Denmark vs EAC: Lessons in Transfer Pricing and Currency Restrictions for Multinational Enterprises

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Case Information

• Court: Østre Landsret
• Case No: BS-12642/2020 and BS-25280/2020
• Applicant: Ministry of Taxation
• Defendant: H1, H2
• Judgment Date: 20 October 2021

Judgment Summary

This case revolves around whether the taxable incomeThe tax base is a fundamental concept in taxation, representing the total amount of economic activity or assets upon which a tax is levied. It is the foundation upon which governments calculate the amount of tax owed, based on factors like income, property value, sales, or corporate profits. Understanding the tax base is essential for tax professionals, businesses, and policymakers,... of H1 and H2 should be increased under Denmark’s Tax AssessmentA tax assessment is a formal determination made by a tax authority to calculate the amount of tax an individual or entity owes. It is a comprehensive evaluation based on financial records, declared income, expenses, deductions, and any applicable tax laws or regulations. Tax assessments may arise from routine self-assessments by taxpayers, or they may be conducted by revenue authorities... Act, Section 2, by reclassifying payments between related entities as interest or royalties. The case encompasses two separate tax disputesTax Disputes arise when there is a disagreement between taxpayers and tax authorities regarding the interpretation or application of tax laws. These disputes may concern various issues such as the accuracy of a tax return, the eligibility for tax deductions or credits, the correct amount of tax liability, or transfer pricing adjustments. Tax disputes can lead to lengthy legal proceedings..., one involving whether interest should be applied to royalties due between a Danish parent company and its Venezuelan subsidiary and another focusing on classifying extraordinary dividends as royalty payments.

The court ruled that the extraordinary circumstances of Venezuela’s currency restrictions and force majeure provisions in the licensing agreements negated the Ministry of Taxation’s attempt to increase H1’s taxable incomeThe tax base is a fundamental concept in taxation, representing the total amount of economic activity or assets upon which a tax is levied. It is the foundation upon which governments calculate the amount of tax owed, based on factors like income, property value, sales, or corporate profits. Understanding the tax base is essential for tax professionals, businesses, and policymakers,... for several years. The court found that the Venezuelan subsidiary had made all efforts to remit royalties but was impeded by governmental restrictions beyond its control. The case also involved the classification of dividends as royalty payments, where the court similarly ruled that the Ministry had not sufficiently proven that an independent party would have acted differently under comparable circumstances. As a result, the court dismissed the Ministry’s claim for both cases, reducing the proposed tax increases to DKK 0 for the respective years.

Key Points of the Judgment

Background

The case involves the Danish Ministry of Taxation’s claims against the multinational group H1 (formerly G1-A/S) and its subsidiary H2. The core issue spans two different tax disputesTax Disputes arise when there is a disagreement between taxpayers and tax authorities regarding the interpretation or application of tax laws. These disputes may concern various issues such as the accuracy of a tax return, the eligibility for tax deductions or credits, the correct amount of tax liability, or transfer pricing adjustments. Tax disputes can lead to lengthy legal proceedings... for the income years 2008-2011 and 2012-2013. H1, the Danish parent company, had a subsidiary (G2-virksomhed) in Venezuela, which was subject to strict currency control regulations under Venezuelan law, making it difficult to remit royalties to H1 in Denmark.

The first dispute, Case BS-12642/2020-OLR, concerns whether the Ministry of Taxation was justified in increasing H1’s taxable incomeThe tax base is a fundamental concept in taxation, representing the total amount of economic activity or assets upon which a tax is levied. It is the foundation upon which governments calculate the amount of tax owed, based on factors like income, property value, sales, or corporate profits. Understanding the tax base is essential for tax professionals, businesses, and policymakers,... by fixing interest on royalties receivable from G2 for the income years 2008-2011, which H1 claimed were unpaid due to Venezuelan currency restrictions. The Ministry argued that H1 should have accrued interest on these amounts in compliance with the arm’s length principle as per Section 2(1) of the Danish Tax AssessmentA tax assessment is a formal determination made by a tax authority to calculate the amount of tax an individual or entity owes. It is a comprehensive evaluation based on financial records, declared income, expenses, deductions, and any applicable tax laws or regulations. Tax assessments may arise from routine self-assessments by taxpayers, or they may be conducted by revenue authorities... Act.

The second dispute, Case BS-25280/2020-OLR, pertains to the reclassification of extraordinary dividends paid by G2 to H1 in 2012-2013 as royalty payments. The Ministry of Taxation argued that, had the parties been independent, royalties would have been prioritised over dividend payments. Thus, the Ministry sought to increase the taxable incomeThe tax base is a fundamental concept in taxation, representing the total amount of economic activity or assets upon which a tax is levied. It is the foundation upon which governments calculate the amount of tax owed, based on factors like income, property value, sales, or corporate profits. Understanding the tax base is essential for tax professionals, businesses, and policymakers,... of H1 and H2 for these years.

In both disputes, the court had to consider the arm’s length principle, the economic context in Venezuela, and the force majeure clauses in the licensing agreements between H1 and G2.

Core Dispute

The core dispute in both cases centres on the application of the arm’s length principle and the question of whether H1’s taxable incomeThe tax base is a fundamental concept in taxation, representing the total amount of economic activity or assets upon which a tax is levied. It is the foundation upon which governments calculate the amount of tax owed, based on factors like income, property value, sales, or corporate profits. Understanding the tax base is essential for tax professionals, businesses, and policymakers,... should be increased due to royalty and interest payments that were either unpaid or reclassified as dividends. The Ministry of Taxation claimed that independent entities in similar circumstances would have made these payments, and therefore, H1 should be taxed on these amounts.

In the first case, the Ministry argued that H1 should have accrued interest on unpaid royalties from G2 for the years 2008-2011. The Ministry claimed that under the arm’s length principle, the interest should have been accrued and taxed in Denmark. However, H1 argued that G2’s inability to pay royalties was due to Venezuelan currency restrictions and that no independent party would have been able to make these payments.

In the second case, the Ministry sought to reclassify dividends paid by G2 in 2012-2013 as royalty payments. The Ministry’s position was that an independent party would have prioritised paying off royalties due before distributing dividends. H1 argued that the payments were made as dividends with the approval of the Venezuelan government and that these could not be classified as royalties under Venezuelan law.

Court Findings

The court ruled in favour of H1 and H2 in both disputes. It found that the Ministry of Taxation had failed to prove that the transactions between H1 and G2 did not comply with the arm’s length principle. In the first case, the court accepted that the unpaid royalties were a result of exceptional currency restrictions imposed by the Venezuelan government, which constituted a force majeure event under the licensing agreements. It was ruled that no interest could be applied under these circumstances, as no independent party would have acted differently.

For the second case, the court held that the Ministry had not sufficiently demonstrated that the dividends paid by G2 should be reclassified as royalty payments. The court noted that the payments had been made legally under Venezuelan law with the necessary government approvals, and therefore, they could not be reclassified as royalties.

The court further observed that the force majeure clauses in the agreements between H1 and G2 shielded G2 from liability for non-payment of royalties due to factors beyond its control, such as the severe currency restrictions in Venezuela.

Outcome

The outcome of the case was a complete victory for H1 and H2. In both disputes, the court ruled that the Ministry of Taxation’s claims were unfounded, and the proposed increases in taxable incomeThe tax base is a fundamental concept in taxation, representing the total amount of economic activity or assets upon which a tax is levied. It is the foundation upon which governments calculate the amount of tax owed, based on factors like income, property value, sales, or corporate profits. Understanding the tax base is essential for tax professionals, businesses, and policymakers,... were reduced to DKK 0. In Case BS-12642/2020-OLR, the court ruled that no interest should be applied to the unpaid royalties from G2 to H1, as the payments were not made due to external circumstances beyond G2’s control, notably the Venezuelan currency restrictions. Therefore, the Ministry’s claim to increase taxable incomeThe tax base is a fundamental concept in taxation, representing the total amount of economic activity or assets upon which a tax is levied. It is the foundation upon which governments calculate the amount of tax owed, based on factors like income, property value, sales, or corporate profits. Understanding the tax base is essential for tax professionals, businesses, and policymakers,... for the years 2008-2011 was dismissed.

In Case BS-25280/2020-OLR, the court found that the dividends paid by G2 in 2012-2013 were not disguised royalty payments and that they had been lawfully distributed under Venezuelan law. The court concluded that the Ministry had not demonstrated that an independent party would have made different decisions regarding the prioritisation of payments, dismissing the claim to reclassify the dividends as royalty payments.

Transfer Pricing Method Used (if relevant)

In both cases, the Ministry of Taxation relied on the arm’s length principle, as outlined in the OECD Transfer Pricing GuidelinesThe OECD Transfer Pricing Guidelines serve as a critical framework for multinational enterprises (MNEs) and tax administrations worldwide. They provide detailed principles for the pricing of intra-group transactions to ensure that profits are allocated fairly across jurisdictions, based on the arm’s length principle. In essence, these Guidelines are instrumental in preventing tax base erosion and profit shifting by MNEs. The..., to argue that the transactions between H1 and G2 should be adjusted for tax purposes. However, the court found that the Ministry had not proven that the arm’s length principle was violated, given the unique circumstances surrounding the Venezuelan currency restrictions.

Major Issues or Areas of Contention

The main area of contention in this case was the interpretation and application of the arm’s length principle in light of the extreme currency controls and economic instability in Venezuela. The Ministry of Taxation argued that independent entities would have behaved differently, particularly in relation to the timing and prioritisation of payments. The Ministry also questioned whether the force majeure clauses in the licensing agreements should relieve G2 of its obligations to pay royalties.

Another significant issue was whether the Ministry had the authority to reclassify dividends as royalty payments. The Ministry contended that, under normal circumstances, an independent party would have prioritised settling royalty obligations before paying dividends to shareholders. However, H1 successfully argued that the payments were made legally under Venezuelan law and were approved by the Venezuelan government.

Was This Decision Expected or Controversial?

The decision was somewhat expected, given the unique circumstances surrounding Venezuelan currency restrictions, but it was controversial in tax circles. The application of the arm’s length principle in such extraordinary circumstances, where government-imposed restrictions prevent normal business operations, posed a significant challenge for both the Ministry of Taxation and the court.

While the Ministry’s arguments were grounded in the OECD Transfer Pricing GuidelinesThe OECD Transfer Pricing Guidelines serve as a critical framework for multinational enterprises (MNEs) and tax administrations worldwide. They provide detailed principles for the pricing of intra-group transactions to ensure that profits are allocated fairly across jurisdictions, based on the arm’s length principle. In essence, these Guidelines are instrumental in preventing tax base erosion and profit shifting by MNEs. The..., the court emphasised companies’ real-world complexities in countries with restrictive foreign exchange regimes. The court’s reliance on the force majeure clauses in the licensing agreements further strengthened the decision in favour of H1. This case highlighted the difficulties of applying strict transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... rules in environments where external factors, such as government controls, significantly impact a company’s ability to act in an arm’s length manner.

Significance for Multinationals

This judgment is significant for multinational enterprisesWhat are Multinational Enterprises (MNEs)? Multinational Enterprises, commonly referred to as MNEs, are corporations that operate in multiple countries through various subsidiaries, branches, or affiliates. These entities maintain a central management structure while leveraging diverse resources, labour markets, and customer bases across borders. The fundamental aspect that distinguishes MNEs from other corporate forms is their cross-border activity, which can include... (MNEsWhat are Multinational Enterprises (MNEs)? Multinational Enterprises, commonly referred to as MNEs, are corporations that operate in multiple countries through various subsidiaries, branches, or affiliates. These entities maintain a central management structure while leveraging diverse resources, labour markets, and customer bases across borders. The fundamental aspect that distinguishes MNEs from other corporate forms is their cross-border activity, which can include...) operating in jurisdictions with restrictive currency controls or other government-imposed limitations. It reaffirms that contract force majeure provisions can relieve certain obligations, such as interest payments on royalties, where external factors prevent performance. MNEsWhat are Multinational Enterprises (MNEs)? Multinational Enterprises, commonly referred to as MNEs, are corporations that operate in multiple countries through various subsidiaries, branches, or affiliates. These entities maintain a central management structure while leveraging diverse resources, labour markets, and customer bases across borders. The fundamental aspect that distinguishes MNEs from other corporate forms is their cross-border activity, which can include... operating in countries with unstable political and economic environments should carefully draft force majeure clauses to ensure they are protected in case of government actions that affect their ability to transfer funds.

Furthermore, the judgment illustrates that tax authorities may face difficulties in applying the arm’s length principle rigidly in such environments. MNEsWhat are Multinational Enterprises (MNEs)? Multinational Enterprises, commonly referred to as MNEs, are corporations that operate in multiple countries through various subsidiaries, branches, or affiliates. These entities maintain a central management structure while leveraging diverse resources, labour markets, and customer bases across borders. The fundamental aspect that distinguishes MNEs from other corporate forms is their cross-border activity, which can include... can take comfort in knowing that courts may take a pragmatic approach, considering the broader context and external factors beyond the company’s control.

Significance for Revenue Services

For revenue services, this judgment serves as a cautionary tale. It highlights the importance of understanding the economic and political context of the jurisdictions in which multinationals operate. The Ministry of Taxation’s attempt to apply a strict interpretation of the arm’s length principle without considering the severe currency restrictions in Venezuela ultimately led to the dismissal of their claims.

Revenue authorities must ensure that their transfer pricing adjustmentsTransfer Pricing Adjustments are modifications made to the pricing of transactions between related entities within a multinational enterprise (MNE) by tax authorities or the MNE itself. These adjustments are carried out to ensure compliance with the arm’s length principle, which stipulates that prices for intercompany transactions should reflect what independent parties would have agreed upon under similar circumstances. The arm’s... are supported by sufficient evidence that independent parties would have acted differently under similar circumstances. This case also underscores the need for tax authorities to engage in constructive dialogue with MNEsWhat are Multinational Enterprises (MNEs)? Multinational Enterprises, commonly referred to as MNEs, are corporations that operate in multiple countries through various subsidiaries, branches, or affiliates. These entities maintain a central management structure while leveraging diverse resources, labour markets, and customer bases across borders. The fundamental aspect that distinguishes MNEs from other corporate forms is their cross-border activity, which can include... operating in high-risk jurisdictions and to consider the practical difficulties they face in complying with transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... regulations.

Three Additional Cases To Look AT

Cadbury Schweppes plc v Commissioners of Inland Revenue (Case C-196/04)

In this case, the European Court of Justice ruled that Cadbury Schweppes had lawfully set up a subsidiary in Ireland for tax purposes. The court found that the subsidiary had real economic activity and was not a wholly artificial arrangement. Similar to the Denmark vs. EAC case, this judgment involved determining whether tax arrangements were in line with EU law and economic realities.

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Lexel AB v Skatteverket (Case C-484/19)

In this case, the European Court of Justice ruled that Sweden’s anti-abuse rules regarding the deduction of intra-group interest payments violated EU law. Lexel AB’s case similarly dealt with the application of tax rules within a cross-border transactionIntra-Group Transactions are interactions between entities within the same multinational enterprise (MNE). Such transactions form the backbone of related-party dealings and are essential in managing global operations and aligning business objectives across jurisdictions. Understanding intra-group transactions is critical in international tax and transfer pricing, as they directly impact a company's tax obligations, profitability, and compliance standing. Tax professionals, accountants, lawyers,..., focusing on whether the rules applied violated fundamental EU principles. The judgment is relevant as it showcases how courts address the interaction between domestic tax lawsTax laws form the backbone of any nation’s revenue system, setting the rules that govern how individuals and corporations contribute financially to support government functions. These laws define the types of taxes, the applicable rates, and the regulations regarding payment and compliance. They also outline the rights and obligations of taxpayers, ensuring a balanced and fair approach to funding public... and external economic factors.

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X Holding BV v Staatssecretaris van Financiën (Case C-337/08)

This case involved the Netherlands’ refusal to allow tax consolidation for a subsidiary established in Belgium. The judgment again revolved around the arm’s length principle and whether cross-border transactionsIntra-Group Transactions are interactions between entities within the same multinational enterprise (MNE). Such transactions form the backbone of related-party dealings and are essential in managing global operations and aligning business objectives across jurisdictions. Understanding intra-group transactions is critical in international tax and transfer pricing, as they directly impact a company's tax obligations, profitability, and compliance standing. Tax professionals, accountants, lawyers,... were artificially structured to minimise tax. It is relevant in the context of examining how courts view cross-border arrangements and their compliance with tax rules.

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