company. Net margins was reduced from around 16% before the restructuring, to 3.5% after the restructuring. Following a thorough examination of the functions, assets and risks before and after application of the new setup, the Tax administration held that Colgate Palmolive Europe could not be qualified as the “principal entrepreneur” in Europe. The swiss company was in substance a service provider for which the remuneration should be determined based on the cost plus method. Judgement of the Court The High Court held in favour of the tax administration and dismissed the appeal of Colgate Palmolive. Excerpt “.…the conclusion, in our opinion, can only be that the Administration is right, since in reality – remember that certain functions were already being carried out by the French Headquarter – there is no significant change in the situation existing prior to the restructuring in the years in question. This being so, it is not surprising that the Agreement reasons that “the existence of transactions between related entities, the Spanish and Swiss entities, determines the application of the regime provided for in Article 16 of the Consolidated Text of the Corporate Income Tax Law (TRLIS) and in its implementing regulations, mainly Chapter V of Title I of the Corporate Income Tax Regulations (RIS), taking into account the change of regulation introduced by Law 36/2006 applicable, in the case of Colgate Palmolive, as from the financial year 2007”. Adding that “in relation to the existence of transactions between related companies, it is also necessary to take into account Article 9 of the Spanish-Swiss Double Taxation Agreement, inspired by the OECD Model Agreement, which provides that the profits of associated companies may be adjusted when the conditions present in their commercial or financial relations differ from those that would be agreed between independent entities. This article recognises the so-called arm’s length principle, the interpretation of which must take into account the OECD Doctrine, contained in the Commentary to Article 9 itself and its 1995 Transfer Pricing Guidelines, which have been significantly updated in 2010”. As reasoned in the Agreement, the Board shares the reasoning, “according to the exhaustive description contained in the verification file, the characterisation of CP Europe as a “principal trader” is inappropriate, it being more correct to consider that such an entity is in reality a service provider. It is therefore considered that the method chosen by the group to value the transactions is inappropriate and that the appropriate valuation method is the cost plus method. This method, in addition to being a traditional method (and therefore preferable under our internal regulations and the Guidelines), is, in accordance with the OECD Guidelines (paragraph 2.32 and 2.39 in the 2010 version), particularly appropriate for valuing the provision of services”. The fact is that ‘the valuation method applied by Colgate Palmolive is not appropriate, as it results in the residual profit of the group’s operations in Spain being concentrated in the CP Europe entity, which makes no sense if the economic activity of each entity (CP USA, CP Spain and CP Europe) in the overall business in our country is taken into account. The Guidelines themselves highlight in their chapter 7 dedicated to intra-group services (paragraph 7.31, before and after 2010) the cost plus method, together with the comparable free price, as the method to be used to value this type of services between related entities. The work of the Joint Transfer Pricing Forum of the European Union, which also assumes that this is the method most frequently used to value this type of transaction”. The Inspectorate adds, quite reasonably, that “until 2005, the group itself valued transactions between the French Headquarter, with the role of service provider, and the other entities of the group – including CP Spain – using the cost plus method”. The consequence of all the above is that, as stated on p. 73 of the report -reasoning endorsed by the Agreement- “in order to value the transactions between CP Europe and CP Spain, the transactional net margin method, taking CP Spain as the analysed party (Tesdet party), is inappropriate. Instead, it is considered that the most appropriate method for valuing the transactions is the cost plus method, which is based on attributing to the provider of those services – CP Europe – a gross margin on the costs it incurs which are attributable to the Spanish market [it should be recalled that following the analysis carried out it has been concluded that CP Europe cannot be considered as a principal trader, but rather as an entity which performs the functions of a service provider]’. This means that, in the years in question, it is not correct to attribute to CP EUROPE the residual profit derived from the group’s operations in Spain, but rather that this residual profit, deducting the remuneration of the owner of the intangible asset -CP USA- and of the service provider -CEP EUROPE-, should fall on CP SPAIN. The calculations are set out in pp. 74 to 81 of the report, as well as in pp. 59 to 62 of the Agreement. The Board, particularly in the absence of any arguments to the contrary, considers them to be correct. For all the foregoing reasons, the plea is dismissed.” Click here for English Translation Click here for other translation ...

Tax administrations have expressed concerns about cases they have observed in practice where an entity voluntarily terminates a contract that provided benefits to it, in order to allow a foreign associated enterprise to enter into a similar contract and benefit from the profit potential attached to it. For instance, assume that company A has valuable long-term contracts with independent customers that carry significant profit potential for A. Assume that at a certain point in time, A voluntarily terminates its contracts with its customers under circumstances where the latter are legally or commercially obligated to enter into similar arrangements with company B, a foreign entity that belongs to the same MNE group as A. As a consequence, the contractual rights and attached profit potential that used to lie with A now lie with B. If the factual situation is that B could only enter into the contracts with the customers subject to A’s surrendering its own contractual rights to its benefit, and that A only terminated its contracts with its customers knowing that the latter were legally or commercially obligated to conclude similar arrangements with B, this in substance would consist in a tri-partite transaction and it may amount to a transfer of valuable contractual rights from A to B that may have to be remunerated at arm’s length, depending on the value of the rights surrendered by A from the perspectives of both A and B ...