Czech Republic: How to correctly make TP adjustments during a time of coronavirus

published on 1 December 2020 | reading time approx. 2 minutes

​The end of the year, the ongoing second wave of Covid-19 infections and transfer prices. Most people would assume that these three terms do not have much in common. But they would be wrong.

One of the main questions that taxable entities that carry out intragroup transactions will need to answer is the question of whether they have correctly set transfer pricing and whether their taxable income has been determined in accordance with the requirements stipulated in § 23 (7) of Act No. 586/1992 Sb., on Income Tax (the Act on Income Tax).

As the year-end approaches, for most taxable entities this also means the end of the tax year and the need to address the issue of how their group, and the related entities making up the group, were impacted by the Covid-19 pandemic.

It is quite clear that for a large number of Czech companies, their profits will be lower in comparison with prior tax years. Their profits will be lower due to objective reasons. The lower profitability or decline in revenues will result in a lower tax obligation, which will naturally attract the attention of the Czech tax authorities. The tax authorities will primarily check whether companies that carried out intragroup transactions set their transfer pricing in an incorrect manner.

Companies typically ensure that their methods in the area of transfer pricing are in accordance with arm's length transactions between independent entities by using TP adjustments (adjustments of transfer prices). In ideal situations, such adjustments are made in accordance with predetermined criteria that are set forth in the relevant contracts.  As the year-end approaches, most multinational groups find that they also have higher volumes of invoices and credit notes that they have issued, specifically higher volumes of invoices and credit notes that necessitate adjustments to the profitability of those group companies that are considered to be related entities.

The TP adjustment consists of adjusting a company's profitability (most frequently this involves companies with a limited functional and risk profile) to an arm's length level, or of reflecting the actually-achieved operating results against the planned values (revenues, costs, units sold and so forth).

TP adjustments are frequently made on the basis of a comparative analysis. Such an analysis consists of comparing how the price set in a specific transaction carried out by a company compares with the profitability typically achieved by independent companies on comparable economic activities. It should be pointed out that the profitability of independent companies is ascertained from historical data, since data are typically entered into databases with a time lag of about 18 months (most databases currently have data available in respect of 2018).

A TP adjustment should also be performed so as to correctly reflect the so-called functional and risk profile of the company concerned. For example, in the case of companies with a routine functional and risk profile one needs to ask to what degree such companies can be expected to bear the reduced profits, or even losses, that are generated by the group or the company itself. The answer to this is not at all simple and each case needs to be assessed individually, taking into account the specific functional profile of the relevant company and the relationships within the group. The primary aspect is the conduct of the parties concerned, but one also needs to review how the group had contractually specified liability for such specific losses.

The above-outlined procedure for making TP adjustments works relatively well in periods where there are no fundamental differences between the period for which the adjustment is to be made and the preceding years. This assumption, however, will naturally not apply to adjustments in respect of 2020, and one will not be able to use the standard approach of comparing 2020 profitability with profitability in previous years. Such previous years were years in which the economy was quite strong, so it would not make economic sense to use them for comparison, since in 2020 we were not dealing with ordinary economic transactions carried out under the same or similar conditions as in previous years.

In practice, this means that, for example, a Czech manufacturing company that does not provide any other economically significant functions other than production (the other functions may be performed by the parent company in Germany, for example) should be generating a relatively low but stable profit. And this requirement for stable profitability could be a problem if the group as a whole generates a loss, a loss that will need to be distributed across the group in accordance with international rules.

Regardless of the method used for distributing (sharing) such lower profitability (either by means of a TP adjustment or via another form of compensation), such method must be based on robust analysis and sufficient evidence.

If you are preparing to adjust profitability by means of a TP adjustment, now is the right time to prepare such evidence.