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Transfer pricing

Transfer pricing in case law: Finnish tax authority vs. A Oy

Author: Parol Jalakas

In this series of articles, we give an overview of case law on international transfer pricing practices.

In the case of the Finnish tax authorities and A Oy, we can see how incompetent preparation of transfer pricing documentation can create a large administrative burden for the company. Although the case ended in A Oy's favor, they had to spend time and money to have the decision of the Finnish tax authorities to adjust the taxpayer's transfer prices and add additional income tax on the adjusted profits annulled.

For more information on transfer pricing regulations and documentation requirements, see our article: "Nine steps for determining transfer pricing".

What was the substance of the case?

A Oy, founded in Finland, is a company specializing in environmental services in the industrial and construction sectors. A Oy operates in Finland as a marketing and sales company for the corporate group. With the exception of 2008, the Finnish company was loss-making between 2003 and 2011, while the group as a whole was profitable. The unprofitable activities of a single group company are among the risk factors that may attract the attention of the tax authority and call into question the legality of the transfer prices used.

A Oy had purchased products from related contract manufacturers. The method used to determine the transfer price of purchased products in the group's transfer pricing documentation was characterized as a modified cost-plus/profit margin method (TNMM). The transactional net margin method determines the transfer price through profitability (profitability in terms of costs or turnover), compared with market data. Market data is based on the profitability of independent companies operating in a similar industry and business. The parties tested in the A Oy documentation were the contract manufacturers belonging to the group, for whom four comparable independent companies had been found by searching the Amadeus database. According to the documentation, the EBITDA margin of the group's contract manufacturers was set at two percent.

Following the submission of A Oy's tax return for 2010, the Finnish Tax Administration found on the basis of the OECD 2010 Transfer Pricing Guidelines (paragraphs 1.70–1.72) that the profit of an independent sales company would have been different. The Tax Board found that when determining the transfer price of the group, the wrong transaction with the parties to the transaction had been observed - instead of the manufacturing company of the group, the profitability of A Oy as a sales company should have been analyzed in comparison with the market data.

How to set transfer prices?

The Supreme Administrative Court found that the losses of a group company do not in themselves mean that the company should receive compensation from other group companies that could have benefited from the activities of the loss-making sales company. In determining the market conditions for the transfer pricing of a loss-making group using the cost-based or transaction-based return method, the OECD transfer pricing guidelines require testing of a company for which more reliable data on the most comparable transactions can be found. In its judgment, the court found that, given A Oy's activities and the group A's contract manufacturers, their own risks and those of their assets, A Oy should not have been chosen as the test party.

According to the OECD guidelines, the rule of thumb is that the tested party is the company to which the transfer pricing method can be applied most reliably and for which the most relevant comparable companies could be found. The contract companies belonging to the group should have been selected as the companies to be tested in this case, as was originally done in the group A transfer price documentation. In addition to the above, A Oy had provided business reasons for its losses, which is why the Supreme Administrative Court annulled the tax adjustments of the Tax Board.

A comprehensive and well-substantiated transfer pricing documentation might have prevented this dispute and saved the parties' resources. The preparation of a correct transfer price documentation is in the interests of the company itself and the documentation must be based on the requirements of legislation as well as the needs and risks of the company.

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