A tax assessment had been issued, regarding an arrangement whereby ownership to intangibles had been transferred to an related party in Switzerland and subsequent royalty payments for use of the intangibles had been deducted in the taxable income.
“… In the course of the general external inspections carried out on the accounts of each of these companies, it was concluded that the costs in question derive respectively from a contract for the use of the F… brand, sold to that entity for a period of no less than 30 years, and from a contract for the use of the P… brand, also sold to the same Swiss entity. brand, also sold to the same Swiss entity, for a period of no less than 30 years, with F… and P… continuing to deduct from their income, costs directly related to the management, promotion and development of the brands they transferred, as well as holding all the risks inherent to them.
Given that F… and P… have transferred their brands, through an operation that could not be carried out between independent entities, and that they continue to bear the costs associated with managing and developing them, as well as all the risks inherent to them, while additionally bearing a royalty for the use of an asset that in practice remains theirs…
Under the terms of article 58 of the CIRC and Ministerial Order 1446-C/2001 of 21 December, a positive adjustment is made to the taxable profit of the controlled company F… in the amount of €4,219,631.00 and a positive adjustment to the taxable profit of the controlled company P… in the amount of €5,383,761.00 (…)’.”
An appeal was filed against the assessment which was dismissed in a 2023 decision. A new appeal was filed by the taxpayer which was referred to the Administrative Court of Appeal.
Judgment
The Administrative Court of Appeal dismissed the taxpayer’s appeal and upheld the transfer pricing adjustment that disallowed deductions for the royalties paid to the Swiss entity.
The court accepted the tax authority’s choice of the profit split method and its conclusion that the arm’s length royalty was zero.
The court held that the authority had proved that the conditions agreed were not at arm’s length, while the taxpayer failed to carry its burden of proof.
The court also confirmed that pending challenges to earlier years that converted losses into profits did not prevent disregarding those carried-forward losses in 2005.
Excerpt in English
“With regard to determining the price that would be charged between non-bound entities for an operation with the exact contours of the one that was found, the inspection report stated (see page 801 of the instructor’s appendix):
‘The remuneration due by the user of an intangible asset to its holder, in order to ensure that values are obtained that safeguard the legitimate interests of both parties, in compliance with the Principle of Full Competition, is usually calculated using the Profit Split Method (MFL). This is considered the appropriate method whenever there are intangible assets whose value and specificity make it impossible to establish comparability with unrelated operations, as is the case here’.
And after explaining the applicability of the method, the tax inspectorate concludes that ‘If the method described had been used in the situation in question, as would have been the case between independent entities, due to the lack of any other suitable method, there would never have been any royalty payable by P… to J…’. And it adjusted its profits accordingly.
The profit splitting method is one of the methods for determining transfer prices in accordance with the arm’s length principle – which determines that the terms and conditions contracted in operations between related entities must be identical to those that would normally be practised between independent entities, thus reflecting market conditions – provided for in Ministerial Order no. 1446-C/2001, of 21 December, article 9.1 of which states: ‘The profit splitting method is used to apportion the overall profit derived from complex operations or series of linked operations carried out in an integrated manner between the intervening entities.’
And, in line with what the judgment under appeal states, as the AT rightly understood, in the case of intangible assets, the other methods provided for do not make it possible to obtain the most reliable measure of the terms and conditions that independent entities would normally agree to, accept or practise, as stipulated in the last part of paragraph b) of no. 3 of article 58 of the CIRC, considering the value and specificity of these assets, which make it impossible to establish comparability with linked operations.
As stated in the Supreme Administrative Court judgment of 05/12/2021 in case 0766/11.2BEAVR, ‘The determination of the situation of special conditions, different from those that would normally be agreed between independent companies, may be made by the AT with a certain margin of technical discretion provided that it adopts a legitimate and duly substantiated method, and that such a situation falls within the concept of special relationships provided for in article 9(1)(b) of the OECD Model Convention’.
To this extent, the choice of transfer pricing method in accordance with the arm’s length principle cannot be validly questioned, unless it is proven to be unreliable or that the method chosen by the taxable person is weak, which was not achieved in the case file by the appellant.
Lastly, it should be noted that there is no inconsistency between the above statement that the circumstances of the business described as anomalous by the tax authorities are of no relevance to the transfer pricing correction and the finding that these circumstances, or part of them, influenced the choice of the comparable and came to be weighted in the application of the transfer pricing method in accordance with the principle of free competition (cf. point 1.3. of the RIT, on page 810 of the enquiry file).”
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