By Erik Koponen, Transfer Pricing Specialist, Censio Tax, Stockholm
On February 28, the Swedish Administrative Court ruled against the Swedish Tax Agency, and in favor of the taxpayer, Pandox AB, in a case dealing with substance and capability to control risk.
The taxpayer’s main business is property management within the hotel industry where affiliated property management entities in various jurisdictions acquire existing operations.
The tax agency claimed that the affiliated property management entities were entitled to a risk-free return and that the residual result should be allocated to the Swedish headquarters.
The taxpayer was able to support that its affiliated property management entities had the capability to control the main business risks in line with the group’s business model.
The Administrative Court stated that existing transactions were priced at arm’s length and that the head office was not entitled to the residual results incurred by the affiliated property management entities.
The tax agency’s claims
The affiliated property management entities’ revenue consisted of lease payments stated as a percentage of revenue from local external hotel operators.
The tax agency argued that the headquarters had conducted all value-creating activities related to the core business, controlled and carried the financial risks, and actively managed the group’s business and operating agreements. This was also supported by the group’s external communications where the business model with active management of holdings was described.
The tax agency claimed that the property management entities were merely legal parties in local agreements without any real control of the relevant risks. The property management entities had no employees and the boards consisted of one or two persons, most of whom were part of management at the headquarters. An example of active management was the renegotiation of certain agreements with hotel operators, and the performance of financial analysis and evaluation of potential acquisitions and investments.
Because the headquarters controlled and managed major decisions and risks, the residual result should, according to the tax agency, be allocated from the property management entities to the headquarters in Sweden. As compensation for the financing service related to the acquisitions performed, the property management entities should instead be entitled to a risk-free return in line with their contributions to the value chain in accordance with paragraph 1.85 in the OECD transfer pricing guidelines. Paragraph 1.85 deals with the capability to make important business decisions.
Thus, instead of adjusting the pricing of the existing transactions, the tax agency adjusted the overall profitability of the property management entities. The risk-free return was calculated as property management entities’ capital invested in 10-year government bonds in the entities’ local currency.
This led to an upward adjustment of taxable income in Sweden of SEK 1.8 billion (approximately USD 190 million) and SEK 366 million (USD 39 million) in additional tax to be paid, plus approximately SEK 65 million
(USD 6.9 million) in tax surcharges and interest for fiscal years 2013 to 2017.
The taxpayer claims
The taxpayer, Pandox AB, argued that the acquired local hotel operations were mostly established businesses with existing revenue streams and that the headquarters had insignificant influence on the actual ongoing operations. The headquarters was remunerated for its services, such as strategic management, communication, back-office functions, treasury, and financing transactions at arm’s length.
The renegotiated agreements only concerned a limited portion of the total agreements and can as such not constitute active management. The headquarters’ main contributions consisted of analysing and finding potential acquisitions. After the acquisitions, the main functions for the group management were limited to passive investment activities.
The property management entities were legal entities with their own capacity to enter into agreements and the boards had the capability to make local business decisions and control risk. Therefore, paragraph 1.85 of the OECD guidelines should not be applicable in this case.
The taxpayer further claimed that the tax agency had not proved that any intragroup transactions were mispriced.
Given that the intragroup transactions were priced in accordance with the arm’s length principle, no adjustments should be made.
The court’s decision
The Administrative Court had to decide whether the residual result should be allocated from the property management entities to the headquarters in accordance with the example provided in paragraph 1.85 in the guidelines. The tax agency had the burden of proof to support that the taxpayer’s result should be adjusted.
The court stated that the taxpayer had provided strong support for the business model where the headquarters was not the main contributor in the value chain after the acquisition process. The tax agency had not sufficiently contested the business descriptions and industry practice the taxpayer provided. Therefore, the headquarters should be assessed as having a limited role in the management of the ongoing local hotel operations after the acquisitions. The property management entities had the capability to control local risks and the existing transactions were priced in accordance with the arm’s length principle.
Even if the headquarters had the capability to negotiate and manage local operations, it had not frequently used these capabilities. The long-term contracts with established local businesses and existing revenue streams further supported that the headquarters should be considered as a passive investor.
The court, therefore, rejected the tax agency’s claims for any tax adjustments for the years under review.
Comments
The Administrative Court concluded that entities without employees can in certain situations be entitled to the residual result, provided that other intragroup transactions are priced at arm’s length, in line with the operational structure and industry practice. The tax agency was not able to fulfill its burden of proof and support the claims that the headquarters possessed the capability and had sufficiently exercised this capability, to control the main business decisions and risks locally.
The tax agency will most likely appeal the decision to the Swedish Administrative Court of Appeal.
-
Erik Koponen is a transfer pricing specialist at Censio Tax in Stockholm.
Erik Koponen
Latest posts by Erik Koponen (see all)
- Swedish Administrative Court rules in favor of the taxpayer in transfer pricing case about control and substance - March 24, 2022
- Swedish court denies telecom giant’s tax deduction for exchange losses - January 20, 2021
- Sweden’s tax agency rejects Puma’s transfer pricing position, concludes risk borne elsewhere - February 11, 2020
- Absolut wins Swedish transfer pricing dispute over application of benchmarking study and multiple year analysis - July 7, 2019
Thanks for the discussion. I’m putting together a critique of the tax authority’s position which focuses on this claim “As compensation for the financing service related to the acquisitions performed, the property management entities should instead be entitled to a risk-free return in line with their contributions to the value chain in accordance with paragraph 1.85 in the OECD transfer pricing guidelines.” The 3rd party lease payments would given the affiliates not only the risk-free return but also a 2% premium for bearing ownership risk (OECD language for the insights of Miller-Upton). When this tax authority error is corrected, there is no residual profits. More may appear soon over at EdgarStat blog.