Transfer pricing, deemed services – ruling in favour of taxpayer

Background

A Danish member of an international group carried on distribution activities for the group and had sustained losses over several years. In the view of the Danish tax authorities (DTA), an independent enterprise in a comparable situation would not have been prepared to tolerate such losses.

As the basis for its transfer pricing adjustment, the DTA argued that the Danish group member, at arm's length, should be remunerated for its contribution to the group strategy on local presence, specifically the maintaining of a distribution network and customer base in Denmark. The DTA deemed the ultimate parent as the recipient of these services and determined the remuneration in accordance with the transactional net margin method (TNMM), i.e. a profitability test. 

The income adjustment was made on a discretionary basis since the DTA found that the transfer pricing documentation prepared by the taxpayer did not satisfy the statutory documentation requirements, in which case Danish statute allows for discretionary assessments.

The Tax Tribunal's ruling

The Danish Tax Tribunal held that the DTA was justified in making a discretionary adjustment given that the transfer pricing documentation did not meet the statutory standard under Danish law.

Contrary to the view of the DTA, however, the Tribunal found that the DTA's adjustment qualified as non-recognition of the actual transactions under the OECD Transfer Pricing Guidelines (2010). Accordingly, the Tribunal noted that, pursuant to paragraph 1.64 of the Guidelines, the adjustment would be allowed only in exceptional cases. Reference was further made to paragraph 1.65 of the Guidelines, which outlines the two circumstances in which non-recognition may, exceptionally, be allowed. 

The Tribunal noted that a discretionary transfer pricing adjustment, as authorised by Danish statute if the taxpayer fails to prepare sufficient transfer pricing documentation, must adhere to the principles of the OECD Transfer Pricing Guidelines. 

In the Tribunal's view, the conditions for non-recognition in the Transfer Pricing Guidelines were not satisfied in the specific circumstances, and the adjustment for "deemed services" was therefore disqualified.

Recognition or non-recognition

This recent ruling could have great impact on Danish transfer pricing audits and disputes. Indeed, the DTA has in many previous and pending cases challenged loss-making companies' transfer prices and made income adjustments under a TNMM profitability approach. It is well known that the combination of losses and intra-group transactions is likely to result in a transfer pricing audit – and a challenge. Also, non-recognition or recharacterization of the actual transactions have been themes in many of these cases.

In the case before the Tribunal, the DTA was successful in arguing that the taxpayer's transfer pricing documentation was flawed to an extent allowing the DTA to make a discretionary income adjustment. This position is customarily adopted by the DTA in Danish transfer pricing cases.

However, the more interesting part of the ruling is the Tribunal's thorough review of the threshold for non-recognition under the OECD Transfer Pricing Guidelines. The DTA argued that the adjustment for deemed services did not fall within the scope of the guidance on non-recognition as no recharacterization was made. The Tribunal gave no consideration to this argument.

In our view, and as confirmed by the Tribunal, the DTA's adjustment in the case falls within the scope of non-recognition pursuant to paragraph 1.64 of the Guidelines (2010), given that the DTA clearly did not base the adjustment on transactions actually undertaken. A distinction, as attempted by the DTA, between deemed – "invented" – transactions or services provision never actually undertaken on the one hand and recharacterization of the taxpayer's actual transactions on the other hand holds no merit. 

Obviously, the line between non-recognition and the adjustment of income attributable to the parties' actual transactions can be blurred. Service fee adjustments in situations where, for example, a group member has provided a distinct and identifiable service of value to another - identifiable - group member which would clearly be chargeable at arm's length, would in our view not qualify as non-recognition under the OECD Transfer Pricing Guidelines, irrespective of whether the parties actually treated this arrangement as an intra-group services arrangement. This was not the case in the matter before the Tax Tribunal, however, and it has indeed not been the case in many other disputes.

A significant defeat for the DTA

The recent Tax Tribunal ruling represents a significant defeat for the DTA. The ruling makes it clear that the DTA must respect the restrictions applicable to non-recognition in the OECD Transfer Pricing Guidelines, even if the DTA is authorised to make discretionary adjustments due to documentation shortcomings.

In many previous cases, the DTA has not restricted transfer pricing adjustments to taxpayers' actual intra-group transactions and have more or less routinely dismissed the view that any kind of recharacterization of the actual transactions would be subject to restrictions. The ruling of the Tribunal, however, makes it clear that the DTA is not free to recharacterize actual transactions or invent deemed transactions based on vague arm's length considerations.

The ruling can further be seen as a victory for the transactional approach embedded in the arm's length principle. Arguably, this approach has been somewhat eroded through the DTA's widespread use of TNMM profitability testing instead of, where possible, arm's length transactional testing, in particular in relation to loss-making companies.

The case was decided under the 2010 OECD Transfer Pricing Guidelines, and rightly so. Arguably, under the 2017 Guidelines (BEPS), recharacterization based on the substance of taxpayers' intra-group transactions is allowed under the initial test of accurate delineation, while such recharacterization under the 2010 (and 1995) Transfer Pricing Guidelines falls within the scope of non-recognition and so is restricted to exceptional cases.