On 10 October 2019, in the case of : n.º 511/2018-T, the Administrative Court issued a decision on the sale of raw materials and goods by a company to related parties. In particular, concerning an undervalued controlled transaction tested using the Transaction Net Margin (TNMM) method.
Fact of the case:
Company A is a Portuguese entity, part of G Group, and is engaged in the production, sale and distribution of footwear, fashion accessories and related products. Company C and Company D are subsidiaries of G Group. Therefore, Company C and Company D are considered to be related parties of Company A under the Portuguese domestic rules. In the tax years 2013 and 2014, Company A sold raw materials and goods to Company C and Company D, and then sold the same type of raw materials and goods to unrelated entities.
An independent auditor (conducting the statutory audit work for Company A) issued a modified opinion showing a reserve to Company A’s financial statements, as a result of the non-compliance with the transfer pricing documentation obligations.
The Portuguese tax authority conducted a tax audit of Company A requiring the submission of the transfer pricing documentation that was then prepared during the tax audit.
Following the analysis of the transfer pricing documentation, the tax authority issued a tax audit report and assessed additional tax with reference to the sale of footwear-related raw materials and goods from Company A (as seller) to Company C and Company D (as buyers) these are the “controlled transactions” and finding the non-compliance of these transactions with the arm’s length principle. Thus, an adjustment was made to Company A´s taxable income.
In this regard, Company A had tested the controlled transactions through the application of the TNMM through the use of a database based on several and non-justified profit level indicators (ten (10) in 2013 and eight (8) in 2014) in testing Company A´s overall profitability. Nevertheless, Company A’s ratios were within the arm´s length ranges for 2013, but with reference to 2014, several ratios recorded by Company A fell outside the arm´s length ranges. No transfer pricing adjustments were made.
The Portuguese tax authority did not agree with the economic analysis performed by Company A in testing the controlled transactions. The Portuguese tax authority conducted an economic analysis through the application of the TNMM, using exclusively internal comparables, and determined the “profit margins” (sales price less cost price) recorded in the transactions with independent third parties, by category (raw materials and goods).
The tax authority emphasized that, when internal comparables exist, these would be preferable because such transactions would mostly better reflect the functions performed and risks assumed by a taxpayer. The Portuguese tax authority, thus, concluded that there was non-compliance of the arm’s length principle, and adjusted Company A’s transfer prices and, consequently, its taxable income.
Decision of the court:
Finally, the Portuguese entity (A) request for judicial review of the findings of the tax authority and the resulting tax assessment was made of the court, and the court issued its judgment in favor of the tax authority on the ground that, it was the most appropriate methodology to test the transactions under analysis.
