By Mario Ortega, Partner, and Rubén López, Associate, with J&A Garrigues, S.L.P. in Madrid
In its judgment of December 20, 2021, the Spanish National Court resolved an interesting case in connection with the selection and application of transfer pricing methods.
The disputed issue concerned the valuation of related-party transactions a group of companies located in Spain carried out, which were engaged in the manufacture and distribution of beer.
The prices set in these transactions were particularly relevant given their impact on the NOLs (Net Operating Losses) one of the entities of the group held.
The judgment confirms the criterion the Spanish tax authorities followed, which the Central Economic-Administrative Court of Spain had previously confirmed.
In essence, the Spanish tax authorities rejected the application of the comparable uncontrolled price (CUP) method, in favor of the transactional net margin method (TNMM), based on the absence of an internal comparable that could be considered compliant with the requirements set in the Spanish legislation (largely aligned with the OECD guidelines), as opposed to what the taxpayer argued in the transfer pricing documentation.
Background
The taxpayer, a corporate group based in and operating in Spain, was engaged in the manufacture and distribution of beer.
One of the group’s companies was responsible for distributing and marketing the products purchased from two of its related-party entities (the first one owning 100% shareholding on the manufacturers).
The Spanish tax authorities questioned the arm’s length valuation of this related-party operational sale of beer, determining the application of the TNMM instead of the CUP method, which the taxpayer selected.
This decision was based on the rejection of the internal comparable the taxpayer selected, based on the differences identified between the controlled and the uncontrolled transactions when reviewing the comparability factors in both cases.
In addition, the distributing and marketing company had significant NOLs pending to be offset during the audited years, a circumstance to which both the tax auditors and the tribunal paid particular attention in their assessment of the case.
Another key element for inspectors and judges was that the TNMM was the method used in the transfer pricing documentation corresponding to financial years before 2010 to prove arm’s length compliance in similar intragroup beer sale transactions. However, from 2010 onwards, when the transaction subject to scrutiny began to take place, the taxpayer used the CUP method.
Rejection of the internal CUP and selection of the TNMM
The Spanish tax authorities’ initial reasoning when auditing the case was that the prices set for the sales the subsidiaries made to the marketing and distributing company were below market value. That led to a higher result, which allowed the compensation of an excessive amount of NOLs by the holding company.
Following this rationale, and further to the tax audit team’s analysis, they chose the TNMM method to the detriment of the internal CUP method that the taxpayer had selected.
Such a decision relies on the outcome of the comparability analysis the auditors performed, which, as stated in paragraph 1.33 of the OECD guidelines, is at the heart of the application of the arm’s length principle, examining the comparability factors provided by chapter one of the guidelines and article 17.2 of the Spanish corporate income tax regulations.
According to their assessment, mismatches between the controlled and uncontrolled transactions were found that led them to conclude that the latter was not a valid internal comparable.
According to the Spanish National Court judgment, some of these mismatches in the comparability factors included different types of beer sold; different periods of time in which the transactions were carried out; different geographic markets where sales were made; and different market phases in which the operations took place.
Specifically, the court judgment pointed out two factors on which the tax authorities had previously applied special emphasis.
The first one related to the volume of operations, which was considered not comparable, because the uncontrolled sales represented only 8.54% and 2.6% of the total volume of the manufacturers’ operations during fiscal year 2010.
Regarding the second one, the tax authorities concluded—and the tribunal confirmed— that there were significant gaps in the prices applied and the margins obtained in the subsidiaries’ sales to independent third parties compared to those applied to their related entity.
Based on the above, the Spanish National Court upheld the position of the tax auditors and the administrative tribunal and declared the absence of valid internal comparables to apply the CUP method in the case. The decision also confirmed that the TNMM was the most appropriate method to determine an arm’s length range of values for the intragroup transaction.
Implications and conclusions
The court’s judgment has several implications as regards to transfer pricing matters.
In relation to the offsetting of NOLs, the impact of transfer pricing policies applied not only by multinational enterprises, but also within groups operating at a domestic level, is clear. The judgment reflects how a variation in the prices applied increases or reduces the degree of offsetting NOLs.
This issue is particularly relevant in countries like Spain, where the Spanish tax authorities can review transfer pricing policies, even with respect to prescribed years, for the sole purpose of assessing whether the amount of NOLs to be deducted in non-prescribed years are still correctly calculated.
Last but not least, this judgment’s crucial implication is that the comparability analysis is the key element when using internal comparables to prove arm’s length compliance.
One must carefully review the applicable comparability factors when trying to apply the CUP method. Controlled and uncontrolled transactions must be clearly identified and properly proven in all transfer pricing documentation.
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