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Use of comparable with losses and its rejection by the Tax Administration in Venezuela: a controversy case

As it is known, and as set out in the OECD guidelines, when applying the Transactional Net Margin method, specifically in the process of searching for functionally comparable companies that may include comparable companies with losses for more than two years, it should be taken into account that the causes of such losses must be attributable to the normal operations or rotation of the sector or industry in which such comparables operate. In this opportunity I bring out the controversy case that took place a few years ago in Venezuela.

The Controversy Case

The tax authority in the audit notification made with the No. 193-10 (SNAT/INTI/GRTI/CE/RC/DF/2012/ISLR/00193-10) of October, 31th of 2012 to COCA-COLA FEMSA DE VENEZUELA, S.A., where is notified of the formulation of income tax surcharges for the 2006-2007 fiscal year, as a consequence adjustments made on transfer prices. The audit resulted in an inappropriate adjustment of the costs declared by COCA-COLA FEMSA DE VENEZUELA, S.A. for transactions referred to purchases of raw materials and fixed assets to related parties. In this regard, the difference in the tax amount that the tax authority argued was arising in terms of transfer prices, specifically, adjustments derived from the implementation of the Net Transactional Margin Method, by arguing adjustments (i) to the Arm's Length range calculated based on 1: exclusion from the set of comparable, those companies with losses for a period of more than 2 years.

As a result of the previous objections, according to the taxpayer, the tax action on the one hand (i) artificially built a new Arm's Length range and on the other (ii) artificially recalculated the the profit level indicator for COCA-COLA FEMSA DE VENEZUELA, S.A. (in this case the Operative Income on Total Costs indicator was applied). This resulted in an adjustment that decreased the costs that was declared originally by COCA-COLA FEMSA DE VENEZUELA, S.A., which in turn led the Audit to determine a tax difference in favor of the Venezuelan Tax Administration (SENIAT).

The Challenge to the Tax Authority

On May 6, 2015, the legal department officials of COCA-COLA FEMSA DE VENEZUELA, S.A. filed a Tax Appeal jointly against administrative acts imposed by the tax authority. A technical expertise was requested by the team of Lawyers acting in defense of the taxpayer. In the technical expertise process, NLC Asesoría participated actively on behalf of COCA-COLA FEMSA DE VENEZUELA, S.A., and therefore, it was determined that the tax authority's position was wrong, in accordance with the OECD Guidelines. The technical position of NLC Asesoría argued that according to the established in the guidelines of the OECD Guidelines 1995, COCA-COLA FEMSA DE VENEZUELA, S.A, in the application of the Net Transactional Margin Method, could select and make use of comparable companies with legitimate and operational losses in order to be included in the calculation of the Arm´s Length range, as long as such losses (i) are subject to normal business and market circumstances of such comparable companies and (ii) that the situation of loss is maintained for a reasonable period of time."

This statement is based on the 1995 OECD Guidelines, in its paragraph 1.54 which states:

"A factor to consider in analyzing losses is that business strategies may differ from MNE group to MNE group due to a variety of historic, economic, and cultural reasons. Recurring losses for a reasonable period may be justified in some cases by a business strategy to set especially low prices to achieve market penetration. For example, a producer

may lower the prices of its goods, even to the extent of temporarily incurring losses, in order to enter new markets, to increase its share of an existing market, to introduce new products or services, or to discourage potential competitors. However, especially low prices should be expected for a limited period only, with the specific object of improving profits in the longer term. If the pricing strategy continues beyond a reasonable period, a transfer pricing adjustment may be appropriate, particularly where comparable data over several years show that the losses have been incurred for a period longer than that affecting comparable independent enterprises. Further, tax administrations should not accept especially low prices (e.g. pricing at marginal cost in a situation of underemployed production capacities) as arm's length prices unless independent enterprises could be expected to have determined prices in a comparable manner".

As can be seen in the quotation above, the guides enable the use of companies with losses when they arise as a result of normal business and market circumstances for a reasonable period of time. In any event, it is necessary to analyze in detail the causes of such losses, without being a single cause of refusal to be considered as a comparable.

At the same time, according to the paragraph cited above, it infers that companies with losses should be excluded from the set of comparables selected companies only where losses do not arise from normal business conditions or where they reflect a non-risk level of risk comparable to that assumed by the tested party.

Case outcome

The decision of the case before the Seventh Court of Tax Litigation, after analyzing all the technical arguments evacuated in the process as the result of the technical expertise, ruled in favor of COCA-COLA FEMSA DE VENEZUELA, S.A. for errors made by the tax audit. This sets a legal precedent for the use of comparable companies that obtain legitimate and operational losses as long as the parameters and conditions set out by the OECD Guidelines are met.