Czech Republic: Functional and risk profile identification as a key issue in current transfer pricing controls

In transactions between two independent enterprises, compensation will usually reflect the functions that each enterprise performs (taking into account assets used and risks assumed). Therefore, delineating the controlled transaction and determining comparability between controlled and uncontrolled transactions or entities requires a functional analysis.

The OECD Guidelines further state that an independent enterprise would not continue loss-generating activities unless it had reasonable expectations of future profits. Also, simple or low risk functions in particular are not expected to generate losses for a long period of time. In the current view of the Czech tax authority, they are not expected to generate profitability lower than the profitability calculated from the financial data of comparable independent companies.

In this respect, we have to point out our particular concern regarding the relationship between identified functional and risk profiles of particular companies and the profit expectations of the Czech tax authority. Based on the information mentioned above, let’s assume a company can be considered, for example, as a limited functional and risk entity, i.e. its position is somewhere between fully fledged distributor and commissionaire. In this situation such a company is generally expected to generate profit, however, under some conditions a loss is also acceptable according to a transfer pricing theory. But not according to the current opinion and approach of the Czech tax authority, which considers limitation of each level as a reason to adjust tax in line with the profitability of independent comparable companies (from our general experience no less than 3% of EBIT related to operating revenue).

Basic information on the functional and risk profile can be obtained from the questionnaire that the tax authority requires entities to fill in before the start of the tax control itself. Based on our experience from recent cases, we believe that a significant tax risk exists for those companies whose profitability differs from what is expected for the identified profile. The tax authority usually challenges this situation and if the company is not able to prove its financial position properly, the tax base for the relevant year is increased, which results in additional tax and penalties.

The extent of this risk depends on the tax authority’s behavior during the tax control and on the strength of the company’s ability to present a reasonable and robust economic explanation.

Our recommendation

Based on the above, we recommend the following:

• Verify that the functional profile specified in the documentation/questionnaire corresponds to the actual profile of the company.
• If the limited functional profile presented in the documentation is in line with the actual profile, we recommend preparing a profitability analysis of independent companies to confirm that the profitability of the company is within the arm’s length range.
• If the profitability of the company is outside the arm’s length range, we recommend finding such arguments (economic circumstances) that would justify a lower operating profit.