Taiwan's Supreme Administrative Court recently handed down a verdict in a case that involved transfer pricing adjustments, marking the first case in Taiwan in which the court has ruled on transfer pricing issues since Taiwan's transfer pricing regulations were promulgated in 2004.
On 5 January 2012, the Court denied a deduction for transfer pricing readjustments in the case of Cadence, a US group in the business of electronic design automation. No further appeal is possible.
The decision offers significant guidance on how future transfer pricing disputes in Taiwan will be resolved.
Cadence Taiwan provided R&D services to Cadence US, its US parent. In 2003, based on a transfer pricing study, Cadence US concluded that the service fees that it had paid to Cadence Taiwan in 2002 were too high. Cadence US therefore instructed Cadence Taiwan to book a significant sales allowance amount in the latter's 2003 accounts, and sent a debit note to Cadence Taiwan. The adjustment was repeated in 2004 for the same reason.
Cadence Taiwan claimed a tax deduction for the sales allowances it booked. The appeal court rejected Cadence Taiwan's claim on the following grounds:
- The intercompany service agreement between Cadence US and Cadence Taiwan did not contain any provision for a retroactive adjustment of the service fees.
- The debit notes from Cadence US were not signed off by Cadence Taiwan to acknowledge its agreement to the adjustments.
- Therefore, the subsequent sales allowances booked by Cadence Taiwan were purely for the purpose of allocating profits without any economic substance, and thus could not be allowed.
Lessons from the case
The rationale behind the court's decision is not logical from a pure transfer pricing perspective. After all, transfer pricing adjustments are made for the purpose of allocating profits between related parties to accord with an arm's length range.
Admittedly, downward TP adjustments are not always welcomed by tax authorities around the world and Taiwan is no different in this regard.
The Taiwan tax authorities might be emboldened by this decision to disallow other downward TP adjustments that reduce taxable income in Taiwan. Taxpayers in this position therefore need to take steps to improve the strength of their claims to tax deductions in such circumstances.
We recommend the following three steps:
- Improve quality of transfer pricing report
Although not mentioned in the court's decision, the Ministry of Finance ("MOF") did challenge the quality of the TP report that Cadence US had prepared, especially the selected data of comparables. The MOF stated in its decision that the TP report prepared by Cadence did not include sufficient information for comparability of the selected companies, including their business scope and scale of assets.
Taiwan's TP guidelines require adjustments to be made to the comparable companies selected to improve the quality of comparability. This is especially important if the Comparable Profit Method is selected. Any GAAP difference and capital and assets intensity should be adjusted to ensure a higher degree of comparability.
Hence, to avoid future challenge, TP reports should contain assets and capital intensity and other necessary adjustments, to make the TP report more acceptable to the tax authorities.
- Timing of the TP adjustment
Taiwan's TP guidelines explicitly disallow any TP adjustment that will lead to reduction of taxable income in Taiwan. In practice, therefore, groups should book their TP adjustments prior to closing their Taiwan statutory accounts for the relevant year. By doing so, they will be reporting taxable income in Taiwan based on the results in their statutory accounts without making a subsequent for-tax-only TP adjustment. Cadence Taiwan made its 2002 adjustments in 2003 and its 2003 adjustments in 2004, and thus made itself more vulnerable to challenge.
Hence, to avoid future challenge, where possible, adjustments should be made in the accounts of the same year to which the adjustment relates.
- Economic substance of the TP adjustment
Traditionally, Taiwan's tax authorities have been very demanding about supporting documentation for profits and losses reported by taxpayers. The following flaws in the Cadence case were fatal in this regard:
- The intercompany service agreement did not contain any clause that provided for a subsequent retroactive adjustment to the service fee.
- The debit note from Cadence US was not countersigned by Cadence Taiwan to acknowledge its agreement to the adjustment.
While the operating results must be within an arm's length range, nevertheless Taiwan's tax authorities and courts require the related documentation to be consistent with normal business practice. In this case, they asserted that Cadence Taiwan should not as a normal business matter have accepted an adjustment when there was no legal obligation to do so contained in the intercompany service agreement. After all, an unrelated party in such circumstances would not have agreed to such a retroactive adjustment.
Also, Cadence Taiwan should not have simply booked the sales allowances upon receiving debit notes from Cadence US. Instead, it should have negotiated with Cadence US and then countersigned the debit note, just as an unrelated person would have been expected to do.
Hence, to avoid future challenge, care should be taken in drafting the legal documents between the parties to provide for a legally binding mechanism pursuant to which transfer pricing adjustment can be made.