The judgment deals with one of the most relevant and disputed legal issues in respect of Danish transfer pricing cases. When do the Danish tax authorities have the authority to make a discretionary increase of a taxpayer’s taxable income in relation to a controlled transaction?

On January 31, 2019, the Danish Supreme Court rendered its decision in a landmark transfer pricing case setting aside the Danish tax authority’s decision to increase Microsoft Danmark ApS’s taxable income with approximately 308 million kroner ($46 million) for the income years 2004–07.

Documentation, Burden of Proof

As a main rule, it is for the tax authorities to prove that a controlled transaction has not been carried out on arm’s length terms before the tax authorities can increase the taxpayer’s taxable income in relation to the controlled transaction.

However, the main rule does not apply in cases where the tax authorities have the authority to carry out a discretionary increase of the company’s taxable income in relation to the controlled transaction. In these situations, it is for the taxpayer to prove that the controlled transaction has been carried out on arm’s length terms. If the taxpayer fails to lift this burden of proof, the tax authorities can carry out the discretionary increase of the taxpayer’s taxable income.

According to the Danish tax authority’s interpretation of the transfer pricing regulations, the tax authorities may carry out a discretionary increase of a company’s taxable income if (i) the company has not submitted its transfer pricing documentation to the tax authorities timely, or (ii) the transfer pricing documentation (although it was prepared and submitted to the tax authorities timely) does not enable the tax authorities to assess, on the basis of the documentation, whether the controlled transactions in question have been carried out on arm’s length terms.

So far, the Danish tax authority’s practice has required that a company’s transfer pricing documentation should be prepared on an ongoing basis and be available by the date of the company’s filing its tax return.

Supreme Court Ruling

According to an agreement with its Irish affiliate Microsoft Ireland Operation Limited, which sells Microsoft’s programs on the Danish market, Microsoft Danmark ApS marketed Microsoft’s products in Denmark. The Danish entity received a fee (commission) for the marketing activities.

The question in the case was whether the fee (commission) received by Microsoft Danmark ApS was on arm’s length terms. The tax authorities argued that the fee (commission) was not on arm’s length terms, because it did not include a remuneration for sale of personal computers (“PC”s) of multinational manufacture with an integrated and pre-installed Microsoft operating system in Denmark. In these cases, the PC manufacturer paid a license to an American company in the Microsoft group.

Microsoft Danmark ApS had prepared transfer pricing documentation for income years 2004 and 2005 as well as collectively for the years 2006–09. However, the transfer pricing documentation was not dated, and there were no indications as to when it had been drafted.

It was evident from Microsoft Danmark ApS’s transfer pricing documentation that the remuneration which Microsoft Danmark ApS received for promoting Microsoft products in Denmark did not include renumeration for the sale of Microsoft products through multinational computer manufacturers’ sale of computers with pre-installed Microsoft software to end-users in Denmark.

The tax authorities argued that they were entitled to make a discretionary assessment because (i) the transfer pricing documentation was not prepared in due time; and (ii) the documentation even if it had been submitted timely was flawed. Consequently, it was for Microsoft Danmark ApS to prove that the discretionary assessment was not in accordance with the arm’s length principle.

The Danish Supreme Court set aside the tax authority’s arguments and ruled that the tax authorities may only carry out a discretionary increase of a company’s taxable income if the company has not submitted the transfer pricing documentation to the tax authorities by the date of the tax assessment, or if the submitted transfer pricing documentation is so flawed that it cannot form an adequate basis for determining whether the arm’s length principle has been complied with.

In such situations, the transfer pricing documentation must be treated as if the company had not submitted the transfer pricing documentation in the first place.

On this basis, the Supreme Court found that the tax authorities did not have the authority to carry out discretionary increases of Microsoft Danmark ApS’s taxable income for the income years 2004–07.

Consequently, it was for the Ministry of Taxation to prove that the remuneration Microsoft Danmark ApS received for marketing activities had not been in accordance with the arm’s length principle. Three of the Supreme Court’s five judges found that the Ministry of Taxation had not satisfied its burden of proof.

The Supreme Court placed emphasis on the fact that, according to the agreement with Microsoft Ireland Operations Limited, Microsoft Danmark ApS was to promote products targeted at direct sale in Denmark.

Accordingly, the Supreme Court found that the agreement did not entail an obligation to promote the sale of computers with pre-installed software. The sale of licenses to multinational computer manufacturers was in the hands of Microsoft companies in the U.S. and countries other than Denmark and other Microsoft companies made contributions to the computer manufacturers’ marketing of Microsoft software to end-users.

The Supreme Court found that it could not dismiss the fact that Microsoft Danmark ApS’s marketing activities may have had an indirect effect on the sale of licenses from the multinational computer manufacturers in the U.S. and countries other than Denmark.

Conversely, it could be assumed that the recommendations for Microsoft products made by the multinational computer manufacturers may have had an impact on the direct sale of Microsoft products in Denmark, Microsoft Denmark ApS thus benefiting from the multinational computer manufacturers’ marketing efforts.

Planning Points

In recent years, the Danish tax authorities have made many significant transfer pricing adjustments, some of which are based on the argument that the tax authorities can set aside the transfer pricing documentation and make a discretionary assessment.

It is good news that the Supreme Court has now clarified that the tax authorities only have the authority to make discretionary assessments if (i) the transfer pricing documentation is not submitted to the tax authorities by the date of the tax assessment; or (ii) the transfer pricing documentation is so flawed that it cannot form an adequate basis for determining whether the arm’s length principle has been complied with.

If the transfer pricing documentation fulfills these requirements it is for the tax authorities to prove that the transactions in question are not on arm’s length terms.

The Supreme Court judgment affects only transfer pricing increases made for accounting periods up to and including the income year 2017. The reason for this is that the transfer pricing regulations have been amended with effect as of January 1, 2019 so that a company’s transfer pricing documentation must be available at the date of filing its tax return.

Kaspar Bastian is a Partner at Bech-Bruun, Denmark.