The Tax Appeals Commission ruled in favour of the taxpayer on the first ever Irish transfer pricing case

The Irish Tax Appeals Commission (the TAC) rejected transfer pricing adjustments sought by the Revenue Commissioners (the Revenue) to the supply of services of an Irish subsidiary (the Taxpayer) to its US parent company (the Parent) relating to share based awards (SBA) granted by the Parent to employees of the Taxpayer.

 

Background and facts

Pursuant to intercompany services agreements, the Taxpayer performed sales and marketing and research and development activities for the benefit of the Parent on a “cost-plus” basis. The Taxpayer charged a fee to the Parent calculated by reference to its costs, plus a mark-up.

The Taxpayer's financial statements included a line item for expenses relating to the SBAs, which is a requirement of the Financial Reporting Standard 102 (FRS 102). However, the intercompany agreement specifically excludes the SBAs accounting expense from the costs used in the calculation of the charges made by the Taxpayer to the Parent for the services provided.

Revenue took the view that the Taxpayer had not demonstrated that the intercompany service fees received from the parent company were at arm’s length, as the cost of the SBAs should not have been excluded from the cost base for the purposes of calculating the relevant mark-up.

It was not in dispute between the Taxpayer and Revenue that the Transactional Net Margin Method (TNMM) was the appropriate transfer pricing method to be applied.

 

Economic Costs versus Accounting Expense

The Taxpayer disagreed with the view of Revenue as it regarded the cost as a notional expense not incurred and, therefore, should not form part of the cost base to determine the intercompany price charged to the Parent.

The Taxpayer’s expert witness argued that:

• From an economic perspective, the most important consideration as to who is incurring an expense is to consider who is bearing the risk associated with the expense being incurred; and
• As a matter of economic reasoning, it is the shareholders of the Parent that are bearing the economic risks associated with having issued the SBAs. This is on the basis that by issuing the SBAs those shareholders have diluted their own fractional ownership in the expectation that the employees of the Taxpayer will be incentivised to improve their levels of performance.

The TAC agreed with the Taxpayer and, in reaching its decision, looked to whether the issuance of the SBAs by the Parent to the Irish based employees created an economic cost for the Taxpayer.

The TAC relied on OECD Guidance and took into consideration the functional analysis rather than the financial statements of the Irish company to determine where the economic cost arose. Based on the detailed evidence provided by the respective parties, the TAC determined that the Parent not only bore the risk of providing the SBAs but also performed administrative functions relating to the employee award scheme.

The TAC accepted that while the correct accounting treatment was applied, it did not address the question as to who bore the legal and economic risk and who should be entitled to earn the profits referable to this cost, in accordance with the OECD Guidelines. While the SBAs amounted to notional costs in the accounts of the Taxpayer in accordance with the accounting treatment, as the cost of the SBAs was not incurred by the Taxpayer, the arm’s length principle requires that the SBAs should be excluded from the Taxpayer’s cost base in providing the services to its Parent.

 

Admissibility of Evidence

Revenue raised objection to the admissibility of the Taxpayer’s expert witness reports on the basis that the reports were opinions on the interpretation and application of matters of Irish domestic law rather than expert economic evidence.

The Taxpayer argued that the expert witness considered the economic principles as set out in the OECD Transfer Pricing Guidelines and sought to apply those economic principles to the particular facts of the case.

The TAC agreed with the Taxpayer and found the expert witnesses to be independent, unbiased and credible in assisting the TAC on the issues surrounding this appeal. In addition, the TAC considered that the evidence of the Taxpayer in relation to the accounting treatment was uncontroversial.

 

Periods of assessment

Another controversial point was related to the 2015 tax return and the four-year statutory time limit that precludes the Revenue from raising an assessment outside the statutory timeline unless the Revenue are not satisfied as to the sufficiency of the return, namely, when the tax return is in fact not full and true in its disclosure.

Revenue argued that the statutory timeline did not apply because the 2015 return was insufficient on the basis that the transfer pricing documentation supporting the tax return was fundamentally flawed based on the approach taken in the comparability analysis giving rise to a very significant understatement of the trading profits.

The Commissioner stated that the requirement for a sufficient return does not mean that the figure assessed by the Taxpayer must coincide with the figure that Revenue considered to be the correct figure, and added that a taxpayer who provides a full and true disclosure of all material facts relevant to their own self-assessment of tax has discharged their obligation in delivering the return. Therefore, the TAC agreed with the Taxpayer and found that “insufficiency” in the context of a tax return did not amount to what in the opinion of Revenue was to be “incorrect” in the case at hand.

 

Other court decisions on SBAs

There is an amount of cases where tax authorities from different jurisdictions have attempted to challenge the transfer pricing treatment of share-based awards.

Two of the most significant ones in recent years are the US cases of Altera Corp. v. Commissioner and Xilinx Inc. v. Commissioner. Altera and Xilinx concerned arrangements that involved intellectual property (IP) cost sharing agreements, where the non-US IP had migrated to a non-US subsidiary (including Ireland).

The cases considered whether the non-US subsidiary had to include the stock-based compensation for research and development employees as a cost and these cases were decided under US IP cost sharing transfer pricing regulations.

Both cases can be distinguished from the present case given that the Irish subsidiary performed sales and marketing and research and development activities for the benefit of its parent on a “cost-plus” basis and was not the owner of IP. Under US rules, these arrangements would be evaluated under transfer pricing regulations for service providers.

 

International implications

Whilst the TAC does not create a binding precedent in relation to the operation of tax law in Ireland, this decision is of international relevance as it is a counterview to the conclusions drew in the Israeli cases of Kontera and Finisar, in which it was held that expenses incurred by an Israeli subsidiary for services to its US parent company relating to employee stock-based compensation plans, should be included in the cost base for calculating the cost-plus remuneration notwithstanding the fact that the Israeli service companies did not actually incur any costs in relation to those share awards.

Therefore, this court decision, informed by extensive expert testimony and based on the application of the OECD Transfer Pricing Guidelines, will have implications for multinational groups which operate SBA schemes. Contact us if you need to review your existing transfer pricing policies following this determination.