Judgment summary
The case concerns corporate income tax for the tax year from 1 January 2020 to 31 December 2020, involving a Polish company engaged in the production of textile products, finishing and dyeing of fabrics, mainly bedding.
Following a tax audit, the Head of the Łódź Tax Office found several irregularities, including understated tax costs, wrongly included depreciation write-offs, overstated costs from invoices issued by a related lessor company B. sp. z o.o. sp. k., and understated tax revenue arising from transactions with a related entity, C. sp. z o.o. sp. k.
The Director of the Tax Administration Chamber in Łódź partly amended the first-instance decision, reducing the determined tax liability, but upheld the finding on transfer pricing and the additional tax liability. The company appealed to the Provincial Administrative Court in Łódź, which dismissed the complaint on 21 November 2024, while agreeing with some of the company's arguments on the classification (but not the ultimate deductibility) of certain expenses.
Background
Company A. was incorporated under an agreement dated 2 November 2012, with partners M. G., G.G. and J. U. in 2020. Its actual business is the production of textile products, finishing of finished products, and dyeing of fabrics, mainly bedding.
After a tax audit, tax proceedings for 2020 corporate income tax were initiated on 21 February 2023. The Head of the Łódź Tax Office identified understated tax costs (PLN 21,919.02), wrongly included depreciation write-offs relating to machines financed by the District Labour Office (PLN 3,983.70 and PLN 4,780.49), overstated costs from three invoices issued by B. sp. z o.o. sp. k. for lease of premises and machinery (total PLN 1,766,278.25), and understated tax revenue from transactions with related entity C. sp. z o.o. sp. k. (PLN 1,133,197.73).
By decision of 14 September 2023, the tax liability was determined at PLN 646,605.00, with an additional tax liability of PLN 113,320.00 (10% of the unreported taxable income), under Article 58a of the Tax Ordinance. The company appealed, and on 26 June 2024 the Director of the Tax Administration Chamber in Łódź partly repealed the first-instance decision, reducing the liability to PLN 645,212.00, while upholding the remainder, including the transfer pricing findings and the additional tax liability.
Core dispute
The company challenged the appellate decision insofar as it failed to recognise certain deductible costs and determined a higher income from the transaction with the related party C. sp. z o.o. sp. k., as well as the maintenance of the additional corporate income tax liability for 2020.
The company argued that expenses arising from invoices issued by B. sp. z o.o. sp. k. for lease of buildings and equipment, including sums relating to destruction or excessive wear of machinery following a flooding incident, were properly deductible under Article 15(1) of the CIT Act. It also argued that Article 11c(2) and Article 11d of the CIT Act had been wrongly applied, contending that prices agreed with the related entity C. were set on market terms and that its chosen transfer pricing method and financial indicator (net sales mark-up) were supported by OECD guidelines and Transfer Pricing Forum recommendations.
Procedurally, the company alleged breaches of Article 121, Article 124 and Article 127 of the Tax Ordinance, including a failure to properly justify the decision, formulation of conclusions aimed at a pre-determined outcome, and a failure to conduct genuine two-instance proceedings.
Court findings
The Court found no infringement of the procedural rules alleged by the company. It held that the facts had been sufficiently and reliably established, that the appellate authority had genuinely subjected the case to its own assessment, and that agreement with the first-instance findings did not itself indicate a breach of the two-instance principle.
On the merits, the Court agreed with the company that the amounts of PLN 1,400,000.00 and PLN 350,000.00 (from invoices No. 4/2020 and No. 10/2020) could, in principle, be regarded as costs incurred to preserve a source of revenue under Article 15(1) of the CIT Act, since they related to charges under the lease agreement's provision on above-normal wear, destruction or devastation. However, the Court held that these expenses were not properly documented: there was no damage report, no photographic or descriptive documentation, no source documents establishing the machines' age or condition, and no clear basis for calculating replacement or destruction values. Since proper documentation is a precondition for recognising an expense as a deductible cost, these amounts could not be treated as tax deductible costs despite meeting the purpose test.
The Court upheld the authorities' treatment of invoice No. 11/2020, accepting PLN 7,333.78 as a deductible reinvoiced insurance cost but disallowing PLN 8,944.47 described as a margin, since the invoice concerned lease of buildings, machinery and equipment rather than the sale of goods, and no credible evidence supported the claimed margin.
The Court agreed with the authorities' unchallenged findings on understated tax costs (PLN 21,919.02) and on the treatment of depreciation write-offs of fabric dyeing machines financed by the District Labour Office (PLN 3,983.70 as tax-free revenue, and PLN 4,780.49 excluded from deductible costs).
On transfer pricing, the Court upheld the tax authorities' comparability and functional analysis of the transaction between the company and related entity C. sp. z o.o. sp. k. The authorities had identified comparable entities, applied the net transaction margin method with the operating mark-up indicator, and found an interquartile range of 4.20% to 9.22% with a median of 5.23%, compared with the company's actual mark-up of 1.61%. The Court found the company performed functions typical of a producer, not a distributor or agent, justifying rejection of the company's proposed net sales mark-up indicator. The Court held that the calculations and method applied did not raise doubts and confirmed a breach of Article 11c(1) of the CIT Act, with income properly determined by increasing tax revenue for 2020 by PLN 1,133,197.73.
Consequently, the Court held that the additional tax liability under Article 58a § 1(4) of the Tax Ordinance was justified, since the terms of the transaction between related parties were not determined on an arm's length basis.
Outcome
The Provincial Administrative Court in Łódź dismissed the complaint pursuant to Article 151 of the Law on Proceedings before Administrative Courts (p.p.s.a.), finding no infringement of substantive or procedural law that affected or could have affected the outcome of the case.
Tp method highlighted
The tax authorities verified the transfer prices between the company and related entity C. sp. z o.o. sp. k. using the net transaction margin method, selected under Article 11d(1) of the CIT Act as the most appropriate method given the type of transaction, functional analysis, and availability of financial data.
Using external databases (CEIDG, REGON, National Court Register, and a company website), the authorities identified eight comparable entities, narrowing these to four for the analysis, covering the period 2015-2019. The financial indicator used was the ratio of operating profit (loss) to operating expenses, referred to as the operating mark-up.
The company's actual operating profit mark-up for 2020 was calculated at 1.61%, while the interquartile range derived from comparable entities was between 4.20% and 9.22%, with a median of 5.23%. The authorities adopted the median of 5.23% as the arm's length value, given the company's functional profile as a producer rather than a distributor or agent, which the Court held justified rejecting the company's proposed net sales mark-up indicator (typically used for distributors or agents). Applying this median, the authorities recalculated the company's income: PLN 31,267,365.14 (operating expenses) x 5.23% = PLN 1,635,283.20 (re-estimated operating profit), less PLN 502,085.47 (operating profit before re-estimation), giving an income adjustment of PLN 1,133,197.73.
Major issues / areas of contention
- Whether expenses arising from three invoices issued by a related lessor company (B. sp. z o.o. sp. k.) for lease, destruction, and above-normal wear of machinery could be recognised as tax deductible costs under Article 15(1) of the CIT Act.
- Whether such expenses, even if meeting the purpose test under Article 15(1), were properly documented so as to qualify as deductible costs.
- Whether the tax authorities correctly applied the net transaction margin method under Article 11d of the CIT Act to verify transfer prices with related entity C. sp. z o.o. sp. k., rather than the net sales mark-up indicator proposed by the company.
- Whether the operating profit mark-up of 1.61% applied by the company in transactions with the related entity reflected market (arm's length) conditions, as required under Article 11c(1) of the CIT Act.
- Whether the additional tax liability imposed under Article 58a of the Tax Ordinance was justified given the findings on transfer pricing.
- Whether the tax authorities breached procedural principles, including the principle of two-instance proceedings, the duty to inspire confidence in tax authorities, and the duty to properly justify decisions.
- Treatment of depreciation write-offs on fabric dyeing machines whose purchase had been financed by the District Labour Office.