Denmark courts reject tax authority’s formalistic transfer pricing approach

By Susi Baerentzen, Ph.D., Copenhagen

In a string of cases decided over the past two years, Denmark’s Supreme Court and high courts have ruled against the tax administration’s formalistic approach to transfer pricing, the most recent example being the July 2 Western High Court ruling in the ECCO shoe case.

Denmark’s tax administration has historically used various theories to claim that a taxpayer’s documentation was insufficient and that, consequently, a discretionary tax assessment was necessary.

These assessments were not based on a proper economic analysis, though; the actual economic aspects of the transfer pricing were omitted in the process. 

Everything changed with the 2019 Microsoft decision. Since then, things have been moving at the speed of light in the tax litigation department.

Denmark tax authority’s transfer pricing homebrew

In short, the Danish tax administration had invented a market argument that subsidiaries exist in Denmark mainly to benefit the overall group and that the subsidiary should be compensated for this benefit. 

This homebrew is a mix based on the OECD transfer pricing guidelines. The tax administration reasons that independent enterprises can not tolerate infinite losses, that the group as a whole may benefit from an associated loss-making enterprise remaining in business, and that this situation may be dealt with as a compensable service transaction.

 Thus, the mere presence of a subsidiary in Denmark may qualify as a compensable transaction service.

This approach was first rejected by Denmark’s Supreme Court in the 2019 Microsoft case (SKM2019.136.HR), and subsequently in the June 2020 Adecco case (SKM2020.303.HR), previously discussed in MNE Tax.

Most recently, on July 2, the Danish Western High Court followed suit in the ECCO ruling (SKM2020.397.VLR), the court of last instance.  

While a pattern seems beginning to surface from these important transfer pricing rulings, there are two outliers. A high court has recently ruled in favor of the Ministry of Taxation in one case (SKM2020.224.VLR) and referred another case back for re-assessment (SKM2020.105.ØLR).

Indirect marketing effects

The January 31, 2019, Danish Supreme Court ruling in the Microsoft case was fundamentally about whether an intragroup commission paid to Microsoft Denmark for local marketing was arm’s length.

It was the first substantial transfer pricing case of general importance to reach the Denmark Supreme Court, and it set some important transfer pricing standards on discretionary assessments, burden of proof, and potential marketing effects.

The case was the result of a multilateral joint audit. 

Microsoft Denmark received a marketing commission from sales of Microsoft software when computers were sold by multinational computer manufactures with pre-installed Microsoft software.

The software itself was sold by Microsoft companies located in the US and other countries to third party multinational computer manufacturers.

According to Denmark’s tax administration, Microsoft Denmark should be rewarded for marketing in Denmark when computers were sold with a pre-installed operating system from multinational producers like Dell, Lenovo, etc. to Danish end-users.

Essentially the tax authority’s claim was that this marketing has the same effect it has on software sold by Microsoft in Denmark and, consequently, Microsoft Denmark’s marketing commission should be reflected in the sales of these products.

Microsoft Denmark’s transfer pricing documentation

The transfer pricing documentation had been challenged by the tax administration based on the fact that it did not include information about the third-party multinational computer manufacturers’ sales in Denmark, as described above.

The Danish Ministry of Taxation argued before the courts that the company had not prepared the statutory documentation in due time and that it was in any case so insufficient that it could not provide a proper base for an assessment, even if it had been prepared in a timely manner.

Consequently, the Ministry claimed that the taxable income for Microsoft Denmark should be increased by more than DKK 300 million (more than USD 47 million) for the income years 2004–2007 in question or that the case should be remitted to the tax administration for re-assessment.

The Danish Supreme Court ruled that for the tax administration to reject the documentation and conduct a discretionary assessment, this documentation must be so inadequate that it does not suffice as a basis for determining whether the arm’s length principle is met at the time of the assessment.

Then, and only then, is it necessary for the tax administration to disregard the transfer pricing documentation. This would be the only situation in which it is justified for the tax authority to conduct a discretionary assessment.

Even though the transactions in question were not included in the documentation, according to the Supreme Court, this was not sufficient grounds for rendering the documentation inadequate.

As the documentation had not been materially challenged in any other aspect, the court rejected the Ministry’s claim.

Potential marketing effects

The Danish Ministry of Taxation’s argument was based on the assumption that Microsoft Denmark’s marketing influenced demand in the Danish market for computers with pre-installed software, which in turn increased the demand for OEM licenses from multinational computer manufacturers like Lenovo and Dell in the US, and that this rise in demand benefitted the Microsoft group as a whole. 

The tax administration allegations regarding potential marketing effects were based on Microsoft’s intercompany market development agreement with an affiliated Irish corporation. 

The heart of the matter was whether this agreement was arm’s length. The sales for which Microsoft Denmark received commission under the Irish agreement were only sales of program packages (program licenses) for end-users in Denmark and sale of original equipment manufacturers licenses to small and medium-sized computer manufacturers in Denmark.

On this question, the ruling came with a dissent, but the majority still ruled in favor of Microsoft Denmark.

According to the Supreme Court, the arm’s length analysis did not hinge on whether the marketing efforts were beneficial to the Irish corporation or other group members.

The agreement created an obligation to maximize the market for all products, which the Supreme Court concluded meant that Microsoft Denmark must market products for which the sale is concluded directly in Denmark.

In other words, the Supreme Court did not find that the agreement created an obligation for Microsoft Denmark to market the sale of computers with pre-installed software. Corporations located outside of Denmark sold the OEM licenses to multinational computer manufacturers even though Microsoft Denmark contributed to these manufacturers’ marketing of programs to end-users, the court said.

Even though the Supreme Court could not entirely dismiss that Microsoft Denmark’s marketing may have had spillover effect on the sales of OEM licenses in the US and other foreign countries, the court did not find that it was probable that this effect surpassed the effect of the computer manufacturer’s marketing on sales of license packages, which were included in the commission to Microsoft Denmark.

The court concluded that the Danish Ministry of Taxation had not substantiated that Microsoft Denmark’s marketing commission was not at arm’s length.

 Consequently, their argument that the non-measurable potential indirect marketing effects at the group level should be remunerated was rejected.

The pharma case and the ice cream case

Almost one year after the Supreme Court ruling in the Microsoft case, Denmark’s Eastern High Court ruled in a case concerning a Danish distributor of generic pharmaceuticals SKM2020.105.OLR.

The heart of the matter was a transactional net margin method (TNMM analysis and whether goodwill amortizations could be disregarded for the purpose of the comparability analysis.

According to the transfer pricing documentation, for purposes of the TNMM method, the company’s earnings, i.e., their average EBIT margin, were significantly below the benchmark, namely, the arm’s length range of net profit.

The corporation claimed that by disregarding, for example, the annual goodwill amortization of DKK 57.1 million (USD 8.9 million), the average EBIT margin was within the benchmark.

Before the Denmark National Tax tribunal, this argument passed muster, but the High Court rejected this claim stating that the goodwill in question had to be regarded as an operating asset, and therefore the depreciation had to be regarded as operating expenses when calculating the net profit (EBIT margin).

The goodwill in question had been determined during a prior acquisition of the company and subsequently booked in the Danish corporation as part of a merger with the acquiring Danish company.

The taxpayer claimed that specific circumstances, such as increased price competition, restructurings, etc., led to a decrease in earnings, not incorrect pricing.

Furthermore, the taxpayer claimed that companies whose results were not included in the benchmark possessed goodwill that was not yet capitalized, and which corresponded to the value of the Danish company’s goodwill. The Danish High Court rejected both claims and therefore did not find that adjustments for goodwill amortization would improve the comparability analysis.

On this basis, the High Court ruled that the tax authorities were entitled to assess additional income for 2006–2009, but not for 2010. The court ruled that an individual estimate must be conducted for each income year based on what the taxpayers could be assumed to have obtained if they had acted in accordance with the arm’s length principle.

The court referred the case for re-assessment of the taxable income for FY 2006–2009.

In a subsequent ruling from the Western High Court on May 1, 2020, the court referred directly to the ruling in the Microsoft case, but this time the outcome was in favor of the Ministry of Taxation.

The case (SKM2020.224.VLR) concerned a Danish company that produced and sold plants for manufacturing and packaging of ice cream.

For the income years 2005–2009, the tax administration had conducted a discretionary assessment based on the group’s transfer pricing documentation being inadequate and continuing losses in the Danish company.

The heart of the matter was whether the documentation had been sufficiently flawed to justify this assessment, and in this regard, the High Court quoted the Microsoft case, stating that documentation that is inadequate to an extent that it does not provide a proper base for the tax administration to assess whether the arm’s length principle is met must be equated with absent documentation.

In the case at hand, the High Court ruled that the tax administration had been entitled to carry out the discretionary assessment and for this purpose had been justified in applying the TNMM using the Danish company as the tested party, as sufficiently reliable information on the group’s sales companies had not been provided.

In relation to the comparability analysis, the court found that the tax administration’s selection of companies was based on functions, assets, and risks comparable to that of the Danish company.

This decision has been appealed to the Danish Supreme Court.

Long-awaited landmark ruling in the ECCO shoe case

The most recent landmark ruling in the long line of significant Danish cases is the July 2 ruling from the High Court of Western Denmark in the ECCO shoe case (SKM.2020.397.VLR).

The case was initiated from an audit 14 years ago, and the continued battle has been a matter of principle for the Danish iconic shoe manufacturer. The Danish Ministry of Taxation has not brought this case before the Supreme Court, so the judgment is now final.

Fourteen years is a long time for a large multinational group, and rigors of this magnitude would have proven an insurmountable challenge for many companies in terms of time and resources spent on litigation.

The ECCO shoe ruling serves as a stark reminder of companies’ challenges when refuting a tax administrations’ claims and theories, especially when they are put forward aggressively, as is the case in Denmark.

The ECCO shoe ruling serves as a stark reminder of companies’ challenges when refuting a tax administrations’ claims and theories, especially when they are put forward aggressively, as is the case in Denmark

The case concerned ECCO shoe company, parent company Danish shoe retailer that purchased goods from external and intra-group manufacturers from the company’s Indonesian and Thailand subsidiaries. At issue was whether these last-mentioned transactions were arm’s length.

ECCO shoe had composed two sets of transfer pricing documentation, both readily available for the tax administration at the time of assessment.

This documentation was comprised of an analysis of the ECCO shoe’s price determination and terms for external and intra-group manufacturers and a comparability analysis.

The questions were, first, whether this documentation was insufficient to the degree that would justify the tax administration conducting a discretionary assessment, and, second, whether the government established that the transactions with the Indonesia and Thailand subsidiaries were not arm’s length.

The documentation’s price determination was done consistently for both external and intra-group manufacturers. The price was determined for each shoe model based on the compiled budgetary production costs and a profit margin, which varied depending on the model of shoe.

This is a customary way of determining prices in the shoe manufacturing business.

In terms of the comparability analysis, a contribution analysis was conducted to determine the average profit ratio from the sale of shoes produced by the manufacturers in Indonesia and Thailand compared to those manufactured by the other intra-group and external manufacturers.

ECCO shoe’s transfer pricing documentation outlined that a comparable uncontrolled price analysis will be conducted; however, this is inaccurate as it is, in fact, a contribution analysis, as described.

The supplementary transfer pricing documentation includes a comparison of the EBIT margins for both corporations based on the transactional net margin method. In total, these two corporations are responsible for approximately 70 percent of the external party turnover.

Based on an overall assessment of ECCO shoe’s transfer pricing documentation, the High Court ruled that the tax administration had a sufficient basis for assessing whether the arm’s length principle was met.

The court also analyzed whether the Ministry had substantiated that the transactions with the two subsidiaries were not on arm’s length terms.

According to ECCO shoe’s transfer pricing documentation, the (simple) average contribution was higher for shoes manufactured by external parties than for shoes manufactured by the Indonesia and Thailand subsidiaries.

The documentation explained this difference on the basis that the intra-group entities in question applied the so-called “injection method,” which is the process of introducing a molten material into the cavity of a mold to achieve the desired shape, i.e., to inject the sole.

The external manufacturers, on the other hand, used the “cemented method,” in which the upper part of the shoe is glued with a strong adhesive to the sole.

This means there is no stitching or welt was used, and the result was a disposable shoe; i.e., this method required less investment, and, consequently, the documentation provided a higher contribution.

The High Court noted that the total contribution for the Danish company did not only depend on each of the manufacturers’ contributions, as these vary greatly depending on the model of shoe, but also very much on the number of shoes sold.

Based on these facts, the court found that the Ministry had not substantiated that the differences in contributions were evidence of non-arm’s length dealing that could not be explained by business reasons, in light of the overall business strategy and manufacturing planning.

Key takeaways from the recent Danish landmark transfer pricing rulings

The taxpayer in the ECCO shoe case showed that even if a national tax administration develops an unprincipled interpretation of the OECD transfer pricing guidelines to suit their needs, it is possible to refute these assumptions by honing in on the facts of the case. What is required, though, is the stamina to press your case for 14-years!

Responding to the Western High Court ruling, ECCO’s Vice President of Group Tax, Majbritt Aarup Lausen, said:

“Judges respond to common sense. We presented impact analysis to substantiate our case demonstrating how the global tax payments had been, had we followed the Danish tax administration’s principles. In ECCO’s case, we computed corporate income taxes paid, withholding taxes and excise duties, and this computation demonstrated that following the tax administration’s principles would in fact have resulted in saved costs. In other words, the setup was not motivated by tax incentives as alleged.”

According to Majbritt Aarup Lausen, ECCO shoe’s court submissions played a significant role, which underscores the importance of keeping track of documentation and preserving it for a long time -not just 5 or 10 years.

During the trial, ECCO was presented with old annual reports available online, indicating that the company had been loss-making back in 2002. To counter that evidence, the company was able to present articles that substantiated their business strategy, as described.

She adds that one factor which likely turned the tables was that ECCO was able to argue their case before the High Court for five days.

In comparison, the taxpayer had only 45 minutes to argue their case before the Tribunal. In addition, ECCO switched tactics. Before the Tribunal, the focus was on invalidating the claims made by the tax administration; before the High Court, though, they focused on substantiating their business strategy.

Denmark transfer pricing jurisprudence

As acknowledged by the Supreme Court in the Microsoft ruling, the mere presence of a Denmark subsidiary is not a remunerable benefit that allows the tax administration to reject arm’s length documentation.

This was reaffirmed by the Supreme Court in 2020 in the Adecco case, sending a clear message that any transfer pricing adjustments made by the tax administration must be based on solid economic analysis and methods.

The Adecco case further clarified and developed the Microsoft case, acknowledging that it is not sufficient for the tax administration to disagree with elements of transfer pricing documentation to deem it inadequate and thus justify a discretionary assessment in its place.

This ruling also clarified that novel third party documentation provided subsequently during the trial does not provide the tax administration with a justification for conducting a discretionary assessment.

In summary, both the Supreme Court and the High Courts have rejected the tax administration’s formalistic approach and highlighted the necessity of the government to conduct a proper economic analysis.

Going forward, it will be interesting to see whether the tax administration will change tactics.

One final remark is that, as described in MNE Tax, proposed amendments to the Danish transfer pricing rules have been drafted and were submitted for public consultation on October 4.

If passed, these amendments will mean that companies must submit their master and Danish local files within 60 days after the deadline for submission of the corporate income tax return. In contrast, according to the current rules, these documents must be finalized but not submitted by the deadline for filing the corporate income tax return.

In addition, the amendments are intended to clarify when the tax administration may conduct a discretionary assessment in case the taxpayer fails to provide the necessary documentation in due time.

The full extent of these amendments is yet to be seen, as the Supreme Court’s rulings in the Microsoft case and later cases and other cases may raise questions about its effect.