Not only the median constitutes the market level

In its judgment of 28 December 2022, issued by the Voivodship Administrative Court in Białystok (ref. I SA/Bk 467/22[1]), the court upheld the taxpayer’s complaint and discontinued the tax proceedings. The court found that the tax authorities had instrumentally initiated fiscal-criminal proceedings in order to suspend the running of the limitation period and had wrongly challenged the results of the comparative analysis carried out by the taxpayer.

Facts of the Case

According to the facts presented in the judgment, a company belonging to a group of related entities provided cigarette manufacturing services based on materials supplied, for the benefit of a related entity based in the United Kingdom, which constituted the company’s main source of revenue. In 2015, the company incurred costs exceeding its realised revenues and reported a loss in its CIT-8 return for 2015. The company’s remuneration for the manufacturing services was determined on a cost-plus basis, with a 10% mark-up.

Position of the Authorities

During an audit launched in January 2019, the authority found that the company had understated its income from the manufacturing services by approximately PLN 47 million. According to the authority, this was due to the fact that, when determining the cost base forming the basis of the remuneration for cigarette manufacturing services, the company had included depreciation charges calculated under group rules (accounting) instead of depreciation charges calculated for corporate income tax purposes (tax). The other data forming the basis for the remuneration calculation, including the amount of the mark-up, were accepted by the authority as correct.

After receiving the audit findings, the company did not exercise the option of amending its return. The audit was transformed by the head of the customs and tax office into tax proceedings and, instead of the loss declared by the company, the authority assessed the company’s tax liability at approximately PLN 2 million. As a result of the company’s appeal, the head of the customs and tax office annulled the decision in its entirety and remitted the case for reconsideration by the first-instance authority. At the same time, fiscal-criminal proceedings were initiated in relation to the provision of false information in the CIT-8 return and the understatement of corporate income tax. The initiation of the fiscal-criminal proceedings resulted in the suspension of the limitation period.

In the course of the reconsideration, the first-instance authority, however, rejected the comparative analysis prepared by the company and carried out its own analysis based on data from the ORBIS database. To estimate the company’s arm’s-length income from the transaction, the authority applied the median of the analysis conducted, amounting to 28.83%. The appellate authority, however, found that the result adopted by the first-instance authority required adjustment. Ultimately, to estimate the company’s income, a mark-up at the level of the median of 12.34% was adopted, based on the company’s analysis, and the tax was assessed at PLN 192,000 instead of the declared loss.

Position of the Taxpayer

The company disagreed with the authority’s decision and appealed to the administrative court. In its statement of claim, the company argued in particular that, according to the calculations presented in the decision of the head of the customs and tax office, the lower quartile of the range obtained in the analysis was 7.55%. According to the company, this meant that at least 25% of unrelated entities applied a mark-up lower than 7.55%. Therefore, the taxpayer disagreed with the authority’s assertion that unrelated entities would not have applied a mark-up of 10%. The company argued that there was no basis for the authority’s arbitrary conclusion that the market level of the mark-up consisted solely of the median of the analysed range. The level of the mark-up regarded as arm’s length lies between the lower and upper quartiles.

Furthermore, the company challenged the initiation of the fiscal-criminal proceedings, pointing out that the sole purpose of initiating such proceedings was to suspend the running of the limitation period of the company’s tax liability.

Position of the Court

The court upheld the company’s complaint and found, firstly, that the initiation of the fiscal-criminal proceedings was unjustified and was carried out instrumentally for the purpose of suspending the running of the limitation period of the company’s tax liability. The fiscal-criminal proceedings were initiated in August 2021, i.e. four months before the expiry of the limitation period on 31 December 2021. Prior to that, from the beginning of the audit in 2019, the authority had not considered it necessary to initiate fiscal-criminal proceedings.

Moreover, the court held that during the audit and subsequent proceedings, the authorities’ findings changed or were contradictory. Initially, the level of the mark-up adopted in the transaction was not challenged. Only later, during the reconsideration, did the authority question the analysis prepared by the taxpayer and the level of remuneration applied. At the same time, the authority encountered difficulties in preparing its own analysis and in correctly calculating the results, which should not burden the taxpayer.

Summary

Despite lengthy audit and tax proceedings at both instances, the authorities failed to clearly demonstrate and prove that the taxpayer had committed tax fraud by understating its transaction income and thus its tax liability, due to transfer pricing. At the same time, the authorities erred in unjustifiably initiating fiscal-criminal proceedings with the aim of suspending the limitation period.

The fact that the company incurred a loss does not automatically mean that the terms of the transactions carried out with the related entity are not at arm’s length. Moreover, there is no basis for considering only the median of the analysis range as the market level of remuneration. In line with the OECD Guidelines, the recommendations of the Transfer Pricing Forum and established practice, any point within the interquartile range can be regarded as the market level. The court rightly upheld the taxpayer’s position and discontinued the proceedings.

[1] https://orzeczenia.nsa.gov.pl/doc/18E378BA34