Article published on Fiscalonline
Given its international dimension and the phenomena it seeks to address, transfer pricing has always been an evolving field. However, it has never undergone so many changes as in the post-BEPS era, under the effect of two forces that are normally complementary, but sometimes antinomic, namely the targeted work of the OECD on the international level, and case law on the domestic level. In this respect, the last few years have seen a marked activism on the part of the tax judge, who has been particularly productive on key issues such as the application of the arm's length principle in the sphere of financial transactions; the empirical apprehension of functional profiles; or the correlation between costs, risks and substance between the parties. A new milestone has now been reached in terms of the burden of proof, with the Issey Miyake Europe ruling handed down by the Paris Administrative Court of Appeal.
THE FACTS
Issey Miyake Europe, more than 99% owned during the period under review by the Japanese company Issey Miyake Inc, is the exclusive distributor of Issey Miyake brand products. In this capacity, it buys the products from the Japanese parent company, then resells them both as a wholesaler to professionals, and as a retailer through its luxury boutiques located in several European cities.
In order to assess the company's financial health in these two roles, the administration reconstituted segmented income statements, allocating certain operating expenses to these two sales channels in proportion to sales. It then compared the net margin generated by the company on these two activities with the median of two panels drawn from separate comparable research. In the administration's view, the difference measured between the median and the company's net margin from its retail business highlighted a presumption of abnormality in favor of the Japanese company, which the department attributed to the costs of maintaining the boutiques. In view of their prestigious location, the department considered that they offered a showcase for the reputation of the brand legally owned in Japan. As a result, the tax authorities rejected the company's tax losses for 5 of the 6 years under review.
THE PROCEDURE
The company put forward several arguments which, in its view, discredited the administration's approach, both from the point of view of the burden of proof incumbent on it, and of the factual elements supposed to explain the volatility of its results. In the first instance, however, the Paris Administrative Court had already rejected her request, a decision once again upheld by the Administrative Court of Appeal.
THE CONCEPT OF TRANSFER PRICING HAS BECOME OBSOLETE
The first lesson to be learned is that tax judges are now recognizing that "transfer pricing" is no longer the same thing as prices, or even transfers.
Indeed, "price" refers to direct remuneration for an individualized transaction. Transfer", on the other hand, suggests an economic transaction, leading to the transfer of value and ownership from one party to another. In this case, however, the tax authorities, following the judge's lead, reduced the company's losses on account of the expenses it had incurred, which in its view helped to increase the value of the brand held by the Japanese parent company. It is not, therefore, the price of the products purchased from the parent company that is at issue - and which, moreover, constitutes the sole intra-group transaction linking the two parties - but rather the financial equilibrium of the two parties and the distribution of profit between them, taking into account the combination of functions, risks and assets that they bear within the value chain.
Transfer prices therefore move away from economic "transactions", which presuppose a sale, to focus on economic "relationships", which are exempt from any transfer. This approach, which breaks with years of previous rulings, enshrines a dynamic that was in fact already apparent between the lines of the OECD's work and the proposals for rectification. It brings the matter a little closer to the praetorian theory of the abnormal act of management, which leads to a holistic analysis of a transaction, without having to qualify the presumed anomaly precisely. It is also interesting to note that, without changing the pricing policy between the companies, Issey Miyake Europe ended up making a profit in two of the years audited. However, this circumstance did not convince the Court, which considered that "the positive operating margins of the profitable years were largely insufficient to make up for the losses of the other years, at a time when the company was not in its start-up phase" (recital 5). It is therefore not so much the flow, but the overall situation that is now scrutinized under the provisions of Article 57 of the CGI.
This also means that situations where a French affiliated company makes low profits or recurring losses in a group environment will now be more easily rectified, even if the individual intra-group transactions appear to be properly remunerated, if these losses result from an unbalanced positioning in the value chain to the detriment of the French company.
CONFIRMATION OF THE NET MARGIN METHOD
Concurrently with the above, this decision also confirms the prevalence of the transactional net margin method over all other methods. In this case, the tax authorities compared the company's reconstituted net margin for its retail activity with that generated by a panel of comparables. However, the economic transaction between Issey Miyake Europe and its Japanese parent company is limited to the purchase of merchandise. The bulk of operating costs are therefore made up of expenses that do not correspond to a clearly designated economic transaction between these two parties.
The transactional net margin method has long been the administration's preferred method. This preference was easily explained by the greater flexibility it offered in the search for comparables, but also, let's face it, by the fact that by focusing on an aggregate close to the tax result, it potentially ensured greater certainty of tax recall. For a long time, the tax judge disagreed with this approach, considering that the analysis of a net margin diluted the intra-group transactions too much, thus requiring the tax authorities to demonstrate that the losses complained of were directly attributable to excessively high purchase prices, or lower sales, and not to excessive management of fixed costs, for example. However, recent rulings in this area had already signalled the beginning of this shift, which is now reflected in a new decision by the Paris Administrative Court of Appeal. For the Court, the responsibility lies with the taxpayer and its management of the adversarial process, stating that "it does not follow from the investigation that the taxpayer had sufficient information, internal to the group, on transfer pricing to enable it to adopt a transaction-based method" (recital 11).
We must now come to terms with the fact that transfer prices no longer remunerate a transaction, but a functional profile. The transactional net margin method should therefore at the very least be used for corroborative purposes as part of an economic analysis.
THE BEPS HAS NOT YET FULLY PERMEATED THE ADMINISTRATION'S APPROACH
It is interesting to note, however, that neither the tax authorities nor the tax judge approached the economic attribution of the trademark from the angle of the so-called "DEMPE" functions suggested by the OECD. On the contrary, both relied without further analysis on the legal ownership of the trademark by the Japanese company. However, in the case in point, the instruction does not refer to a trademark royalty invoiced to the French subsidiary. From an economic point of view, this is therefore not recognized as being distinctly concentrated in the hands of the Japanese parent, even though its high value is indisputably recognized. A defense might therefore now be to try to allocate a share of the economic ownership of the trademark to Issey Miyake Europe, in view of its exploitation and its contribution to its renown, which would correlatively justify its being able to bear a portion of the resulting costs.
This also shows that our praetorian law is not yet ready to fully embrace the very liberal concepts of Common Law, and particularly the preference for economic ownership over legal ownership of valuable intangible assets. In this case, the solution can be summed up simply by the fact that the French company has incurred costs on behalf of a third party, and is simplistically reminiscent of cases involving an act that is abnormal in nature.
A PAUPERIZATION OF ECONOMIC ANALYSIS?
In order to establish the advantage granted to the Japanese company, the tax authorities carried out a search for comparables, which identified 7 companies involved in clothing retailing. A reading of the decision shows, however, that these references were not engaged in the luxury sector. On the contrary, it would appear that these comparables may have been multi-brand, positioned in different ranges, or subject to lower sales volumes. These are all criteria which, if we adhere to the comparability factors suggested by the OECD, are differentiating factors affecting the comparability and, therefore, the reliability of these companies and the results they produce when studying their margins.
Nevertheless, the judge validates this panel, on the grounds that the transactional margin method of net margin is exempt from these fundamental differences. In this regard, the Court points out that "the transactional net margin method aims to compare, unlike price-based methods, which require similarity in the products sold, the results of controlled transactions with those of third-party companies performing comparable functions and assuming comparable risks" (recital 12). In so doing, the burden of proof, which should fall on the service provider, is shifted onto the taxpayer. We read that "Issey Miyake Europe, which does not, moreover, propose any adjustment relating to the impact of the specific charges it claims do not contribute to the valuation of the brand, argues that it was itself unable to identify independent French companies distributing luxury ready-to-wear clothing".
Here again, this decision breaks with earlier rulings, which for a long time discredited the adjustments made by the tax authorities when they were unable to identify relevant comparables. From now on, it will be sufficient for the tax authorities to rely on a net margin method and simply capture independent companies engaged in a broad typology of activity (distribution, manufacturing, service provision), without having to apply adjustments to perfect comparability.
THE CONSECRATION OF THE MEDIAN
Finally, this decision puts an end to a debate that the GE Healthcare case had left hanging, and which had apparently paved the way for the service to systematically rectify margins at the median of the interval. A reading of this earlier decision suggested, however, that this assumed tendency on the part of the administration stemmed from a misinterpretation of the 2018 ruling. Doubt is now no longer permitted, and it is up to the taxpayer to provide all the elements needed to assess the automatic inadmissibility of the median, in favor of a more appropriate point in the interval.
We read in this sense that Issey Miyake Europe "does not cite any specific circumstances justifying deviation from the median, whereas the administration itself has not noted any such circumstances with regard to the facts and characteristics specific to Issey Miyake Europe" (recital 13). Here again, it is regrettable that the burden of proof has been shifted onto the taxpayer, who might be expected to have less information on the state of the market, or on his competitors, enabling him to target a point in the interval that better reflects his situation.
IN BRIEF...
This decision clearly makes the taxpayer's efforts to defend against transfer pricing adjustments more rigid. It breaks with a long tradition of previous case law, and seems to be in line with the post-BEPS trend to strengthen the means available to tax authorities to analyze and rectify intra-group transactions. More specifically, this ruling highlights the following points:
- CAA Paris, 2nd ch. June 29, 2022, no. 20PA03807.
- TA Paris, Oct. 7, 2020, no. 1806236/1-3.
