I. Case Overview
The SKF Group, a Swedish multinational specializing in the production of ball bearings and seals, established Company A, a large industrial ball bearing manufacturer, in France.
Company A sells its finished products directly to sales companies within the SKF Group, which then sell these products to third-party customers. The sales prices of Company A’s products are set monthly by the Swedish parent company to ensure a 3% overall gross profit margin for the SKF Group. This pricing strategy does not consider Company A’s production costs. As a result, Company A has reported losses for most years since 2005 (except for 2008), while SKF Group’s overall profit margin has remained between 6% and 14%.
II. Key Point of Dispute
Under Article 57 of the French Tax Code, if a French resident company is controlled by or controls a foreign entity and profits are transferred abroad (e.g., through lowering sales prices, raising purchase prices, or other means), these transferred profits should be reassigned to the French company and subject to corporate income tax. The main dispute between Company A and the French tax authorities is whether there was hidden profit shifting and whether Company A’s prolonged losses were justified.
The French tax authorities argued that Company A is not a core company within the SKF Group with significant functional risks, making its sustained losses unreasonable. They proposed adjusting the transfer prices between Company A and its related parties using the transactional net margin method to maintain a net profit margin of around 2.5%. (The French tax authorities conducted audits on Company A for 2009 and 2010, issuing adjustment notices with revised net profit margins of 2.33% for 2009 and 2.62% for 2010).
Company A contended that its losses were justified. First, the business model is B2B, where product quality is more critical than marketing, and Company A has over 80 years of expertise in this field, making its role significant and justifying the associated risks. Second, the market for its products is niche, with less than 15 customers, and external economic changes had reduced demand. Additionally, rising raw material costs, specifically for steel, were the primary reasons for Company A’s losses rather than SKF Group’s transfer pricing methods.
Company A challenged the adjustment notices issued by the French tax authorities and appealed to the Administrative Court of Montreuil. On April 23, 2018, the court ruled in favor of Company A. The tax authorities subsequently appealed to the Versailles Court of Appeal.
III.Final Ruling
In June 2020, the Versailles Court of Appeal ruled in favor of the French tax authorities, overturning the lower court’s decision. The reasons are as follows:
First, to apply Article 57 of the French Tax Code, the court determined that there was a related-party relationship between Company A and the transaction counterparties. Second, the French tax authorities presented a functional risk analysis of Company A as evidence for adjusting its taxable income. The appellate court held that Company A also had the burden of proof to counter the tax authorities’ functional risk analysis and demonstrate that its continuous losses over the relevant tax years were reasonable. Based on the information available, except for the ball bearings used in the wind power sector where market demand had contracted, the demand and steel prices remained relatively stable. Moreover, Company A could not provide evidence of operating independently, such as patents or trademarks. Therefore, the court concluded that Company A’s losses were the result of SKF Group’s transfer pricing policies rather than external economic conditions.
Ultimately, the Versailles Court of Appeal upheld the position of the French tax authorities, ruling that the transfer pricing policies among related parties within SKF Group were aimed at shifting profits to foreign entities and had indeed caused Company A’s losses.
IV. Insights for International Businesses
（A）Select Transfer Pricing Methods Carefully
When setting prices for related-party transactions, companies must adhere to the arm’s length principle. They should develop transfer pricing policies based on a comprehensive understanding of their business operations and the functional risks assumed by each group company. Companies should regularly review their transfer pricing methods, agreements, and documentation to ensure that related-party transaction pricing is reasonable and reflects current business conditions.
（B）Consider Using Advance Pricing Arrangements (APAs)
To better avoid potential transfer pricing disputes, companies can consider using APAs to agree on transfer pricing methods with tax authorities in advance. Especially with bilateral APAs, tax authorities can reach mutual agreements, effectively avoiding or resolving double taxation issues and providing tax certainty for businesses.
（C）Understand Legal Procedures for Resolving Tax Disputes in Host Countries
When tax disputes arise, companies should maintain proactive communication with tax authorities and courts, thoroughly understand local laws, and prepare necessary supporting documentation as required by law. Companies can also consider resolving tax disputes through the mutual agreement procedures provided in tax treaties.
