A…, S.A. was the parent company of a Portuguese group of companies subject to the Special Taxation Regime for Groups of Companies (RETGS). Its subsidiary, C…, S.A., was engaged in the installation and technical support of computer vision, biometric and electronic security systems, including facial recognition. C… held 100% shareholdings in subsidiaries located in the Netherlands, the United States, Brazil, Hong Kong, the UAE, the United Kingdom, Australia, Japan and India. In the 2019 tax period, C… carried out related-party transactions with these entities totalling approximately €13.5 million, representing approximately 28% of its total operating income, including sales of biometric equipment, provision of consultancy and R&D services, cost-sharing arrangements, and financial transactions.
C… prepared a transfer pricing dossier applying the Transactional Net Margin Method Tuto its overall business. C… calculated its operating margin at 0.09% by excluding losses of €3,781,598 allocated from subsidiaries through the Equity Method (MEP). A benchmarking study identified 32 comparable entities using mark-up on total cost as the profitability indicator.
Following an audit, the Portuguese Tax Authority recalculated C…’s operating margin at -7.67% by including the MEP losses in the operating result. The Tax Authority also excluded nine entities from the comparable sample for failing to meet the taxpayer’s own selection criteria and for being statistical outliers under the Tukey test, resulting in a reduced sample of 23 companies. Using the median of the recalculated arm’s length range of 6.31%, the Tax Authority made an upward adjustment of €6,815,708.14 to C…’s taxable income pursuant to Article 63(8) of the Portuguese Corporate Income Tax Code. This adjustment resulted in additional corporate income tax and compensatory interest totalling €31,803.29 at the group level.
A…, S.A. challenged the assessment, arguing that MEP gains and losses are not operational in nature and are unrelated to the controlled transactions, and therefore should be excluded from the TNMM calculation in accordance with paragraph 2.83 of the OECD Transfer Pricing Guidelines 2017. A…, S.A. also argued that the Tax Authority’s approach created a comparability mismatch, as the comparable entities selected had shareholdings below 20% and therefore would not have MEP reflected in their financial statements.
Judgment
The Arbitral Tribunal ruled in favour of A…, S.A. and annulled the corporate income tax assessment and compensatory interest for 2019.
The Tribunal held that amounts recorded under the equity method reflect the results of subsidiaries and have no direct or indirect connection with the series of related-party transactions under review. Citing paragraph 2.83 of the OECD TPG 2017, the Tribunal confirmed that only items directly or indirectly related to the controlled transaction and of an operational nature should be taken into account in determining the net profit indicator under the TNMM. Including MEP losses artificially reduced C…’s operating margin by incorporating losses arising from the operating activities of other entities. The Tribunal further noted that Article 18(8) of the Portuguese Corporate Income Tax Code expressly neutralises the tax effects of the equity method, making it inconsistent to use MEP figures for transfer pricing adjustments. Additionally, the Tribunal observed that the Tax Authority’s approach was internally contradictory, as it included MEP in C…’s margin while comparing it against entities whose financial statements, by design, excluded MEP. The Tribunal also noted that since the controlled transactions represented only 28% of C…’s revenue, applying the TNMM to overall entity profitability without addressing this distortion was technically incorrect. The Tribunal ordered reimbursement of the tax paid plus compensatory interest.
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