Supreme Administrative Court Judgment: Parent Company Instructions and Transfer Pricing

In its recent judgment, case No. 3 Afs 165/2024, concerning Hitachi Astemo Czech s.r.o., the Supreme Administrative Court once again addressed the question of how to assess situations in which a subsidiary implements a significant change to its business at the instruction of its parent company and, as a result, reports a tax loss. The decision sheds light on the application of transfer pricing rules and the related tax base adjustment under Section 23(7) of the Income Taxes Act.

The key issue was whether the costs associated with the introduction of a new type of production, which the subsidiary incurred on the basis of a strategic decision of the parent company, should have been compensated within the group, and whether the failure to compensate those costs may give rise to a tax base adjustment under Section 23(7) of the Income Taxes Act. The subsidiary changed its operations from the original production of LCD televisions to the production of automotive components. This step resulted from a strategic decision taken at the group level. In connection with the change in its production portfolio, the subsidiary made investments in the new production line and incurred related costs, which led to the recognition of a tax loss. The subsidiary received neither any compensation for that investment nor any commitment regarding the future offtake of the new production. The parties to the dispute agreed that the company operated as a contract manufacturer with a limited functional and risk profile.

According to the tax administrator, the costs of establishing the new production should have been compensated already in the relevant period, since independent parties would not have entered into such an arrangement without appropriate compensation, and a contract manufacturer would not have assumed the risks associated with a change in production without a guarantee of compensation. The tax administrator therefore concluded that the arm’s length principle, within the meaning of the OECD Transfer Pricing Guidelines, had been breached and made a tax base adjustment in accordance with Section 23(7) of the Income Taxes Act. The management of the subsidiary took the view that no tax base adjustment could be made because there had been no transaction between associated persons in the first place, but rather an exercise of business management by the parent company, as a result of which the subsidiary incurred costs relating to the change in production vis-à-vis unrelated parties. Initially, the Regional Court did not agree with the tax administrator’s argumentation and upheld the action.

The Supreme Administrative Court quashed that decision and remitted the case for further proceedings. The SAC stated that controlled transactions between associated persons may arise even outside formal arrangements, in the form of strategic business decisions. For the purposes of applying the OECD Guidelines and the tax base adjustment under Section 23(7) of the Income Taxes Act, what matters is how the parent company’s instruction was reflected in the commercial relationship between the parent and the subsidiary. The subsidiary repeatedly reported tax losses as a result of the parent company’s investment decision, while at the same time it “undoubtedly contributed” to the profit of the rest of the group. The parent company, however, provided no corresponding consideration. This resulted in such an allocation of costs and risks as would not have occurred between independent parties under comparable conditions.

The SAC confirms that, in the application of tax law, it is necessary to proceed primarily from economic reality rather than from the formal arrangement of relationships. As a general rule, where a decision is initiated at the group level and its economic benefits accrue primarily to other group members, the subsidiary should be appropriately compensated for assuming the related costs. In the absence of corresponding consideration, the application of Section 23(7) cannot, according to the SAC, be ruled out.