Swedish ruling examines arm's-length principle

A Swedish court case strengthens the Swedish position that an operating profit margin within an arm’s-length range, that is not in line of a fixed margin stated in an agreement, cannot be considered to be arm’s length. Annika Lindstrom and Karolina Viberg of KPMG discuss.

The ruling, issued by the Swedish Administrative Court of Appeal on July 5 2017, regarded transfer pricing for remuneration to distributors which deviates from the contracted level but which is within the arm’s-length range for comparable companies, as well as a compensatory claim.

The Administrative Court of Appeal’s ruling

According to the written agreement with the Swedish company, the group’s distributors shall report an operating margin of 3% on their sales. For the financial year in question, the US distributor had reported a margin higher than that which had been agreed. In practice however, the company maintained that the group had consistently adjusted earnings to 3% only if it was outside the arm’s-length range of a benchmarking study, while operating margins within the range had not, in practice, been adjusted. The company therefore argued that the parties had consistently applied a scheme which deviated from the written agreement. As the reported margin was within the interquartile range according to the company’s benchmarking study, the company therefore maintained that the pricing had been arm’s length.

Furthermore, the company contended that the group’s other distributors in Germany had reported a margin which was too low and that this compensated for the higher margin which the US distributor had shown, i.e. a compensatory claim. According to the company, precedence does not support the necessity for compensation to be between the same contractual parties. Thus, the Swedish company had not reported a lower income due to incorrect pricing.

The Administrative Court of Appeal stated in the ruling that the wording of the agreement was clearly defined and that there was therefore no scope for interpretation. The agreement had also been followed and the compensation had been adjusted to the agreed level when additional invoicing had occurred. Solely the circumstance that the parties had deviated from the terms, only where the distributor’s operating margin did not fall within the interquartile range, could not mean that the agreement was imbued with a different meaning. The Administrative Court of Appeal therefore found that such a derogation would not have been accepted by an independent party and that it was clear that the pricing had not been arm’s length which had had a negative effect on the company’s earnings.

Regarding the compensatory claim, the Administrative Court of Appeal maintained that the basis of the assessment was the contractual relationship between the parties. In the view of the Administrative Court of Appeal, there is therefore no grounds for considering other transactions than those arising under the contractual relationship in question.

Written agreement most important

Our experience is that it is very common for multinational groups to have written agreements in place which regulate the level of compensation. Furthermore, our experience is that, particularly in the case of sales of goods, it is difficult to adjust prices so that the group’s distributors report an exact margin year on year. As a result of this, it is also common for the group’s distributors to report margins which nonetheless fall within the arm’s-length range of a comparability analysis. Historically, it has been our view that this should be regarded as arm’s length from a Swedish perspective. It is therefore surprising that a tax adjustment may occur despite the fact that the operating margin of the US company in this case was within the arm’s-length range.

As a result of this Administrative Court of Appeal ruling, it is clear that the court has largely disregarded the parties’ actual actions and instead placed the greatest weight on the written agreement. Groups which have entered into agreements with specific levels of operating margins which are not complied with, even though the reported margins are within the interquartile range of a comparability study, are at risk of a tax adjustment and surcharges. We therefore recommend that groups with such agreements and policies review them in order to minimise such risks in the future.

Annika Lindstrom
Annika Lindstrom
  Karolina Viberg
Karolina Viberg