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Comparables and transfer pricing: when the authorities fight the wrong battle

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THE FACTS

SAS Weg France trades in industrial electric motors and electrical equipment.
Following a tax audit of the 2011 and 2012 financial years, the tax authorities noted that the company paid its suppliers, who were members of the group, within a maximum of 30 days of shipment of the goods, whereas delivery times averaged two months. At the same time, its customers paid within 45 to 90 days of invoicing. In practice, therefore, this mechanism led SAS Weg France to bear a high cash flow risk, resulting in recourse to borrowing from its parent company in Spain and from various banking establishments in order to honor its debts to related suppliers.

ADMINISTRATIVE CONTROL

In view of the financial charges it incurred, the French tax authorities took the view that SAS Weg France was providing a service to Group companies by granting cash facilities that it did not invoice. Consequently, this failure to bill for the service rendered constituted a transfer of profit within the meaning of article 57 of the CGI. It then compared the company's adjusted net margin with the median of a range derived from a search for comparables.
In addition, the tax authorities pointed out that, despite a formal notice sent to the company, it had failed to produce the transfer pricing documentation referred to in article L 13 AA of the LPF, even though it fell within its scope. Naturally, the tax authorities then applied the penalties provided for in article 1735 ter of the CGI, which in this case amounted to 81,733 euros.

DECISION BY THE TA OF GRENOBLE

In judgment no. 1902236 of September 16, 2021, the Grenoble Administrative Court rejected SAS Weg France's claims, adopting the now classic approach to transfer pricing by comparing the company's net margin with the median of a panel of database comparables.

DECISION OF THE CAA DE LYON

The Court overturned the Grenoble Administrative Court's ruling and reinstated the company's losses, on the grounds that of the panel of comparables produced by the tax authorities, only five could be considered functionally comparable. However, these companies showed net margins consistent with SAS Weg France's margin adjusted for financial charges over the period under review. In so doing, the Lyon CAA ruled that the tax authorities had failed to demonstrate an indirect transfer of profits under Article 57 of the General Tax Code. It therefore follows that, in the absence of income deemed to have been distributed, the tax authorities cannot uphold the ancillary reassessments in respect of withholding tax and the 10% penalty for late declaration.

OUR ANALYSIS

A FINE EFFORT DENIED BY THE COURT

First of all, the orthodoxy with which the administration has apparently attempted to extract comparable references is to be commended. Practitioners are well aware of the difficulty of this exercise and, above all, of the subjectivity to which it often leads.
In this case, the authorities have probably used the Diane® database, which lists only French companies. This makes it possible to capture references subject to economic conditions close to or similar to those of the party being tested, which is an essential comparability criterion according to the OECD, as well as having been highlighted by a landmark Man Camions et Bus ruling (CAA Versailles, May 5, 2009 n° 08VE02411). Going even further, the French tax authorities had applied a sales filter, as well as a ratio of sales of goods to sales, precisely to capture companies primarily engaged in distribution activities.
However, the CAA rejected certain references. We understand that retail distributors were excluded, since SAS Weg France acts as a wholesaler. This difference has already been considered material enough to pollute the economic analysis by previous rulings (e.g. CE,March 16, 2016, n° 372372 Amycel). Similarly, the rejection of companies distributing their goods to individuals, where SAS Weg France operates in a B-2-B environment, seems logical, given that the difference in clientele leads to differences in functions and risks that blur comparability.
However, we may be surprised at the zeal with which the CAA analyzed the ruling, given that we know that the method used (net margin method) and the use of an interval make it possible to smooth out certain functional differences. In this respect, the ruling is unique and suggests a more orthodox approach to the search for comparables.

THE WRONG FIGHT

It seems to us that, in trying to do the right thing, the tax authorities engaged in a demonstration that ultimately backfired. It seems to us that the administration had correctly identified the presumption of abnormality linked to the financial charges borne by the company in respect of the loan it took out with the group, to finance the cash flow conditions linked to the time lag between the payment of suppliers (members of the group) and the payment of its customers. Insofar as the very purpose of this loan was to finance intra-group flows of goods, the tax authorities considered that the resulting expenses were operating expenses. This approach is also taken in other situations, such as when the taxpayer incurs high interest charges because of the interest it pays to suppliers within the same group. It therefore adjusted the company's net (operating) margin, and in so doing, necessarily placed itself on the ground of "comparative advantage", seeking to quantify the abnormality by using a panel of comparables. This approach is notoriously complex, and case law abounds, opening the door to easy criticism of the degree of comparability of the references used. In fact, there has been no shortage of such criticism.
On the contrary, it seems to us that the administration would have been more successful if it had focused on two areas. Firstly, it would have been easier to question the very purpose of the loan, and therefore the deductibility of the resulting charges. Secondly, it could have used Article 212-I of the General Tax Code, already applicable to the years in question, to attack the interest rate applied. Finally, it should be noted that the tax authorities considered that SAS Weg France was providing a service to Group companies by granting cash facilities that it did not charge for. We were therefore dealing with a non-remunerated service, and therefore with a liberality constituting a "benefit in kind", which is therefore exempt from any search for comparables. The tax authorities could easily have claimed remuneration for this service, without the tax judge disallowing it.

EXPENSIVE DOCUMENTATION

Finally, we note that despite a formal notice, the company failed to produce transfer pricing documentation, even though it fell within the scope of Article L 13 AA. As a result, it incurred penalties of over €81,733, which are obviously non-deductible. Surprisingly, the company did not take advantage of the 30-day formal notice period to prepare such a document, given that such formal notices are often issued several weeks after the start of the audit. This serves as a reminder of the importance of such documentation, especially in view of the penalties that may be claimed.

Do zero-interest cash-flow agreements constitute an abnormal act of management?

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STARTING SITUATION

SAP France is indirectly owned by the German company SAP AG. Under a contract signed in 2009, SAP France entered into a centralized cash management agreement with its parent company, under which it deposited its cash surpluses with the German company, which were remunerated on the basis of an interest rate equal to the EONIA interbank reference rate less 0.15 points. In 2012 and 2013, the application of this formula resulted in a negative interest rate, due to changes in the EONIA, and the parties to the cash management agreement agreed to set this rate at 0%.

ADMINISTRATIVE CONTROL

Following an audit of SAP France's accounts for the 2012 and 2013 financial years, the tax authorities questioned the normal nature of this nil remuneration, considering that the absence of interest on this cash flow agreement constituted a benefit in its own right. It therefore corrected the company's taxable income, and considered this benefit as income deemed distributed to the German company, subject to withholding tax.

DECISION OF THE CAA DE VERSAILLES

In ruling that SAP France had granted SAP AG a liberality by waiving the right to remuneration in return for depositing its cash surpluses with the latter, the Administrative Court of Appeal based its decision on the fact that this zero remuneration was unrelated to that to which the company would have been entitled if it had deposited its cash surpluses with a financial institution over the same period, without this absence of remuneration being offset by the possibility of financing cash requirements, which were non-existent for the years in question.

DECISION BY THE CONSEIL D'ÉTAT

The Conseil d'Etat annulled the CAA's decision and referred the parties back to the CAA. According to the tax judge, the CAA erred in law when it ruled of its own motion that the application of a zero rate constituted a liberality, on the sole grounds that it was lower than what a financial institution could have granted to SAP France. In the CE's view, the Court should have examined whether the modification by the parties of the initial terms of the contract, which led to the application of a negative rate, and the substitution of a rate which was then zero (and therefore more advantageous for SAP France), still represented an abnormal act of management for the company.

OUR ANALYSIS

IS A NEGATIVE RATE POSSIBLE UNDER A TREASURY AGREEMENT?

The case concerns the replacement of the contractual rate, which in view of market trends led to the application of a negative rate, by a 0% rate. Applying a negative rate would have led SAP France, which was in a credit position, to pay interest on the investment of its funds. The mechanics may seem abstruse, even though they reflect a market situation. In our view, the question of the applicability of negative interest rates to cash management agreements poses two major problems: (i) firstly, cash management agreements are specific to corporate groups, so there is no external comparable reflecting market conditions (at arm's length); (ii) secondly, the subject also brings into conflict two opposing visions: fiscal on the one hand, and economic on the other. Indeed, there is an economic current that recognizes the possibility of the financial market applying negative interbank rates. Earlier decisions also suggested that, in the absence of a specific clause implementing a floor rate, it could not exist implicitly (see e.g. TGI Strasbourg, January 5, 2016; CA Colmar, March 8, 2017). However, we believe that a holistic legal approach should lead us to consider that negative rates do not reflect normal management. Firstly, loans governed by the Monetary and Financial Code imply that the lender is acting for consideration (art. L 313-1 Code mon. et fin.). The lending activity must generate an economic benefit. Moreover, the commercial status of the companies involved in the transaction theoretically requires them to pursue a profit-making objective. We therefore believe that, irrespective of the state of the market, the application of a negative interest rate constitutes an abnormal act of management, unless the parties renegotiate the terms of their agreement.

WHICH REFERENCES TO USE?

It is interesting to note that to assess the deemed arm's length rate, the CAA had validated the reference used by the department to the average rate of remuneration on sight deposits calculated by the Banque de France. No reference was made to the rate referred to in article 39-1-3 of the CGI, which is the rate to which the application of article 212-I of the same code leads. In our view, the reason for this is that the rectifications were made under the sole authority of article 57 of the CGI, and not 212-I. Nonetheless, in our view, this ruling allows us to derogate from the systematic application of the Article 39-1-3 rate, insofar as a cash flow agreement is, by its very nature, necessarily liquid and short-term. Nevertheless, we believe that a more appropriate benchmark would be the yield on money-market mutual funds (Sicav monétaires) or units in money-market mutual funds (fonds communs de placement monétaires), which are used to invest cash surpluses or highly liquid capital.

PAY ATTENTION TO OPERATION QUALIFICATION!

The ruling concerns a treasury agreement, which remains a special financing tool, specific to groups of companies, and theoretically liquid and available. However, groups must ensure that the repetition of flows over time, and in a single direction, does not lead to the reclassification of all transactions as longer-term loans with successive drawdowns. Such reclassification would necessarily lead to the application of a different rate, as this would be correlated to the specific factors of the transaction (duration, currency, borrower's credit rating, etc.), all parameters which have been largely defined by recent case law (see for example CE, 29/12/21, 441357, Apex Tool).

Reversing the burden of proof in financial matters: is the pendulum swinging back?

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STARTING SITUATION

SAS Willink issued two ten-year bonds convertible into shares at an interest rate of 8% per annum, subscribed by two French venture capital funds and a UK company.

ADMINISTRATIVE CONTROL

The tax authorities questioned the deductibility of the financial charges incurred by this transaction, insofar as the fraction of interest paid to the funds and the British company exceeded the rate stipulated in article 39-I-3° of the CGI. In addition, the tax authorities considered that the interest due on the differential constituted a gift to the British company.
To justify its position, the company subsequently produced a rate study using Riskcalc software. This study is based on a model calculating the probability of default in the short and long term, and then associates implicit scoring. A search for comparable transactions on the open market was then carried out using the SetP Capital IQ database.

DECISION OF THE CAA DE PARIS

In rejecting the company's argument, the CAA dismissed the results obtained from the Riskcalc scoring tool, finding that it was a statistical model based on historical quantitative data from companies that were not representative of the market, since defaulting companies were over-represented; that it only took into account a dozen or so financial data items supplied by the company itself; and that there was no evidence that the risk rating obtained using this tool would adequately take into account all factors recognized as predictive, and in particular the specific characteristics of the business sector concerned.

DECISION BY THE CONSEIL D'ÉTAT

The Conseil d'Etat considered that the Court, which had followed the tax authorities, had erred in law by rejecting the probative value of the Riskcalc tool used, and by giving preference to the rating agencies. In rejecting the probative value of the risk estimate obtained from the Riskcalc scoring tool, without investigating whether elements relating to the use of this tool in the case in question or derived from other elements of comparison led to calling it into question, the Court vitiated its ruling with an error of law.

OUR ANALYSIS

IMPOSSIBLE PROOF" PUT TO THE TEST BY CASE LAW

Article 212-I, which leads to the application of the reference rate referred to in article 39-1-3 of the CGI, has already undergone a clear shift under the impetus of the tax judge. For the record, when a loan is granted by an affiliated company, interest is deductible up to the limit of that calculated on the basis of a rate defined in article 39-1-3° of the CGI. However, the borrowing company benefits from a mechanism of proof to the contrary: it may deduct interest calculated on the basis of a higher rate if it demonstrates that the latter corresponds to the rate it could have obtained from independent financial institutions or organizations under similar conditions (article 212-I-a of the CGI). The administration's strict reading of the texts had led to a mechanism of "impossible proof" according to practitioners. However, the tax judge has tempered the rigidity induced by administrative practice by validating the fact that (i) alternative searches for comparables may not be contemporaneous with the financial transactions (e.g.: TA Paris, June 7, 2018, Paul Ka); the credit rating systems employed are deemed to sufficiently reflect the intrinsic elements of the economic markets concerned (e.g.: CE, Dec. 29, 2021, Apex Tool); or (iii) the rate may be determined by reference to the bond market (CE opinion, Jul. 10, 2019, SAS Wheelabrator Group).

HOW IS CREDIT RATING DEFINED?

Determining the borrower's credit rating is the first step in the analysis, insofar as this indicator reveals the company's overall solvency. On this point, the Conseil d'Etat formally acknowledges that ratings obtained using "RiskCalc" type tools are admittedly more approximate than a credit rating that might be carried out by a rating agency. However, it pragmatically admits that "the use of such a rating is not necessarily appropriate, given its cost, in an intra-group transaction". On the other hand, contrary to what the Paris CAA ruled, this tool does take into account the company's sector of activity, which must be entered by the user. In fact, the resulting ratings are based on data taken from the company's accounts, without the latter being able to modify the parameters used by the application. In this case, the Minister did not dispute the overall robustness of the application. The reference to such a tool can therefore be considered sufficiently reliable to justify a company's risk profile. Taxpayers therefore have two ways of establishing their credit rating: using a specialized computer tool (e.g. RiskCalc), or referring directly to a rating agency. It should be noted that the use of the RiskCalc tool has already been validated in the Studialis ruling (CAA Paris, Oct. 22, 2020).

REBALANCING THE BURDEN OF PROOF

The burden of proof under article 212-1 of the CGI does indeed shift to the taxpayer. However, the tax judge has gradually repositioned the administration in the system of proof, making it responsible for demonstrating the inaccuracy of the taxpayer's analysis. In so doing, the Conseil d'Etat laid the foundations for a 3-step waltz:

If the rate referred to in article 39-1-3 is not applied, the taxpayer bears the full burden of proof.

The latter can nevertheless carry out alternative economic analyses using specialized statistical and digital tools.

These alternative analyses are deemed reliable, unless the administration can demonstrate that the approach is flawed. For example, the tax authorities may provide detailed criticism of the use made of the RiskCalc tool in the case in point, or evidence that the resulting valuation was flawed in the particular case. It can also demonstrate that reference to the bond market does not constitute a viable reference when such loans constitute, in each case under consideration, an unrealistic alternative to a traditional intra-group loan.

Should the CIR be neutralized for intra-group invoicing?

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STARTING SITUATION

STMicroelectronics carries out R&D in the field of
semiconductor technologies, for which it receives a research tax credit. It has signed a framework agreement with its parent company, STMicroelectronics NV, under which STMicroelectronics carries out R&D operations on behalf of STMicroelectronics NV. STMicroelectronics NV defines the research program and owns the resulting intellectual property rights. STMicroelectronics NV pays STMicroelectronics NV a fee calculated by applying a mark-up of 7% to the costs of R&D operations incurred by STMicroelectronics NV (Net Cost Plus), less the amount of research tax credits and public subsidies linked to research operations received by STMicroelectronics NV.

ADMINISTRATIVE CONTROL

Following an audit of STMicroelectronics' accounts for the years ended 2012 and 2013, the French tax authorities considered that the deduction of research tax credits and public subsidies from the basis of costs re-invoiced by the company led to an indirect transfer of profits abroad, within the meaning of Article 57 of the French General Tax Code. It increased the income recorded by the company by the amount of the subsidies and the research tax credit added back to the cost price used to determine the sale price, and notified the company of the increases in its corporate income tax assessment bases. Drawing the consequences, for the determination of the controlled company's added value, of the rectification of the income booked, the tax authorities notified STMicroelectronics of reminders of the company's added value contribution, its additional taxes and management fees for the years ended 2012 and 2013.

ADMINISTRATIVE COURT DECISION

In judgment no. 1907583 of December 17, 2020, the Montreuil Administrative Court discharged the company from paying the additional corporate income tax, social security contributions and exceptional corporate income tax, as well as the corresponding penalties. However, the company considers that this ruling is vitiated by a clerical error, and is seeking discharge from the additional corporate income tax, social security contribution and exceptional contribution and from the corresponding penalties.

DECISION BY THE ADMINISTRATIVE COURT OF APPEAL

On August 16, 2022, the Court of Appeal overturned the ruling and discharged the tax.

In the opinion of the tax judge, the deduction of the CIR by a French company to determine the sale price of the product to be invoiced to a foreign company with which it has a contractual relationship, cannot in itself be considered to give rise to a presumption of the existence of a transfer of profits abroad, within the meaning of Article 57 of the French General Tax Code.

OUR ANALYSIS

BENEFITS BY NATURE VS BENEFITS BY COMPARISON
In this case, the Court reiterates one of the foundations of the dialectic of evidence in transfer pricing matters, which consists in apprehending in a different way what the Commissaire du Gouvernement Emmanuel Glaser described as advantages "by nature", as opposed to advantages "by comparison". The former are easy to perceive, as they are not offset by any direct consideration, such as interest-free loans. The latter are more tenuous, as they require an economic analysis (a benchmark) aimed at identifying third-party references that are necessarily independent and placed in conditions similar to those surrounding the intra-group transaction that is the subject of the rectifications. This distinction has given rise to a recital almost systematically taken up by judges in transfer pricing matters, inviting the tax authorities, in order to provide a presumption of indirect transfer of profits abroad, according to which "in the absence of having carried out such a comparison, the service is not, on the other hand, is not entitled to invoke the presumption of profit transfer thus established, but must, in order to demonstrate that a company has granted a liberality by invoicing services at an insufficient price, establish the existence of an unjustified difference between the agreed price and the market value of the asset transferred or the service rendered".

It is interesting to note here that the Court considers that the advantage criticized by the administration is an advantage by comparison, which therefore required the department to demonstrate, by means of a search for comparables, that third-party and independent references would (or would not) have deducted the amounts of the CIR and other subsidies from their cost base on which the margin is based.

WHAT DEDUCTION?
In this case, the ruling highlights the fact that the company had deducted the CIR amounts from its cost base, thus reducing the base on which the 7% margin is based. In doing so, the company applied the transactional net margin method, coupled with a "Net Cost Plus" profit indicator. An alternative would have been to deduct the CIR not from the cost base, but from the total amount comprising this 7% Net Cost Plus. The decision might then have been different, since the CIR compensates for the costs incurred. The company's approach thus respects the very nature of the CIR, by considering that its impact is on costs, and not on the company's total profitability.

ONE MORE STONE
The Paris CAA's decision adds another stone to the solution provided by the Versailles CAA's decision of October 11, 2016, Sté Philips France (n°14VE02651). In this former case, the judge had rejected the administration's claims on the grounds that the comparables produced were not independent. The evidence was therefore inherently flawed. Before the Conseil d'Etat, the Minister was again dismissed on the grounds that no more well-founded economic analysis had been provided (CE, September 19, 2018, n°405779). However, it was already clear that the advantage deemed to exist was an advantage by comparison, and not by nature.

BEWARE OF CONTRACTS!

In the Conseil d'Etat's 2018 ruling, the tax judge considered "that even though the agreement between the two companies did not expressly stipulate that the cost price taken as the basis for calculating the sale price would be the cost actually incurred, net of the amount of subsidies, the Minister is not entitled to argue that the administrative court of appeal erred in law". At the time, only the comparative analysis counted. It seems to us that this approach could now be called into question, not least because of the decision SAP France Holding (CAA Marseille, July 08, 2021, n°20MA00804). This decision reminds us of the imperative need to specify, in the contract, the exact components of the cost base on which the margin is based. In the SAP case, the contract stipulated that all costs had to be rebilled. Inspired by this, the department deduced that the CVAE, which is deducted from the company's income, should therefore be included in the costs re-invoiced to the foreign partner.

Interest deduction on intra-group loans: the end of the saga?

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STARTING SITUATION

WB Ambassador has taken out two loans with its parent company and another group company, bearing interest at an annual rate of 7%.
The tax authorities considered this rate to be excessive in the light of Articles 212-I and 39-1-3 of the General Tax Code, and consequently proposed a correction, reinstating a fraction of the interest incurred.

JULY 07, 2017: ADMINISTRATIVE COURT DECISION

In a ruling dated July 07, 2017, n°16007683, the Paris Administrative Court rejected WB Ambassador's request for a discharge of the additional corporate income tax assessments and reinstatement of the carry-forward of the deficit recognized on January 1, 2020.
The judges made a strict assessment of the provisions of Article 212-1 and the evidence that taxpayers could provide. The three studies provided by the company were rejected for lack of precision and detail. However, they confirmed that the taxpayer's supporting analysis need not be contemporaneous with the loan offer.

DECEMBER 31, 2018 : DECISION BY THE ADMINISTRATIVE COURT OF APPEAL

On December 31, 2018, in ruling no. 17PA0318, the Paris CAA upheld the administrative court's decision and dismissed the appeal lodged by the company.
According to the judges, the comparison used by the company was not relevant, as it was based "on rate comparables from bond financial markets" and agreed with the tax authorities' position that only a bank offer or references to the debt market were acceptable within the meaning of article 212-I of the CGI.

DECEMBER 10, 2020 : DECISION BY THE CONSEIL D'ÉTAT

In a ruling dated December 10, 2020, no. 428522, the Conseil d'Etat, seized of a power of attorney brought by the company, overturned the ruling of the Administrative Court of Appeal.
According to the Conseil d'Etat, the court erred in law by excluding the possibility for the company to justify the rates by using the yield of bond issues granted by companies in comparable conditions.
The Conseil d'Etat continues, and its 2019 "Wheelabrator" opinion, and the trend started by the "Studialis" decision, and validates the use of bond issues as comparable.

JUNE 29, 2022: DECISION BY THE ADMINISTRATIVE COURT OF APPEAL

On June 29, the 2nd chamber of the Paris Court of Appeal, on a referral from the Conseil d'Etat, overturned the decision of the Paris Administrative Court and reinstated the losses incurred by AB Ambassador.

OUR ANALYSIS: Problem posed by the ruling

THE TAXPAYER'S FREEDOM OF PROOF IS ENSHRINED

The Court of Appeal has endorsed the December 10, 2020 ruling by the Conseil d'Etat, which had adopted a position favorable to taxpayers. Indeed, this ruling confirms the opinion issued a year earlier (CE July 10, 2019, n°429426, SAS Wheelabrator), by reaffirming the principle of freedom of proof in determining the interest rate on loans concluded between companies belonging to the same group.
From now on, tax authorities and judges must genuinely debate the evidence provided by the taxpayer to justify the normal and arm's length nature of an intra-group interest rate.
It is in the context of this debate that the Administrative Court of Appeal assesses the evidence provided by AB Ambassador and confirms that the interest rates charged on bond loans can constitute proof of the arm's length nature of the rate on an intra-group loan, provided that it is proven that these loans constitute a realistic alternative to an intra-group loan (i.e. a reference to the debt market).
In this case, the evidence provided by the company was sufficiently elaborate to justify the rates applied to the intra-group loans.

THE FINAL EPISODE IN THE WB AMBASSADOR SAGA, BUT WHAT ABOUT THE SEQUEL?

The ruling handed down on June 29, 2022 brings to a close the WB Ambassador saga, which has given rise to a number of issues and questions that have fuelled a strong movement in case law on intra-group loans, as well as debate on the link between transfer pricing and Article 212-1 of the French General Tax Code.
The Administrative Court of Appeal has clarified the nature and mechanics of proving the normality of the interest rate applied in the case of an intra-group loan. This decision is in line with the analysis inspired by the Bercy guidelines on intra-group financial transactions, and by the body of case law comprising the Studialis, Wheelabrator, Appex Tool and BSA decisions.
Nevertheless, while this decision clarifies intra-group loan situations, many uncertainties remain as to how to demonstrate the arm's length rate attached to other financial vehicles, notably the Cash Pool. The decision also leaves minority shareholders still subject to the compartmentalization of Article 212-I and the strict application of the Article 39-1-3 rate, as the Trocadéro decision recently reminded us.
Finally, although the taxpayer can now refer to the bond market, he still needs to be able to demonstrate that such a reference constituted a realistic alternative given his situation. While the burden of proof on the taxpayer has been eased (somewhat), justifying a borrowing rate different from that referred to in article 39-1-3 of the CGI still remains a challenge for taxpayers. The judges have not yet given us all the keys to transfer pricing applied to financial flows.

CARA supports the LOU RUGBY women's team and becomes a jersey sponsor!

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CARA Société d'Avocats is proud to be a shirt sponsor of the LOU Rugby women's team! We were keen to support these talented players, who courageously juggle different profiles: students, employees, company directors, professionals, women and committed sportswomen. Examples of tenacity, courage and commitment, all values that inspire us and inform our own choices. We are proud to make our small contribution to their wonderful adventure, and may our colors be carried by them to victory!

Because supporting your partners; always moving forward, staying solid in defense; being aggressive when necessary, and stalling when the situation calls for it; setting your strategy and, patiently but surely, leading the group to victory, are all points in common with their formidable tenacity on the pitch and our business model at CARA.

Transfer pricing: has proof become impossible for the taxpayer?

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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:

  1. CAA Paris, 2nd ch. June 29, 2022, no. 20PA03807.
  2. TA Paris, Oct. 7, 2020, no. 1806236/1-3.

Interest deduction on intra-group loans: the end of the saga?

Posted on by admin1708

CAA PARIS, 2ND CH., JUNE 29, 2022, 20PA03996 WB AMBASSADOR

OUR ANALYSIS

Problem posed by the judgment

THE TAXPAYER'S FREEDOM OF PROOF IS ENSHRINED

The Court of Appeal has endorsed the December 10, 2020 ruling by the Conseil d'Etat, which had adopted a position favorable to taxpayers. Indeed, this ruling confirms the opinion issued a year earlier (CE July 10, 2019, n°429426, SAS Wheelabrator), by reaffirming the principle of freedom of proof in determining the interest rate on loans concluded between companies belonging to the same group.
From now on, tax authorities and judges must genuinely debate the evidence provided by the taxpayer to justify the normal and arm's length nature of an intra-group interest rate. It is in the context of this debate that the Administrative Court of Appeal assesses the evidence provided by AB Ambassador and confirms that the interest rates charged on bond loans can constitute proof of the arm's length nature of the rate on an intra-group loan, provided that it is proven that these loans constitute a realistic alternative to an intra-group loan (i.e. a reference to the debt market). In this case, the evidence provided by the company was sufficiently elaborate to justify the rates applied to the intra-group loans.

THE FINAL EPISODE IN THE WB AMBASSADOR SAGA, BUT WHAT ABOUT THE SEQUEL?

The ruling handed down on June 29, 2022 brings to a close the WB Ambassador saga, which has given rise to a number of issues and questions that have fuelled a strong movement in case law on intra-group loans, as well as debate on the link between transfer pricing and Article 212-1 of the French General Tax Code. The French Administrative Court of Appeal has clarified the nature and mechanics of proving the normality of the interest rate applied in the case of intra-group loans. This decision is part of the analysis inspired by Bercy's fact sheets on intra-group financial transactions, and by the body of case law formed by the Studialis, Wheelabrator, Appex Tool and BSA decisions.
Nevertheless, while this decision clarifies intra-group loan situations, many uncertainties remain as to how to demonstrate the arm's length rate attached to other financial vehicles, notably Cash Pools. The ruling also leaves minority shareholders still subject to the compartmentalization of Article 212-I and the strict application of the Article 39-1-3 rate, as the Trocadéro decision recently reminded us. Lastly, although the taxpayer can now refer to the bond market, he still needs to be able to demonstrate that such a reference was a realistic alternative given his situation. While the burden of proof on the taxpayer has been eased (somewhat), justifying a borrowing rate different from that referred to in article 39-1-3 of the CGI still remains a challenge for taxpayers. Judges still have some way to go before giving us all the keys to transfer pricing applied to financial flows.