K.P. belongs to the K. Group, which is among the world leaders in the supply of electrical systems, cables and plastic components. The company is a contract manufacturer of electrical harnesses and for that purpose, purchases components (semi-finished products, goods and materials) from a related party, KSA, and subsequently sells the products to an unrelated party. The remuneration of K.P. aimes at a target operating margin of 1.25%. This margin has been determined by applying the transactional net margin method. In the event that, K.P.’s yearly results deviate from the target operating margin, an adjustment of component prices is made in order for K.P. to achieve the contractually agreed target margin of 1.25%.
For the financial year ended on 1 May 2016, K.P.’s margin was higher than 1.25% so in order to bring the remuneration to the agreed arm’s length levels, K.P. received on 6 May 2016 an adjustment note from KSA increasing the purchase costs for the components and lowering K.P.’s profits to 1.25%.
The tax authority disallowed the tax deduction claimed for the payment under the adjustment note, finding that the payment lacked cause-and-effect relationship with the revenues earned by K.P.
A complaint was filed by K.P. with the Director of the Tax Chamber, which, by decision of 27 July 2023, upheld the decision of the tax authority.
An appeal was then filed with the Provincial Administrative Court.
Judgment
The Provincial Administrative Court ruled in favour of K.P. and set aside the assessment of the tax authority.
Excerpts in English
“The company indicated that if it had not purchased goods from KSA, then it would not have been able to produce and sell products to its customer and, consequently, would not have been able to conduct business. Purchasing goods from KSA was a prerequisite for the company to operate its business and also a prerequisite for K.P. to generate revenue. In turn, KSA agreed to cooperate with K. P. on the terms and conditions set out in the contract, the most important of which remained the terms relating to the prices of the goods. Thus, the inability to produce and sell the products if the goods are not purchased from KSA exhausts the elements of maintaining the source of revenue.
The manner in which K.P. and KSA’s business relations were shaped also makes it possible to link the expenditure in the form of an adjustment of the prices of goods with the premise of purposefulness, i.e. achieving, preserving or securing a source of revenue, resulting from the content of Article 15(1) of the A.p.d.p. K. P. and KSA agreed, within the framework of the agreement, on the conditions concerning the prices of goods subject to their transactions, including a provision on annual price adjustments with regard to the original transactions performed during the year. The absence of such a provision could have led to a situation where KSA would not have chosen to cooperate with K.P. at all and, as a result, the company would not have been able to realise the sales made to its client.
In those circumstances, there can be no doubt that the upward or downward margins will constitute revenue or deductible costs respectively. The payment by the applicant of the expenses associated with levelling the margin to the level provided for in the contract is one of the conditions for achieving the remuneration provided for in the contract.”
“Acceptance of the authority’s view assuming that expenses related to levelling the margin to the assumed amount cannot constitute tax deductible costs would lead to unacceptable consequences. Indeed, a taxpayer carrying out transactions with a related party would be deprived of a mechanism intended to lead to the implementation of the arm’s length principle. Depriving the taxpayer of the right to recognise as a deductible expense the expenses connected with the adjustment of the level of profitability would be an unreasonable action, because the implementation of the latter principle could not take place as a result of actions taken by the taxpayer, but only as a result of interference from the tax authorities. Preventing the taxpayer from making an adjustment to the level of income on its own could have the effect that the income in the relationship between the applicant, as the domestic controlled entity, and K.S.A., as the foreign controlling entity, would be allocated in a manner inconsistent with the arm’s length principle. To remedy the above condition, adopting the interpretation of Article 15(1) of the A.P.C. presented by the authority, would require an adjustment of the profitability of both the applicant and the controlling foreign supplier under the terms of Article 9 of the OECD Model Convention, which would be a much more complicated and time-consuming solution. It would also be irreconcilable with the principle of self-assessment of tax to deprive the applicant in this type of situation of the right to treat as a deductible expense the expense of adjusting the margin to the contractually stipulated level. Indeed, the applicant would be deprived of its right to declare tax at an arm’s length and would be forced to await the intervention of the tax authorities, which could only lead to its realisation.”
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