Nejvyssi spravni soud k prikazu materske spolecnosti k zastaveni vyroby

The Supreme Administrative Court on the order of the parent company to stop production

We bring you an interesting recent judgment of the Supreme Administrative Court (SAC) on the topic of transfer pricing and the tax administrator's claim for lack of compensation for stopping production under the order of a foreign parent company.

Situation

• A company historically procured materials for the manufacture of knitting machines at the behest of its parent company.
• The production of knitting machines proved to be unprofitable. The company therefore - again on the orders of the parent company - stopped production and disposed of the material.
• The tax authorities adjusted the company's tax base by an amount corresponding to the impact of the disposal of the material.
• According to the tax authorities, the company suffered a material loss from the disposal of the material which was not compensated by the parent company. The company lost profit as a result. The tax authorities considered the disposal order to be a transaction between related parties.

The view of the Regional Court

• The Regional Court (CC) concluded that Section 23(7) of the Income Tax Act (ITA) was not applicable to the transaction in question, as the case at hand does not concern a price agreed between related parties.
• In the present case, Article 9(1) of the Double Taxation Treaty could be applied as it has a wider scope than Section 23(7) ITA.
• It cannot yet be said that in the present case there is a commercial transaction which does not comply with the economic principles of normal commercial relations.
• According to the CC, the purchase and disposal of inventory can be the result of a legitimate business decision, which would be taken even by a completely independent entity. The tax authorities must revisit this issue in further proceedings, including the role played by the subsidiary.

The view of the SAC

• The SAC upheld the conclusion of the CC.
• The transfer pricing provisions do not apply at all. The order for liquidation of the inventory was made in the course of business management of the company. If the parent company had not issued such an order, the company would have made further losses as the production was objectively unprofitable. The parent company did not receive any direct profit as a result of the decision.
• Contrary to previous case law in similar situations, here no contractual arrangements, purchase or sale are considered, but only the parent company's order.
• More on the details of the reasoning of the SAC below.

It is clear that the topic of controlled transactions is being addressed by tax authorities with increasing intensity. The question is whether this dispute would have turned out the same way if the tax authorities had changed their strategy and focused primarily on framing the "transaction" in question within the overall transfer pricing setting between the Czech company and the group and the corresponding functional and risk profile, rather than an isolated assessment of the disposal of the material. We have also seen similar reactions from the tax administration on social media.

Details of the reasoning of the SAC

• The SAC notes that in the present case it is not necessary to consider whether the scope of Section 23(7) of the ITA is narrower or broader than Article 9(1) of the DTT. According to the Supreme Administrative Court, those cited provisions do not apply to the present case at all.
• In the present case, according to the SAC, no multilateral legal transaction (commercial or financial relationship) and an agreed price or non-standard terms can be identified in the parent company's decision to liquidate the inventory, which was made in the course of the company's business management.
• The tax authorities saw the parent company's order for the subsidiary as something of a hypothetical service. However, it was not an obligation within the meaning of section 23(7) of the ITA, but a normal business management of the company. According to the Supreme Administrative Court, it is certainly a sign of related parties in a parent-subsidiary relationship that the parent company decides on the production direction of its subsidiary.
• From the point of view of assessing the economic rationality of the case, it is relevant that the subsidiary purchased supplies (materials) for the production of knitting machines from the parent company in 2011 and disposed of these supplies in 2014 on the basis of the parent company's decision (order), as the production of the knitting machines in question was loss-making.
• The circumstances suggest that, as a result of its decision (order), the parent company merely avoided the negative consequences that would have been associated with the continuation of unprofitable production. Those negative consequences (increasing losses) would have primarily affected the subsidiary directly. The parent company did not receive any direct profit as a result of this decision alone. Nor is there any indication that the parent company's conduct under assessment constitutes conduct which would have caused the subsidiary damage. Furthermore, in the present case, it cannot yet be concluded that the parent company, for example, sought (unjustifiably) to reduce its tax base.
• In this context, the SAC reiterates that it is a perfectly legitimate business judgment if a parent company, as part of its business management, stops unprofitable production at its subsidiary and decides to liquidate the already acquired and no longer needed stock (material). In the present case, therefore, the parent company has merely made a rational decision which any other businessman would probably have made.
• The tax authorities state that it was 'the parent company which, within the group, had the functions of purchasing materials and making production decisions which, in effect, rendered the inventory acquired from the parent company unusable'. In the present case, however, the complainant also overlooks the significance of the fact that the decision to cease production was not taken by the parent company for no reason, but on the basis of an objective fact - the unprofitability of that production. There is no doubt that, as a result of that fact, the company made a loss. If the parent company had not taken that decision, the company's losses would obviously have increased as a result of the unprofitable production. However, in the logic of the tax authorities, the parent company should also be responsible for the latter loss and compensate the company for the loss. However, according to the SAC, this constitutes an intractable and illogical "circle".
• With regard to compensation for the disposal of the material, the SAC considers that it depends in particular on the contractual agreement of the parties involved on how to proceed in a similar situation and whether and to what extent any disposal of the material will be compensated. The tax administrator has so far only made unsubstantiated assumptions about the contractual partner compensating the costs of disposal of the purchased material.
• The SAC sees a fundamental difference between this case and the case dealt with in the judgment 7 Afs 398/2019, where the disproportion in question arose from the fact that the company was forced to sell its products "below cost" as a result of the actions of its parent company and sister companies, without being able to influence the transactions and contractual arrangements described. As a result, it did not achieve even a minimum profitability. The compensation, according to the judgments referred to above, was an amount corresponding to the minimum operating profitability. However, the present case is different, according to the SAC. In this case, no contractual arrangements, contractual obligations, purchase or sale are at issue. The subject of the assessment, as defined by the tax authorities, is only the parent company's decision (order) to stop production of knitting machines and to dispose of stocks (materials). It is therefore not a contractual obligation (transaction) but a decision on the commercial management of the company.

If you have any questions, please contact the authors of the article or the EY tax team with whom you regularly work.

Authors:

Libor Frýzek

Michal Kašpar