Stora Enso Wood Products Ždírec s.r.o. a the Czech subsidiary in the Stora Enso Group, a multinational manufacturer of packaging and building products.
In the years in question, Enso Wood Products Ždírec s.r.o. provided manufacturing services to its parent company and made losses.
An audit was initiated by the tax authorities focusing on the method of determining transfer prices between related parties as defined in Article 23(7) of the Income Tax Act (which contains the Czech arm’s length principle). On the basis of a functional and risk analysis (in which it examined the extent to which the applicant depended on the decision-making mechanisms of another entity in the group), the tax administration concluded that Stora Enso Wood Products Ždírec s.r.o. did not act as a fully-fledged independent entity in its production and related activities, but as a producer with a limited functional and risk profile, since its production activities were influenced by transactions and relationships with its parent company, SEWP, which provided direct direction, coordination and management, both in terms of personnel and in terms of the competences and decision-making powers which it, as a superior entity to the applicant, possessed. The business model set up by the parent company SEWP did not therefore allow the applicant to negotiate contractual terms with its customers, nor was the applicant directly responsible for the purchase and delivery of goods. In the proceedings, the tax authorities did not dispute that the production and sale of lumber by the applicant was made both to related parties and to unrelated third parties (hereinafter referred to as ‘independent customers’). However, what was relevant in the present case was the finding that the sales to independent customers were also influenced by the ‘orders’ of SEWP’s parent company.
The tax authorities made a transfer pricing adjustment based on the transactional net margin method and issued an assessment of additional income.
Stora Enso Wood Products Ždírec s.r.o. filed an appeal, and in 2021 the regional court decided in favor of the company.
An appeal was then filed by the tax authorities with the Supreme Administrative Court.
Judgement of the Court
The Supreme Administrative Court overturned the lower court’s decision and ruled in favour of the tax authorities.
Excerpts
“…the tax authorities took the legal view that the principle that a company should not be forced to carry out transactions which are disadvantageous to it applies in a group. If a controlling person (typically the parent company) exerts its influence to implement a transaction which causes the company to suffer a pecuniary loss, the controlling person is obliged to compensate the company for the relevant loss by the end of the accounting period at the latest, or, at least within the same period, to conclude an agreement with the company in which the manner and time limit for compensating such loss are agreed. In the present case, since the applicant did not prove how the loss incurred in the determination of the sales prices applied between the applicant and its business partners (related and unrelated parties) was compensated by the parent company, nor did it explain why it was not adequately compensated for its service to the multinational Stora Enso group in its income, the tax authorities proceeded to determine the normal price and to increase the income tax base by the difference found.
[18] In the light of the above, the Court finds that, in so far as the Regional Court held in the judgment under appeal that the tax authorities had unlawfully applied Section 23(7) of the Income Tax Act or Article 9 of the double taxation treaty to the applicant’s transactions with its independent customers, who were not demonstrably connected persons, that argument cannot be upheld. “
“…Since the applicant, on the instructions of its parent company, was selling its products below its operating costs and thus losing profit, the applicant should, according to the tax authorities, have received a payment from its parent company to compensate for the loss thus incurred (the difference between its profitability and that of independent comparable operators). Therefore, on the basis of the relevant evidence, the tax authorities concluded that a service was provided between the applicant and its parent company SEWP, thereby creating a relationship between them to which Section 23(7) of the Income Tax Act could be applied. The complainant then defined the service in question as ‘a service consisting in bearing risks which are beyond the control of the taxable person and which are determined by related parties’ (see paragraph 99 of the contested decision).
[19] With regard to the Regional Court’s assertion that the tax authorities should have distinguished whether the business transactions were made with related parties or with unrelated third parties, since the applicant’s sales to unrelated parties amounted to 60 % in terms of both production and revenue, the Supreme Administrative Court, in agreement with the complainant, states that this issue may be relevant at the stage of determining the price of the service performed by the applicant for the parent company. In the present case, however, the Regional Court did not assess whether the price of the service was correctly set, but only whether the first condition was met, i.e. whether Section 23(7) of the Income Tax Act was applied to the relationship of related parties.”
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