How to defend losses in 2020 in the context of transfer pricing before the tax authorities?
Are you one of the companies that will generate a significantly lower profit or even report a loss in 2020 as a result of the pandemic? Is your company part of a group of companies whose consolidated financial results are negatively affected by the ongoing pandemic?
If you answered yes and the defensibility of these results before the tax administrator seems completely logical to you, beware – the tax authority may not agree with you!
Why are losses dangerous?
Many companies will report a loss or at least a significantly worse economic result due to the ongoing pandemic compared to previous years. However logical this may seem, given the exceptional circumstances, from the transfer pricing perspective, defending the loss before the tax administrator may be very complicated or even impossible.
From the transfer pricing perspective, the key consideration is which companies should bear the loss within the group and which, on the contrary, should be compensated for the loss - despite exceptional circumstances.
Have you considered the arguments to rebut the possible view of the tax authority that the drop in profit or loss should have been taken over by another company in the group?
The defensibility of losses is a relevant topic for every group company, regardless of its functional and risk profile. A full-fledged company must be able to prove that the loss is related to the materialisation of the risks that the company is lawfully exposed to and is therefore not caused, for example, by incorrect transfer pricing set-up in individual transactions with related parties. The defensibility of losses is crucial for companies with a so-called limited functional and risk profile. These are companies whose role in the group can be compared to the position of the employee vis-à-vis the employer. The company performs the assigned tasks (e.g. it manufactures, distributes), but performs only limited functions within the defined role and should therefore not (like the employee) bear significant risks (borne by the employer).
The tax administrator expects the limited company to achieve a relatively stable level of profitability, regardless of the current development of the economic cycle. At the same time, this implies that any loss caused by circumstances outside the influence of a limited company should by default be borne by another company in the group, the so-called principal. In the context of the above, it is, therefore, necessary to consider whether it can be justified why a limited company should also bear the loss or a worse result in a given situation.
Responsibility of statutory bodies
As part of the duty to act with due managerial care, statutory bodies should ask the following questions:
- Should the loss or lower profit be borne by the Czech company, or should they be compensated by another company in the group?
- Will the final result of the company be defensible from the transfer pricing viewpoint?
- Did local management do its best to mitigate the negative impacts on the company's results? Did it have the opportunity to do so?
It is precisely these considerations and questions that the tax authority can discuss with the statutory body during the tax audit, which can be initiated even several years later. Nevertheless, searching for evidence retrospectively is usually very difficult. It is, therefore, appropriate to start preparing supporting arguments and collecting relevant evidence, ideally at least in the form of transfer pricing documentation.
Retroactive utilisation of a tax loss
From 1 July 2020, it is possible to utilise the tax loss not only in the five taxation periods immediately following the period for which the tax loss is assessed, but newly also in the two taxation periods immediately preceding it, specifically up to a total amount of CZK 30 million.
Based on our experience with the tax authorities' approach to tax audits, it can be assumed that the application of the institute of retrospective utilisation of the tax loss by taxpayers will be monitored and taken into account by the tax administrator when preparing the tax audit plan. The subject of the audit will certainly be not only an examination of the fulfilment of the conditions for retrospective utilisation of the loss but, in particular, the circumstances of the loss itself and its legitimacy in connection with the applied transfer pricing set-up. Moreover, the utilisation of such institute extends the period for an additional tax assessment for the relevant immediately preceding periods, i.e. the period for a tax audit carried out by the tax authority.
Main areas for reflection
Transfer pricing model applied
- Do your existing group transfer pricing set-up provide flexibility to deal with exceptional circumstances like the pandemic?
Transfer pricing documentation
- Is the company’s functional profile correctly determined and interpreted? Is the company able to prove the declared functional profile?
- Does the existing documentation create the possibility, for example, for reducing the profitability of a company with a limited profile?
- Are existing benchmarking analyses also applicable in the current situation?
- If not, how can benchmarking analysis in 2020 and in subsequent years be dealt with?
Advance Pricing Agreement (APA)
- Is the company able to continue with the approved set-up? If not, what does that imply?
- Is it appropriate to consider submitting a (new) advance pricing agreement in order to obtain a decision of the tax administrator confirming the compliance of the selected method of pricing with the arm’s length principle?