Aisan Industry Czech, s.r.o. is a subsidiary within the Japanese Aisan Industry Group which manufactures various engine components – fuel-pump modules, throttle bodies, carburetors for independent car manufactures such as Renault and Toyota. According to the original transfer pricing documentation the Czech company was classified as a limited risk contract manufacturer within the group, but yet it had suffered operating losses for several years.
Following a tax audit an assessment was issued resulting in additional corporate income tax for FY 2011 in the amount of CZK 11 897 090, and on top of that a penalty in the amount of CZK 2 379 418. The assessment resulted from application of arm’s length provisions where the profitability of Aisan Industry Czech, s.r.o. had been determined on the basis of the profitability of comparable companies – TNMM method.
An appeal was filed by Aisan Industry Czech, s.r.o. with the Regional Court which – by judgment of 30 October 2019 – dismissed the appeal and confirmed the additional payment order issued by the tax authorities.
In its decision the Regional Court concluded that Aisan Industry Czech, s.r.o. should have been compensated for carrying out manufacturing services to the benefit of the multinational Aisan Industry group. The court also concluded that Aisan Industry Czech, s.r.o. was in fact a contract manufacturer – as stated in the original transfer pricing documentation – and not a full-fledged manufacturer as stated in the later “updated” transfer pricing report in which the FAR profile of the company had been significantly altered after receiving the initial assessment.
According to the Regional Court, it had been established that the price of the service negotiated between the Aisan Industry Czech, s.r.o. and its parent company Aisan Industry Co., Ltd. was different from the price that would have been negotiated between independent parties under the same commercial conditions. By selling products to related and unrelated parties at prices determined by the group, Aisan Industry Czech, s.r.o. did not even achieve a minimum level of operating profitability. In FY 2011 Aisan Industry Czech, s.r.o. had a negative profit margin of 3,27 %. According to the court Aisan Industry Czech, s.r.o. should have received a remuneration of CZK 61 080 700 from the Aisan group for the manufacturing services, i.e. the difference between the operating margin it would have achieved at at arm’s length, 1,26 % (the minimum of the profit margin of comparable entities), and the profits it had actually achieved -3.27 %.
According to the Regional Court, it was not the pricing of the individual products that was relevant, but rather the overall set-up of Aisan Industry Czech, s.r.o.’s operation within the Aisan group as a contract manufacturer bearing disproportionate risks which were not compensated. Therefore it was not appropriate to set a reference price and analyse the individual transactions since the involvement in the group distorted both transactions with related and unrelated parties, as all the prices had been determined by other group entities.
An appeal was then filed against the decision of the Regional Court with the Supreme Administrative Court.
Judgement of the Supreme Administrative Court
The court fully agreed with the decision and conclusions of the Regional Court, which it considered to be correct and well reasoned.
Excerpts
“In the course of the tax audit, the tax administrator found, on the basis of an analysis of the transfer prices, that the complainant bore risks that were beyond its control and that this fact was not reflected in the pricing policy, which was influenced by the connected persons. The influence of related parties resulted in the complainant selling its products below its operating costs and not being compensated for those losses. ”
“Given that the complainant could not influence from whom and for how much it would purchase inputs, nor to whom and for how much it would sell its products (output price), the tax authorities considered the transactions carried out to be controlled, since it was the parent company Aisan JP together with its sister companies ACE and ACA that influenced this, although the risks involved were borne by the complainant.”
“As regards the plea that the defendant and the Regional Court erred in law in failing to distinguish between transactions with related parties and those with unrelated parties, that plea is also unfounded. In that regard, it should be noted that the complainant was represented by the companies of the Aisan group, which concluded the transactions to which the complainant was bound. It is clear from the commission agreements that the sister companies ACA and ACE did so in relation to all customers, irrespective of whether they were related or unrelated. The e-mail communications also show the influence of the parent company Aisan JP regarding the final approval of the sale. It is clear from the summary of the functions of the original transfer pricing report that the selection and final approval of material suppliers, setting of delivery terms, price negotiations and negotiation of delivery terms with end customers is without the influence of the complainant. These decisions are made by the parent company Aisan JP and its sister companies ACA and ACE, which also determine the final prices and quantities of products. Although the complainant sells production and purchases materials from unrelated parties, all sales plans are provided by related parties of the Aisan group…..Therefore, in the present case, all transactions carried out by the complainant are considered to be controlled transactions on the basis of a function and risk analysis. The conclusion of both the defendant and the Regional Court that it was not appropriate to analyse individual transactions, since related parties influenced all transactions, is therefore correct.”
“The Regional Court and the defendant also correctly stated that the reasons given by the complainant for the negative operating profitability cannot be accepted, also because the complainant did not show negative profitability only in 2011, but it was a long-term trend from 2009 to 2012. For these reasons, the administrative authorities were justified in concluding that the conditions during the relevant period were set for the complainant contrary to the principle of economic profitability, i.e. with a view to making a profit.”
“For the sake of completeness, it should be added that, in terms of the application of Article 23(7) of the Income Tax Act, the determination of the specific related party which should have compensated the complainant for the risks is not really decisive. As the Regional Court correctly stated, what was relevant was that the complainant bore such risks for the benefit of the multinational group Aisan and did not receive adequate compensation for that to the extent that it achieved at least a minimum operating profitability.”
“As regards proving the existence of controlled transactions, the complainant’s case therefore involved a different evidentiary situation. On 19 February 2013, in a recorded oral hearing, the complainant submitted documents relating to transfer pricing, namely the original transfer pricing report of January 2013, in which it was characterised as a contract manufacturer performing only limited functions and bearing mainly routine risks. The updated transfer pricing report of December 2013 was submitted by the complainant only after the first audit finding had been communicated (report No 1828600/13/2509-05401-500852 of 14 October 2013) and after almost a year since the original transfer pricing report had been submitted……The tax authorities were justified in requesting evidence of the changes made to this functional analysis, since the updated transfer pricing report did not include any other material that was not already drawn upon in the original analysis. The complainant was assigned functions and risks in the updated transfer pricing report for which no evidence was provided to support a change in this assessment from the original figures.”
“In summary, the Supreme Administrative Court thus fully agrees with the assessment and conclusions of the Regional Court in the contested judgment in the present case, which it considers to be correct and well reasoned. The fact that the applicant disagrees with them and takes a different view does not, of course, in itself mean that the judgment under appeal is unlawful.”