Denmark: Danish Supreme Court rules in favour of taxpayer in landmark Transfer Pricing case
The EET Group Case - Factual Circumstances
The EET Group operated a business involving the purchase and resale of IT components and spare parts. During the period 2010–2012, which was the subject of this case, the group dealt in, among other things, spare parts and accessories for computers, printers, tablets, and mobile phones, as well as video surveillance equipment.
EET Group A/S, domiciled in Denmark, purchased products from independent suppliers and manufacturers and resold them to the group’s various European sales companies. These sales companies were free to purchase products either from EET Group or from external suppliers, including directly from EET Group’s own suppliers. While the sales companies mainly purchased goods from EET Group, the sales companies in Norway and Spain also sourced a significant portion of their products from external suppliers during the income years in question.
EET Group sold the products to the sales companies at a price based on the purchase price plus various surcharges to cover costs such as freight to EET Group’s warehouse in Denmark, obsolescence risk, insurance, handling, warehousing, and a markup to ensure a profit for EET Group. All sales companies paid the same price for a specific product. The sales companies only purchased goods from EET Group once they had entered into a contract with a customer. The goods were shipped directly from EET Group’s warehouse to the sales companies’ customers, with shipping costs borne by the sales companies in addition to the product price.
The sales companies were free to set their own sales prices and independently determined, for example, the number of employees, salary expenses, office facilities, travel and transport, and local marketing.
The case concerned the assessment of EET Group’s taxable income for the income years 2010–2012, specifically the company’s revenue from the sale of goods to seven of the group’s sales companies.
On 8 July 2016, the Danish Tax Agency increased EET Group’s taxable income by DKK 17,720,000 for the 2010 income year, DKK 65,950,000 for 2011, and DKK 45,140,000 for 2012.
By decision of 28 October 2020, the Danish Tax Tribunal (in Danish "Landsskatteretten") annulled the increase for the 2010 income year and reduced the increases for 2011 and 2012 to DKK 2,670,294 and DKK 26,916,841, respectively.
The Case Before the Supreme Court
The Danish Ministry of Taxation argued that the decision issued by the Danish Tax Agency on 8 July 2016 should be up-held, thereby reversing the decision of the Danish Tax Tribunal.
EET Group argued that the decision of the Tax Tribunal was to be reversed for the income years 2011 and 2012, such that no income adjustment would be made.
The primary issue before the Supreme Court was whether EET Group’s transfer pricing documentation regarding the sales companies in Norway and Spain was so deficient that the Tax Agency was entitled to make a discretionary increase of EET Group’s taxable income with respect to revenues from the sale of goods to these two companies. The secondary issue was whether the Ministry of Taxation had substantiated that EET Group’s transactions with the sales companies were not conducted on arm’s length terms, and whether the Tax Agency's income adjustments were justified.
The Supreme Court Judgment
The Supreme Court first assessed the quality of the transfer pricing documentation to determine whether the Tax Agency was entitled to make a discretionary assessment. Subsequently, the Court addressed whether the pricing complied with the arm’s length principle. This approach taken by the Supreme Court can almost be characterised as standard procedure in Danish transfer pricing cases. The reason for this may lie in the approach of the Ministry of Taxation, which in nearly every case argues that the transfer pricing documentation is deficient.
Assessment of the Transfer Pricing Documentation
At first the Supreme Court referred to the legal basis for discretionary assessment, stating that the provisions in force at the time in Section 3B(8), see Section 5(3), of the Danish Tax Control Act, provide that if the taxpayer has not prepared the required transfer pricing documentation, the tax assessment may be made on a discretionary basis.
However, the Supreme Court has earlier had the opportunity to conclude on when transfer pricing documentation is sufficient. In a judgment of 31 January 2019 (the Microsoft Case), the Supreme Court held that if transfer pricing documentation is so significantly deficient that it fails to provide the tax authorities with an adequate basis for assessing compliance with the arm’s length principle, this must be regarded as equivalent to absence of documentation. Furthermore, in a judgment of 25 June 2020 (the Adecco Case), the Supreme Court held that any disagreement or legitimate doubt raised by the tax authorities concerning the comparability analysis does not in itself mean that the documentation is significantly deficient.
The Supreme Court concluded that the burden of proof was on the tax authorities to demonstrate that the transfer pricing documentation was so deficient that it must be regarded as equivalent to absence of documentation.
The Ministry of Taxation primarily argued that the comparability analysis contained in EET Group’s transfer pricing documentation was not applicable to the sales companies in Norway and Spain, as these companies had, to a non-negligible extent, purchased goods from external suppliers. The Ministry of Taxation further argued that the comparison was not reliable with respect to these two companies, as the analysis included the total profit margin of the sales companies - i.e., the profit from both controlled and uncontrolled transactions, based on purchases from both EET Group and external suppliers - in comparison with the profit margins of independent companies (the benchmark companies).
In response, EET Group argued that a segmentation of the sales companies’ sale of goods based on supplier was not practically feasible, due, among other things, to the number of product items (more than 400,000), the number of goods sold (more than 2.8 million in 2010), and the use of the FIFO principle in the accounting records. Furthermore, during the Tax Agency's handling of the case, EET Group conducted a partial segmentation of the goods and provided an explanation of what, in the group's view, accounted for the differences in profit margins on goods purchased from EET Group versus external suppliers - namely the fact that the goods are of different types.
The Supreme Court found that there was no basis for concluding that the documentation was so significantly deficient as to be regarded as equivalent to absence of documentation - even though the lack of segmentation of the goods made it more difficult to assess whether the arm’s length principle had been complied with. This finding was based on the arguments presented by EET Group, the information available in the case, and, of course, the actual content of the transfer pricing documentation. Therefore, the Tax Agency was not entitled to make a discretionary increase of EET Group's taxable income for the years 2010-2012.
Assessment of the transaction and arm's length terms
As mentioned, it was for the Ministry of Taxation to prove that EET Group’s pricing was not at arm’s length. In regard to the burden of proof, the Supreme Court noted that the question whether the burden of proof had been discharged had to be determined based on a conventional assessment of the evidence in the case. The assessment had to take into account the activities and overall circumstances of the taxpayer. Further, the Supreme Court noted that statistical analyses could form part of the evidentiary assessment in the same manner as other types of information.
With reference to the OECD Transfer Pricing Guidelines 2010, para. 3.57, the Supreme Court found that when statistical methods are used as part of the evidence to enhance the reliability of a comparability analysis, caution must be exercised, particularly where the basis for comparison does not include a sizeable number of observations - for example, regarding prices or margins in transactions between independent parties.
It is stated in OECD Transfer Pricing Guidelines 2010, para 3.57 that "It may also be the case that, while every effort has been made to exclude points that have a lesser degree of comparability, what is arrived at is a range of figures for which it is considered, given the process used for selecting comparables and limitations in information available on comparables, that some comparability defects remain that cannot be identified and/or quantified, and are therefore not adjusted. In such cases, if the range includes a sizeable number of observations, statistical tools that take account of central tendency to narrow the range (e.g. the interquartile range or other percentiles) might help to enhance the reliability of the analysis."
In support of the claim that EET Group has not acted on arm’s length terms with the sales companies, the Ministry of Taxation argued that, in the arm’s length assessment, the profit margins of the sales companies should not be compared with the full range of margins observed in the independent companies (the benchmark companies) used for comparison. According to the Ministry, the comparison should be limited to the interquartile range (i.e. the middle 50% of the observations) of the margins of the benchmark companies.
The Ministry of Taxation had in particular submitted that this approach allows for corrections for so-called comparability defects. For instance, in 2010 and 2011, comparisons were made with companies holding inventory levels between 5% and 25% of revenue and intangible assets of up to 5% of revenue, even though most of the EET Group's sales companies had no inventory of their own and none of them had recorded intangible assets. The Ministry further submitted that the profit margins of several of the EET Group's sales companies fell outside the interquartile range of the margins observed for the benchmark companies.
The arguments put forward by the Ministry of Taxation did not persuade the Supreme Court, which concluded that the fact that the profit margins of several of the EET Group's sales companies fell outside the interquartile range of the margins of the benchmark companies was not, in itself, sufficient to demonstrate that EET Group and the sales companies had not acted on arm’s length terms. The interquartile range calculations are only of limited use in assessing whether the transactions in question were not carried out on arm’s length terms, given that only limited data on gross and net margins were available for a relatively small number of benchmark companies. Moreover, the Ministry of Taxation has not demonstrated that this statistical method is suitable for addressing the alleged comparability defects.
Based on the above and the overall evidence presented in the case, the Supreme Court found that the Ministry of Taxation had not discharged the burden of proof. The reasoning provided by the Supreme Court for reaching this conclusion was that the Ministry of Taxation had failed to demonstrate that any of the benchmark companies were not comparable, nor had it been established that the transfer pricing method applied by the Tax Agency produced more reliable results than the method applied by EET Group. The Supreme Court furthermore considered it significant that EET Group sold its products to all sales companies at the same price, that the Tax Agency did not challenge the transactions with all of the sales companies, that no examples were provided showing that EET Group, in specific instances, sold products at prices that did not reflect arm’s length terms, and that it had not been demonstrated that EET Group incurred losses on the intra-group transactions. Furthermore, the Supreme Court attached importance to the fact that the total tax payments made by the EET Group in Denmark and by the sales companies in their respective home jurisdictions in 2010, 2011, and 2012 were not, based on the information available, lower than they would have been had EET Group conducted its transactions on the terms considered by the Tax Agency and the Ministry of Taxation to reflect arm’s length terms.
Based on the above, the Supreme Court ruled in favour of EET Group, thereby acquitting EET Group of the Ministry of Taxation’s claims and ordered the Ministry of Taxation to acknowledge that EET Group’s taxable income for the financial years 2011 and 2012 was reduced, so that no income increase was made for these years either.
Into the future
The Supreme Court confirmed that EET Group's transfer pricing documentation was sufficient, that the transactions were conducted at arm’s length, and that the Ministry of Taxation failed to demonstrate a more accurate method of determining an arm's length transaction.
While the Supreme Court case is fact-specific, of course, one element stands out as being of general interest. I.e., that even if the margins fell outside the interquartile range, that alone was not sufficient for the Tax Agency to substantiate that the transactions were contrary to the arm’s length principle. The argument presented by the Ministry of Taxation to the effect that the arm’s length assessment should be based only on the interquartile range of the benchmark companies’ profit margins, and not on the full range, has consistently been the position of the Tax Agency. However, as stated by the Supreme Court, this is not, in itself, sufficient to substantiate that a company has failed to act on arm’s length terms. It all comes down to the actual transaction in question and the full set of circumstances surrounding it.
This ruling marks the Supreme Court’s first judgment on the scope of the Danish tax authorities’ administrative practice concerning the interquartile range, and it is expected to have significant implications for both current and future transfer pricing cases.
The ruling also underlines the importance for taxpayers of having complete and adequate transfer pricing documentation in place to avoid situations where tax authorities adjust the transaction. It is equally important that intercompany agreements are drafted as if the transaction had been entered into with a third party. As illustrated by this case, the Supreme Court assessed an income year that dates back more than 13 years. Transactions that took place more than a decade ago may have been commercially rational at the time. However, when viewed in hindsight and in light of facts and information available today, the commercial rationale behind such transactions may be reassessed or interpreted differently. That is one of the reasons why data and documentation play a crucial role when defending the taxpayer’s position. As Danish case law shows, the Danish tax authorities will not hesitate to audit and challenge the setup. Therefore, in order to ensure a strong starting position from the taxpayer’s perspective, it is crucial to have data and documentation in place.
