By Patrick Donsimoni, Partner, La Boetie, Geneva
A decision of the French supreme tax court (the third and final degree of jurisdiction in France) dated October 4 (decision #443133) underlines the fact that a group’s transfer pricing policy must be in line with the structuring of its supply chain since the functional analysis is decisive for its determination.
The case involved taxpayer RKS, a French corporation controlled and wholly owned by the Swedish group SKF through a French holding company, SKF Holding France. Its activity consisted of the manufacturing of very large made-to-measure bearings for the civil and military industries. RKS was the subject of a tax audit for the financial years that ended in 2009 and 2010.
At the end of the tax audit, the French tax authorities challenged the prices at which RKS had invoiced its products to the distributors of the SKF group established outside of France.
As a result, the taxable results of RKS were reassessed and SKF Holding France, head of the integrated tax group to which RKS belongs in France, was subject to additional corporate tax contributions for the 2009 and 2010 financial years, in the amount of EUR 5,385,325 (about USD 6.2 million), penalties included.
In a judgment dated April 23, 2018, the administrative tax court (first degree of jurisdiction) pronounced the discharge of these taxes. However, on appeal from the French tax authorities, a French administrative tax court of appeal (second degree of jurisdiction) annulled the lower court decision in a judgment dated June 22, 2020. SKF Holding France appealed in cassation against the judgment of the court of appeal.
French tax law (i.e., article 57 of the French general tax code) allows the French tax authorities to reinstate in the taxable results of French corporations the profits they indirectly transfer to companies located outside of France of which they are de facto or de jure dependent.
In line with the OECD principles of transfer pricing for multinational enterprises and public administrations, such indirect transfers of profits may be organized, either by way of increase or decrease of purchase or sale prices or by any other means.
Tax authorities may, thus, reintegrate in the taxable results of taxpayers the advantage resulting from the fact that the prices invoiced by these companies to foreign companies which are related to them (or those which are invoiced to them by the latter) are lower (or higher) than those practiced between independent companies – that is to say, not at arm’s length.
In the absence of precise elements to make such adjustments, the taxable results may also be determined by comparison with those of similar companies normally operated – that is to say, at arm’s length.
That’s what the French tax authorities did in the case at stake when comparing the taxpayer’s relevant financial ratios (net profit margin on transactions) with those of eight similar businesses operating at arm’s length in related fields of activity.
It should be noted that this comparison process is of paramount importance as the burden of proof of the existence of an undue advantage lies with the tax authorities, and the latter are not justified in invoking the presumption of profit shifting without making such a comparison.
In doing so, the French tax authorities found that the taxpayer’s net margin ratio was -10.46% in 2009 and -21.87% in 2010 when it averaged 2.33% in 2009 and 2.62% in 2010 in the companies used for comparison. This, the authorities concluded, unquestionably established a presumption of transfer of profits for the transactions in question, up to the difference between the recorded amount of revenue and that which would have resulted from the application of the average net margin rate of the panel of comparable companies.
However, this principle is applicable EXCEPT when the advantage granted is justified by commercial reasons or when the taxpayer may justify that this advantage was balanced by, at least, equivalent counterparts.
In the particular case of RKS, the taxpayer argued that the discrepancy was justified by the risks it assumed and which affected its profitability.
It is the functional analysis of the supply chain – which was not carried out here by the tax authorities – that makes it possible to ascertain this fact. This is because it highlights the functions actually performed, the tangible and intangible assets owned and the risks incurred within his group by the audited taxpayer.
It is, indeed, necessary to determine whether the functional position of the taxpayer within the group gave it vocation to bear the specific risks which it invoked, namely the strategic risks linked to the choice to reorient its only activity (towards the wind energy sector) and to develop new products (wind turbines), the operational risks linked to the efficiency of production processes and the related commercial risks.
In this regard, simply noting that the taxpayer is not the main entrepreneur of the group (i.e., the so-called principal in a centralized business model) is not sufficient to consider that the latter is not intended to assume economic losses linked to the operations of its business activity.
Also, simply noting that during the same period the consolidated result of the SKF group, all activities combined, was between 6% and 14%, the purchases of raw materials of RKS had been stable and its sales had not suffered a decline in volume except for wind turbines, is not sufficient to consider that the negative margin of RKS may have indeed resulted from the realization of the risks that it was intended to assume.
RKS actually exercised a more important functional role than that of a simple production unit within his group, which gave it the vocation to assume risks affecting its operating profits.
Beyond that, one shall also remember that, in any case, for a company that is a member of a group to be able to effectively assume the economic risks that the group’s transfer pricing policy leads it to bear and for this policy to respect the arm’s length principle, this company must have effective control and mitigation functions over these risks, as well as the financial capacity to assume them.
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