The applicant, ARROW International CR, a.s., seeks a judgment of the Supreme Administrative Court annulling the judgment of the Regional Court, and referring the case back to that court for further proceedings.
The question of whether the applicant carried out business transactions in the tax year 2005/2006 with a related party (Arrow International, Inc., hereinafter referred to as ‘Arrow US’) in a manner which did not comply with the principles of normal business relations and whether, as a result, the applicant’s basis for calculating the corporate income tax rebate was unjustifiably increased and the special condition for applying the tax rebate under Article 35a(2)(d) of Act No 586/1992 Coll. was breached is decisive for the assessment of the merits of the present case, on income taxes, as in force until 31 December 2006 (‘the Income Tax Act’). Pursuant to Section 35(6) of the same Act, such an act has the effect that the entitlement to the discount ceases and the taxpayer is obliged to file additional returns for all tax periods in which the discount was claimed. The applicant was therefore also under that obligation in respect of the tax year 2002, for which it was additionally assessed by the decisions of the administrative authorities in the amount of CZK 7 505 031 (‘the tax’).
According to the contents of the administrative file, the Financial Directorate concluded that the part of the applicant’s activities which consisted in the distribution of medical devices from the Arrow group to customers in the Czech Republic, whereby the goods distributed by the applicant were purchased from Arrow US, did not comply with the principles of normal business relations. On this distribution, the applicant achieved a gross profit margin of 171,45 % in the tax year 2005/2006, whereas other distributors of similar goods found by the tax authority achieved average gross profit margins ranging from 28,40 % to 80,60 %. In each case, the tax authorities found that the goods which the applicant had purchased for redistribution in the Czech Republic from Arrow US at a certain price had previously been sold by the applicant itself – as goods manufactured by it – to Arrow US at a higher price than the price at which it then bought them from Arrow US. Furthermore, the tax authorities found that the applicant’s gross profit margin in 2005/2006, the last period of the investment incentive, had increased significantly compared to the previous and subsequent tax periods, roughly three to four times. The Financial Directorate found that the distribution of Arrow medical devices in the Czech Republic was an activity separable from the applicant’s other activities (production of medical devices for the Arrow group or central purchasing of medical devices for the Arrow group from other manufacturers in the Czech Republic) from an economic point of view. The conclusion that the distribution of Arrow medical devices in the Czech Republic is separable from the applicant’s other activities was also reached by the Financial Directorate taking into account the fact that this activity is significantly less important for the applicant from an economic point of view than the other activities (the two types of distribution activities together accounted for only 6 % of the applicant’s total turnover, while the rest of the turnover was accounted for by the production of medical devices for the Arrow group). Thus, the Directorate of Finance treated the distribution of medical devices of the Arrow group in the Czech Republic as a separate activity for the applicant and as such assessed it separately in terms of the prices negotiated between the applicant and Arrow US in the context of that activity, which differed from the prices (and the gross profit margins based thereon) of other distributors of medical devices in the Czech Republic according to the criterion of the gross profit margins achieved therein. Thus, in considering whether the applicant had breached the special conditions for the application of the tax rebate pursuant to Article 35a(2)(d) of the Income Tax Act, the Financial Directorate considered only the prices (and the markups based thereon) achieved in the context of that one of the applicant’s activities, since it considered that it should be regarded as an economically relatively separate activity, not sufficiently linked to the applicant’s other activities and, on the contrary, separable from them in those respects. It therefore did not accept that the applicant’s activities should be considered as a whole (the sum of all their activities taken together) in the sense that, for the purposes of examining whether there has been a breach of the conditions of that provision, it is possible for significant profits from one activity to be offset by smaller profits from other activities, so that the overall profitability of the applicant’s business remains within the limits of what is normal for other comparable operators.
The Regional Court agreed with those conclusions of the tax authorities and therefore dismissed the action brought by ARROW International CR, a.s. as unfounded.
An appeal was then filed with the Supreme Administrative Court
Judgement of the Court
The Court dismissed the appeal and decided in favour of the tax authorities.
“In the present case, the tax authority bore its burden of proof to establish that the complainant’s business operations involved transactions with the persons referred to in section 23(7) of the Income Tax Act which, by their specific objectively identifiable features, appeared outwardly, on the basis of rational consideration, not to correspond to the economic principles of normal business relations. First of all, it established that the three types of activity of the applicant, which could be regarded as relatively independent of each other in terms of the conditions of their technical implementation (independent in the sense that, in principle, each of them could be carried out independently in such a way that – in the abstract – it could make economic sense in itself, and that none of them necessarily required, in itself, either for production or commercial reasons, legal or otherwise, to operate in conjunction with any of the other activities), were operated in such a way that one of those activities at a particular time had a gross profit margin that differed significantly from the gross profit margins achieved by similar activities by other operators in the relevant market who were, in a number of respects at least from an external perspective, comparable to the complainant. Comparability here must be understood to mean that, to a roughly similar extent, those entities also carried out one of the activities which the complainant also carried out (here, the distribution of medical devices in the Czech Republic).
In itself, a gross profit margin which differs significantly from that achieved in similar activities by other entities on the market in question might not, under certain conditions, in the slightest mean that the business operations by which that margin was achieved in relation to a person who, in relation to the complainant, fulfils the characteristics of a person under section 23(7) of the Income Tax Act, do not comply with the economic principles of normal business relations (section 35a(2)(d) of the Income Tax Act). It is perfectly permissible, and especially logical, if the taxable entity within a group of related persons performs a specific, specialised role for the whole group or a significant part of it, or benefits from the general commercial position of the group in the market, given for example by its overall market power, reputation, etc. or from other group synergies, so that the parameters of its individual sub-activities (typically gross margins and, in general, various price parameters or delivery terms) differ from those achieved by entities not operating within the group of connected persons. If a legally separate entity effectively plays the role of a branch, production plant, subcontractor, sub-unit or representative office in a particular region within a group of connected persons, the economic conditions of its activities are generally significantly different from the situation where the same activities it carries out would be carried out completely independently and comprehensively, without the integration (and the resulting specialisation and support) within the group of connected persons. In such a case, a legally autonomous person within a group of connected persons must be judged on the basis of his actual role within the group and must be compared with entities performing a similar role. If, for example, such a person is a simple manufacturing plant, not carrying out independent development, independent commercial activities and not acting as a separate ‘brand’ in the eyes of customers or consumers, it is quite logical that it will achieve different (usually lower) prices (and profit margins) in the sale of its products than if it were an autonomous person in terms of production, development and distribution. Similarly, where a legally autonomous person receives ‘support’ in its activities from other persons within the group of connected persons, it is logical that such ‘support’ has some economic value and is not contrary to the economic principles of normal commercial relations, provided that the person concerned ‘pays’ for it in a form other than through prices agreed with a particular partner within the group of connected persons.
The use of various synergies between cooperating entities is a perfectly legitimate and economically rational way of doing business. It should be borne in mind that a complex business structure created by a system of agreements between a number of unrelated parties may also lead to the creation of specialised roles and the division of functions within such a structure. If the persons involved are not connected, it is essential that each of the persons involved in such a structure participates in it of his own free will because he has assessed the involvement as advantageous, more advantageous than other forms of commercial activity which, under the conditions in which he operates, would also have been appropriate. Thus, the arrangement of the economic activity of a person who is part of a group of connected persons will comply with the conditions of Section 35a(2)(d) of the Income Tax Act if the relationships between that person and other connected persons are of such a nature that, in their overall economic effect, they are so advantageous to that person that a similar arrangement of relationships would be chosen by a person not connected with other persons within the meaning of Section 23(7) of the Income Tax Act. The purpose and intent of the two cited provisions is not to prevent synergies aimed at economic savings in general, but only such synergies that would achieve economic savings by “artificially” adjusting the flow of economic values between related persons (i.e. such synergies that have no other economic reason than to affect the tax base favourably for the tax subject).
As already described above, the Tax Directorate found, on the basis of specific and uncontested findings of fact by the complainant, that the part of the complainant’s activities which consisted in the distribution of medical devices from the Arrow group to customers in the Czech Republic, where the goods distributed were purchased by the complainant from Arrow US, did not comply with the principles of normal business relations. On this distribution, the complainant achieved a gross profit margin of 171,45 % in the tax year 2005/2006, whereas other distributors of similar goods found by the tax office achieved average gross profit margins ranging from 28,40 % to 80,60 %. In each case, the tax authorities found that the goods which the complainant had purchased for redistribution in the Czech Republic from Arrow US at a certain price had previously been sold by the complainant itself to Arrow US as goods manufactured by it at a higher price than the price at which it had then purchased them from Arrow US. Furthermore, the tax administrator found that the complainant’s gross profit margin in 2005/2006, the last period of the investment incentive, had increased significantly over the previous and subsequent periods, roughly three to four times. The Tax Directorate thus discharged its burden of proof, since it proved that the complainant’s business operations involved transactions with persons referred to in section 23(7) of the Income Tax Act which, on the surface, by their specific objectively identified features, appeared to the rational mind not to correspond to the economic principles of normal business relations. In such a case, it was then for the complainant to prove what reasons corresponding to the economic principles of normal commercial relations led it to carry out those commercial transactions.
For the purposes of examining whether the condition under Article 35a(2)(a)(i)(2)(A) is met. (d) of the Income Tax Act, it was therefore necessary for the complainant to provide a plausible explanation that it would have achieved the unusually high gross profit margin achieved in 2005/2006 even if it had not been a related party to Arrow US, but had been linked to it only by a network of relationships (typically contractual) between independent entities, albeit perhaps under conditions of specialisation of roles and division of functions between several entities within a contractually linked structure.
However, the complainant has not offered such an explanation. Instead, it focused its arguments on issues which were irrelevant to its burden of proof.
The complainant’s activities as a whole could only be considered if it could show that three relatively separate parts of its activities – namely the manufacture of medical devices for the Arrow Group (‘the manufacture’) – had been the central purchase of medical devices for the Arrow Group from other manufacturers in the Czech Republic (‘central purchasing’) and, finally, the distribution of medical devices for the Arrow Group in the Czech Republic (‘distribution’) – were in fact so economically interlinked (for example, by synergies, economies of scale, use of market reputation, linking business relationships, etc.) that the Complainant’s activities were in fact economically interlinked. ) that the complainant had in fact ‘no choice’ from an economic point of view but to maximise its overall economic profit by a certain specific setting of gross profit margins in one part of its business. In the view of the Supreme Administrative Court, it is clear from an external point of view, both from a substantive and an economic point of view, that each of the three parts of the complainant’s business could – in the abstract – be carried on separately. It is very conceivable that the complainant would concentrate only on production, only on central purchasing or only on distribution. It is equally conceivable that it could concentrate on any combination of two of the three activities. The fact that, according to the complainant’s unchallenged allegations, central purchasing and distribution in particular were linked by a common logistical structure and staffing structure does not alter that conclusion. Therefore, the tax authorities were entirely justified in analysing the three activities of the complainant as relatively separate. It was then for the complainant to argue and prove that, in fact, the interdependence of those activities was significant and so conditional on each of them that it was not contrary to the economic principles of normal commercial relations but, on the contrary, entirely in accordance with their logic that the complainant, by setting ‘non-standard’ pricing parameters for one of the activities, maximised its actual overall economic performance considered for the three activities taken together as a whole. However, the complainant has not only failed to prove this, but has not even alleged it.
The complainant’s arguments in the OECD interpretative documents were also irrelevant in the present case. Such aids for determining the true economic substance of the transactions under examination can certainly be an important guide for the purposes of both Section 23(7) of the Income Tax Act and Section 35a(2)(d) of the Income Tax Act, as well as for the purposes of bilateral double taxation treaties, in order to resolve a particular case. They cannot, however, be regarded as legal rules in the strict sense of the word, but rather as a possible aid in analysing the actual economic substance of the relationships under examination and in seeking to establish what function and what economic reasons the various elements of the applicant’s business operations had in its business as a whole.
The complainant’s primary focus in the tax proceedings should therefore have been to explain why the gross profit margin on distribution in 2005/2006 was as high as it was, particularly in light of the fact that it was purchasing distributed goods from Arrow US which it had produced itself. In some cases even at lower prices than the prices at which it had previously sold them to Arrow US. Furthermore, the complainant should have concentrated on explaining what particular circumstances justified such a significant difference between its gross profit margin for distribution and the gross profit margins of the other entities with which the tax authorities compared it. It should also have been able to explain, in the light of the economic principles of normal commercial relations, why the gross profit margin for distribution in 2005/2006 differed so significantly from those in previous and subsequent years. However, the complainant has failed to do any of this.
On the basis of the specific findings of fact, the Directorate of Revenue was therefore quite right to conclude that the complainant had increased the basis for calculating the tax credit by means of commercial transactions with the persons referred to in Article 23(7) in a manner which did not comply with the economic principles of normal commercial relations and that it had therefore not fulfilled the necessary condition for the application of the tax credit. In so far as the Regional Court accepted that factual and legal conclusion of the Tax Directorate and dismissed the action brought by the applicant, its judgment is in accordance with the law.
The Supreme Administrative Court therefore dismissed the complainant’s cassation complaint against the judgment of the Regional Court in Hradec Králové of 11 October 2012, No 31 Af 5/2012 – 50 (Article 110(1), last sentence, of the Code of Civil Procedure).”