Transfer Pricing in the Czech Republic – Cost Base Complications

The number of tax audits focused on transfer pricing and the amounts of the resulting tax adjustments have skyrocketed in the Czech Republic in recent years. This has largely been caused by the Czech tax authorities’ systematic risk assessments, which are subsequently used to select taxpayers for transfer pricing audits. The decision-making authority is subject to scrutiny of the local tax authorities.

Recently, the Supreme Administrative Court of the Czech Republic issued a pivotal ruling that addresses the treatment of goodwill amortization for transfer pricing. This development holds substantial implications for how multinational enterprises manage their business operations and tax strategies.

Case Overview

The subject matter was the inclusion / exclusion of goodwill amortization in the cost base for determining transfer prices for a contract manufacturer.

The group headquarter decided to spin-off the Czech entity; the manufacturing activity was demerged from the rest of the business into the new entity. This new entity manufactured products for its related party and was characterised as a contract manufacturer from the transfer pricing point of view. The transfer price was based on the cost-plus methodology.

As a result of the spin-off, the new entity booked goodwill (valuation difference tied to spun-off assets). Based on the Czech tax law, goodwill is amortised as tax non-deductible cost up to 15 years.

The entity excluded amortisation of goodwill from the cost base to determine the transfer price for manufactured products. The entity argued that the goodwill and its related amortization constituted an extraordinary accounting item, not an actual expense. In addition, it is specification of the Czech GAAP to recognise goodwill this way in the accounting books. On the other hand, the goodwill is not amortised under the IFRS, i.e. cost is not booked.

Conversely, the Czech tax authorities argued that (i) the goodwill and its amortization is linked to the assets used for manufacturing activity; (ii) transfer pricing is tested using the financials derived based on the Czech GAAP; and (iii) it is inappropriate to transfer the consequences of the decision of the group entity onto a contract manufacturer (i.e. a routine entity) and thus lower its profit.

The Czech Supreme Administrative Court confirmed the tax authorities’ opinion to include the goodwill amortization in the cost base to determine transfer prices of the contract manufacturer.

Please note that, in the Czech Republic, entities invoicing directly to third party customers can be also considered as contract manufacturers from the transfer pricing perspective if they act under the instructions of the parent or another group entity (e.g. they manufacture products based on the framework agreements negotiated by headquarter).

Takeaway

The Czech tax authorities place great emphasis on the economic substance of the transaction and the decision-making authority. Transfer pricing documentation is requested during the tax audits to defend the taxpayer position. Special attention is paid to local requirements set by the Czech legislation and decrees with respect to the content of the documentation, substance of transactions, local facts and circumstances. In addition, the differences between the Czech GAAP and IFRS or US GAAP must be taken into account for transfer pricing analyses of the Czech entities.

In this environment, the best possible way to mitigate the risks of the intercompany pricing arrangements and avoid a tax assessment is the Advanced Pricing Agreement, which often takes the unilateral form of an agreement between the taxpayer and the Czech tax authorities.