According to Colgate Palmolive, following a restructuring, the local group company in Spain was changed from being a “fully fledged distributor” responsible for all areas of the distribution process to being a “limited risk distributor” (it only performs certain functions). A newly established Swiss company, Colgate Palmolive Europe, instead became the principal entrepreneur in Europe.
The changed TP setup had a significant impact on the earnings in the Spanish group company. Net margins was reduced from around 16% before the restructuring, to 3.5% after the restructuring.
Following a thorough examination of the functions, assets and risks before and after application of the new setup, the Tax administration held that Colgate Palmolive Europe could not be qualified as the “principal entrepreneur” in Europe. The swiss company was in substance a service provider for which the remuneration should be determined based on the cost plus method.
Judgement of the Court
The High Court held in favour of the tax administration and dismissed the appeal of Colgate Palmolive.
“.…the conclusion, in our opinion, can only be that the Administration is right, since in reality – remember that certain functions were already being carried out by the French Headquarter – there is no significant change in the situation existing prior to the restructuring in the years in question.
This being so, it is not surprising that the Agreement reasons that “the existence of transactions between related entities, the Spanish and Swiss entities, determines the application of the regime provided for in Article 16 of the Consolidated Text of the Corporate Income Tax Law (TRLIS) and in its implementing regulations, mainly Chapter V of Title I of the Corporate Income Tax Regulations (RIS), taking into account the change of regulation introduced by Law 36/2006 applicable, in the case of Colgate Palmolive, as from the financial year 2007”. Adding that “in relation to the existence of transactions between related companies, it is also necessary to take into account Article 9 of the Spanish-Swiss Double Taxation Agreement, inspired by the OECD Model Agreement, which provides that the profits of associated companies may be adjusted when the conditions present in their commercial or financial relations differ from those that would be agreed between independent entities. This article recognises the so-called arm’s length principle, the interpretation of which must take into account the OECD Doctrine, contained in the Commentary to Article 9 itself and its 1995 Transfer Pricing Guidelines, which have been significantly updated in 2010”.
As reasoned in the Agreement, the Board shares the reasoning, “according to the exhaustive description contained in the verification file, the characterisation of CP Europe as a “principal trader” is inappropriate, it being more correct to consider that such an entity is in reality a service provider. It is therefore considered that the method chosen by the group to value the transactions is inappropriate and that the appropriate valuation method is the cost plus method. This method, in addition to being a traditional method (and therefore preferable under our internal regulations and the Guidelines), is, in accordance with the OECD Guidelines (paragraph 2.32 and 2.39 in the 2010 version), particularly appropriate for valuing the provision of services”. The fact is that ‘the valuation method applied by Colgate Palmolive is not appropriate, as it results in the residual profit of the group’s operations in Spain being concentrated in the CP Europe entity, which makes no sense if the economic activity of each entity (CP USA, CP Spain and CP Europe) in the overall business in our country is taken into account. The Guidelines themselves highlight in their chapter 7 dedicated to intra-group services (paragraph 7.31, before and after 2010) the cost plus method, together with the comparable free price, as the method to be used to value this type of services between related entities.
The work of the Joint Transfer Pricing Forum of the European Union, which also assumes that this is the method most frequently used to value this type of transaction”.
The Inspectorate adds, quite reasonably, that “until 2005, the group itself valued transactions between the French Headquarter, with the role of service provider, and the other entities of the group – including CP Spain – using the cost plus method”.
The consequence of all the above is that, as stated on p. 73 of the report -reasoning endorsed by the Agreement- “in order to value the transactions between CP Europe and CP Spain, the transactional net margin method, taking CP Spain as the analysed party (Tested party), is inappropriate. Instead, it is considered that the most appropriate method for valuing the transactions is the cost plus method, which is based on attributing to the provider of those services – CP Europe – a gross margin on the costs it incurs which are attributable to the Spanish market [it should be recalled that following the analysis carried out it has been concluded that CP Europe cannot be considered as a principal trader, but rather as an entity which performs the functions of a service provider]’. This means that, in the years in question, it is not correct to attribute to CP EUROPE the residual profit derived from the group’s operations in Spain, but rather that this residual profit, deducting the remuneration of the owner of the intangible asset -CP USA- and of the service provider -CP EUROPE-, should fall on CP SPAIN. The calculations are set out in pp. 74 to 81 of the report, as well as in pp. 59 to 62 of the Agreement. The Board, particularly in the absence of any arguments to the contrary, considers them to be correct.
For all the foregoing reasons, the plea is dismissed.”