Do-it-yourself transfer pricing

After the European Court’s decision in the Hornbach case, EU groups may feel a lot more comfortable about extending soft loans, or giving fee-free guarantees for external loans to their ailing subsidiaries. If this happens to result in a lower tax bill for the group, lucky them. The Court basically said that if the lending company can show that the benefit was provided for commercial reasons such as the need to provide economic support to a financially distressed group company in another member state, no taxable income may be imputed to reflect that benefit. Yes you heard that correctly: so even if the arrangements are non-arm's length under normal OECD principles, the lending company cannot be taxed on what it should but didn't charge.

The question is whether this decision is sound and, if it isn't, whether there is a risk of it being cut back at some stage in the future. In some ways the decision makes a lot of sense if one assumes that the purpose of transfer pricing rules is to prevent tax avoidance and one defines the latter as action whose essential aim is to obtain a tax advantage that would not normally be available (see e.g. most recently, AG Kokott in N Luxembourg 1, case C-115/16). If the reason for the non-arm's length prices is not to obtain a tax benefit but instead to provide financial support to a group company then there would be no tax avoidance. A member state which did not make a transfer pricing adjustment in a purely domestic situation could not then argue that it was justified in making such an adjustment in a cross-border situation on the grounds of preventing tax avoidance. Surprising as it may sound, the idea is not at all new, having been around for at least the last 10 years (see AG Geelhoed in Thin Cap, case C-524/04).

What at first sight seems strange is that although it was not being argued that the taxpayer was seeking to avoid tax or that it had set up an artificial arrangement, the Court still required the taxpayer to provide evidence of a commercial reason for the non-arm’s length prices (para. 55-56). A possible explanation for this is that the Court considered the fact of non-arm’s length prices to be prima facie evidence of tax avoidance, even In the absence of a subjective intention to obtain a tax advantage. Requiring the taxpayer to be given the opportunity to show a commercial justification would then be in line with its settled case law on transfer pricing cases where tax avoidance was being argued (e.g. SGI, case C-311/08).

What is even more puzzling is why the Court focused on tax avoidance, when this was not even being alleged, and effectively ignored the argument that the German government was actually making, that the transfer pricing adjustment was required in order to preserve the balanced allocation of taxing rights between member states. The likely explanation is that its other case law in this area tended to focus on the two arguments taken together and the Court saw no reason not to continue to do this (e.g. SGI). Had they just focused on the balanced allocation argument the outcome would likely have been completely different as the question of commercial or other justifications for the incorrect transfer pricing would not have arisen in the first place. The risk alone of profits being shifted from one state to the other would have been enough to justify Germany's transfer pricing adjustment. By making the implicit assumption that transfer pricing rules are only about tax avoidance the Court overlooked the fact - that the AG did note - that such rules are also intended to apply generally, irrespective of the intentions of the particular taxpayer.

The European Court is not in the habit of reversing its decisions, so for now taxpayers can profit from this decision. Whether or not it is a good decision depends on your perspective.

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