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 2 December 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.