Judgment summary
This is a Czech Supreme Administrative Court (SAC) decision concerning a transfer pricing adjustment made under Section 23(7) of the Income Tax Act. The tax authorities had increased the applicant's tax base in relation to a transaction involving the purchase of hard disk drives (HDDs) on the order of a related party, Banta Ireland, treating part of the arrangement as equivalent to an interest-bearing deposit of funds and applying the USD LIBOR rate as the reference price.
The Regional Court in Brno annulled the tax authority's decision, finding that although Section 23(7) ITA was properly engaged, the tax authorities had failed to adequately establish the reference price or to justify their inability to identify comparable transactions, rendering the decision unreviewable for lack of reasons. The defendant tax authority appealed to the SAC, which dismissed the appeal and upheld the Regional Court's judgment.
Background
The applicant, RR Donnelley Czech s.r.o., was assessed by the Specialised Tax Office by decision of 17 February 2021 for the tax period 1 January 2015 to 31 December 2015. The assessment increased corporate income tax by CZK 61 650 and imposed a penalty of 20% of the assessed tax, amounting to CZK 12 312.
The assessment concerned a transaction in which the applicant purchased part of the material, HDDs, into its ownership on the order of a related company, Banta Ireland. The tax authorities considered that part of this transaction should be treated, for transfer pricing purposes under Section 23(7) ITA, as akin to a deposit of funds attracting interest, rather than solely a manufacturing service arrangement.
The defendant, Odvolací finanční ředitelství, rejected the applicant's appeal by decision of 12 September 2022, confirming the tax office's assessment. The applicant challenged that decision before the Regional Court in Brno.
Core dispute
The central dispute concerned whether the tax authorities had properly discharged their burden of proof in establishing the reference (comparable) price under Section 23(7) of the Income Tax Act, in circumstances where they characterised the funds tied up in purchased HDD stock as equivalent to an interest-bearing deposit and applied the 12-month average USD LIBOR rate, without a risk premium, as the applicable market rate.
The applicant argued that its business strategy and risk profile, as a contract manufacturer bearing no risk on the purchased stock (the buyer assuming all risk of sale, loss and damage), differed fundamentally from short-term interbank lending, for which USD LIBOR is the reference rate. It contended that a proper benchmarking exercise using comparable manufacturing companies with similar inventory levels was required, and that the profit margin already reflected the relevant risks.
The defendant maintained that, in the absence of data on prices of similar transactions between genuinely independent entities, USD LIBOR was an appropriate and even favourable proxy, given the risk-free nature of the funds tied up in the stock, and that the applicant had failed to satisfactorily prove that the agreed price differed from the reference price it disputed.
Court findings
The Regional Court found that the tax authorities were correct to apply Section 23(7) ITA to the HDD purchase transaction, and rejected the applicant's arguments that the purchase increased its turnover and that it did not value its funds. However, it held that the tax authorities bore the burden of proving the reference price and had failed to do so: no effort was made to establish a proper reference price or to select an adequate sample of comparable transactions, and no explanation was given as to why a comparative sample could not be drawn.
The Regional Court further held that, even accepting the analogy to an interest-bearing deposit, the administrative authorities should have compiled a comparative sample of broadly comparable deposit transactions. Instead, the USD LIBOR rate was applied without further consideration, justified only by its denomination in USD and its status as an average annual figure. The Court noted that USD LIBOR is the reference rate for short-term international interbank borrowing, and that neither the applicant nor Banta Ireland were banking institutions, making the rate's application unexplained and the decision unreviewable for lack of reasoning.
The SAC agreed with the Regional Court's reasoning in full. It confirmed that the tax administrator bears the burden of proof and allegation in establishing the reference price, and that a reference price should ordinarily be derived from actually existing comparable transactions between independent parties, adjusted where necessary; only in the absence of such data may a hypothetical estimate based on logical and rational reasoning be used, but this still requires some comparable parameter. The SAC found that neither the administrative file nor the contested decision showed any effort to establish a proper reference price, select comparable transactions, or explain the impossibility of doing so, and that the justification for using USD LIBOR was insufficient.
Outcome
The Supreme Administrative Court dismissed the defendant's appeal against the Regional Court's judgment. The Regional Court's annulment of the defendant's decision of 12 September 2022, and the return of the case to the defendant for further proceedings, therefore stood.
The SAC ordered the defendant to pay the applicant's representative, BDO Czech Republic s.r.o., costs of the appeal proceedings amounting to CZK 4 114, within 30 days of the judgment becoming final. No further appeal was permitted against this judgment.
Tp method highlighted
The tax authorities treated part of the transaction, the funds tied up in HDD stock purchased on the order of the related company Banta Ireland, as analogous to an interest-bearing deposit of funds. They applied the 12-month average USD LIBOR rate, without an additional risk premium, as the reference market rate of return, reasoning that the purchase did not represent a significant risk and that the applicant had effectively granted a loan to a related company by tying up funds in the stock.
The courts found this approach inadequately reasoned: no comparable sample of deposit or interbank transactions was compiled, no adjustment for differences was considered, and the choice of USD LIBOR, a rate for short-term interbank lending between banking institutions, was unexplained given that neither the applicant nor Banta Ireland were banks. The applicant had argued that a benchmarking exercise using manufacturing companies with comparable inventory levels and risk profiles would have been the appropriate method, since it bore no risk on the purchased stock and was remunerated through a profit margin reflecting the risks it did bear.
Major issues / areas of contention
- Whether the tax administrator discharged its burden of proof in establishing the reference price under Section 23(7) of the Income Tax Act.
- Whether it was appropriate to characterise part of the HDD purchase transaction as equivalent to an interest-bearing deposit of funds.
- Whether use of the USD LIBOR rate, without a risk premium, was adequately justified as a reference price given that neither party was a banking institution.
- Whether the tax authorities were required to compile a comparative sample of comparable transactions, or to explain why no such sample could be drawn, before relying on a hypothetical estimate.
- Whether the administrative decision was unreviewable for lack of reasons in its determination of the reference price.