Editorial: A war on multiple fronts
The Supreme Administrative Court (SAC) issued a long-awaited decision in the case of a pharmaceutical company that had purchased and sold medicines purchased from its group on the Czech market (with Czech VAT applied). At the same time, it provided marketing services to the group (with no Czech VAT applied). It had to, otherwise it would have made a loss thanks to price regulation. The tax authority assessed Czech VAT on services because the services were – in their view - an integral part of the main supply, the sale of goods. The SAC annulled the assessment. Big victory. For the given pharmaceutical company, no question. Certainly good news for the rest of the pharma market, too. For other industries with similar alignments, it’s hard to say.
At the outset is the unfortunate coexistence of price regulation and tax rules. The distributor must sell at a loss or violate price regulation. So it buys and sells at a loss. However, if it makes a loss, the tax authorities will charge transfer prices. So, it has to use some kind of adjustment. Maybe a marketing service. And it’s forced to claim that the service is part of its business and overall profitability, and therefore that the transfer prices are fine. The more transfer pricing is okay, the more it will lead the tax authorities to believe the services are actually an integral part of the supply of goods and subject to VAT. It’s a balancing act between three risks, a roulette game of whether there will be penalties for price regulation violations, transfer pricing violations or VAT violations.
In this case, the tax administrator opted for VAT and tried to claim that everything is one big supply to the customer – even the marketing service is provided to the end customer. Now, after reading the SAC judgment, this seems naive. Although the customer is the target of the marketing effort, he is certainly not the one to whom the marketing service would be provided. Perhaps naive in today’s optics, but it made perfect sense to the tax authorities in both instances and to the regional court. Moreover, the taxpayer had shown that he was actually doing some general marketing and not necessarily just marketing for the goods he was distributing.
The question is what happens when a slightly less naive tax administrator comes to someone who’s documentation of the services provided isn’t as robust and/or doesn’t provide separable marketing services for products other than those they distribute. And if I let my imagination run wild, I also see those who didn’t bother with the service and just pay some kind of compensation or bill a content-free “transfer pricing adjustment”. I think then the tax authorities might not even bother with the sophisticated “integral part of the main supply” and simply say the substance is a payment from a third party for goods subject to VAT.
It will be even more interesting in models where the group does not sell anything to the Czech subsidiary and just tells it what to produce and what to sell to whom and for how much. At the end of the year, it either takes a chunk of the profit (because it arranged the business) or, on the contrary, compensates for the losses (because it forced its subsidiary to sell to the group’s major customers below cost). A perfectly working transfer pricing model with a completely bulletproof transfer pricing study. However, knowing the above-mentioned court case, it would not be surprising if the tax administrator were to come to collect VAT from the loss compensation. Here, it could try to argue that the service is not very separate and nicely tie it to the supplied goods.
In the opposite scenario, where the excess profit is subsequently transferred to the group, the tax authorities could then say they won’t waste their time with VAT and just say it’s a distribution of profit, which is a priori not deductible for income tax. This could be offered in particular in “profit split” transfer pricing models where the name itself suggests that it is a (non-tax deductible?) profit transfer.
Only practice will tell which end the tax administrator will grasp. There are counter-arguments, of course, but something will have to fund all the planned tax breaks in the coalition program…
