Financial transactions in capital groups – analysis of case law of Polish administrative courts – part. 2

This Article is a continuation of publication 1 , to discuss the issues of financial transactions carried out in capital groups and their tax consequences. These transactions are important for the management of entities belonging to the capital groups, groups of affiliated companies.

Action in a group of companies makes it easier to raise external capital and distribute the funds available to individual entities. The provisions laying down the tax consequences of such transactions are rather palpable, often taxpayers must apply general tax rules accordingly.

In this section of the publication, the author presents the position of tax authorities on the possibility of comparing intragroup financial transactions with data on the financial services market offered by banks.

1. Introduction

A company operating in a group looking for funding shall analyse the possibility of obtaining the capital needed in both external sources of financing and within the group of affiliated entities in which it operates.

When deciding on intra-group financing, entrepreneurs are aware that the terms of loans concluded between related entities are often of interest to tax authorities.

In order to ensure that intra-group financing conditions do not deviate from the market, traders compare these requirements with the conditions and costs they would have to bear in the event of using the financing from an independent bank.

In many cases, the tax administration, verifying the market nature of financial transactions, also eats bank offers.

This practice has become quite common in tax investigations relating to the verification of loans between related entities, but raises some serious doubts as to the principles of benchmarking and in particular the proper application of the comparability criteria. The question whether the interest rate on loans granted to the non-bank commercial sector can be explicitly referred to as interest rate on bank loans is very controversial, given the need for a reliable benchmarking.

2. Decisions of the administrative courts

The tax authorities in the verification activities shall consider first and foremost whether the provisions of the loan agreements and the implementation of those contracts give reasons to consider that more favourable conditions have been applied to the borrower than for loans/loans granted by banks. The courts shall examine closely, having regard to the case-law on the assessment of the legality of the proceedings of the tax authorities verifying the terms of intra-group loans, whether they have collected a complete and exhaustive evidence, which is clear, of course, because of the role of the administrative court in monitoring the activities of tax authorities.

However, the impression may be that a little less attention is paid to the proper handling of the analysis and application of the comparability criteria, which seems to be a key issue in many of these cases.

At the outset, it is worth noting the NSA position in the judgment of 3 March 2016 2 , which became a reference point for many decisions issued in subsequent years.

In the view of the court expressed in that judgment, it was pointed out that it is permissible to estimate the proceeds of loans made by non-bank entities on the basis of loan interest rates (credits) for a similar period under comparable conditions provided by banks as other unrelated providers of services on the market.

The Supreme Administrative Court considered it appropriate for tax authorities to compare the terms of the loan granted by the company to a natural person who was a member of its Supervisory Board with those of loans granted by banks (i.e. financial institutions).

The Court of First Instance based its argument on the interpretation of the provision Article 11(2)(1) Act on 15 February 1992 on corporate income tax 3 (Next: the Corporate Income Tax Act) and section 12 and section 21 Regulations of the Minister of Finance 10 September 2009 on how and how corporate income is determined by estimation and how and how to eliminate double corporate taxation in the event of adjustment of profits of related parties 4 (hereinafter: ‘MF Regulation’) stating that these provisions clearly allow for comparison of prices applied by entities other than the taxable person with those applied between the taxable person and the associated entity.

He also pointed out that Under section 21 section 1 and 2 The MF Regulations align loans and loans, i.e. forms of money provision by both financial institutions and entities for which the activity does not constitute a basic profit profile, and therefore does not constitute an improper application of the provisions in question to the comparison of prices applied by other external entities, including those that are professionally engaged in financial services, i.e. banks.

In its interpretation, the NSA considered that the above-mentioned provisions define as comparable transactions in which none of the possible differences between comparable transactions or between those involved could significantly affect the price of such transactions on the free market.

In applying this provision, the tax authority should therefore select for comparison transactions that meet the above requirements. They need not be the same transactions by the same entities.

According to the Court of First Instance, the provision in question indicates that there may be differences between transactions carried out by related and independent entities. It speaks of comparable rather than identical transactions by other independent entities, defining an external price comparison.

It can therefore be concluded that the court in the judgment cited proposed a broad understanding of the concept of ‘comparability’ and, consequently, the criteria of comparability.

This approach represents a certain risk – it allows one of the parties to use the data which, at a relatively small level, will meet the criteria of comparability, which allows tax authorities to identify more data potentially comparable, and secondly, the parties indicate that taxpayers may also use data which are not necessarily at the highest level of comparability.

According to the author, such an approach may represent a significant risk, in particular since benchmarking for the verification of financial transactions is carried out using a method of comparable uncontrolled price, in which, according to established practice under OECD regulation, the highest possible degree of comparability is expected.

The similar reasoning was reflected in other judgments of the administrative courts; in some cases such understanding of comparability in the context of financial transaction data was supplemented by additional arguments – for example in the judgment of the CSA of 16 May 2018 in Gorzów Wielkopolski 5 The Court of First Instance held that the essential criterion to confirm the appropriateness of the adoption of financial data from banks is that: ‘In the view of the Court of First Instance, the method of comparable uncontrolled price adopted by the authorities is justified by the circumstances of the case and aims to establish the tax base in a manner similar to that in fact.

It was based on logical reasoning and rational assumptions. Data from 10 banks were a sufficient sample to estimate income.’

A slightly different position was presented in another NSA case in the ruling with 10 October 2013 6 , in which he criticised the judgment of the WSA regarding the narrowing of the court first the comparison of interest rates applied to the bank credit market only, and has completely ignored the economic events of non-bank lending, including the so-called joint loans.

The Supreme Administrative Court found it unreasonable to align the institutions with the joint loan and the bank loan, arguing that the loan is a bank instrument, while the lender is generally a different entity than the bank and that the loans (granted by other entities than the bank) are the most frequently traded economic.

The loan is a civil law institution and the loan is a banking institution.

The NSA further stated that the determination of whether the conditions for specific transactions between capital-related economic operators are more favourable and different from ‘the conditions generally applicable at the time and place of performance of the benefit’ requires account to be taken of the various comparable economic events occurring at the same time, including the forms of agreements leading to a more effective financial management policy.

The NSA pointed out that when comparing the terms of transactions concluded by entities related to similar transactions concluded by unrelated entities, differences between parameters of both economic transactions may be the result of their economic specificities (e.g.

different distributions of costs, risks, different functions, formal conditions, etc.). Therefore, using a comparative method, it is not appropriate to seek perfectly comparable transactions by unrelated parties, and at the most limited to similar transactions in similar situations.

It can then be determined whether the interest rates applied corresponded to market conditions relating to business loans contracts and this was the result of capital links between the parties to the transaction.

It was also necessary to take into account the relevant circumstances of the transaction during the selection of the data to the sample that the WSA in Łódź also drew the attention from the judgment of 16 July 2016, in which he pointed out that since the credit agreements were largely mortgage-backed, they could not be comparable to the contracts in question because they did not have any collateral for repayment[7].

The judgments cited above were also examined later by legal representatives, including Tomasz Kolanowski and Krzysztof Winiarski.[8]. They pointed to the problematic aspect of how the tax authority set a specific reference point in determining the taxable person's income and the tax due without the transactional conditions resulting from the links.

The tax authority's problematic assessment of income/income tax on the basis of market rules for establishing the transaction price with the related entity also referred to Włodzimierz Nykiel's comment[9].

He noted that the case-law often shows that comparing the conditions under which a bank loan is obtained with the conditions for granting loans from entities not belonging to the banking sector does not seem entirely appropriate.

The courts find that the sequence of actions should be limited to determining whether there are operators in the market that could lend to the taxpayer for the purpose of the contracts concluded.

It is only if it is established that there are credit granting companies on the market on such a basis as a related entity that the tax authority will be able to examine whether the conditions proposed by independent entities differ from those contained in the loan agreements between related parties. If there are no companies able to provide such loans, the practice in the banking sector can only be addressed.

These positions were reflected in the later case law.

From the most recent case law in this matter, it should be noted, at least, that the judgement of the WSA in Warsaw 28 May 2019 10 , in which it pointed out that the authorities ‘(...) in fact (in some way) questioned the marketability of the loans on the basis of the transfer pricing documentation (based on the geographical criterion and on the fact that the underlying amount of the transaction is very open), asked the banks on the basis of the material comparability factors they considered to be relevant, and then, on the basis of the information received, on the basis of the lowest interest rate, determined, in advance, the relevant adjustments based on the transfer pricing model, the market level of the loans concerned’.

However, the court considered that the analysis of comparability was not carried out correctly by the tax authorities because the information concerning the taxpayer, its business environment, its functions, the assets involved and the risks incurred in the context of the purpose of the loans received (the acquisition of the commercial centre) was not analysed.

The Court of First Instance stressed that the analysis of comparability should take into account the specificity of the particular transaction, in this context receiving a loan to finance the designated shopping centre (...).

In this respect, the Authority limited itself to formally describing the applicant, formally describing the loans, indicating that they were intended to finance the acquisition of the mall (...) and, after questioning the marketability of the loans on the basis of the model presented in the transfer pricing documentation, asked the banks on this basis.

In the absence of a description and an appropriate analysis of the comparability of the transaction in question (taking into account the fact that the acquisition was a shopping centre), including the risks involved, the Authority incorrectly identified all relevant factors of comparability.

In its speech to the banks, the Authority requested information on the interest rates and the percentage of the commission (additionally asking whether the interest rate was fixed/variable and whether the bank was using the collateral and whether it was mandatory or optional) for the loans/loans they provided, except in their parameters the total amount of the loan and its collateral.

The incorrect (incomplete) determination of the factors of comparability resulted in the Authority obtaining information from banks which, in the judgment of the court, could not be used to estimate the applicant's income and the tax due.

A similar position of the WSA in Warsaw was later expressed in the judgment of 5 September 2019 11 , ruling that it is not possible to refer to the average lending rate data when assessing the market behaviour of the loans if these data are determined on the basis of generally formulated criteria.

Referring to the interpretation section 6 section 4 point 1-2 The MF Regulations stated that the Authority did not properly analyse the comparability as it had to analyse the information concerning the taxpayer, his business environment, his functions, the assets involved and the risks incurred in the context of the loans received, taking into account the purposes for which they were granted and their amount.

Instead, it limited itself to formally describing the applicant and the loans, indicating that they are intended to finance the acquisition of the property and the implementation of the project and to finance the current activities of the applicant company.

Therefore, he did not carry out the above-mentioned analysis of the information in connection with the achievement of the objectives for which the loans were granted, as he practically did not address these issues at all.

The Court of First Instance pointed out that when carrying out the comparability analysis, the Authority should take into account the specificities of those transactions, namely the granting of loans for the abovementioned purposes rather than the granting of loans in general.

The Provincial Administrative Court pointed out that, first of all, the factors affecting the assessment of the risk of non-payment of these loans by the applicant had to be examined, since it is clear that the interest rate that the economic operators determine by granting themselves loans has the effect of not returning these loans.

The position presented by the courts in the latter judgments appears to be closer to such proceedings in search of the appropriate level of comparability resulting from the purpose of the transfer pricing rules introduced into the Polish tax system under the OECD Guidelines.

There is no doubt that it is neither possible nor the task of the administrative courts to formulate a coherent, closed list of guidelines or specific guidelines for the conduct of a universal benchmarking for a number of different loan agreements between different groups of affiliated entities.

However, it is worth using the acquis presented to consistently indicate that all the circumstances in which the group funding took place have an impact on what the remuneration was ultimately used in the transaction.

This reliable approach, both at the stage of the transaction description in the tax documentation and at the stage of the benchmarking, certainly increases the tax security of the transaction.

3. Summary

This section presents the issues relating to the approach of administrative courts to the use of funding terms data used by banks in credit agreements for comparative analyses carried out to verify the conditions applied in financial/loan transactions in groups of related companies.

The positions presented by the courts provide important guidance to taxpayers – they can both provide a basis for the creation of a detailed practice of examining all the circumstances of the transactions involved in its conclusion and a position where the authorities accept a fairly broad approach to comparability.

With that in mind, we can formulate two key conclusions.

After first, the existence of a discrepancy in the case-law results in significant uncertainty from the taxpayer's position as to how his case will be dealt with.

After second, The practical effect is that the taxpayer still has a significant burden, not only to ensure that the market conditions of the transaction are actually met, but also to develop and develop exhaustive documents, analyses and descriptions to be protected in case of possible discussion with the tax authority.

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1 Cf. L. Dutkiewicz, Financial transactions in capital groups – analysis of the case law of Polish administrative courts – p. 1, „Legal and Tax Advisory – RB Newsletter” No. 2 (19) February 2020.

2 reference no. II FSK 3571/13, See also judgment of the WSA of 8 March 2018 in Olsztyn, reference no. I SA/Ol 88/18.

4 Journal of Laws, item 1268 as amended

5 reference no. I SA/Go 79/18.

6 reference no. II FSK 2297/11.

7 reference no. I SA/Łed 391/16.

8 T. Kolanowski, K. Winiarski, What can administrative courts in terms of transfer prices?, “Tax Review” 2018, No 12, p. 21-27.

9 W. Nykiel, D. Sagittarius, Estimate on transactions between related entities. Practical comments, 2014.

10 reference no. III SA/Wa 1777/18.

11 reference no. III SA/Wa 2116/18.