Michał Gosek

Tax adviser (Poland)
Associate Partner
Phone: +48 61 624 49 39

Agnieszka Szczotkowska

Tax adviser (Poland)
Phone: +48 616 24 49 22

Taxpayers making transactions with associated enterprises are obliged to follow the arm's length principle, i.e. effect the transactions on market terms. By introducing the relevant provision in the CIT Act the lawmakers wanted to ensure that the profits are allocated in a way that does not understate the taxable base for income tax purposes, and thus does not undermine the state budget. Businesses operating in a SEZ must observe that rule at two levels, so to say, because under §5(5) of the Regulation on SEZ, transfer pricing laws apply also to units of the same enterprise, of which one is located within a SEZ, and the other outside the SEZ.

In order to fulfil the requirements imposed by the lawmakers, taxpayers determine arm's length prices of their goods and services or an arm's length profitability ratio appropriate for a given entity. That time-consuming (and often costly) analysis is performed in consideration of the functions performed by the transacting parties, assets employed and the risks and costs incurred by them. What is important is that despite all the due care, the assumed profit distribution between the parties to the transaction differs from the profit actually earned during the year. This happens because the profitability of associated enterprises is affected not only by the price of goods or services sold by them to each other, but also other circumstances related to the pursued business. Consequently, taxpayers must take into account that the profitability disclosed by an entity may happen to fall outside the range considered at arm's length (when the analysis is based on the data of independent entities, it is assumed that interquartile range sets the arm's length threshold values of the achieved mark-ups).

Transfer pricing adjustments

More and more often tax authorities check during their inspections the compliance with the arm's length principle when making transactions, which can end up with tax authorities' making a transfer pricing adjustment. The adjustment shifts profits between associated enterprises in such a way that allocation of additional income to one of the taxpayers (primary adjustment) should involve an appropriate reduction of profit of the other taxpayer (corresponding adjustment). The aim of the corresponding adjustment is to avoid double taxation of profits which have already been taxed by the other taxpayer. In practice, the process takes a lot of time and the procedure is complicated, especially when the adjustments are made to transactions between residents of different countries.

An instrument which can be used to minimise the risk is the so-called transfer pricing adjustment. It consists in comparing the actual profit(loss) of the transacting parties with the planned values after the end of the accounting period (which is most often a year, although quarterly accounting is also frequent). If the comparison shows that due to various circumstances, such as unexpected change of economic situation, foreign exchange rate fluctuations etc., the assumed profitability (mark-up) is not achieved, corresponding adjustments are made.

This solution, which is accepted by tax authorities of many countries, was introduced to the Polish CIT Act on 1 January 2019. However, it does not mean that Polish taxpayers were not parties to agreements allowing the adjustment of higher or lower profits. All the more so that the adjustment, called compensating adjustment, have also been approved by the OECD as an adjustment in which the taxpayer reports a transfer price for tax purposes that is, in the taxpayer's opinion, an arm's length price for a controlled transaction, even though this price differs from the amount actually charged between the associated enterprises.

And what tax authorities say about that? It could be assumed that if the lawmakers wanted associated enterprises to make transactions on arm's length terms, taxpayers who take due care of their payments should expect favour with tax authorities. Unfortunately, they could not be more wrong.

Taxpayers' dispute with tax authorities over adjustment

In practice, profitability adjustment may be made by correcting the individual invoices documenting the sale of goods or services, or without adjusting the prices of goods or services, that is, on the total profit(loss) on taxpayer's activity. In the latter case such an adjustment, as unrelated to any specific purchase or sale transaction and relating to the total of revenues or expenses, should be documented by means of an accounting note.

The standpoint presented in advance tax rulings suggests that as a rule tax implications of profitability adjustments in corporate groups depend on the method of making the adjustment. This concerns both corporate income tax and VAT. In the opinion of tax authorities, only if profitability adjustment is made by adjusting each time the sale prices of goods or services is it possible to match correcting invoices with specific transactions, thereby entitling taxpayers to reduce or increase the revenues or expenses. This approach was presented, for example, in the advance tax ruling of the Head of NTIS of 27 January 2017 (file no. 2461-IBPB-1-1.4510.366.2016.1.MJ).

However, if the price adjustment is made by means of one document which does not refer to the original invoices, the taxpayer must disclose a revenue (in the case of upward adjustment) and is not entitled to income reduction (in the case of downward adjustment). Such a standpoint was presented, for example, in the advance tax ruling of the Head of NTIS of 2 August 2018 (file no. 0111–KDIB1–3.4010.286.2018.3.IZ) and in the advance tax ruling of the Director of the Tax Chamber in Katowice of 5 September 2016 (file no. IBPB-1-2/4510-542/16-2/KP).

The same approach is taken by tax authorities for adjustments to tax-deductible costs. In the opinion of tax authorities, amounts shown on invoices (or notes) adjusting profitability in such a way that the taxpayer ends up obliged to pay a certain amount, cannot be tax-deductible costs. Of course, tax authorities do not question the economic sense of incurring the revenue which results in profitability adjustment. However, in their opinion, the revenue cannot be recognised under tax-deductible costs because it has no cause and effect relationship with the revenue earned by the taxpayer.

Another argument raised by tax authorities is that companies do not have confirmations of correct profitability adjustment under Chapter IIa of the Tax Act issued by the competent authority (so-called APAs).

Additional problems for SEZ entities

As we have indicated above, the bone of contention between tax authorities and taxpayers is how the profitability adjustment affects enterprises' tax accounts. In the case of companies operating in SEZs, an additional issue is how to recognise that adjustment in the profit(loss) on tax-exempt activity and on the activity taxable under general principles.

This taxpayer-unfriendly approach was presented, for example, in the advance tax ruling of the Head of NTIS of 23 March 2018 (file no. 0111-KDIB1-3.4010.62.2018.1.PC). That advance tax ruling concerned a manufacturing company operating in the SEZ.

The applicant purchased from the associated enterprise ("the supplier") semi-finished goods used in the production of goods manufactured in the SEZ. Then, the goods were sold to third parties. Pursuant to the agreement, the applicant placed an order and the supplier supplied him with the raw material in a specified amount and of specified quality standards. Bearing in mind the fact that the applicant and the company supplying the semi-finished goods to it were associated enterprises, their mutual settlements should have been made in consideration of transfer pricing regulations. Therefore, before the commencement of each accounting period, the price of semi-finished goods was determined in a way that would ensure an appropriate profitability level determined in accordance with the arm's length principle for the supplier as an entity bearing limited market risk. However, due to such factors as fluctuating prices of raw materials, market changes or a change in foreign exchange rates, the supplier's profitability in a given accounting period might vary from the budgeted level.

Pursuant to their arrangements, if the actual profitability level of the supplier differed from the target level, the companies would make mutual settlements of accounts by evening out the profitability to the guaranteed level. If the supplier's profitability was higher than expected, it would issue a correcting document (other than a VAT invoice) to the applicant and would pay the relevant amount. If it was the other way round, i.e. when the supplier's profitability turned out too low, it would issue to the applicant a correcting document (other than a VAT invoice) under which the applicant will make a payment.
The question in controversy boiled down to determining whether the adjustment of profitability of the associated enterprise, which affected the income of a company operating in the SEZ, should have been allocated in full to the company's operations in the SEZ and taken into consideration when calculating income from a tax-exempt source. The taxpayer assumed that profitability adjustment would be connected with operating the SEZ. The logic was that if the profit(loss) on the acquisition of semi-finished goods and their processing was exempt from CIT under Article 17(1)(34) CIT Act, the adjustment should have resulted in an appropriate change (increase or decrease) in tax-exempt income.

Tax authorities did not agree – in the reasons why the taxpayer was wrong they only indicated that the revenue earned by the company from profitability adjustment could not be included in tax-exempt activity because the revenue was not mentioned directly in the permit to pursue business activity in a SEZ. At the same time, any and all expenses incurred by the company on the profitability adjustment would not be tax-deductible because the expenditure could not reasonably be connected with the company's revenue or with maintaining or securing the company's source of revenue. So as far as tax-deductible costs were concerned, the Head of NTIS followed the argumentation presented by tax authorities for many years. Then, tax authorities concluded that if the taxpayer did not have an APA, the adjustments would not be tax-deductible, so it was pointless to consider whether the expenditure should have been included in the company's activity in the SEZ or taxed under general principles.

Ruling of the Provincial Administrative Court (PAC) favourable to taxpayers

In its ruling of 4 July 2018 (file no. I SA/Gd 541/18), the PAC in Gdańsk repealed the above advance tax ruling, which in the opinion of the authors was the right thing to do.

Like the tax authorities, the PAC opened its reasoning by quoting Article 17(1)(34) or Article 17(1)(34a) CIT Act pursuant to which income is exempt from tax when the following two conditions are met jointly:

a) the income is earned from the activity specified in the permit (or in the state aid decision)
b) the income is earned from business activity pursued within SEZ.

Unlike in the advance tax ruling of the Head of NTIS, the PAC concluded in its opinion that in the case in question the taxpayer met both conditions so the amounts following from the adjustment should have been recognised under profit(loss) on tax-exempt activity. At the same time the PAC emphasised that the adjustment was not a separate kind of business activity – it is was difficult to expect a taxpayer to have a permit in which income from profitability adjustment would be directly listed as a type of business activity. Profitability adjustment is just a method of adjusting settlements between parties to arm's length conditions, and not a separate economic transaction with a specific purpose.

Furthermore, the panel of judges held that the approach of the Head of the NTIS was unrealistic business-wise. Moreover, the tax authorities wrongly divided the transactions effected between the company and the associated enterprise into two transactions, i.e. one transaction consisting in purchasing semi-finished goods (which is connected with the tax-exempt business activity) and the other consisting in profitability adjustment, whereas the latter should have already been included in business activity taxable under general principles.

Next, the PAC stated that the tax authorities were wrong to have considered the amounts following from profitability adjustment as non-tax-deductible costs. Expenses incurred for the purchase of semi-finished goods served earning a revenue so they were tax-deductible. Expenses connected with the profitability adjustment were expected to ensure that the transaction was made on arm's length terms – they actually preconditioned the arm's length purchases of semi-finished goods (raw material necessary for carrying out a revenue-earning business by the company).

A very important argument among taxpayers (not only those operating in SEZs) is also the PAC's approach to taxpayers' holding of APAs. The administrative court emphasised that holding an APA was not a condition for tax-deductibility of an expenditure, which tax authorities seemed to forget about. There is no tax legislation obliging taxpayers to obtain a confirmation of transfer pricing correctness under Chapter IIa of the Tax Act or else the expenditure would not be tax-deductible.

If you would like to know more on that subject, our specialists in Rödl & Partner offices in Cracow, Gdansk, Gliwice, Poznan, Warsaw and Wroclaw will be glad to provide more information.

Michał Gosek,

Agnieszka Szczotkowska