Dear clients and cooperation partners,

This newsflash will tell you about findings reflected in court judgements with regard to application of resale price method, and in particular – contradictions in calculation of arm’s length profit level.

Recent transfer pricing judgements in Latvia lead to increased controversy in application of resale price method.

In recent years the Latvian tax authority – the State Revenue Service (SRS) – has significantly increased its capacity for transfer pricing (TP) audits. This has resulted in increased TP courtroom disputes.

One particular issue analysed in several recent judgments delivered by the Latvian courts is at least debatable. That is, in several cases1 the court supported the view presented by the SRS that when applying the resale price method, related parties should gain arm’s length profit both on the gross and operating (EBIT) levels simultaneously. The court refers in its judgments to the regulation in Latvian tax lawwhich in general is similar to Paragraph 2.21 of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD TP Guidelines). However, the devil is in the detail, and Latvian local tax law states that an entity which purchases goods from related parties and then resells them to unrelated clientsshall cover its sales and general administration (SGA) costs from its gross profit and earn an appropriate profit on an operating (EBIT) level. However, the OECD TP Guidelines instead use the wording would seek to cover its SGA costs and make an appropriate profit.

Based on the formulation in Latvian tax law, the Latvian courts argue that even if a taxpayer has proved that its gross margin is arm’s length, taxpayers should demonstrate that the operating (EBIT) margin gained in controlled transactions is also arm’s length. And in both reviewed cases the operating profit level was the trouble-maker as in most cases the SRS performed its own benchmarking study, which resulted in the conclusion that the operating (EBIT) margin of an audited company falls outside the arm’s length range of profits realised by comparable companies.

We assume that this approach by the courts stems partially from incorrect adoption of OECD TP Guidelines in national legislation and partially from the fact that during tax audits the SRS has made controversial decisions, i.e., applied the resale price method using the operating (EBIT) profit level indicator. If the court decides that the SRS has selected the wrong TP method, then, according to Latvian law the court is not allowed to change the TP method applied during court proceedings. In these circumstances the court’s only option is to declare the decision of the SRS void and annul it.

The approach described is contrary to the OECD TP Guidelines and the aim of the resale price method. Firstly, the main difference between the resale price method and the transactional net margin method is use of different profit level indicators. The former TP method uses gross margin as a profit level indicator, whereas the latter uses an operating (EBIT) level profit level indicator. Therefore, the main difference between both methods is which profit level indicator is used to substantiate compliance with the arm’s length principle. Furthermore, neither Latvian tax law nor the OECD TP Guidelines prohibits using more than one TP method to substantiate TP; however, the SRS has not applied this option in cases under review.

As several judgments have been delivered by the Supreme Court and the Administrative Regional court, most likely the SRS and the courts at first instance will follow the path set by the Supreme Court, i.e., that a taxpayer applying the resale price method should gain arm’s length gross margin as well as arm’s length operating (EBIT) margin, unless the Supreme Court overturns its earlier case law in cases pending before it. For now, we expect even more controversy in application of the resale price method in TP analysis in Latvia.