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Jiří Jakoubek | May 16, 2023

Case law on transfer pricing: profit mark-up on value added vs. total cost

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In a recent judgment, the Regional Court in Brno dealt with a dispute between a taxpayer and the tax administration regarding the choice of a profitability indicator in the context of the evaluation of transfer prices of a Czech company engaged in the production of computer servers.

The point at issue in the present proceeding was whether, in the context of transactions between a manufacturing company and its parent company, the surcharge on the so-called value-added costs applied by the taxpayer to wages and overheads was sufficient, or whether the surcharge should also be applied to the value of materials (generally speaking, to the entire operating costs).

The taxpayer carried out assembly and installation of server cabinets based on orders from the parent company. The production process, which the Czech company followed, was determined by its parent company, which was also responsible for providing all the necessary materials for the subsidiary to fulfil the required production process. The material supplied by the parent company subsequently became the property of the Czech taxpayer.

Based on these facts, the tax administrator concluded that the Return on Total Costs (ROTC) was the appropriate indicator for assessing profitability, as opposed to the profitability indicator chosen by the taxpayer, which related only to Return on Value Added Costs (ROVAC), i.e., relating to total operating costs excluding material costs.

The court agreed with a number of arguments raised in the taxpayer’s action against the tax administrator’s decision and stated that when assessing the functional and risk profile of the examined person, the actual condition is decisive, not the formal condition. The mere fact that the taxpayer acquired the material in its possession and accounted for its stock does not automatically imply that the manufacturing company bears the risks associated with the material. In this case, while the taxpayer had acquired the material in its possession (and theoretically should bear the related risks), the risks associated with the supply of the material were fully transferred to the parent company in this transaction (e.g. if a defect were found in the supplied material, the costs of repair or possible disposal would have been compensated by the parent company). The facts further revealed that the taxpayer does not process the material or change its properties, but only assembles the servers according to the set assembly procedure in order to maintain the properties of the individual components in terms of quality and functionality. Thus, there was no value added of the material on the part of the taxpayer.

In this context, the Regional Court emphasised that in order to select the appropriate indicator for the assessment of transfer prices, the overall context of the transaction and the business model of the taxpayer must always be assessed. According to the court’s assessment of the case, the tax administration did not sustain the burden of proof, as it did not prove that the application of a mark-up to the total costs in the transaction in question was a more appropriate approach than that chosen by the taxpayer. The court annulled the defendant’s decision on that ground and remanded the case back to the defendant for further proceedings.

In conclusion, it follows from the judgment that, in the case of assessing the cost base of transfer prices for a manufacturer, who is not subject to the risks associated with a particular cost item, a mark-up applied only to the value added, i.e. in this case to wages and overheads excluding material costs, may be sufficient. Currently, such transfer pricing is widely discussed in a number of specific cases, often triggered by pressure from foreign tax administrations. In these situations, we encounter a number of points for discussion, whether related to the economic setting, the ability to sustain the burden of proof, or the rationale for a change in methodology compared to the historical methodology. We strongly recommend discussing these pitfalls with a tax advisor when considering the application of an adjusted cost basis. Our transfer pricing team has rich experience in this area, so do not hesitate to turn to our experts with confidence.

Author: Jiří Jakoubek, Veronika Hohnová