Czech Republic vs. M.V., April 2018, Supreme Administrative Court , Case No 3 Afs 105/2017 – 22

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The reason for the adjustment of the tax base was, among other things, the finding that M.V.sold on 4 January 2010 all the stock of goods of the range of garden supplies to AGROTECHNIKA Vaněk s.r.o. (“Agrotechnika”) at an 80% discount on the sales price (i.e. purchase price + margin). M.V. and Agrotechnika were related persons within the meaning of Article 23(7) of Act No 586/1992 Coll., on Income Taxes, as M.V. is the managing director and sole shareholder of Agrotechnika. The sale price after the discount corresponded to approximately 40 % of the purchase price, which, according to the tax administrator, did not correspond to the price that would have been agreed between independent persons in normal commercial relations under the same or similar conditions. The prices established with comparable operators showed that the normal price corresponded to the purchase price of the goods. M.V. did not provide satisfactory evidence of the difference of CZK 1 557 720.

The Regional court dismissed M.V.’s appeal by the decision set out in the body of the judgment. It did not accept the plea that the difference found was not supported by the evidence in the administrative file. The tax administration determined the normal price on the basis of a comparison with two comparable entities, for which it drew data from its own database and from the files of those tax entities. In the first case, the taxpayer was a natural person who had sold to a related person in the tax years 2009 and 2010 a stock of goods (garden equipment and garden supplies in 2009 and army clothing in 2010) at the purchase price in each case. In the second case, two natural persons operating in an association of natural persons without legal personality set up a legal person into which they contributed in the tax year 2005 stocks of goods (household goods, hardware) which they owned jointly, and these stocks were valued on the basis of an expert’s report at an amount corresponding to the cost and book value of the stocks of goods + a 30% margin. With regard, inter alia, to the taxable period, the tax authorities narrowed the collection to the former entity and set the normal price of the stocks sold at the purchase price of the goods.

Although the tax administrator did not have a 100% identical comparable entity, the selected entity met the comparability criterion because it was doing business in the same region as the plaintiff, sold goods to a related person in the same taxable year, traded goods of a similar nature, and sold a complex group of goods identical to the plaintiff at the purchase price of the goods. Therefore, the defendant did not accept the objection that the tax authorities had violated Section 23(7) of the Income Tax Act by increasing the applicant’s tax base without meeting their burden of proof. On the contrary, the burden of proof was on the applicant, who did not, however, satisfactorily prove the difference between the agreed price and the normal price.

Judgement of the Court

The Supreme Administrative Court thus concludes that the contested order of the Regional Court is lawful. It therefore dismisses the appeal as unfounded

“The basic condition for establishing the reference price is an independent relationship between the entities that negotiated it. This condition follows directly from the wording of Section 23(7) of the Income Tax Act, which expressly and unambiguously refers to a price agreed between “independent” (or unrelated) persons in normal business relations (see above). This price is determined on the basis of the arm’s length principle, which is based on the conditions that would apply between independent entities in comparable transactions and circumstances, i.e. in so-called ‘comparable independent transactions’. The purpose of this provision is to view the legal transactions in such a way that the result is the same situation from a tax point of view as in the case where the legal transaction occurs between entities that are not connected persons (see the judgment of the Supreme Administrative Court of 18 March 2015, No. 6 Afs 176/2014 24).
[19] The reference price is therefore essentially a simulation of a price created on the basis of a consideration of what price those persons would have negotiated in a situation identical to that of related persons if they were not related and if they had normal business relations with each other. The reference price may be determined by the tax authorities by comparing the prices actually achieved for an identical or similar commodity between actually existing independent operators or (in particular because of the absence or unavailability of data on such prices) only as a hypothetical estimate based on logical and rational reasoning and economic experience. In the event that it is not possible to establish the reference price in this way either, the price established in accordance with a special legal regulation, namely Act No 151/1997 Coll., on the valuation of property, shall be used in accordance with Article 23(7) of the Income Tax Act (see, for example, Supreme Administrative Court Judgment No 7 Afs 74/2010-81).
[20] Therefore, the mutual independence of the entities that have entered into a comparable transaction is a necessary requirement for establishing a reference price. However, the tax administrator did not comply with this condition, since it chose transactions between related entities as comparable transactions against which to measure the transfer price agreed between the applicant and Agrotechnika. Although the complainant claims in its appeal that it established a price range for two comparable independent persons, it also admits that they were natural persons who, in connection with a change in the legal form of their business, sold all their stock of goods to a newly established legal person in which those natural persons were also partners and managing directors. It is therefore clear that the transfer of stocks took place in both cases between related persons – the natural person and the legal person who was linked to him personally.
[21] The complainant wrongly criticised the Regional Court for anticipating the distortion of the relationships between the entities used by the tax authorities as comparable entities. The Regional Court did not argue that the transactions on the basis of which the tax authority determined the reference price were without more ‘distorted’, but pointed out that they could be ‘distorted’ in view of the personal links between the parties. It is for this reason that Section 23(7) of the Income Tax Act requires that the transaction between related parties be verified against other independent comparable transactions. A contrary approach would lead to an uneconomic and irrational further round of comparisons as to whether the transactions between related parties, whose mutually agreed price was used as a reference price, were in accordance with the arm’s length principle. Although a comparison with a transaction between a natural person and a related legal person in circumstances similar to those of the present case might appear to be more advantageous to the taxpayer, that advantage is only apparent. Sales between related parties can be made at below normal prices as well as at higher prices.
[22] Although it may be accepted that a transaction between related parties, the price of which was determined on the basis of an expert’s report, could be accepted as a comparable independent transaction (in the absence of independent comparable transactions, which should be the primary criterion), the tax administrator did not carry the burden of proof in the present case. It is apparent from the tax inspection report and the contested decision of the complainant that the case concerned two natural persons carrying on business in an association of natural persons without legal personality, who set up a legal person into which they contributed, in the tax year 2005, stocks of goods (household goods, hardware) which they owned in joint ownership, and those stocks were to be valued on the basis of an expert’s report. In the light of the circumstances described above, it may be doubted whether the transaction was comparable in terms of the range of goods (garden supplies in the case of the applicant as opposed to household goods and hardware in the case of the comparator) and the relevant period (tax year 2005 as opposed to 2010). First of all, the determination of the price on the basis of the expert’s report is merely a statement in the official record of the tax administrator of 18 February 2013, without it being possible to verify the existence of the expert’s report and compliance with its legal requirements. Moreover, when determining the reference price, the tax administrator should start from a certain price range, i.e. compare the transaction carried out by the applicant with more than one transaction between independent persons (see the judgment of the Court of Justice of 31 March 2009, no. 8 Afs 80/2007-105, published under No 1852/2009 Coll. of the Supreme Administrative Court). This transaction, even if comparable and supported by an expert’s report, would therefore not be sufficient in itself for a proper determination of the reference price.
[23] Nor can the complainant’s reference to the fact that the applicant, in the normal course of business, sold goods to independent persons (customers) at a discount of 10 % to 15 % lead to the conclusion that the tax administration carried the burden of proof. Although the tax inspection report and the contested decision refer to that fact, they do not consider those transactions to be comparable to a one-off sale of stock of a certain product range, which is relevant to the case under examination. Indeed, even in the appeal, the complainant admits that the sale of individual items of stock is not comparable to the sale of the whole. However, it wrongly considers that the only alternative is the sale of the stock as a whole to a legal entity established directly by the individual whose tax liability is controlled, but it ignores the possibility of selling the stock as a whole to an independent entity. Neither the tax authorities nor the complainant have yet attempted to find such comparable independent transactions.”

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Case No 3 Afs 105-2017 - 22

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