Transfer Pricing for Manufacturing Affiliates in the Czech Republic

The Czech Republic is one of the four Visegard economies, which also includes Hungary, Poland, and Slovakia. Simon Tilford discussed in a November 2017 piece for Center for European Reform how these economies have relied on foreign direct investment to increase their gross domestic product:

the Visegrad countries – the Czech Republic, Hungary, Poland and Slovakia – are doing well economically. The data for GDP per head suggest a gradual convergence in living standards with Western Europe. They continue to attract a disproportionate share of inward investment in EU manufacturing, and their integration into EU-wide supply chains helps to explain why they are now collectively Germany’s most important trade partner … In 2016 worker ‘compensation’ (wages and salaries and other benefits) ranged from just 50 per cent of the eurozone’s in Hungary to 59 per cent in the Czech Republic. And the rate of convergence of compensation with the eurozone average has been slower than the rate of convergence of GDP.

Much of the increase in GDP has been captured in terms of the profits for the foreign owners of capital. Many of the key sectors represent the affiliates of foreign based multinationals. A recent litigation and a recent transfer pricing presentation discussed how to address the transfer pricing for manufacturing affiliates in the Czech Republic.

LTA Legal’s Lenka Pol Brozkova discussed certain issues during a June 2023 webinar entitled “Variable license/service fees as a tool to manage profitability at contract manufacturing companies”. This presentation contrasted the issues for the traditional contract manufacturing affiliate the issues for an affiliate that licenses the intangible assets of the parent corporation for domestic production and distribution. An April 2023 Regional Court decision in Czech Republic vs ESAB CZ, s. r. o. (Case No 31 Af 21/2022 – 99) addressed the contract manufacturing arrangement between ESAB Europe and its Czech affiliate ESAB CZ during 2014 and 2015.

ESAB CZ as a Contract Manufacturer

ESAB Corporation is a leading multinational in sectors such as connected fabrication technology and gas control solutions. ESAB CZ produces welding equipment on behalf of ESAB Europe, which is a Swiss affiliate. The Swiss affiliate was responsible for all design and marketing functions. The Regional Court decision noted the intercompany policy as:

was a contract manufacturer for ESAB Europe. The contract set ESAB CZ’s target profit margin for 2014 and 2015 at between 2,5% and 3,5%, with an adjustment to 3% if the actual profit margin achieved was outside that range.

This range of markups was derived by examining the ratio of operating profits to total costs for 56 privately held companies. The only dispute between the multinational and the Czech tax authorities was whether depreciation and amortization should be included in the cost base and the definition of operating profits. While the multinational implemented its policy using earnings before interest, taxes, depreciation, and amortization (EBITDA), the tax authority defined operating profits as earnings before interest and taxes (EBIT). The Regional Court decision noted:

the valuation of the spun-off part was carried out using the discounted cash flow method (see section 7.2.5 of expert report No. 211-14/13 Valuation of the spun-off part of the assets) and the capitalized net income method for the valuation of non-operating assets. As a result of this valuation, a valuation difference totalling EUR 1.027 million was recognised in the applicant's opening balance sheet. In accordance with the Czech accounting rules, the difference was amortised over 15 years.

No other financial information with respect to the income statement or the balance sheet was provided. The debate over the use of EBITDA versus EBIT will be explored using a hypothetical illustration of how the role of the asset intensity of the Czech manufacturing affiliate should have been a central issue that was not properly considered in the application of the Transactional Net Margin Method (TNMM) used to suggest that the appropriate markup was near 3%.

Our hypothetical illustration assumes the following:

• the Czech affiliate incurred €10 million a year in labor costs;
• the Czech affiliate purchased €10 million a year in material costs;
• the market value of the operating assets was established as €10 million by the valuation.

If the book value of these assets at the time of the spin-off was €9.963 million, then the valuation would record $1.027 million as goodwill representing the difference between the market value of operating assets and their book value. Let’s also assume that the economic useful life of the operating assets is 20 years with no scrap value at the end of this useful life. We consider four alternative markups over labor and material costs excluding depreciation and amortization using EBITDA as cash flows for a discounted cash flow evaluation of the appropriateness of each markup. Table 1 presents the assumed cash flow model and the internal rate of return (IRR) required to have the cash flows have a value = €10 million.

Table 1: Illustration of the ESAB CZ Issue (in Thousands)

If the markup were only 3%, then EBITDA would be only €0.6 million per year, which implies an IRR = 1.8%. The tax authority’s position was that the analysis should include the amortization of the $1.027 million of goodwill in the cost base with amortization calculated as goodwill divided by 15 years or €68 thousand per year. If this amount is marked up by 3%, the additional income would be approximately €70 thousand per year. This alternative position would be equivalent to a 3.35% markup over labor and material costs, which implies an IRR = 2.97%. Both positions would represent a return to assets less than the risk-free rate, which at time was near 3%. Table 1 also considers higher markups and their implied IRR. A 4% markup over labor and material costs would imply EBITDA = €0.8 million per year, which implies an IRR = 4.96%. A 5% markup over labor and material costs would imply EBITDA = €1 million per year, which implies an internal rate of return = 7.75%.

This discounted cash flow approach requires estimates of the economic useful life and the scrap value of the assets at the end of the useful life as a substitute for economic depreciation. Had our illustration assumed a longer useful life or a higher scrap value, the estimates of the IRR would have been higher. While it would have been useful to know how the valuation approached these issues, the Regional Court decision did not disclose this information.

Brozkova’s webinar noted that the markup could be evaluated using a TNMM with either a markup over total cost approach or a return to capital approach. If the third party companies chosen as alleged comparables had the same asset intensity as the manufacturing affiliates, then the two approaches would lead to similar results. In this litigation, however, there was no assurance that this comparability ad of asset intensities existed. In our illustrative example, we have suggested that the abuse of a markup approach may have led to an absurdly low return to capital.

A Licensed Manufacturer Example

Brozkova’s webinar focused on a different intercompany arrangement where the Czech manufacturing affiliate licensed the parent’s intangible assets and was engaged not only in production activities but also in selling the products. Let’s consider a similar example as our previous case but in this case, the Czech affiliate sells its products to European customers using European sales affiliates. European sales will be assumed to be €25 million per year with selling costs = 5% of sales or €1.25 million per year, which implies consolidated profits = 15% of sales or €3.75 million per year. Table 2 presents our new illustration with an allocation of consolidated profits dependent on the intercompany pricing policies.

Table 2: Illustration of Licensed Manufacturer Issue (in Thousands)

Table 2 sets the intercompany price between the Czech manufacturing affiliate and the European distribution affiliate (I/C price 1) such that the distribution affiliates receive a 6% gross margin. Since selling costs = 5% of sales, the distribution affiliates operating profits represent 1% of sales or a 20% markup over selling expenses. The intercompany payments from the Czech manufacturing affiliate to the Swiss affiliate (I/C price 2) = 10% of sales, which leaves the Czech affiliate with profits = €1 million or a 5% markup over production costs.

Brozkova’s webinar noted a variety of means for the Swiss affiliate to impose these intercompany charges including intercompany royalty fees, intercompany procurement charges, and intercompany management fees. Charging multiple intercompany fees risks the possibility that the Czech tax authority would deny intercompany management or intercompany procurement fees. Brozkova therefore recommended combining these intercompany fees in a single intercompany license fee. This approach, however, risks the possibility that the Czech tax authority asserts that a 10% royalty rate is above third party royalty fees for similar intangibles.

The webinar also suggested that the intercompany license fee could be variable so as to keep the Czech affiliate’s profit margin within a TNMM range. During periods of higher than average consolidated profits, the intercompany royalty rate would be increased. During periods of lower than average consolidated profits, the intercompany royalty rate would be decreased. If consolidated profits fall below the routine returns for the Czech license, this variable license approach would have the parent corporation making an intercompany paymen to the licensee to place its profit margin within the TNMM range. In other words, this approach has the implication that intercompany royalties might be negative.

Brozkova’s approach is effectively the IRS look back commensurate with income approach. The look back commensurate with income version of TNMM was severely criticized by Gordon V. Smith, Roger D. Lorence, and Paul H. Prentiss severely:

This look-back rule is not only at odds with the rules of other major jurisdictions, to whose tax authorities retroactive application of a transfer pricing method in derogation of contractual agreements can be anathema. The U.S. rule is also contrary to virtually universal business practices. In the senior author's experience of more than 30 years as a valuation consultant it is extremely rare for unrelated parties dealing at arm's length to negotiate a royalty rate that is not set at the outset of the license, either a fixed amount or rate, or at a rate determinable under a formula.

Third-party licensees take systematic risk when they agree to a fixed royalty rate, which would require that they be compensated for taking commercial risk. The implication of this risk taking is that TNMM approaches tended to overstate the arm’s length royalty.

References

Simon Tilford, "All is Not Well in the Visegrad Economies”, Center for European Reform, November 29, 2017.

Czech Republic vs ESAB CZ, s. r. o., Case No 31 Af 21/2022 – 99.

Gordon V. Smith, Roger D. Lorence, and Paul H. Prentiss, “Why the Cost Sharing Regulations Are Unworkable,” BNA Transfer Pricing Report, March 13, 1996.