By Heikki Vesikansa (Partner and Head of Tax), Jenni Parviainen (Managing Associate), and Stefan Stellato (Senior Associate), Hannes Snellman Attorneys Ltd., Helsinki
On 13 September, Finland’s Supreme Administrative Court published a year-book decision (SAC 2021:127) examining the use of comparable data in determining the arm’s length range and the transfer pricing adjustment point and generally aligning the Finnish practice with OECD transfer pricing guidelines.
Background
The case involved a company, Finnish A Oy, that was the parent company of a group. Since 2011, the company had charged royalties, or a “concept fee”, to subsidiaries for using the company’s intellectual property rights in the subsidiaries’ service businesses.
The concept fee was broadly calculated as a profit-split of residual profit. The residual profit was calculated by deducting a routine operating profit, which had been determined as 4.5% based on a benchmarking study, from each subsidiary’s adjusted operating profit. The company did not charge any concept fee if the subsidiary’s adjusted operating profit was less than the routine operating profit, or if the concept fee charge would have been less than EUR 500,000 (approximately USD 578,000). Generally, the company was entitled to 80% and the subsidiary to 20% of the residual profit.
The company had been subject to a transfer pricing audit covering tax years 2010–2012. The audit report had concluded that the company had not charged sufficient royalties to some of the group’s subsidiaries for the use of the company’s intellectual property rights. As a result, the tax administration had adjusted the company’s taxation by increasing the taxable income.
In determining the amount of adjustment, the tax administration had determined a routine operating profit level for the subsidiaries by combining two benchmark studies. Based on the studies, the full range of the comparable companies’ operating profit was -0.2–13.5%, the interquartile range was 1.1–8.4% and the median was 3.7%. The tax administration had concluded that the arm’s length routine operating profit was 4.5%, a level that also the company had used in calculating the concept fee. Therefore, the tax administration had adjusted the company’s taxable income based on subsidiaries’ operating profit level of 4.5%.
The ruling
The company’s primary claim before the court was that the full range of the benchmark study should be accepted as the arm’s length range when evaluating the arm’s length compensation for use of intellectual property rights. Consequently, the company’s taxable income should be adjusted based on the subsidiaries’ operating profit level of 13.5%, i.e., the benchmark study’s highest point. Secondarily, the company claimed that the benchmark study’s interquartile range should be accepted as the arm’s length range and that the adjustment should be based on the subsidiaries’ operating profit level of 8.4%.
The court considered the number of the comparable companies, the dispersion of their operating profits, and the fact that the operating profits of five comparable companies had been below the 4.5% level used in the concept fee model. The court concluded that, in determining the subsidiaries’ arm’s length profit level, the full arm’s length range could be narrowed to the interquartile range in accordance with paragraph 3.57 of the OECD transfer pricing guidelines. That paragraph allows the use of statistical tools, such as interquartile ranges, when the number of observations is high and there are unidentifiable and/or unquantifiable comparability defects.
The court further concluded that the company’s taxable income should be adjusted only to the extent the subsidiaries’ operating profits had exceeded the upper quartile of the comparable companies, not to the extent they had exceeded the median. The court based this conclusion on paragraph 3.60 of the OECD transfer pricing guidelines, which states that no adjustments should be made when the controlled transaction is within the (in this case, narrowed) arm’s length range. This conclusion was supported by the significant variation of the company’s involvement in the subsidiaries’ businesses, a reason for multiple subsidiaries having had a higher operating profit level than the 4.5% routine operating profit applied in the concept fee model.
Conclusion
Generally, the ruling aligns the Finnish transfer pricing practice with the OECD transfer pricing guidelines. The ruling highlights that the arm’s length range may be narrowed through statistical tools and that no adjustment to taxable income should be made when the controlled transaction is already within the (narrowed) arm’s length range.
“the company was entitled to 80% and the subsidiary to 20% of the residual profit”
The potential role of this would be clearer if we knew what the consolidated profit margin was and how the transfer pricing policy translated into royalties as a percent of sales.