TP functional profile explained

Today we wish to remind you of how important it is to properly determine the functional profile for TP purposes.

The functional profile results from the entity’s involvement in the transaction: the functions performed, the assets involved and the level of risk exposure. Importantly, the functional profile should support the management of the assigned risk in organizational and financial terms.

Failure to properly assign a functional profile to the entity may involve a significant risk in the event of a tax inspection. Tax authorities pay special attention to entities assigned with a limited functional profile that report losses. This is because – by definition – a functional profile with limited risks should be associated with achieving a stable and low level of profit.

The following is an example of an actual tax audit (in Czechia). It offers insight on how the matter is reviewed by the authorities.

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The company’s TP documentation stated that it acts as a contract producer in the group while suffering several years of operating losses.

As a result of the tax inspection, the authority estimated an additional corporate income tax of CZK 11,897,090 (approx. PLN 2.2m) and a penalty of CZK 2,379,418 (approx. PLN 400k).

During the proceedings, the company tried to demonstrate that its profile corresponds more to that with extended risks. However, it failed to convince the authorities and the courts even more so given that it had previously stated a different profile.

The authority proved the company has been facing risks beyond its control and has been selling its products below operating costs without any compensation.

At the same time, the parent company had a significant influence on the selection and final approval of the suppliers of materials, setting supply terms, price negotiations and negotiating delivery terms with end customers. Although the Czech company sold products and purchased materials from third parties, all sales plans were provided by group related entities. Therefore, according to the court, all transactions made by the Czech company, including those with third entities, are controlled transactions.

Please note that the Polish Ministry of Finance-released general interpretation regarding the definition of a controlled transaction also emphasizes that a controlled transaction is made when its terms are imposed as a result of relations. This does not mean that the transactions must be made directly by related parties – it means that the relations influenced the determination of its terms. Therefore, it is possible that the terms of a given transaction may be set or imposed by a related entity that is not directly a party to the transaction.

You should pay special attention to two matters:

• reviewing whether the functional profile assigned is consistent with the facts and has been properly described in the transfer pricing documentation, in particular whether the company is able to bear the consequences of materialized risks assigned to it, and
• identifying transactions whose terms are imposed by another entity, e.g. the parent company.

This is particularly important when the company incurs losses for several years.