Supreme Administrative Court of Bulgaria Rules on the application of TNMM

The Supreme Administrative Court of Bulgaria, in its judgment of 24.07.2024, dealt with an important issue concerning the application of the transactional net margin method to a contract manufacturer.    

After a meticulous examination of the case, the Court set aside the decision of the Court of First Instance that allowed adjustments for comparability purposes in the results of the controlled transactions. It upheld the contention of the tax authorities based on substantive law and Regulations and the OECD Guidelines 2010, which state that adjustments are made to the results of comparable uncontrolled transactions when significant differences are found.

The Court found common ground with the tax authorities' argument that there is no difference between controlled and comparable transactions in the absence of evidence of inflated labour costs for the 25 comparable companies. Based on sound reasoning, this agreement with the tax authorities led the Court to conclude that launching new projects and increasing the cost of employee training was part of the audited company's normal production activities and could not be considered extraordinary.

The tax authorities found that the losses assumed by the audited Company do not correspond to the functions, responsibilities, and risks of the controlled transactions. According to the documentation, market and price risk is borne by the related party in the group and not by the manufacturer.

 Based on the Court's agreement with the tax authorities, this shared perspective formed the basis for rejecting the audited Company's net income adjustment for unanticipated labour costs.

Facts of the case

Yazaki Bulgaria Limited, a wholly owned subsidiary of Yazaki Corporation Japan, produced, assembled, and sold electrical and other components for the automotive industry. During the audited periods of 2014, 2015 and 2016, the Company transacted with related parties by manufacturing automotive products on a subcontract basis for other group companies. For these transactions, Yazaki Bulgaria Ltd. submitted documentation for transfer pricing (local file) prepared by Deloitte for each of the audited periods, according to which the pricing was carried out using the transaction net profit method (TNPM) provided for in § 1(10)(b) of the Regulation of the Tax Procedure Code and Article 43 of Ordinance No. N-9/14.08.2006 on the procedure and manner of application of the methods for determining market prices ("Ordinance N-9/14.08.2006").

From the documentation on transfer pricing, the tax authorities found that the TNMM was applied at a net profit margin indicator - "Net Cost Plus", defined as a ratio between operating profit/total costs (an indicator based on return on total costs), with the tested party being Yazaki Bulgaria Ltd. Twenty-five comparable companies, with functions and risks similar to the audited Company, were identified by the taxpayer. A three-year comparison period was defined for which the financial data of the comparable companies were examined. From the comparative and economic analysis performed for the controlled transactions, the transfer pricing documentation calculated the interquartile range (a range of market values) of the Net Cost Plus profit margin indicator of the comparable companies for the selected three-year comparison period as follows:

2014 weighted average Net Cost Plus - lower quartile 2.27%, median 4.16% and upper quartile 7.02%;

weighted average net price plus 2015 - bottom quartile 1.68%, median 4.31% and top quartile 6.80%;

weighted average net price plus for 2016 - bottom quartile - 2.22%, median 3.95% and top quartile 7.66%;

The indicator for the net profit margin - "Net Cost Plus" - realised by Yazaki Bulgaria Ltd. for the corresponding periods was also determined: -1.02% for 2014, 1.43% for 2015 and 0.46% for 2016.

The transfer pricing documents for the years indicated that the Company incurred operating losses from 2104 to 2016. It did not achieve the planned production capacity in any of the years. It had started new projects and could not achieve the budgeted productivity. It also incurred extra costs for recruiting and training a large number of employees. It also had agreed to unfavourable terms with Mercedes and Renault, third parties. The document stated that the Company followed the transfer pricing methodology based on the budgeted operating cost, and it achieved a net profit margin based on the budgeted cost within the interquartile range of comparable transactions.

According to the written explanations of the taxpayer (dated 22.01.2021) given under Article 56 of the Civil Procedure Code in the course of the audit, while calculating the average margin price (net profit margin on controlled transactions), apart from the amount of operating expenses, the impact of low productivity loss has also been taken into account. The Company has indicated that in accordance with the transfer pricing policy, its selling prices to related group entities are calculated based on the assumed budgeted cost plus a mark-up. A return of around 2.5% to  4% will be achieved if the production targets are achieved. However, the Company may realise a negative financial result (loss) due to production overruns resulting from low efficiency, unplanned production losses, material losses or other inefficiencies. A key indicator is the operators' productivity since the bulk of production is based on manual labour, the magnitude of which has the most significant impact on the financial results.

Audit by tax authorities

The revenue authorities have accepted that the method of transfer pricing - TNMM applied by "Yazaki Bulgaria" Ltd. is the most appropriate for testing the market nature of the pricing of transactions for the production of automotive products to related parties. The net profit margin indicator chosen, 'net cost plus', based on cost recovery, was appropriate given the audited Company's operations. It also considered that Yazaki Bulgaria Ltd should be the tested party as its functions and risks are sufficiently simplified for analysis i.e. the party with the most reliable information that would require the minimum possible and most reliable adjustments and for which reliable information can be found for uncontrolled comparable companies.

The revenue authorities also accepted the comparability analysis carried out for transactions relating to the manufacture of automotive products, including the calculated interquartile range of market values established based on data for 25 comparable companies. Still, they considered that there were no grounds for adjusting the auditee's net profit margin by the costs resulting from the reported lower-than-budgeted staff productivity.

The Revenue authorities, based on specific reasons, held that the net profit - net cost plus ratio of the audited automotive products company should be defined as the ratio of operating income/total expenses without adjusting its expenses for the loss of unbudgeted productivity: -1.02% for 2014, 1.43% for 2015 and 0.46% for 2016, and these result does not fall within the interquartile range of comparable companies for these periods. Therefore, the Company's financial result for these periods has been restated as necessary to correct the discrepancy to ensure compliance with the arm's length principle. According to the audit team, this is achieved by adjusting the Company's result to the amount of the calculated lower quartile within the framework of the results of the examination carried out by the audited entity to ensure consistency of the results of its related party transactions with arm's length transactions and the upward adjustments based on the difference of lower of interquartile range and the financial results achieved by the Company were made. 

Proceedings in the Administrative Appeal and before the Court of First Instance

In the administrative appeal, the adjustments made by the revenue authority were upheld. However, the Court of First Instance held in its assessment of its compliance with the substantive law that there is no basis for transformation of the Company's financial result under Article 15, Article 16 and Article 78 of the Tax Code based on the tax deviation adopted in the revision, due to the discrepancy of its net profit rate with the market values for the periods of 2014, The Court based its decision on the report of the forensic economic expertise, which it reproduced in full in the reasoning of the decision. The court order refers to a forensic economic expert report referring to various factual aspects of the new projects, productivity achieved, and training cost of new employees.

According to the Court, the revenue authorities erred in finding that the cost structure had no impact on net profit because labour costs as part of production costs for 2014, 2015 and 2016 were disproportionate to the growth in sales revenue. The economic expert has confirmed that the costs that the Company has eliminated are the training costs and the costs for the additional staff that the Company has excluded in order to convert its profit to market values. The Court held that the additional labour and training costs affect the structure of the total operating costs and are a factor within the meaning of Article 46(2)(1) of Regulation H-9/14.08.2006, which affects the net profit margin.

From the conclusion of the Economic Expert Report, the Court found that according to the established internal rules of operation of the companies of the Yazaki group, the revenue from sales to related parties is planned by Yazaki Bulgaria Ltd. on the basis of the budgeted operating costs of the undertaken orders plus a mark-up. The cost of sales to related parties is calculated based on estimated material costs, estimated labour costs for cable installations, estimated logistics costs, and mark-up.

With regard to the estimated costs of materials and logistics costs, the expert indicated that they were settled by long-term contracts at the group level for all the plants of the Yazaki group and were considered to be a factor in which there was no deviation between budgeted and reported costs and, accordingly, were not considered to be a factor which would contribute to achieving a higher or lower operating profit than that assumed according to the calculated mark-up.

As regards the estimated labour costs, the expert has indicated that they are considered to be a factor which, if the selling prices were set (budgeted) at the beginning of the year and subsequently unchanged (price = costs + mark-up), could be a reserve for an increase or decrease in its operating profit. The impact of the 'labour cost' factor on the actual operating profit or operating loss recorded at the end of the period on plant production is related to the degree of productivity (output) achieved.

The Court held that the adjustments made by the audited Company for comparability were to the amounts of additional labour costs for each of the periods at issue and that, after the adjustments, its net profit rate for 2014, 2015, and 2016 fell within the interquartile range of comparators. The adjustments were made to eliminate the effect of additional personnel and training costs that affected the auditee's net profit margin and, in the Court's view, are consistent with the objective of Article 4 of Regulation No. N-9/14.08.2006 - to achieve a result that would be achieved in an arm's length commercial or financial relationship under comparable conditions. The revenue administration also recognised the additional labour costs as actually incurred and as part of the costs taken into account in the Company's declared financial result. 

Proceedings before the Supreme Administrative Court 

The Supreme Administrative Court, based on detailed reasoning, held the Court of First Instance's decision as incorrect. These reasons are summarised below. 

The dispute concerns the compliance of the sales prices of the transactions of the audited Company for the production of automotive products to affiliates of the Yazaki group with the arm's length principle established in Article 15 of the Income Tax Act (TCGA). This provision stipulates that where related parties carry out their commercial and financial relations under conditions that affect the amount of the tax base differently from those between unrelated parties, the tax base shall be determined and taxed under the conditions that would arise for unrelated parties.

According to Article 116(2) of the CCC, where the audited person carries out a transaction with related parties, it is obliged to prove its conformity with the market price and the reasons for deviating from it, including by submitting all relevant evidence from abroad.

In the instant case, Yazaki Bulgaria Ltd. has stated that as per the transfer pricing policy, the selling prices of its automotive product manufacturing transactions to related parties of the Yazaki group are calculated on the basis of the budget adopted plus a mark-up. To justify the arm's length nature of the prices of these transactions, the Company applied the transaction net profit (TNP) method provided for in § 1(10)(b) of the Regulation of the Tax Procedure Code and Article 43 - Article 50 of the Regulation No. N-9/14.08.2006 on the Procedure and Methods of Application of the Methods for Determining Market Prices ("Regulation N-9/14.08.2006", "Regulation N-9/2006", "the Regulation"), for which it has prepared and submitted transfer pricing documentation (local file) under Article 71b of the Tax Procedure Code.

Pursuant to Article 43 of Ordinance No. N-9/14.08.2006, the Transactional Net Profit (TNP) method compares the net profit margin on a controlled transaction, calculated as a ratio of net profit to a selected base (sales revenue, expenses, assets), with a comparable net profit margin calculated against the same base for unrelated parties.

The method's application requires selecting a net profit margin indicator, a tested party, an analysis period, a comparability analysis, and the determination of an interquartile range to verify that the audited entity's net profit margin falls within the range of market values consisting of the results of uncontrolled transactions for which a sufficient degree of comparability has been achieved. 

The dispute concerns Yazaki Bulgaria Ltd's net profit rate—net cost plus for the periods under the controlled transactions.

In the prepared transfer documentation, the Company indicated that its net profit margin, Net Cost Plus, for the periods under review, calculated as a ratio of operating profit to total expenses, is -1.02% for 2014, 1.43% for 2015 and 0.46% for 2016.

The Company asserts and has indicated in the transfer pricing report that it incurred losses in the periods at issue from not achieving planned productivity due to newly initiated projects, the losses of which are unique to the Company and are not shown to exist for comparable companies. It, therefore, considered that these losses should be eliminated from its total costs, that these specific costs should adjust its total costs and that the net profit margin 'net costs plus' should be defined as the ratio of operating profit/budget costs. Determined in this way, its net profit margin for 2014 is 2.34%, for 2015 4.3% and for 2016 2.56% and falls within the interquartile range of market values of comparable companies for the relevant period.

The revenue authorities do not accept the adjustments thus made. They consider that the net profit margin of the audited Company is calculated in the transfer documentation as a ratio between operating profit/total expenses and does not correspond to the market prices determined under the TNMM. Therefore, and based on Article 50 of Regulation N-9/14.08.2006, they have equated the net profit margin of the controlled transactions to the lower quartile of the range of market values of the net profit margin of the comparable companies determined in the transfer documentation and on the basis of Article 15 in conjunction with Article 16 and Article 78 of the Income Tax Act and have increased the financial result of the audited entity for 2014, 2015 and 2016 and have established the disputed additional corporate tax and interest liabilities. 

The Court of First Instance held that, in applying the method, the audited Company had lawfully made the comparability adjustments to the net profit margin of the controlled transactions where the difference had been identified in accordance with the comparability analysis carried out. The Supreme Administrative Court held that this conclusion is contrary to Article 11 of Regulation H-9/14.08.2006. The provision, as mentioned earlier, stipulates that where, as a result of the comparability analysis, significant differences are found between the controlled transaction and the comparable uncontrolled transaction, adjustments shall be made to the results of the uncontrolled transaction when applying the relevant method in order to achieve a sufficient degree of comparability between the compared transactions. These adjustments reflect the effect of such differences on price or profit.

According to Article 46(1) of Regulation N-9/14.08.2006, when applying the transactional net profit method, adjustments under Article 11 are made to eliminate differences between the net profit rate of the controlled transaction and the comparable uncontrolled transaction. Article 46(2)(1) to (14) of the Ordinance sets out the factors affecting the net profit margin on the basis of which the differences in the comparable transactions are established.

It follows from the reference in Article 46(1) of the Ordinance to the adjustments under Article 11 of that Ordinance that adjustments for comparability in the application of the most appropriate method are made in the results of comparable uncontrolled transactions. In the present case, no such adjustments have been made since no evidence of losses such as those found in the case of the audited Company from new proceedings has been established for the comparable companies. Such data in respect of the 25 comparable companies have not been established either during the preparation of the transfer pricing documentation by the audited entity or in the course of the audit by the revenue authorities, which have the possibility of collecting evidence under the administrative cooperation procedure.

In the present case, the audited Company alleges the existence of losses from new projects during the audited periods that are specific only to the controlled transactions in the manufacture of automotive products, which were not found in the comparator companies. The impact of group-specific events on the profitability of the examined and compared businesses and the reliability of the comparability analysis is identified as a feature of TNMM in the OECD TP Guidelines, 2010 (paragraph 2.72) and the NRA Handbook on Transfer Pricing. These interpretative sources should be considered in the interpretation and application of the substantive law - Article 15 of the Tax Code and Article 46 of Regulation N-9/14.08.2006.

Paragraph 6.2 of the NRA Handbook on TNMM states that there are possible events or specifics that may temporarily affect the net profit margin of an affiliate while leaving the comparables unaffected by the underlying business difficulties. Such events, according to the Guide, could be reduced sales or additional costs resulting from a restructuring of the sales network or a merger of the teams of the acquired and acquiring Company, product obsolescence, or loss of an important customer. The additional costs claimed by the audited entity for labour and training of personnel directly involved in production, in excess of the previously foreseen costs in connection with new production projects launched in 2014 and 2016, can be defined as an event from which it suffered losses and which affected its net profit margin based on a cost recovery indicator (Net Cost Plus). No such events and losses are reported for the 25 comparable companies. As a possible solution in this case, the manual suggests analysing profits over several years (between three and five), i.e. taking into account years not affected by the specific events, averaging the results and comparing the resulting average with comparable market levels. Therefore, that authorisation does not inherently exclude the possibility of adjustments to the results of controlled transactions when using the TNMM and the comparability analysis, based on a longer time period, in order to account for the effect of product life cycles and short-term economic conditions.

To qualify as specific to the audited entity, the losses should result from the occurrence of events of an extraordinary and temporary nature.

In the present case, the evidence on record does not establish that the losses from labour costs on the said projects are of such a nature. On the one hand, the audit found that launching new projects was part of the normal production activities of the audited Company within the Yazaki group. The auditing authorities have also analysed the budgeted productivity, on the basis of which the Company has formed its transfer prices for the production transactions, in the audited periods of 2014, 2015 and 2016 and the subsequent periods of 2017 and 2018 and have found that, despite the reported losses, it remains around 80% and has not been reduced. Both the transfer pricing documentation and the conclusion of the forensic economic expert established that the losses realised by the audited Company were due to the difference between the planned (budgeted) staff productivity and the achieved productivity, which decreased from 21.1% in 2014, 15.4 % in 2015 to 9.9 % in 2016, but there is no data and no evidence that the initial losses recorded in the audited periods were overcome in subsequent periods of the life cycle of the product concerned. The comparability analysis performed for the selected three-year period does not include years unaffected by losses.

According to paragraph 1.70 of the OECD Guidelines, 2010, related enterprises may incur real losses due to high initial costs, including inefficiencies or other legitimate business reasons. However, under market conditions, the losses would be temporary. Paragraph 1.72 states that losses such as those in the trial from unforeseen start-up labour costs can be expected for a limited period in order to increase profits in the long term. Such circumstances are also reflected in the transfer documentation prepared by the Company, where the comparability analysis on the 2014, 2015 and 2016 automotive transactions indicates that Yazaki Bulgaria's long-term projections are that for future periods, the Renault Edison and Ford Transit projects, respectively the Renault Edison and Mercedes MFA2 projects will be more efficient and better revenue generating. Still, the case has not established that such results have been achieved. The valuation of the Renault Edison project in 2017 as a loss-maker and its discontinuation in 2017 is aimed at overcoming losses in accordance with paragraph 1.72 and the arm's length principle. For the remaining projects, the case does not establish, including from the conclusion of the forensic economic expert, that the losses from the difference between the reported low productivity and the budgeted productivity during the periods at issue, resulting from higher labour costs at start-up, have been overcome in the long term in view of the life cycle effects of the products and that the profitability of the net profit indicator used, net cost plus, has been achieved in accordance with the arm's length principle. Therefore, it cannot be assumed that the Company's elimination of the impact of labour cost losses for additional staff employed in 2014, 2015 and 2016 in connection with new production projects, when comparing the net profit indicators within the meaning of Articles 43 and 44(2) of Regulation N-9/2006, is in line with the objectives set out in Articles 4, 12 and 14 of the Regulation and with the arm's length principle.

Reasonably, in this respect, in the audit, it is accepted that the losses assumed by the audited Company do not correspond to the functions, responsibilities and risks of the controlled transactions, which it has assumed according to the data in the documentation for transfer pricing. According to the documentation, market and price risk is borne by the related party in the group and not by the manufacturer.

Because of the above, it is to be held that the increase in the financial results of a company for the year 2014-16 made by the audit revision order based on section 15 of the Income-tax Act to the lower quartile of the range of market values found in comparable independent companies is lawful.

In holding to the contrary, the Court of First Instance rendered a judgment contrary to the evidence in the case and in violation of substantive law, which should be set aside. In its place, another judgment should be entered dismissing the appeal.

Take away

The court's decision underlined the importance of documenting the delineation of the controlled transaction and the material differences between controlled and uncontrolled transactions that affect the computation of the arm's length price. Adjustments, if any, could only be made to the profit level indicator of the comparable uncontrolled transactions.