In this regular review of the past year’s key transfer pricing cases a shift from financial transactions to goods and intangibles is noted, but other than that the main themes remain unchanged and a consistent body of case law is developing which can serve as a reference in future cases and for transfer pricing policy-making and documentation. The details of the cases including full case references, making links between them and to earlier cases, are set out in a separate article.
An analysis of the industries in which this year’s taxpayers operate shows a dominance of goods manufacturers/distributors and extractives:
- Goods manufacturing and distribution—AgraCity, Ice Machine Manufacturer, ECCO, A Oy, A Oyj, Kellogg, Toyota, KEC, Federal Mogul, Altera, The Coca-Cola Company;
- Extractives—Glencore, Cameco, Transalpino, Zinc Smelter, Prime Plastichem, Shell, Mopani;
- Professional services—Engine Branch, Adecco, Corbus, Orange;
- IP licensing—Engine Branch, Apple; and
- Financial services—Irish Banks.
Types of Transaction
The type of transaction (contractual or imputed) in this year’s cases was mainly goods, followed by intangibles:
- Goods—Glencore, Cameco, Ice Machine Manufacturer, ECCO, A Oy, Federal Mogul, Zinc Smelter, Prime Plastichem, The Coca-Cola Company, Mopani;
- Intangibles—Engine Branch, Adecco, Apple, Toyota, Shell, Altera;
- Finance—A Oyj, Corbus, KEC, Irish Banks; and
- Services—AgraCity, Kellogg, Transalpino, Orange.
Types of Transfer Pricing Issues
This year’s issues—and the decisions—can be summarized as follows:
Continued Losses—In Adecco and A Oy, the taxpayers succeeded in justifying their continued losses by reference to an unsuccessful business strategy, but in Ice Machine Manufacturer it failed to do so because of its inadequate transfer pricing documentation;
Choice of Tested Party—in Ice Machine Manufacturer, the court allowed the tax administration to benchmark the manufacturer (the taxpayer) rather than the related party sales companies because the taxpayer had not provided sufficiently robust information about the sales companies to allow them to be benchmarked reliably.
In ECCO, the court ruled that the tax administration was not allowed to benchmark the sales company (the taxpayer) rather than the related party manufacturers because the taxpayer’s transfer pricing documentation justified its benchmarking approach.
In A Oy the court prevented the tax administration from benchmarking the sales company (the taxpayer) rather than the related party manufacturers because the taxpayer had shown that the manufacturers were the simpler parties with reliable benchmarks.
In Zinc Smelter, the litigants agreed during the trial that instead of benchmarking the toll manufacturer (the taxpayer) there should be a profit split with the related party full risk manufacturer, because of their joint activities.
In Orange, the court prevented the tax administration from benchmarking the local entrepreneur company (the taxpayer) because it was engaged, with its related parties, in providing highly integrated services.
Choice of Transfer Pricing Method—in A Oy the court ruled that the tax administration could not use a different transfer pricing method without confirming that it would give a more reliable result, taking into account the quality of the comparables, but in Ice Machine Manufacturer the tax administration was allowed to do this because the taxpayer had not demonstrated why its own method was reliable.
In ECCO the court prevented the tax administration from using the transactional net margin method (TNMM) to assess the income of a loss-making company.
In Toyota the tax administration was prevented from applying a new transfer pricing method for later periods because it had not shown that the functional analysis (in this case, in respect of IP) had changed.
In Prime Plastichem the court ruled that the taxpayer’s CUP method could be replaced by the TNMM because the benchmarks for the CUP method were not reliable (being related party ones).
In The Coca-Cola Company, the court allowed the tax administration to benchmark the manufacturers using the comparable profits method (CPM) rather than accept the existing formulary apportionment method, on the basis that the intangibles in the group made both production and selling merely routine activities;
Restructuring (commercial rationality/recharacterisation, compensation and new transfer pricing policy):
- In Glencore, Cameco, and AgraCity the courts ruled that the tax administration was not allowed to recharacterize or set aside the switch to a new trading arrangement, because it had not shown that it was not commercially rational. In A Oyj the court ruled that the fact that one of the parties continued to perform certain important functions did not justify the recharacterization of a new group financing arrangement—this would also require the tax administration to show a main tax avoidance motive.
- In Engine Branch the court ruled that if termination of a service agreement involved effective termination of IP rights, then the compensation should take into account the forgone IP profits (which could continue for longer than the compensation period in arm’s-length service agreements). In Zinc Smelter the parties agreed that conversion from full risk manufacturer to toll manufacturer required compensation based on the forgone profits from the transferred intangible assets.
- In A Oyj the court prevented the tax administration from imputing only a risk-free rate of return to a new group finance company, because it did perform some of the key functions. In Zinc Smelter the parties agreed that the separation of production responsibilities into a principal and a toll manufacturer was in fact an arrangement of joint activities requiring a profit split approach. In Orange the court prevented the tax administration from replacing the new profit split method with the TNMM because the highly integrated nature of the transactions made the profit split the more appropriate method.
Unrecognized Transactions—Adecco and A Oy the courts ruled that continued losses could not simply be assumed to result from a subsidiary being kept in existence for the benefit of the group as a whole, and the existence of a separate unacknowledged transaction had to be confirmed before a profit could be attributed to it.
In Kellogg, the court decided that a relatively high level of AMP expenditure did not imply a related party marketing service and that this would have to be demonstrated by the presence of such an agreement between the parties.
In Corbus the court ruled that extended credit did not imply a separate loan transaction in addition to the underlying goods transaction, and that it was only necessary to benchmark the goods transaction, adjusting for its extended credit feature.
In KEC, the court ruled that interest did not need to be imputed on a cash advance if it was an emergency loan to protect the shareholder’s interest.
Standard Of Documentation Required—inadequate contemporaneous transfer pricing documentation caused Pharma Distributor,Ice Machine Manufacturer, Transalpino, Prime Plastichem, and Mopani to lose in court.
However, in AgraCity and ECCO the court took into consideration both the taxpayer’s contemporaneous documentation and the documents which it prepared in response to the subsequent tax audit, and found for the taxpayer. Indeed, on Oct. 4, 2020, the Danish Parliament published a proposal that would require the tax administration to take into account any information provided after filing of the tax return for a particular year.
In Federal Mogul, the decision was that a tax administration’s comparables could be rejected if the selection process was not made available to the court;
Static or Ambulatory Approach to the Transfer Pricing Guidelines—in Shell the court referred to versions of the Transfer Pricing Guidelines from after the time of the transaction, but saying that it was only appropriate to do so if it helped the taxpayer.
Relevance of Independent Party Arrangements—in Glencore and Altera the courts rejected the argument that the absence of similar third party arrangements should justify recharacterisation or the use of a different transfer pricing method.
Use of the Profit Split Method—in Toyota the court ruled that a tax administration could not use a profit split method simply because the taxpayer was the entrepreneurial local exploiter of the IP, and a full analysis of the applicability of the OECD tests for use of the profit split method (PSM) had to be performed.
In Transalpino, the taxpayer failed in preventing an additional factor being added to its profit split formula because the tax administration had shown that it would have been an important consideration in an arm’s-length negotiation.
In Zinc Smelter the parties agreed that the new split of production responsibilities involved joint activities with no routine elements such that a contribution profit-split method should be used.
In Orange the court ruled that the profit split method was the most appropriate because of the highly integrated nature of the services;
Attribution of Profit to Permanent Establishments—In Apple the court ruled that evidence of the limited substance of a head office is not in itself sufficient to allocate additional profit to a permanent establishment. In Irish Banks the court decided that a branch should be assumed to have the equity and loan capital which it would need to carry on its business on a standalone basis, and that this should set a limit to its claim for interest deductions.
Deviation From Transfer Pricing Agreements—in Shell, the court prevented the tax administration from imputing charges for certain R&D services because it would be a deviation from the cost sharing agreement between the parties. In Mopani, the taxpayer lost partly because it was unable to explain why it appeared to have deviated from its own transfer pricing policy.
Combining Transactions for Benchmarking—in Toyota the court ruled that it was permissible to combine transactions and benchmark the overall profitability (effectively, the U.S. CPM) as long as it could be shown that the transactions could have been benchmarked separately;
Basing Transfer Prices on Budgeted Costs—in ECCO it was decided that it could be appropriate for transfer prices to be set on the basis of budgeted costs; and
Comparability Adjustments—in Pharma Distributor it was decided that it could not be assumed that the benchmark companies did not take the same accounting practice as the tested party and this had to be confirmed before making the relevant comparability adjustments.
In Federal Mogul, it was ruled that comparables could be excluded on the basis of very different size and possession of intangible assets to a significantly different extent, and that it was valid to make working capital adjustments to profit margins.
The key themes from this year’s cases appear to be:
(1) a focus on goods and intangibles transactions in the extractives and goods manufacturing/distribution industries,
(2) a resistance to assertions (e.g. about unrecognized transactions) without a detailed functional analysis and robust benchmarks,
(3) a resistance to recharacterization except where the arrangements were clearly not commercially rational or were motivated by tax avoidance,
(4) flexibility as to how the transfer pricing guidelines can be applied (e.g. combining transactions, use of budgeted costs), and
(5) considering what is possible within the constraints of the transfer pricing agreement (i.e. a legal analysis).
Compared to 2018 and 2019, the same themes continue to appear, although financial transaction disputes seem to have been displaced by goods and intangibles disputes (perhaps explained by new OECD guidance on risk and the allocation of IP profits). Given the time taken for controversies to come to court, the cases of 2021-2023 may draw on the February 2020 OECD financial transfer pricing guidance and again feature financial transactions.
The cases of 2018-2020 provide a strong body of references dealing with losses, deviations from transfer pricing agreements, and restructuring of related party arrangements, and perhaps these rather than the December 2020 OECD guidance will prevent the courts from being dominated by Covid-19 related cases over the next few years.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Danny Beeton is of counsel in the London and Luxembourg offices of Arendt & Medernach. He can be contacted at: firstname.lastname@example.org. The views expressed in this article are those of the author only.