The Spanish Tax administration made an income adjustment of Citresa (a Spanish subsidiary of the Schweeps Group) Corporate Income Tax for FY 2003, 2004, 2005 and 2006, resulting in a tax liability of €38.6 millon.
Citresa entered into a franchise agreement and a contract manufacturing agreement with Schweppes International Limited (a related party resident in the Netherlands). The transactions between the related parties were not found to be in accordance with the arm’s length principle.
- In the parent company, CITRESA, the taxable income declared for the years 2003 to 2005 was increased as a result of an adjustment of market prices relating to the supply of certain fruit and other components by Citresa to Schweppes International Limited.
- In the subsidiary, SCHWEPPES, S.A. (SSA), the taxable income declared for the years 2003 to 2006 was increased as a result of adjustment of market prices relating to the supply of concentrates and extracts by the entity Schweppes International Limited, resident in Holland, to SSA.
The taxpayer had used the CUP method to verify the arm’s length nature of the transaction while the Spanish Tax administration – due to lack of comparable transactions – found it more appropriate to use the transactional net margin method (TNMM).
Prior to 1 December 2006, the Spanish Corporate Income Tax Act (CIT) established three methods of pricing related transactions (the “Comparable Uncontrolled Price Method”, the “Cost Plus Method” and the “Resale Price Method”) and if none were applicable it established the application of the “Transactional Profit Split Method”. Thus, the “Transactional Net Margin Method” was not included at the time the market value of related transactions was established.
However, as the Tax Treaty between Spain and the Netherlands was applicable, the Spanish Tax Authorities considered that the OECD Transfer Pricing Guidelines could be directly applicable. Consequently, as the “Transactional Net Margin Method” was envisaged in the above-mentioned Guidelines, the Spanish Tax Authorities understood that this method could be used as a valid pricing method.
The case ended up in Court where Citresa argued that the assessment was in breach of EU rules on freedom of establishment and that the TNM method had been applied by the authorities without any legal basis in Spain for the years in question.
Judgement of the Court
In regards to the claimed violation of the principle of freedom of establishment cf. TFEU article 49, the Court stated:
“….the mere purposes of argument, that there can be no doubt as to the conformity with European Union Law of the regime of related-party transactions in Spain, in the terms in which this infringement is proposed to us, which is what is strictly speaking being postulated in cassation for the first time, it being sufficient to support this assertion to record some elementary considerations, such as that the censure is projected indiscriminately on the whole of the law (that is to say, on the legal regime of related-party transactions), which is to say, on the legal regime of related-party transactions, on the legal regime of related-party transactions regulated by Article 16 of Law 43/1995, of 27 December 1995, on Corporate Income Tax, and then Article 16 of Royal Legislative Decree 4/2004, of 5 March 2004, which approves the revised text of the Law on Corporate Income Tax – TRLIS), while, at the same time and in open contradiction, it advocates the application of the precept to resolve the case, thus starting from its compliance with European Union Law.”
In regards to application of the transactional net margin method, the Court stated:
“…tax years cover the period from January 2003 to February 2006. Article 16.3 of Law 43/1995, in the wording applicable to the case, and the same provision of the TRLIS, in its original version, established the following:
“In order to determine the normal market value, the tax authorities shall apply the following methods:
- Market price of the good or service in question or of others of similar characteristics, making, in this case, the necessary corrections to obtain equivalence, as well as to consider the particularities of the transaction.
The following shall be applicable on a supplementary basis:
- The sale price of goods and services calculated by increasing the acquisition value or production cost of the goods and services by the margin normally obtained by the taxable person in comparable transactions entered into with independent persons or entities or by the margin normally obtained by companies operating in the same sector in comparable transactions entered into with independent persons or entities.
- Resale price of goods and services established by the purchaser, reduced by the margin normally obtained by the aforementioned purchaser in comparable transactions arranged with independent persons or entities or by the margin normally obtained by companies operating in the same sector in comparable transactions arranged with independent persons or entities, considering, where applicable, the costs incurred by the aforementioned purchaser in order to transform the aforementioned goods and services.
- Where none of the above methods are applicable, the price derived from the distribution of the joint result of the transaction in question shall be applied, taking into account the risks assumed, the assets involved and the functions performed by the related parties”.
This hierarchical list exhausts the possible methods available to the administration for establishing the market value of the transactions to which it has been applied. It consists of four methods: one of them, which we can call direct or primary, that of the market price of the good or service in question (art. 16.3.a) LIS); two others that the law itself declares to be supplementary, that of the increase in acquisition value and that of the resale price (art. 16.3.b) of the legal text itself); and finally, as a residual or supplementary second degree method, that of the distribution of the joint result of the operation in question (art. 16.3.c) LIS). These obviously do not include the valuation method used by the tax inspectorate in this case, that of the net margin of all transactions, introduced ex novo by Law 36/2006, of 29 November, on measures for the prevention of tax avoidance.”