Transfer Pricing Dilemma: Cost Exclusion and TP Documentation Challenges

It’s a classic transfer pricing dilemma: when using a cost-based method, can a company exclude some costs from the markup because they don’t add value? This scenario frequently arises in controlled transactions involving shared service centers, contract manufacturers, or toll manufacturers. Now, a recent decision from the Czech Supreme Administrative Court offers new insights—and a few cautionary notes—for multinational enterprises navigating this murky terrain.

The case centered around Inventec (Czech), s.r.o., a subsidiary of Inventec Corp. (Taiwan), and its treatment of material costs under the arm’s length principle. At issue was whether those costs were truly pass-through or whether they should carry a profit markup under the transfer pricing methods applied.

The Case of Inventec (Czech)

Inventec (Czech) was involved in the production of server racks, purchasing materials from its Taiwanese parent and then selling finished goods to HP. While the local entity held legal title to the inventory, all pricing and sales activities were managed by the parent company.

During a routine transfer pricing audit, Czech tax authorities applied the Transactional Net Margin Method (TNMM) with a Return on Total Costs (ROTC) profit level indicator. This approach includes material costs in the markup base. The initial audit led to a major tax adjustment—over CZK 101 million.

The Company’s Argument

Inventec (Czech) disagreed with the approach, claiming that material costs should not be marked up. They argued that:

• They bore no economic risk related to the materials.
• They lacked the liquidity to absorb risk associated with CZK 19.5 billion worth of materials.
• A better method would be Return on Value Added Costs (ROVAC), excluding material costs altogether.

Essentially, the company claimed to operate like a toll manufacturer, even though they held legal title to the materials.

The Court’s Ruling: Legal Title Means Something

The Regional Court sided with the tax authorities, and the decision was upheld by the Czech Supreme Administrative Court (SAC). Here’s what the SAC concluded:

• ROTC was a legitimate method because it reflected the formal accounting and economic reality.
• Legal ownership of the materials implied risk-bearing, regardless of how limited the company’s role was.
• The tax authority made a reasonable adjustment to reflect the company’s limited functions and risks, applying a reduced markup (24.62% of the standard market rate).
• Inventec (Czech)’s liquidity issues were not sufficient to invalidate its ownership responsibilities.

A Novel Approach: Adjusted ROTC with Functional Scoring

One of the most interesting takeaways from the case is how the Czech tax authority calibrated the ROTC method:

1. Initial Adjustment: They applied a standard markup on total costs (including materials), resulting in a high tax adjustment.
2. Risk-Based Revision: Recognizing the company’s limited economic role, they reduced the markup applied to material costs significantly.
3. Functional Scoring System: Functions and risks were weighted between Inventec (Czech) and its parent. Only the Czech entity’s share of functions was used to calculate its markup.
4. Final Result: A hybrid outcome that acknowledged some economic substance of the company’s claim while still respecting formal ownership of the goods.

Key Lessons for MNEs: Where TP Documentation Mattered Most

• Legal Ownership Carries Weight

Even if your group’s structure resembles a pass-through model, legal title to inventory implies liability and risk. This makes it difficult to fully exclude such costs from markup calculations.

• Partial Adjustments Are Possible

The Czech case shows that tax authorities may be open to partial markup adjustments—but only if supported by clear functional analysis and risk documentation.

• ROVAC Isn’t a Free Pass

Just because a cost appears non-value-added doesn’t mean it can be excluded from your profit calculation. If it shows up in your P&L, it will draw scrutiny.

• Documentation Is Key

The ruling reinforces the importance of thorough transfer pricing documentation to support claims of limited risk or function. Taxpayers must show why a certain pricing method or adjustment is appropriate.

Reptune’s Insight: TP Documentation in Complex Cost Structures

With Reptune.net. Reptune’s transfer pricing documentation platform, companies can efficiently handle scenarios like Inventec’s. The system allows:

• Automated cost allocation based on risk and function profiles.
• Real-time comparisons between ROTC, ROVAC, and other benchmarks.
• Transparent audit trails to support intercompany transactions and price charged explanations.

Whether you’re in contract manufacturing, shared services, or distribution, Reptune helps ensure you’re not overexposing yourself—or your tax compliance team—to unnecessary risk.

Conclusion

The Inventec (Czech) case is a reminder that not all costs are created equal. If you want to treat inventory costs as pass-through, you’ll need more than an economic theory—you’ll need evidence, documentation, and a watertight argument. The courts are unlikely to accept complete exclusion unless the legal and operational facts clearly support it.

For multinational corporations managing intercompany pricing, transfer price regulations, and tax liabilities across multiple tax jurisdictions, this case sets a precedent: legal title equals economic responsibility—at least partially.

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