Stora Enso Wood Products vs Czechia

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Case Information

• Court: Supreme Administrative Court of the Czechia
• Case No: 7 Afs 358/2021 – 36
• Applicant: Stora Enso Wood Products Żdírec s.r.o.
• Defendant: Odvolací finanční ředitelství
• Judgment Date: 25 August 2023

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Judgment Summary

The Supreme Administrative Court (SACC) of the Czech Republic annulled the judgment of the Regional Court in Hradec Králové, which had previously annulled the tax assessment decision of the Odvolací finanční ředitelství against Stora Enso Wood Products Ždírec s.r.o. The case was returned to the Regional Court for further proceedings. The primary issue was the misapplication of Section 23(7) of the Income Tax Act to transactions between Stora Enso and unrelated parties.

Key Points of the Judgment

Background

Stora Enso Wood Products Żdírec s.r.o. (the applicant) is part of the global Stora Enso group, which operates in the fields of packaging, biomaterials, wood products, and paper. For the 2012 tax year, the Czech tax authorities conducted an audit focusing on transfer pricing between the applicant and its parent company, Stora Enso Wood Products GmbH (SEWP). The tax authorities concluded that the applicant did not act as an independent entity but rather as a producer with limited functions and risks, heavily influenced by its parent company.

Core Dispute

The core dispute revolved around the application of Section 23(7) of the Czech Income Tax Act, which pertains to transfer pricing between related parties. The tax authorities adjusted the applicant’s tax base, arguing that the prices set between the applicant and its parent company were not in accordance with the arm’s length principle. The applicant contested this adjustment, arguing that the tax authorities incorrectly applied the provision to transactions with unrelated third parties.

Court Findings

1. Application of Section 23(7): The SACC found that the tax authorities correctly applied Section 23(7) of the Income Tax Act to the relationship between the applicant and its parent company, SEWP, and not to transactions with unrelated third parties.
2. Influence of Parent Company: The court acknowledged that the applicant’s operations were significantly influenced by the parent company, which directed the production and sales activities, leading to transactions below operating costs without appropriate compensation.
3. Legal Misinterpretation by Regional Court: The Regional Court had erred in its interpretation by suggesting that the tax authorities applied the provision to unrelated third-party transactions.

Outcome

The SACC annulled the judgment of the Regional Court and remanded the case for further proceedings, instructing the Regional Court to reassess the case in line with the legal interpretation provided by the SACC.

Transfer Pricing Method Used

The tax authorities used the Net Margin Method (NMM) to determine the arm’s length price for the transactions between the applicant and its parent company. This method involves comparing the net profit margin of the controlled transaction to that of comparable independent transactions.

Significance of Intra-Group Losses

Intra-group losses were significant in this case as the applicant was selling products below operating costs due to the influence of its parent company. The tax authorities argued that this resulted in a loss that should have been compensated by the parent company to ensure the transactions were at arm’s length.

The case highlighted the importance of properly documenting and compensating intra-group losses to adhere to the arm’s length principle. The lack of adequate compensation for loss-making transactions with the parent company SEWP was a critical issue.

Major Issues or Areas of Contention

1. Application of Transfer Pricing Rules: Whether Section 23(7) of the Income Tax Act was correctly applied to the transactions between the applicant and its parent company.
2. Role of Unrelated Third Parties: The Regional Court’s misinterpretation that the tax authorities applied the transfer pricing rules to transactions with unrelated third parties.
3. Compensation for Losses: The lack of compensation from the parent company for the losses incurred by the applicant due to below-cost sales.

Expected or Controversial Decision

The decision was somewhat controversial due to the complexity of transfer pricing rules and the initial misinterpretation by the Regional Court. The controversy stemmed from the application of transfer pricing adjustments and the influence of the parent company on the applicant’s operations.

Significance for Multinationals and Revenue Services

This case highlights the importance of adhering to transfer pricing regulations and ensuring that intra-group transactions are conducted at arm’s length. For multinationals, it underscores the need for proper documentation and justification of transfer pricing practices. For revenue services, it emphasizes the necessity of thorough audits and clear legal interpretations to avoid misapplications of tax laws.

Value of Transfer Pricing Expertise

Transfer pricing expertise is invaluable in ensuring compliance with tax regulations, minimizing disputes, and providing robust documentation to support transfer pricing policies. Expert advice can help multinationals navigate complex tax laws and avoid costly adjustments and penalties.

Preventative Measures for Better Management

To avoid similar disputes, companies should implement a robust tax risk management process, including:

• Tax Steering Committee: Establishing a tax steering committee to oversee tax strategy and compliance. Click here to download our FREE eBook: THE ESSENTIAL ROLE OF THE TAX STEERING COMMITTEE.
• Documentation: Maintaining comprehensive and accurate documentation of transfer pricing policies and transactions.
• Regular Audits: Conducting regular internal audits to ensure compliance with transfer pricing regulations.
• Training: Providing ongoing training for staff on transfer pricing rules and best practices.