Hitachi Astemo is a Czech manufacturing company in an international group. After the group decided to discontinue the company’s prior LCD television production, the company was instructed to switch to producing automotive components. In the tax period from 1 April 2012 to 31 March 2013 it incurred significant start up expenditures to build the new production capability, including conversion of premises, purchase and installation of machinery, and employee training, and it reported a tax loss. The controlled transaction at issue was not a classic priced supply contract in that period but rather the group instruction and its economic consequences, namely that the subsidiary made the investment for the group without compensation or other market value consideration, while the resulting automotive production and sales to related parties occurred in later periods.
The tax authority applied Section 23(7) of the Czech Income Tax Act (containing the Czech arm’s length provision) and treated the absence of compensation as non arm’s length because an independent enterprise would not have accepted to incur those costs and risks without being compensated or otherwise protected through enforceable consideration. On that basis it reduced the tax loss reported for the period and treated the costs as effectively quantifying the compensation that should have been provided under arm’s length conditions. It also linked its approach to the arm’s length principle reflected in the applicable treaty rule and to Czech transfer pricing guidance and OECD guidelines.
Hitachi Astemo challenged the adjustment and succeeded before the Regional Court, which held that Section 23(7) and the treaty provision did not apply because the disputed matter was merely a management decision of the parent rather than a contractual commercial or financial relationship with an agreed price or non standard conditions.
The tax authority then filed an appeal with the Supreme Administrative Court, arguing that related party transactions for transfer pricing purposes can arise from actual conduct and informal group directions, that the Regional Court had applied earlier case law too broadly, and that OECD guidance and Czech practice require analysing the economic effects of such group driven restructuring decisions on the subsidiary’s tax base.
Judgment
The Supreme Administrative Court agreed with the tax authority, set aside the Regional Court judgment, and remanded the case.
It held that, for tax purposes, the relevant question is how the parent’s instruction manifested itself in the business relations between the associated enterprises and in the subsidiary’s actual conduct, not whether there was a formal written contract.
It found that the instruction produced a de facto arrangement in which the subsidiary invested in new production for the group at zero compensation, a key economically relevant characteristic that an independent enterprise would not accept without compensation or legally secured consideration such as guarantees of future returns.
It therefore concluded that the Regional Court’s categorical exclusion of Section 23(7) and the treaty arm’s length principle was unlawful, and that the relationship had to be analysed under transfer pricing principles, including identification of the controlled transaction based on actual conduct and then a comparability and arm’s length assessment.
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