November 15, 2024 - Cara Avocats

THE FACTS

Following an audit of GEII Rivoli Holding's accounts for the 2013 and 2014 financial years, the tax authorities questioned the deductibility of the difference between the 5.08% rate applied and the 2.79% corresponding to the value mentioned in 3° of 1 of Article 39 of the CGI.
During the litigation phase, the company produced an initial analysis based on the RiskCalc tool developed by Moody's, identifying the risk rating that could have been assigned to it, as well as a rate range established by reference to those obtained by fifteen non-financial companies, belonging to heterogeneous business sectors.
A second corroborative analysis was submitted to the Paris CAA, based on the calculation of two financial ratios, one of which, known as the "loan-to-value" (LTV) ratio, was based on bond market data taken from the Standard & Poor's Capital IQ financial database.

THE RULE

A trend in case law built up around the 2020s has redrawn the contours of proof with regard to the deductibility of rates charged to majority shareholders.
Specifically, the borrowing company may rely on the rates of bank loans granted, under arm's length conditions, to companies in the same non-financial sector, which have obtained credit ratings close to that which can be determined for it, even though these other companies may belong to heterogeneous business sectors.
The borrowing company may also take into account the yield on bonds issued by companies in comparable economic conditions, where such bonds represent a realistic alternative to an intra-group loan.

THE JUDGES

The TAA de Paris in 2021, then the CAA de Paris in 2022, rejected the company's claims and confirmed the rectifications made.
Firstly, the judges noted that, in order to justify the 5.08% rate applied to its parent company, GEII Rivoli Holding had produced a report using the RiskCalc tool developed by Moody's, which identified the risk rating that could have been awarded to the company, i.e. Baa1. However, this risk rating had been obtained without entering the applicant's business sector in the RiskCalc tool. Thus, the CAA was able to dismiss this method as inconclusive on this ground, without committing an error of law, since such a circumstance meant that the company's particular economic situation was not taken into account.
Secondly, in rejecting the corroborative method proposed by the company, the CAA considered that the company did not justify that a bond issue would have constituted a realistic alternative to an intra-group loan.
Finally, the CAA considered that the company had not been provided with any precisely identified comparables whose relevance it would have been able to assess.

THE CONSEIL D'ÉTAT'S SOLUTION

The EC accepted the first argument of the lower courts, rightly considering that the company's sector of activity is an important parameter to be taken into account when calculating the credit rating on the RiskCalc tool.
However, it rejected the rest of the arguments, thus validating the company's economic and statistical demonstration. More specifically, the EC emphasized:
- "The size of a company is not in itself such as to hinder access to this market, and that the realistic nature, for a company having recourse to an intra-group loan, of the alternative hypothesis of a bond issue can only be assessed in the light of the specific characteristics of this company and of the transaction, the rates observed on this market having to be adjusted if necessary".
- The arm's length rate put forward by the company as corresponding to its level of risk was based on the use of rate curves established on the basis of all the transactions recorded, for loans of the same duration contracted by companies with the same risk profile, and it was not argued that the recording of transactions in this database was unreliable".

OUR ANALYSIS

THE RISKCALC TOOL IS USEFUL, BUT NOT ALL-POWERFUL

Developed by Moody's, the RiskCalc tool has gained legitimacy among tax judges since the Studialis ruling by the Paris CAA in 2020 (no. 18PA01026).
This tool can be used to determine a borrower's risk rating, which is the first essential step in demonstrating the arm's length nature of a rate charged to majority shareholders. However, this tool requires a detailed analysis of the borrower's intrinsic parameters, both quantitative and qualitative, including in particular its business sector.
This latter indicator has a major influence on the past and future prospects for growth, profitability and therefore risk, of the players making up a given market. If this essential criterion was not included, the analysis produced initially could not be relevant or complete, as it necessarily misunderstood the company's economic situation.
It is interesting to note, however, that neither the contemporaneity of the analysis nor the relevance of the tools cited were discussed, thus validating, and no doubt definitively, the praetorian trend initiated by the aforementioned Studialis, BSA de la CAA de Versailles (n°20VE03249), and Willink du Conseil d'Etat (n° 446669) rulings.
Above all, it should be noted that the demonstration that finally won over the Conseil d'Etat was based on an alternative financial ratio known as "loan to value" (LTV), which relates the level of indebtedness to the value of the company's real estate assets. In this case, this indicator led to an estimate, based on a comparison with the ratios of listed French and European property companies, that the financial rating it could have obtained would not have exceeded BBB, i.e. a level close to that initially proposed by RiskCalc.
In this case, the LTV ratio had been calculated taking into account a financial debt corresponding exclusively to the loan whose rate had to be assessed. One might have thought that the calculation was flawed because it was circular. However, by focusing on the principal loan (the purpose and amount of which were not in dispute), without taking into account the interest (the rate of which was at the heart of the debates), the ratio was indeed relevant and valid.

THE CONSECRATION OF THE BOND MARKET

In its July 2019 Wheelabrator opinion, the Conseil d'etat paved the way for a pragmatic approach, in line with OECD practice, to the taxpayer's demonstration of the "arm's length" nature of an interest rate charged in the context of intra-group financing, allowing in particular the use of bond benchmarks.
However, this opinion, as well as subsequent rulings, seemed to contain a reservation, by making reference to the bond market conditional on demonstration that "these loans constitute, in the hypothesis under consideration, a realistic alternative to an intra-group loan". In other words, the taxpayer appeared to have to prove that issuing bonds was a realistic alternative to taking out a conventional loan with a bank or credit institution.
In recital 10, however, the CE seems to reinforce the burden of proof on the tax authorities. The judge considers that "the realistic nature, for a company having recourse to an intra-group loan, of the alternative hypothesis of a bond issue can only be assessed in the light of the specific characteristics of the company and the transaction, with the rates observed on this market having to be adjusted, where necessary, to take account of the specific features of the company in question". In order to disregard the reference to the bond market, it would seem that the tax authorities would have to demonstrate that, given its specific and intrinsic parameters, this option would have no purpose, or would be inappropriate.
In our view, such proof is impossible.

BENCHMARKS FOR ALL?

While the two-step economic analysis now seems to be well recognized by the tax judge, both in its credit risk calculation component and in its search for comparables on bond markets, it should be remembered that this approach is only valid if the lender is a majority shareholder within the meaning of Article 212-I. Minority shareholders cannot use this analysis to justify a different rate from that referred to in article 39-1-3 of the CGI (see CAA Versailles, Sté Financière Lilas, n°19VE00546). This trend further reinforces the difference in treatment between taxpayers.

Facts, Procedures, and the Decision

STATEMENT OF FACTS

SAS Itron France ("Taxpayer") (a manufacturer and distributor of water, electricity and gas meters) was the subject of a tax audit for the financial years 2012 and 2013, which resulted in an assessment. The tax authorities ("TA") considered that the transfer pricing applied by the group had resulted in an understatement of taxable income in France and a transfer of profits to a Hong Kong-based distributor of the group. An appeal was filed by SAS Itron France and in a ruling handed down on December 2, 2021, the Administrative Court annulled the assessment. The TA filed an appeal against this ruling. The Administrative Court of Appeal dismissed the appeal and decided in favor of SAS Itron France. The TA concluded that the Taxpayer had granted an unfair advantage to its related party distributor within the meaning of Article 57 of the French Tax procedure Code.

ARGUMENTS OF THE TAX ADMINISTRATION

The Taxpayer is a manufacturer as well as a distributor of water, electricity, and gas, therefore it is in a situation of mutual dependence with its Group entities. The TA tested the Taxpayer's relations as a producer with group distributors and followed a "profit-sharing" method. It further functionally analyzed the Taxpayer and then attributed the following distribution margin between the manufacturer and the distributors:
(i) 53% and 47% for "gas" product line respectively;
and
(ii) 51% and 49% for water and electricity respectively.
The TA stated that the Taxpayer's profit as a manufacturer was insufficient in relation to the overall margins determined by the TA (i.e., 53% and 51%).

THE DECISION

The Court rejected the adjustment sought by the TA in terms of the group's transfer pricing policy as such adjustment can only be warranted in the event of a significant differences between the transfer price resulting from this method and the economic reality, such adjustments are provided for only in exceptional circumstances and under a procedure that derogates from the "cost-plus" method. The Court observed that the TA failed to demonstrate whether any special circumstances arose during the period of assessment (FY2012 and FY2013) which could justify the adjustment. The Court ultimately stated that the TA had failed to interpret tax law as they could not establish any consistency to their allegations. The case was therefore dismissed in the final appeal.

CARA ANALYSIS

BREAK DOWN OF THE DECISION

On one hand, the Court gave consideration to the Taxpayer's claim that in order to reconstitute the transfer prices between SAS Itron France as a manufacturer and its related party distributors, the TA used the margin of the distributing entities after deducting the sale price of SAS Itron France's products, without taking into account the distributor's own operating expenses (such as cost of discounting ; commissions paid to agents; rebates and discounts; product shipping costs; insurance costs incurred in transporting products; customs duties; product packaging costs), even though these expenses contribute to the distributors' share of the Group's net margin to which they should be entitled.
On the other hand, the TA deducted their direct expenses from the margin of the manufacturing entities, including SAS Itron France, to which the gross margin rates mentioned in the previous point apply under the cost-plus method.
Without calling into question the parameters used by SAS Itron France to determine its transfer prices as a producer (costs used and margin rates mentioned) determined within an arm's length interval), the TA had carried out a comparison of heterogeneous margins, gross for the distributing entities and net for the producing entities. Moreover, for an adjustment to be applied, three conditions must be met:

existence of new markets or invitations to tender;
existence of a turnover exceeding 10% of the distributor's revenue;
existence of a variation in the distributor's turnover of at least 500,000
euros.

The Court observed that the TA failed to demonstrate the existence of the above elements.

THE CONCLUSION

At CARA we always stress on the importance of really understanding the functions and risks undertaken by the parties to a given controlled transaction, as it is extremely crucial not only in determining the range but also in applying the correct methods and profit level indicators (PLIs) to derive the range. This decision of the Court is a case in point for the same.
Different methods and PLIs test different functions of the tested party, especially when the tested party has dual profiles. Therefore, one must be sure to test the correct profile (for e.g., distributor or manufacturer) and the risks associated with that profile, as demonstrated by this case law.
Moreover, experience has shown us that the application of most methods will be imperfect, even, for example, by applying the CUP method which bases itself on very precise internal and/or external comparables. The reason for the same is that
(i) comparable data available for testing such method may certainly not take into account the various risks undertaken by the parties; or
(ii) it may not reflect the economic reality at a given period of time.

However, we may conclude that clear and cogent functional and risk characterization is key in determining a relevant interquartile range, and is therefore, THE antidote to tax assessments.

Day: November 15, 2024

Deductibility of intra-group interest : The proof is clearer and more flexible!