Assessing the functions and risks of a company in the light of recent case law

Contract manufacturers under Group control

What all the recent judgments have in common is that the tax authorities concluded that taxpayers were contract manufacturers with limited functions and risks. In internationally accepted terminology, this is an entity that carries out production activities with minimal business risk and limited functions. This model is often used in transfer pricing, where the contract manufacturer focuses on production to the exact specifications and instructions of the customer, with most of the risks associated with production, inventory and sales remaining with the customer. Also in these cases, the tax authorities concluded that the companies performed functions 'under the control' of the group and were therefore not autonomous in deciding on certain key functions (purchase of inputs, sale of products, strategic decision-making or decision-making on production capacity). 

Judgment of the Supreme Administrative Court of the Slovak Republic

Judgment of the Supreme Administrative Court of the Slovak Republic No. 2Sfk/36/2023 confirms that companies which do not perform autonomous key functions may be considered as "dependants" within the group. Such an assessment may lead to an adjustment the company's profit margin on operating expenses (profit adjustment) if that margin is not within the independent range, even if the vast majority of the company's transactions are with independent persons. In the present case, the tax authorities increased the tax base by more than EUR 6 million. Although the judgment does not address the correctness of the application of the transactional net margin method or the correctness of the calculation of the difference in the prices of the controlled transactions, it does bring an important shift in the assessment of functions and risks. 

Critical views of the administrative courts

On the other hand, the judgments of the Administrative Court in Bratislava (No. BA-1S/111/2019-107) and the Administrative Court in Košice (No. KE-7S/148/2020) bring more critical views on the procedure of the tax authorities in determining the market profit and assessing the taxpayer's transactions.

• In the case of the judgment of the Administrative Court in Bratislava, the court objected to the inclusion of dependent companies and the exclusion of loss-making companies in the comparability analysis. According to the court, the tax authorities's assumption that companies with limited functions and risks cannot make a loss was insufficiently proven.
   
• The judgment of the Administrative Court in Košice criticized the tax authorities for applying the arm´s lenght principle to independent transactions, the use of the interquartile range or median without further justification (only with reference to the OECD Guideline), and insufficient justification for the use of so-called "aggregate approach" in the assessment of controlled transactions. The Court also criticised the lack of justification for the use of the double tax treaty, where a formal reference to the treaty was insufficient.

Assessment of intra-group services

In addition to the assessment of the contract manufacturer, the judgment of the Supreme Administrative Court of the Slovak Republic confirmed the correctness of the tax authorities' procedure in assessing intra-group services. The tax authorities excluded from tax expenses services received from a related person in the amount of more than EUR 3 million, as the taxpayer did not provide specific outputs as to what services were actually received, what specific benefits accrued to the taxpayer from those services and how the costs were allocated to the company. The submission of an invoice, a contract or a general list of services is not sufficient evidence to recognize  the costs of the services as a tax expenses. This topic was addressed in our previous article. 

What can be seen from examples from court practice

In our experience, this issue is often the subject of disputes with the tax authorities and there is not a lot of case law to date compared to other countries. The new judgements are very useful for practice and contribute to a shift in the development of case law and thus to increasing legal certainty. They also emphasize  the importance of carefully prepared transfer pricing documentation, proper definition and documentation of functions (activities), risks as well as evidence keeping to demonstrate intra-group services. Underestimation of this preparation may expose companies to significant tax risks.

If you are interested in this topic, please do not hesitate to contact our experts - we will be happy to discuss with you the impact of the judgments on your situation and provide a thorough analysis.