Dutch court of appeal rules on reversal and increase of the burden of proof in transfer pricing disputes

On 19 July 2024, the Dutch court of appeal of Amsterdam (the ‘Court’) issued an important (and lengthy) judgement that clarifies who has the burden of proof in Dutch transfer pricing disputes. The Court held that in accordance with the general rules, also in transfer pricing disputes, the penalty for taxpayers that knowingly and willfully file a wrong tax return is that the burden of proof shifts from the inspector to the taxpayer and the taxpayer’s proof for its position must adhere to a higher standard. A taxpayer is considered to have filed an incorrect tax return if, due to defects in the return, the amount of tax that is due in excess of the amount that is due on the basis of the tax return is substantial, both in relative (compared to the amount that follows from the tax return) as well as absolute terms. This is known as the so-called ‘relative and absolute materiality criterion’. For transfer pricing disputes in particular, the inspector can prove that a wrong tax return has been filed if he can prove that the transfer price applied falls outside of the arm’s length range. The ‘relative and absolute materiality criterion’ will then be met if the difference between the amount of tax due on the basis of the tax return and the tax due on the lowest amount of the arm’s range profit, is relatively and absolutely material.

In this update, we provide you with a summary of the judgement and our takeaways.

Summary of the facts

The taxpayer is part of one of the world’s largest commodity traders. In 2009, two Dutch subsidiaries of the taxpayer (the ‘DutchCos’), that were part of the same fiscal unity as the taxpayer, converted their operating model from full-fledged manufacturers to toll manufacturers of cocoa and soy related products (the ‘Restructuring’). The Dutch tax authorities (‘DTA’) argued that the Restructuring constituted more than just the transfer of certain assets and liabilities to the group’s new European principal company in Switzerland and that the Restructuring would result in a substantial profit. During lengthy, but unsuccessful discussions about the tax consequences of the Restructuring that preceded the filing of the tax return concerning the Restructuring, the taxpayer had argued that, if indeed the Restructuring constituted more than just the transfer of certain assets and liabilities, the profit on the Restructuring would have been € 7.7 million. This amount was calculated by deducting the value of the DutchCos post-restructuring (i.e., based on toll manufacturing) from the value of the DutchCos pre-restructuring (i.e. as if they remained full-fledged entrepreneurs). Both pre- and post-restructuring values were determined in a discounted cash flow analysis. The DTA had rejected this proposal, arguing that the taxpayer cherry-picked its parameters. If the DTA adjusted for this alleged cherry-picking, they found a Restructuring value of € 455 million. Based on a multiples analysis, this value could even be more than € 1 billion, according to the DTA.   

Pending the discussions with the DTA, the taxpayer filed its tax return reporting a profit of only € 1.8 million on the Restructuring, comprising the profit made on the transfer of certain assets and liabilities. When filing its tax return, the taxpayer sent a letter to the inspector that suggested a meeting to discuss the point further. Instead, the inspector imposed a tax assessment based on a counter-valuation of € 320 million that was performed by the DTA’s valuation experts.

In the appealed decision, the district court (the ‘District Court’) held that the DutchCos had transferred part of their business as part of the Restructuring. The District Court appointed a valuation expert (the ‘Expert’) to determine the minimum arm’s length value of the business transferred by the DutchCos. By applying a similar method as the taxpayer and the DTA, the Expert found that a minimum value of € 85 million had been transferred by the DutchCos as a result of the Restructuring. We refer to our previous update on the District Court’s decision.

The inspector appealed against District Court’s decision which was based on the Expert’s valuation, on four points:

1. The standard applied by the Expert is not correct, because the Expert was instructed to find the minimum arm’s length value, whereas the median value of the arm’s length range should be used.
2. A tax amortization benefit should be taken into account.
3. The Expert used revenue forecasts that were too pessimistic.
4. The long-term growth rate of 1% that was used in the terminal value calculation should be 2%, based on the targeted inflation rate by the ECB.

The decision of the Court

The Court held that also in transfer pricing disputes, the general rules on the burden of proof apply. This means that the inspector has the burden of proof to adjust transfer prices on the basis of the arm’s length principle. The Court then held that also the penalty for knowingly and willingly filing a wrong tax return applies in transfer pricing cases. Knowingly and willingly in this case means ‘knew or should have known’. This penalty comprises that the burden of proof shifts to the taxpayer, and also that the burden of proof for the taxpayer is increased. The penalty can only be imposed if the relative and absolute materiality criterion is met.

On the required awareness, the Court held that whether a taxpayer was aware (or should have been aware) that he was filing a wrong tax return should be tested on a standalone basis (i.e., without considering any knowledge or awareness about this in the rest of group) and at the moment on which the tax return is filed. The Court determined that the taxpayer’s functional analysis that was prepared for the € 7.7 million valuation indicated that the taxpayer was aware that more than just certain assets and liabilities were transferred in the Restructuring. It furthermore ruled that the inspector proved that a wrong tax return had been filed, because by reporting only € 1.8 million profit, the relative and absolute materiality criterion was met, as this profit was substantially lower than the lowest point of the arm’s length range (which was the € 85 million minimum value found by the Expert). Therefore, the Court reversed and increased the burden of proof to the taxpayer.

Finally, the Court decided that the inspector did not impose its corrections based on reasonable estimates, considering the extensive amount of information he received from the taxpayer. This must take into account the extent of the information that the inspector has for imposing a tax assessment and the extent to which the taxpayer is able to disclose all relevant information. In this regard, the Court ruled that:

1. The inspector is correct when arguing that the value should be adjusted to the median value of the arm’s length range. However, as the Expert only used median values in his analysis, this does not result in a material difference from the valuation of the Expert.
2. A tax amortization benefit should indeed be considered, but not a full tax gross-up because the tax amortization benefit is not without risks. The taxpayer failed to prove that no, or a lower, tax amortization benefit should be taken into account.
3. The inspector’s arguments for higher revenue forecasts were based on very general arguments, whereas the Expert substantiated its revenue forecasts based on arguments that were specific to the case. The proposed adjustment for the revenue forecasts was therefore not accepted by the Court.
4. The inspector did success in proving that the long-term growth rate should be 2% instead of 1%. The taxpayer failed to prove differently.

As a result, the Court adjusted the profit on the Restructuring to € 128 million; € 43 million more than the € 85 million Restructuring profit determined by the Expert and used in the District Court’s judgement, but € 192 million less than the € 320 million Restructuring profit imposed by the DTA in the tax assessment. 

Takeaways

• When considering a business restructuring, it is crucial to consider to what extent this may result in exit taxation. To assess whether a (part of a) business has been transferred, it is important to consider the taxpayer’s own transfer pricing documentation. Arguing against your own transfer pricing documentation, like the taxpayer did in this case, is almost never successful. It is therefore also very important to prepare robust transfer pricing documentation.
• It may appear harsh that the burden of proof is reversed and increased in this case, because the taxpayer has been very transparent and indicated that it wanted to continue with the discussions about the amount of profit that should be reported with the DTA. However, the Court confirmed that tax returns must be filed clearly, firmly and without any reservations, also if filed pending discussions between the taxpayer and the DTA. Filing a tax return pending ongoing discussions with the DTA does not mean that you are relieved from filing it correctly. Therefore, it should be carefully considered that the positions taken in the tax return are always within the arm’s length range.
• One of the main reasons that the amount transferred found by the Expert was much higher than the amount of € 7.7 million found by the taxpayer, was that the Expert used a discount rate that was significantly higher than the discount rate used by the taxpayer for the post-restructuring toll manufacturing activities. As the risks assumed by routine entities are very specific for transfer pricing, it is important to engage a valuation expert that understands these risks to ensure that this is correctly reflected in the discount rate when valuing an entity that is part of a transfer pricing model.
• The Court held that a transfer price is adjusted to a measure of central tendency, like the median or mean, if it falls outside the arm’s length range. The Court based this argument on the OECD TP Guidelines, which state that “… it may be appropriate to use a measure of central tendency…”. Insofar this left uncertainty for the Dutch transfer pricing practice, the Court has now taken a clear position on this.
• The burden of proof can be increased if the inspector successfully argues that the transfer price used falls outside the range of arm’s length transfer prices, and that this leads to a substantial additional amount of tax payable. However, the taxpayer must also be aware, or should have been aware of the fact that he filed a wrong tax return. This is tested on a standalone basis and on the date on which the tax return was filed.
• Even if the burden of proof is reversed and increased, the inspector must make reasonable estimates when imposing a tax assessment. Whether an estimate is reasonable, depends on the amount of information available and the amount of information shared with the inspector.

Contacts

Quirijn Knab +31 20 247 03 03 +31 6 10 89 76 10 quirijn.knab@huygenstax.com

Mark van Casteren +31 20 247 03 04 +31 6 10 89 88 38 mark.van.casteren@huygenstax.com