The Supreme Administrative Court Assessed Markup on Material Costs: What Does This Mean for Manufacturing Companies?

The company argued that the material cost should not be included in the cost base for calculating the arm’s length profit markup because the material was procured by the parent company (in cooperation with the customer) and the Czech company's ownership of the material was only formal. However, the tax administrator insisted on using the transactional net margin method, which is based on assessing the profit markup in relation to all operating costs, including material. He argued that the Czech company not only formally acquired ownership of the material, but also stored it, handled it, performed quality control, and assumed responsibility for any damage – in other words, it performed certain functions and bore the risks associated with the purchased material.

The Court confirmed that, in this case, formal ownership of the material is inseparably connected with certain business risks, which, according to the Court, establishes an obligation to include material costs in the cost base for calculating the arm’s length markup.

However, the Court also acknowledged that the risks associated with the material were borne only to a limited extent. Based on a functional and risk analysis, the profit markup on material costs was therefore reduced to approximately one-third of the original value.

The judgment confirms the long-standing approach of the Czech tax administration, which normally apply a profit markup to material costs for manufacturing entities (with the exception of toll manufacturers that do not own any materials). In this respect, its approach differs from that of some foreign tax administrations, which in certain cases (e.g., when the purchase of material for a contract manufacturer is centrally managed by the parent company) allow material costs to be excluded from the cost base for assessing the profitability of the contract manufacturer. The judgment also emphasizes the need for an individual assessment of the functional and risk profile of the manufacturer, which, in certain cases, may lead to the application of a lower markup on material costs than is normally applied to other production costs.

In this context, we recommend to manufacturing entities that apply or are considering applying a reduced profit markup on material costs (including zero markup) to carefully evaluate whether and under what conditions such an approach will be accepted by the tax administrator.

Author:

Vít Fritzsche, Tax Department Manager