A Dutch Court of Appeal published an interesting judgment providing insights in their views on a number of important transfer pricing related topics, such as the treatment of business restructurings (conversion of fully fledged to routine operations), the application of BEPS Action 9 in the comparability analysis, the appropriateness of transfer pricing documentation and the burden of proof.
In this article, we provide you with a summary of the judgment, an (unofficial) English translation of the (transfer pricing related parts of the) judgment, and our take aways and recommendations.
Taxpayer operated a production facility in the Netherlands, acting as a fully fledged manufacturer. Taxpayer subsequently expanded its production facility, significantly increasing production capacity (the surplus amounted to 39% of the total production capacity after the expansion). Taxpayer entered into a supply agreement with a group company, on which basis taxpayer ‘converted’ from a fully fledged to a contract manufacturer (remunerated with a 5% mark-up on costs for the surplus products) for the surplus part (and the surplus part only). The tax inspector did not agree with this conversion, arguing that the contractual transfer of taxpayer’s manufacturing risks is in conflict with historical, economical and actual reality.
In addition, taxpayer took the position that it had reported profits that were not at arm’s length (i.e., too high) in its own corporation tax return, which deviated from its internal transfer pricing documentation.
Partial conversion of full-fledged to routine manufacturing operations
According to the Court, the contractual arrangements (which form the starting point of the comparability analysis) must be aligned with the economic reality, particularly where the allocation of risks plays an important role. The risk allocation must be economically rational and should be allocated to the party that has the knowledge and capabilities to manage the relevant risks and has the financial capacity to assume those risks. Economic analysis is required.
In this case, the Court disallowed this conversion, holding that it was not in taxpayer’s interest to enter into the supply agreement, particularly as:
- it was unlikely that an unrelated party, acting at arm’s length, would have be willing to surrender the substantial (expected) margins for a ‘risk free’ return of 5%, despite taxpayer operating in a volatile market (the Court referred to both taxpayer’s historical performance, as well as the financial performance it could realistically expect for future years at the time of the conversion). In the language of the OECD Transfer Pricing Guidelines: the conversion was not the best among the options realistically available;
- taxpayer depended on the return from its production, following the € 400 million investment in an increase of the production capacity, which possibility was limited through agreeing to a relatively low cost plus remuneration only; and
- taxpayer’s operations (e.g. production and logistics, but also its asset base) and risks (economically) assumed did not change as compared to the pre-conversion situation; the Court, based on the group’s own transfer pricing documentation, also considered taxpayer a full-fledged manufacturer.
Whether a particular risk can be transferred requires an economic analysis.
A separate transfer pricing report substantiating taxpayer’s pricing as contract manufacturing did not change the Court’s conclusion, but the Court did review this report. Most importantly, it found that the companies included in the report were not comparable, as there was too large of a difference between taxpayer’s annual revenue (approx. € 1 billion) and the comparables’ revenues (ranging from a few millions to € 30 million) and that taxpayer should not have been considered the ‘tested party’, as it was a complex undertaking with many functions and a high and diverse risk profile.
According to the Court, the transfer pricing correction was to be made on a recurring basis, rather than as a one-off transaction at the moment of entering into the supply agreement (i.e., the net present value of the future foregone profits).
Comparability analysis, appropriateness transfer pricing documentation and burden of proof
Taxpayer wished to deviate from its own corporation tax return and internal transfer pricing documentation and for this purpose referred to a report later on drawn up by a different advisor. According to this report, taxpayer’s operating margin largely exceeded the operating margins of ‘comparable’ companies and should accordingly be reduced.
The Court of Appeal placed the burden of proof on the taxpayer, inter alia stating that taxpayer would be the most diligent party in this respect, as it was the taxpayer that deviated from the group’s transfer pricing documentation. The Court then ruled that taxpayer incorrectly derived from the new report that it was not acting at arm’s length and, as such, its profits were not too high. The Court came to this conclusion based on the following:
- The new report is of a generic nature and did not include the information that is required to make a proper transfer pricing analysis such as a description of activities, a functional analysis and a description of the transfer pricing method(s) applied. The new report is to be seen as a benchmark report, but does not constitute (or replace) the group’s transfer pricing master file, which according to the Court is to be considered taxpayer’s formal transfer pricing documentation.
- The companies included in the new report are for various reasons insufficiently comparable to taxpayer. The Court explicitly mentioned that there is too large of a difference between taxpayer’s annual revenue (approx. € 1 billion) and the comparables’ revenues (ranging from a few millions to € 30 million) while scale is of essential importance in taxpayer’s industry, and that (differences in) the nature of goods and services of the companies included in the new report were not (sufficiently) addressed.
- A mere comparison of competitors’ operating margin percentages is insufficient to support taxpayer’s position, as the level of comparability is to be determined by analysing the five comparability factors.
Our take aways and recommendations
This judgment provides substantial insight in the Court’s reasoning in a transfer pricing case and is a welcome addition to the (relatively limited) existing transfer pricing case law in the Netherlands. Certain elements of the judgment (and the Court’s extensive analysis) particularly drew our attention:
- The Court explicitly mentioned that the party to whom the risks are (contractually) allocated should have the knowledge to manage and the financial capacity to bear the risks, which is in line with part of the guidance added to the OECD Transfer Pricing Guidelines following BEPS Action 9. It remains to be seen whether courts in the Netherlands will consistently apply BEPS Action 9 type of reasonings going forward.
- The Court acknowledged that the question whether a particular risk can be transferred requires an economic analysis. Too often, transfer pricing documentation (only) includes a qualitative description and analysis of risks assumed by each party. In our view, it is key to a transfer pricing analysis to do so quantitatively, i.e., by analysing the significance and sensitivity of risks based on numbers instead of just in words.
- The economic rationality of a business restructuring transaction is to be analysed for both the pre- and post-restructuring situation to ensure that the restructuring is the best among options realistically available. This entails a review of whether risk and remuneration are aligned in both (pre- and post-restructuring) situations. A case-specific quantitative analysis provides a good solution to demonstrate such alignment. We refer to our case study for an example of our experience and approach on this subject matter.
A case-specific quantitative analysis provides a good solution to demonstrate the economic reality of a business restructuring.
- There appears to be increased emphasis on the comparability of data in benchmark studies. Often, traditional benchmark studies do not provide sufficient detail to perform a full on comparability analysis and, therefore, to assure the benchmark study returns truly comparable data. This can be overcome by sanity checking the benchmark data based on economic / corporate finance theory and data.
- The Court recognised the existence of the supply agreement as such (or in other words: did not disregard the supply agreement), but made corrections to certain conditions of the supply agreement to arrive at an at arm’s length outcome. In this case, the Court determined that an at arm’s length outcome would be equal to the existing situation. It can be questioned whether the Court’s analysis would have been different if parties had entered into an (explicit) agreement based on which the economic ownership of the surplus capacity transferred to another group company.
- Taxpayer may appeal the Court’s decision in cassation. However, given the factual nature of the decision, it is questionable whether the Supreme Court will materially change the Court’s outcome when it comes to the transfer pricing analysis.
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