The dispute concerns whether Íslenska kalkþörungafélagið ehf., a local Icelandic producer of calcareous algae, properly determined its transfer prices when selling its production to its Irish parent company in the years 2016 – 2020.
According to the Icelandic tax authorities, the company’s cost-plus method did not comply with the OECD transfer pricing guidelines. In particular, the authorities concluded that the company had incorrectly determined its cost base by excluding both payroll expenses and depreciation of fixed assets, thereby understating actual costs and reducing taxable income in Iceland. The authorities also found that the transfer pricing documentation submitted by Íslenska kalkþörungafélagið ehf. was insufficient.
Íslenska kalkþörungafélagið ehf. argued that it correctly applied the cost-plus method by focusing only on “variable” costs and claimed that adding such fixed costs would make its exports uncompetitive and that much of the group’s value was created by the parent company’s investments and expertise in Ireland.
After receiving the assessments, Íslenska kalkþörungafélagið ehf. appealed to the State Revenue Board, which later upheld the assessment in a decision issued in December 2022.
The company then appealed to the District Court, again arguing that its pricing was in fact at arm’s length and should not be adjusted.
Judgment
The District Court ruled in favor of the tax authorities and rejected the company’s claims. It upheld the assessments of the tax authorities and the 25% surcharge imposed by the Director of Internal Revenue, concluding that Íslenska kalkþörungafélagið ehf. had not met its burden of proving that its transfer pricing was arm’s length.
The court found no procedural or substantive defects in the decisions of the Director of Internal Revenue or the State Internal Revenue Board. As a result, the Icelandic State was acquitted of all claims and the company was ordered to pay the State’s legal costs.
Excerpts
“104 In paragraphs 2.39–2.55 of the OECD guidelines, the cost-plus method is described for determining transfer pricing between related entities, including how it should be applied. Under that method, the market price is found by determining the cost base to the seller and adding an appropriate markup. In other words, the focus is on the seller’s cost in transactions with a related party, and a suitable margin is placed on that cost base, having regard to market conditions and the burden of effort. From the OECD guidelines, it is clear that the cost-plus method is best suited for the sale of semi-finished products between related parties, for the sharing of joint facilities, or for long-term product transactions, as well as for certain service transactions between related parties, cf. final part of paragraph 2.39 in the OECD guidelines.
105 Paragraph 2.47 of the OECD guidelines states that although accounting standards vary by country, a seller’s cost is generally considered threefold: direct production cost, e.g. cost of raw materials; indirect production cost, e.g. cost of asset maintenance that might be shared by other production items besides the one being priced; and general operating cost, e.g. management, supervision, or overhead.
106 Paragraph 2.48 of the OECD guidelines makes clear that under the cost-plus method, the cost base of the goods or services sold includes both direct and indirect production cost, plus a markup. From the wording, one also sees that the cost-plus method is distinguished from profit-based methods in that it is less crucial under cost-plus to separate precisely between the three categories enumerated in paragraph 2.47; cost-plus may even account for overhead if it is part of the cost structure of production (operating expenses).
107 The State Internal Revenue Board’s ruling states that the OECD guidelines assume that for the cost-plus method, direct production costs are always included in the cost base. Otherwise, the entire rationale of the method would fail. The court agrees, referencing paragraphs 2.47 and 2.48. It is undisputed that wage cost and depreciation are typical production cost items.
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122 Otherwise, the Court does not accept that it has been shown that maintaining an unchanged markup benchmark, i.e. continuing to use a 50% gross margin on the cost price of goods sold after wage costs and depreciation of fixed assets have been added to the cost base, violates the proportionality principle. Regarding this, reference is made to the above discussion in subsection I of the judgment’s conclusion, and especially the reasoning in the State Internal Revenue Board’s ruling about the markup, i.e. that the plaintiff’s contribution to the production and market conditions were considered, which the Court accepts is consistent with paragraph 2.39 of the OECD Guidelines. The plaintiff has not demonstrated that the mentioned cost-plus method or the tax authorities’ determination of the cost base, which includes wage costs and depreciation, breaches that paragraph in the OECD Guidelines or any of their other provisions, or that it is excessive. Still less has the plaintiff shown any comparable basis of calculation for other companies mentioned in its comparison analysis regarding cost base and markup or the interaction of those factors. In this context, the Court reiterates its conclusion that the plaintiff carries the burden of proof on these matters.
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124 Concerning the plaintiff’s reference to paragraph 4.13 of the OECD Guidelines on the burden of proof, the Court finds it appropriate to note that the provision addresses the point that when the burden of proof rests on the taxpayer, the tax authorities are generally not permitted to increase the taxpayer’s levy in ways not clearly provided in law. In this case, the Court considers that the basis for the tax authorities’ rulings is clearly provided in the Income Tax Act, Regulation No. 1180/2014, and the OECD Guidelines, and the OECD Guidelines specifically set out in detail with examples how the cost-plus method is to be applied, as has been recounted above. The provision also states specifically that if the taxpayer demonstrates in court that its pricing fulfilled the arm’s length rule, the burden of proof shifts so that the tax authorities then must show the contrary. As previously recounted, however, the plaintiff in this case is not considered to have discharged that burden of proof that its pricing was consistent with the arm’s length rule under paragraph 3 of Article 57 of the Income Tax Act.”
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