Tax audits of subcontractors in the automotive industry

Reports from the Czech Statistical Office published in early May show that the 2.2% year-on-year increase in industrial production that occurred in March 2023 was mainly influenced by the production of motor vehicles. This increased by 42% year-on-year. The problems with component supply, which in 2022 were one of the reasons why almost all car manufacturers increased prices, and the extension of delivery times, seem to be over.

What impact will this positive development have on the prices at which Czech manufacturers belonging to multinational groups supply their products directly to car manufacturers? Will the expected increase in the sales of these direct subcontractors also equate to an increase in their profits and, therefore, in tax payments to the state budget?

A specific feature of the automotive industry is the strong bargaining position of the automakers, which is reflected in price pressure. Subcontractors are exposed to the market risk of increases in the inputs necessary for production that fail to be reflected in prices to the carmakers. The solution to maintaining profitability is therefore to strive for greater efficiency, which can be achieved through research and development of new technological solutions for production. However, in multinational groups of companies that are direct suppliers to car manufacturers, research and development is often carried out by foreign entities. As a rule, Czech companies are fully responsible only for the mass production function of the products.

In the area of transfer pricing, the Financial Administration has long held the view that Czech subcontractors of automobile companies, which have the status of routine production entities with limited powers in the area of price negotiations with the automobile company, should achieve low but stable profitability, regardless of the rapid increase in energy and commodity prices due to the energy crisis and the war in Ukraine. A note on the impact of the energy crisis on transfer prices, published in December 2022 on the website of the Financial Administration, states that "Energy costs are undoubtedly one of the costs that enter the cost basis to which the usual profit markup is added."

However, this theoretical notion of a market-based price calculation is far from the real contractual conditions in the automotive industry. As a rule, contracts for the implementation of production projects for automotive companies are concluded for many years in advance, while the price per unit of production to be produced in a Czech production plant is set as fixed and corresponds to the assumptions and conditions at the time the contract is signed. The length of the project often reaches seven years or more. Each project has at least three phases. In the second phase, when the project's feasibility in terms of technological complexity is examined, the Czech manufacturer may incur more costs than those calculated in the first phase, when the price was agreed. However, contracts do not always take account of these extra costs. In some cases, the contracts also lack an inflation clause setting a tolerance band for fluctuations in the price of inputs needed for production, which, if exceeded in the last phase of the project (serial production), would give the subcontractor the right to increase the original price agreed in the first phase.

In practice, it is quite common to encounter Czech manufacturing companies whose price negotiations with the car company were conducted by the parent company abroad, while the price per unit of production set five or more years ago is now insufficient to cover production costs, let alone to generate a profit. In such cases, the contractual agreement does not allow the management of the Czech company to initiate negotiations on price increases, as the Czech company is viewed as a separate production facility, not as a separate legal entity that would be able to negotiate directly with the carmaker.

If a Czech manufacturer, which has been making losses for a long time as a result of fixed prices, is subject to a tax audit on transfer prices, it is highly probable that the Tax Office will apply the net profit margin method, which will ultimately increase the Czech manufacturer's turnover by a fictitious amount. The notional amount is set by the tax administrator so that the company achieves a post-tax profitability of the amount determined based on a comparative analysis.

The tax administrator compiles the comparative analysis using an external database. It does not allow the tax administrator to take into account the length of time for which the companies concerned – which operate in the automotive sector independently without the influence of the group – have negotiated their prices. It is also not possible to verify whether the selected companies supply their products directly to the car companies (Tier 2) or are involved in the supply chain as a subcontractor of another direct supplier to the car companies (Tier 3 or 4).

Czech manufacturing companies operating in the automotive industry are significant payers of income tax on their employees' income. It is therefore a question of what the goal of the Financial Administration will be in the coming years. Whether the Financial Administration will continue to carry out tax audits initiated more than three years after the end of the audited period, which result in additional tax being assessed for loss-making manufacturing companies, often in the order of tens of millions of crowns, or whether the current methodology will be changed.

In any case, the management of Czech companies should be interested in the contractual conditions under which the prices of the production supplied to the car companies were negotiated by the group and should be able to document, in the event of a tax audit, how the production company has reacted in the past to market fluctuations and the associated change in demand from the car companies. 

The shift towards electromobility suggests that the question of increasing support for research and development in the Czech Republic could be raised again. If Czech companies are to benefit from such support, it is essential that they engage in activities with higher added value instead of routine "assembly plant" activities.