Administrative Court of Appeal rules on control over risk in transfer pricing case

On 10 April 2024, the Stockholm Administrative Court of Appeal (ACA) overturned a ruling of the Stockholm Administrative Court (AC) in a transfer pricing case concerning a Swedish-headquartered multinational group (case no. 6754–6759-22).

Unlike the AC, the ACA agreed with the Swedish Tax Agency’s (STA’s) interpretation of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (“OECD guidelines”). The STA delineated the actual transaction attributing residual profit to the Swedish parent entity, based on conduct (control over risk functions) and contrary to the contracts, leaving only a net cost-plus and a risk-free return for the counterparty.

Summary of the regulatory background

The arm’s length principle is codified in chapter 14, paragraph 19, of the Swedish Income Tax Act (the “correction rule”). The domestic legislation is based on article 9 of the OECD Model Tax Convention on Income and on Capital. Although not formally binding, the OECD guidelines provide guidance for the application of the domestic arm’s length principle (established in the Shell case (RÅ 1991 ref 107) and the Nobel Biocare case (HFD 2016 ref 45)).

Generally, taxation is based on civil law unless there is specific tax regulation or precedence. A possibility to tax the substance of a transaction when it clearly differs from the civil law form (“verklig innebörd” in Swedish) has developed through domestic case law.

The concept of accurate delineation in the OECD guidelines requires the determination of the factual substance of a transaction by corroborating the contractual terms with the conduct of the parties (for example, which party exercises control over economically significant risks). The delineated transaction is then compared with what unconnected parties would have agreed under comparable circumstances to assess the arm’s length nature.

From a procedural perspective, tax reassessment more than two years after the end of the fiscal year can only take place if the taxpayer provided incorrect information, or omitted information, from the return. In such cases, there are also grounds for tax penalties. However, if the information required for a correct tax assessment is disclosed in the tax return, or the taxpayer highlights the tax issues, the STA can only reassess the taxpayer up to two years after the end of the fiscal year and tax penalties cannot be imposed. Penalties can be reduced where the tax issue is considered complex.

Summary of the case background

The background to the case before the ACA can be summarized as follows: 

• A Luxembourg subsidiary in the group (“LuxCo”), acquired intellectual property (IP) from unconnected parties. The IP was later licensed to connected and unconnected parties.
• LuxCo had a board and two to five employees (varying over the relevant period).
• LuxCo initially had shareholders’ capital of EUR 25,000. The acquisitions of IP were of significant amounts and one of the largest was funded in its entirety by related party loans.
• The STA argued that key decision-making functions and control over economically significant risks (e.g., the acquisition risk) of acquiring the IP had not been performed by LuxCo. Accordingly, LuxCo was not entitled to intangible-related returns (residual profit).
• The Swedish parent and other group entities had performed key decision-making functions and controlled significant risks.
• As a result, the STA argued that a proportion of the residual profit (60%) should have been attributed to the Swedish parent under a profit split method, while LuxCo should have earned only a routine return (cost coverage plus a mark-up) and a risk-free return for funding the IP investment. This conclusion is contrary to the contract between the parties.
• The taxpayer argued (i) that LuxCo had controlled the risks associated with the IP acquisitions and that the STA’s investigation was flawed, and (ii) that because the STA had not claimed or evidenced that the contracts differed from the civil law form it is not possible to make a substance over form assessment under the domestic tax law.

Rulings of the AC and ACA

The AC concluded that control over economically significant risks could indicate that the substance of an arrangement differs from its form; however, this alone would not be sufficient to disregard civil law agreements. The STA had not claimed that the substance of the arrangement differed from its civil law form, nor provided relevant evidence under Swedish case law. The AC ruled in favor of the taxpayer.

The ACA held that the correction rule assessment is not limited to contractual terms, noting that the rule is based on a comparison with what independent parties would agree under comparable circumstances. When applying the correction rule, the OECD guidelines are applicable and not the domestic substance over form case law. The ACA based the delineation of the actual transaction under the OECD guidelines on circumstances from the time of the IP acquisitions. The ACA found that the Swedish parent had controlled the relevant risks in relation to the IP. LuxCo’s legal ownership and the formal approval of the acquisitions were not significant. As a result, the ACA agreed with the STA’s position.

The ACA agreed with the taxpayer that the STA had not demonstrated the profit split by referencing what unconnected parties would have agreed. However, the court accepted the profit split stating that it cannot be required for the STA to find third party evidence, because comparable transactions may not exist between unconnected parties. The ACA considered that the disputed questions were not difficult tax matters (which would provide grounds for penalty relief), affirming the STA’s decision to impose full tax penalties.

Deloitte Sweden comments

This is one of several cases concerning delineation of actual transactions that differ from the contract, because of control over risks under an interpretation of the OECD guidelines, and to what extent the domestic substance over form case law must be considered in relation to the correction rule. The reasoning and outcomes between the cases vary and are to some extent inconsistent.

The ACA found that decision-making functions and control over risk in relation to the IP acquisitions entitled the Swedish parent to a proportion of the residual profit annually (with the same fixed percentage), thus highlighting the importance of historical contributions. In other cases, the STA and the ACA have taken the position that the right to returns should be attributed to the party that currently performs control functions. In Datawatch and Twilio (Stockholm ACA, case no. 4775-4777-19 and Gothenburg ACA, case no. 17-22, respectively) Swedish entities had developed IP but because of acquisitions it was considered that decision-making functions were performed by foreign related parties which, as a result, were entitled to the intangible-related returns. In such case, it was deemed the Swedish entity should have been indemnified as if the assets had been sold (i.e., a one-time remuneration). The fact that the Swedish entities had controlled the development historically, when independent, was not considered by the courts.

According to the ACA it was not possible (or not necessary) to evidence what unconnected parties would have agreed in the situation, as the basis for the STA’s profit split. Without access to the complete reasoning of the court this conclusion is surprising, considering that the arm’s length principle (and the legal prerequisite for performing the reassessment under the correction rule) involves evidencing what unconnected parties would have agreed. Therefore, the STA would be required to evidence that unconnected parties would have agreed as claimed. The fact that the court concluded that third party evidence may not be available would suggest that the matter is complex, which may at least be a ground for penalty relief.

The AC concluded that guidance from the OECD concerning the delineation of the actual transaction may be applied when it is aligned with domestic law and principles. The ACA, however, seems to apply the OECD guidelines directly. It is established that the OECD guidelines may provide guidance in asserting arm’s length terms when the correction rule is applicable. However, there is no established case law from the Supreme Administrative Court (SAC) suggesting that the OECD guidelines may be applied to tax a transaction that differs from the contracts unless the assessment is also compatible with the domestic substance over form case law, or that this case law is not applicable in relation to the correction rule. Whether the OECD guidelines can be used to delineate a transaction that differs from what is allowed under the domestic substance over form principle, as in the current case, is a legal matter that requires guidance from the SAC.

The court ruling highlights that transfer pricing matters are complex and the current legal situation is unpredictable. In the event of acquisitions, restructurings, or organizational changes that affect Swedish entities, the case highlights a risk that conduct, and control functions, may result in transactions being delineated for tax purposes in a manner that was not intended, such as a disposal of all the acquired entities’ intangibles or a right to intangible-related returns. By ensuring that incorrect information is not provided in the tax return, the risk of tax penalties can be mitigated and the statute of limitations can be reduced to two years. Tax return disclosures and appropriate transfer pricing documentation are effective means to navigate the uncertainty.

Content provided by Deloitte Sweden.