Decision from the lower administrative Court of Montreuil, July 1, 2014, no. 1206254, Philips France SAS

The French company Philips SA (hereinafter the “Company”) provided research and development services to its Dutch parent company KPE NV. Its remuneration was determined according to the cost plus method. In determining the cost base, the Company deducted the amount of subsidies it received from the French State for business investment projects aids.

The French Tax Administration (hereafter the “FTA”) considered that the deduction of subsidies for the calculation of the cost base constituted a price reduction and therefore a non arm's length transfer of profits under Article 57 of the French Tax Code (which embodies the arm's length principle in French domestic law). The Company and the FTA were in opposition before the Court concerning the nature of the subsidy. The FTA considered that the subsidy in question was an investment subsidy and not a directly additional revenues. By contrast, the Company considered that the subsidy paid by the State was a component of the cost of its services.

Moreover, the Company claimed that it was performing routine research and development functions, while KPE NV bore the risks of the activity and assumed the entire funding of the developed intangibles.According to the FTA, however, the risks borne were already balanced by the fact that KPE NV owned research results and could charge royalties to third parties or subsidiaries.

The lower administrative Court of Montreuil ruled in favor of the FTA which concluded that a transfer of profits had taken place, arguing that “the transfer of profits is established since the applicant could not include the subsidies in the cost of the services rendered”.

In our opinion, the relevance of a mechanical application of a standard for determining the cost base is arguable. According to the arm's length principle, “the price between two dependent enterprises must be the same as the one which would have been in the market between two independent enterprises.”[1] The possible existence of a price reduction within the meaning of Article 57 of the French Tax Code must be assessed by comparison with market conditions, and not with any accounting classification. This is all the more the case as there is no binding provision in French law for the determination of the cost base for transfer pricing purposes. In other words, any deduction made to determine the cost base does not necessarily amount to a price reduction within the meaning of Article 57, unless the FTA demonstrates that such a deduction would not have been agreed upon between independent parties. A binding and systematic definition of the cost base would seem contrary to contractual freedom and to the arm's length principle if it is not rooted in a comparison with market practices.

Furthermore, regarding investment subsidies for research and development, various treatments exist:

  • The French General Accounting Plan (PCG) provides that investment subsidies are either immediately recognized as income or spread over time.
  • The IFRS standard requires that subsidies related to assets can be recognized either as deferred income or as a deduction from the asset value.
  • The French tax legislation provides that subsidies received should be taxed over the same period as the amortization of the capitalized costs.

Therefore, there is no obvious reason to impose one treatment or another to taxpayers regarding the determination of cost bases.

In the case at hand, regarding contractual freedom, the master agreement provided that “the net costs related to the research activities borne by [the Company be] billed to KPE NV plus a margin of 10% (...).” Subject to further information not in our hands, we note that the reference to net costs seems compatible with the deduction of an investment subsidy for the calculation of the cost price.

Finally, from an economic standpoint, it seems that, by granting investment subsidies, the French government wants to encourage companies to invest while remaining competitive, that is without increasing their prices. If the FTA does not allow a deduction of subsidies for the calculation of the cost base, this would lead to an increase in the resulting prices charged to customers and thus defeat the purpose of promoting competitiveness.