Importance of comparability factors in transfer pricing analyses

The Italian Supreme Court has ruled that transfer pricing adjustments applied by the tax authorities may be deemed legitimate even if they have been applied after a comparison between the transactions assessed and the ones carried out by and among third independent parties.

In the case at issue, the tax authorities recaptured tax on non¬declared proceeds derived from sales made by the plaintiff company to the foreign associated companies. The sales w ere considered to have been carried out at a low er price than one that w ould have applied to unrelated customers. The audited company lodged an appeal against the notified tax assessment.

Both First Instance Judges and the Regional Tax Court of the Veneto Region upheld the tax authorities’ adjustments and rejected the taxpayer’s appeal, which resolved to lodge a further appeal with the Supreme Court.

The Supreme Court reiterated that national regulations, as well as international transfer pricing rules, require a comparison between transactions carried out between two group companies (controlled transaction) and the ones entered into between independent parties, in order to identify a so¬called “normal value” (arm’s¬length value) which is representative of free competition values.

In particular, Italian tax provisions define the arm’s¬length value as the average price or consideration generally applied for identical or similar goods and services, under arm’s¬length conditions and at the same stage of distribution, at the time and place in which the goods or services were either purchased or loaned or, in the absence of such information, at the nearest place and time.

To such effect, the OECD requires that there be actual comparability between the tw o transactions being compared, thereby meaning that it is essential that there not be any differences that may affect the price of the transaction or, should there be any, such differences may be eliminated
through specific and objective adjustments.

To such purpose, it is necessary to consider and assess whether any differences were actually established within the context of the five comparability factors, and following indications provided by the OECD transfer pricing guidelines:

1) Goods and services characteristics;

2) Functional analysis;

3) Contractual terms

4) Economic conditions;

5) Commercial strategies.

In the case at issue, the Plaintiff had already emphasised ever since the ruling issued by the Court of First Instance, that there w ere two different price lists, in view of there being significant differences between the transactions effected by the foreign associated companies and the ones
with third¬party Italian clients in terms of both “stage of distribution” of the relevant parties (and therefore in terms of functions carried out by the latter) and in terms of contractual agreements underlying the sales.

In particular, the follow ing documents were exhibited:

– Price list for Italian clients (with a detailed retail sales report, modest quantities, prompt deliveries, post¬sales assistance, lengthy payment terms, commissions and agents);

– Price list for associated foreign companies (with report on sales to distributor, considerable quantities, 60¬day deliveries, scheduled orders, nonexistent costs for catalogues and agent commissions).

Such differences in sales conditions had also been strongly emphasised under the Appeal ruling, since the Second Instance Judges had pointed out that “in their equitable reduction of the recaptured tax, the Provincial Tax Court had already taken into account the different conditions in the comparisons vis¬à¬vis the associated companies, which consisted in higher quantities, lack of commissions, prompter payment, etc..”.

Therefore, the Plaintiff had draw n attention to the tax authorities’ improper approach, as the latter made a comparison between sales carried out by the self¬same company to its associated companies and the ones carried out towards third Italian independent parties operating at a
different stage of distribution.

Conversely, according to Plaintiff, it would have been more appropriate to make a comparison between sales carried out vis¬à¬vis third independent foreign parties, because the latter were distributors just as the associated companies were.

Consequently, the Supreme Court resolved that the arm’s¬length value of intercompany transactions must be identified after “a strongly contextualized comparison from a qualitative, commercial, time¬related and local standpoint”.