Recent years have seen the State Revenue Service (SRS) increasingly focus on transfer pricing (TP) risks, particularly management services and business support services rendered within a multinational enterprise (MNE) group. These services between related companies aim to promote a group member’s business, to cut costs it would have incurred in performing the particular functions on its own, or to offer some other comparable benefit from the synergy of doing business together. Yet there is also the other side of the coin – TP and corporate income tax (CIT) risks may arise if the recipient of services is unable to prove they were actually received and the fee was justified.
To find out how such risks can materialise in practice, let us now explore a recent court case that saw a ruling made on 12 February 2024.
A company operating in Latvia is a member of an MNE group. Its core business activity is manufacturing goods according to a production plan, volumes and sales organised by the group. To remunerate a group company for business support, in 2015 the Latvian company started receiving capacity management services from a related company in the same group. The services included production capacity planning, financial analysis and planning, preparation of reports, advice on decision making, etc. The company paid a quarterly fee based on a profit margin that matches its functional profile. The margin should not exceed 2.7% as per a benchmarking study analysing profit margins earned by comparable manufacturing companies.
In 2019 the SRS launched a CIT and a TP audit of the company for the period from 2015 to 2017. The audit found the service fees had been taken to the company’s profit and loss account as administrative costs and significantly reduced its taxable income, with the transactions exceeding EUR 10 million in each of the financial years being audited.
The SRS found a lack of sufficient and reliable evidence to prove the company had received the services and derived a commercial benefit from them. The SRS also found the services were used to shift the company’s profits away to the related foreign service provider. The audit was completed on 26 May 2021 and the head of the SRS Tax Compliance Promotion Board decided to assess CIT of EUR 5.65 million, plus a late fee of EUR 0.98 million and a penalty of EUR 0.85 million.
The company asked the District Administrative Court to reverse the SRS General Director’s decision.
The company challenged the SRS General Director’s decision and offered the following key arguments to support its position:
During the litigation, the SRS did not change its position and claimed the capacity management services were a fictitious transaction that allowed the company to siphon its profits off to another tax jurisdiction. The main SRS arguments were as follows:
Having heard both sides and perused the evidence over a period of several years, the court found the SRS had correctly concluded that the capacity management service agreement was a fake after carefully and objectively checking all the evidence and circumstances. The company did not offer any evidence to allow a third party to verify the company had received the services and derived a commercial or economic benefit from them. The fee is not based on the market value of services but rather on the margin the group has determined the company should earn, thereby significantly reducing its taxable income.
Accordingly, on 12 February 2024 the District Administrative Court dismissed the company’s application seeking reversal of the SRS General Director’s decision of 29 September 2021.
This case shows the SRS is increasingly focusing on intragroup services because they may pose significant TP and CIT risks. Related companies that perform such controlled transactions in practice, especially with a high materiality threshold, should be able to provide robust evidence that proves receipt of services and the resultant commercial or economic benefit, eliminating duplication with functions the company performs on its own or with other similar services received from third parties or related companies. Another point to note is that justifying intragroup service fees will be the last stage of a tax audit. If the company is unable to prove it actually received services and they were truly necessary, the consequences may significantly exceed a potential TP adjustment.
What makes this case stand out is how the fee was calculated. The SRS challenged receipt of services mainly because the fee calculation was not based on the cost plus a markup, which is the generally accepted practice in intragroup service transactions, but rather on the profit arising from the value added by the group’s business. In fact, this approach to calculating service fees is fairly common elsewhere in Europe and tends to show up in the TP policies of certain Latvian companies, as it’s in line with the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. Given the Latvian CIT system, however, this approach leads the SRS to believe the Latvian taxpayer is making a deemed profit distribution that escapes CIT.
Since services with a similar fee calculation often have a high materiality threshold that may result in substantial CIT assessments, penalties and late fees being charged during a tax audit, plus potential litigation costs, we recommend that Latvian taxpayers making controlled transactions with a similar pricing mechanism should evaluate the need to alter the fee structure.
If you have any comments on this article please email them to lv_mindlink@pwc.com
Ask questionThe European Central Bank (ECB) has been increasing its key interest rates since June 2022 to mitigate the high inflation caused by Covid-19. Taxpayers have good reason to debate whether they should revise the interest rates historically applied in their long-term financing transactions between related parties and apply new rates that are arm’s length and reflect the current economic conditions. This article explores the vision of the State Revenue Service (SRS) and recommendations for mitigating potential transfer pricing (TP) risks.
Setting an arm’s length fee for your intragroup services is one of the transfer pricing (TP) challenges you might face. In 2018 Latvia decided to offer relief for low value-adding services (LVAS) to facilitate this process for companies. If certain criteria are met, LVAS can be analysed under a simplified procedure, meaning the service provider can apply a 5% markup on costs without undertaking a detailed benchmarking study. This article serves to remind you of a key requirement when it comes to taking the simplified approach to LVAS.
We have written before about the profit split method (PSM) and its potential in transfer pricing (TP) analysis, looking at the essence of this method and the scope for using it. This article explores PSM’s advantages and disadvantages.
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