• Can an Arm's-Length Principle Fall outside the Arm's-Length Range?
  • June 20, 2013 | Author: Pál Jalsovszky
  • Law Firm: Jalsovszky Law Firm - Budapest Office
  • On the basis of the court judgement, in such case, the tax authority is not obliged to examine whether the price used by the taxpayer falls within the arm’s-length range. It is sufficient for the tax authority to choose one specific price falling within the arm’s-length range, and if the price applied by the taxpayer differs from that price then tax arrears can be established. The judgement opens the way for a very dangerous practice that taxpayers need to prepare for.

    The case

    In the given case the Hungarian subsidiary of an international corporate group raised financing from the Luxembourg-based treasury centre of the group. Upon the audit of the Hungarian subsidiary the tax authority concluded that the company paid interest to the Luxembourg entity at a rate higher than the arm’s-length rate and assessed tax arrears.

    The company supported the arm’s-length nature of the applied interest rate with a transfer pricing document. The document started from the interest statistics of the National Bank and such interest rates were adjusted by certain premiums, like the country risk premium. The tax authority argued that the calculation is incorrect as the interest statistics of the National Bank already contain those risk premiums the company included in the calculation of the arm’s-length interest rate. Therefore the tax authority refused to accept the transfer pricing document of the company, it determined an arm’s-length interest rate at its own and established a tax default on the basis of such interest rate.

    Expert opinion

    In the lawsuit, at the request of the company, an expert was appointed by the court. The expert concluded that those interest rates can be considered arm’s-length that fall within a certain range. According to the expert opinion both the rate applied by the company and the rate determined by the tax authority fall within the range, therefore both interest rates could be considered as arm’s-length.

    The expert has therefore established that the interest rate used by the company was an arm’s-length interest rate regardless of the fact that the company may have applied an incorrect calculation method in its transfer pricing document. The expert opinion has also confirmed that the interest rate applied by the company did not lead to a tax shortfall.

    The judgement

    Notwithstanding the above the court decided that the procedure of the tax authority and the establishment of tax arrears were lawful. According to the court the duty of the tax authority is to audit the transfer pricing document of the company and fix its defects. The court concluded that the tax authority had acted accordingly, and had established justifiably that the transfer pricing document of the company was incorrect.

    In the interpretation of the court the obligation of the taxpayer to prepare a transfer pricing obligation puts the burden of proof on the taxpayers. Therefore the company cannot argue that it applied an arm’s-length price if its transfer pricing document was incorrect.

    Furthermore, the court concluded that the tax authority had correctly established the customary arm’s-length interest rate at a given value instead of a range of interest rates. According to the court, in related party transactions, the arm’s-length price needs to be established at a given value, an arm’s-length range needs to be applied as a subsidiary method, only. As the expert opinion supported that the interest rate established by the tax authority is arm’s-length, the court found the procedure and the resolution of the tax authority lawful.

    Conclusions

    The interpretation adopted by the court gives an easy way for the tax authority to establish tax default in the future. On one hand, in order to establish tax arrears, it will be sufficient for the tax authority to merely find a mistake in the transfer pricing document of the company. After that, the tax authority will not be obliged to examine the merits of the case, i.e. whether the price applied by the taxpayer differs from the arm’s-length price, indeed. On the other hand, if the tax authority chooses any price within the arm’s-length range, it can impose penalties even if the price adopted by the taxpayer falls within the arm’s-length range as well.

    Although it may not be foreseen if the interpretation of the court will be followed by other courts or by the Supreme Court, taxpayers should pay special attention on the merits of the current judgement. If the tax authority is able to challenge the correctness of their transfer pricing document, then it will be difficult to avoid tax penalties.