Czech Republic: Contract manufacturer’s losses disallowed by Tax Authorities and Supreme Administrative Court

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Published on July 14, 2017

 

The Czech Tax Authorities performed a tax audit in a company which was a part of an international group of companies and operated as a detached manufacturing plant having its related party as the only customer. The related party made decision on all strategic aspects of the business and the controlled entity, as it was described in transfer pricing documentation provided to the Tax Authorities, operated as contract manufacturer with limited functions and risks.
 

The transfer price for manufacturing services was set based on working hours. The transfer pricing documentation stated that cost plus method was applied which implies that the controlled entity should have been compensated for all production related costs and should have earned certain profit. Moreover, the transfer pricing documentation stated that the detached manufacturing plants do not bear any other risks but those linked to their production function.
 

However, the controlled entity incurred losses in 2008 due to unfavourable situation on the target market.
 

Tax Authorities’ approach to determine the arm's length remuneration

The Tax Authorities did not aligned with the losses incurred and levied additional tax based on a percentage of actually incurred costs, using own benchmark analysis prepared in databases AMADEUS and ALBERTINA  (database included financial figures of Czech companies).
 

One of the supporting arguments provided by the Tax Authorities was the controlled company did not have any control over utilization of its capacity. Moreover, the Tax Authorities argued that there had been a significant increase of prices invoiced by the controlled entity for manufacturing activities in 2009 compared to 2008 which confirmed that the prices invoiced in 2008 were set incorrectly.
 

The controlled entity did not agree with the decision of the Tax Authorities and went to the court. At the first stage, the court confirmed the Tax Authorities approach as well as the tax audit result. The controlled entity addressed the case further to the Supreme Administrative Court. The Supreme Administrative Court supported the Tax Authorities as well as it agreed with both the process and the tax adjustment.
 

Conclusion on the Czech court decision

There are several aspects to be pointed out.
 

A positive aspect about the Tax Authorities’ approach is that it compared the controlled entity’s profitability with the lowest profitability value gained in a benchmark analysis, and not with 1st quartile value, which is more common approach of tax authority.
 

On the other hand, the Tax Authorities did not perform detailed qualitative analysis in terms of activities of the companies being compared and relied only on the NACE codes stated in the databases they used for benchmark analysis preparation, and Supreme Administrative Court accepted such approach, which differ to prior own decisions in similar cases.
 

It is also obvious that any evidence needs to be analysed and considered very carefully before it is provided during tax audits (e.g. provided documentation stated low function profile of the company).

Finally, it could be expected that this decision will support the Tax Authorities and further tax inspections will be performed in a rather similar way.
 

Such a decision basically confirms the Tax Authorities’ consistent, long-term approach towards companies with limited functions and/or incurring losses.

 

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