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New powers for tax authorities – recharacterisation and non-recognition of transactions


by Daria Walkowiak-Dobner


One of the key changes introduced to the transfer pricing regulations with effect from 1 January 2019 (by virtue of the amended Corporate Income Tax Act and Personal Income Tax Act) is that tax authorities will now have new tools to challenge payments between associated enterprises.

Transaction terms

Article 11c of the Corporate Income Tax Act, which sets out the terms on which associated enterprises should make transactions, has been in force since the beginning of the year. By law, terms and conditions set between associated enterprises should not differ from terms and conditions which independent enterprises would agree. It requires associated enterprises to set market prices according to their best knowledge already at the time of concluding the transaction.

Article 11c of the Corporate Income Tax Act clearly differentiates between:


  • the tax authorities' right to assess income of associated enterprises exclusively through price adjustment;
  • the tax authorities' right to claim while assessing the amount of income or loss that under similar circumstances independent prudent enterprises either would not make the transaction (non-recognition of transaction) or would make a different transaction or would act differently (recharacterisation).

The lawmakers have in no way narrowed down the transactions subject to such an assessment, and the above-mentioned regulation may apply to any transaction.

Recharacterisation and non-recognition of transaction – when are they possible?

When tax authorities want to recharacterise or do not want to recognise a transaction they take into account:


  • the terms and conditions set by associated enterprises;
  • he fact that the terms and conditions set between associated enterprises prevent transfer pricing at a level that prudent independent enterprises would agree taking into account options available on the transaction date.

This means that in investigating transactions between associated enterprises tax authorities look at the actual course of the transactions and their circumstances as well as the actual behaviour of the parties, and not necessarily at the contractual provisions or other arrangements between the parties.

Tax authorities cannot use any of the tools discussed here just because:


  • they struggle with verifying the transfer price;
  • there are no comparable transactions between non-associated enterprises in comparable circumstances.

In the justification to the amending act the lawmakers explain that they have included those two criteria that rule out the recharacterisation and non-recognition of transaction in order to prevent tax authorities having problems with transfer pricing from cutting corners. They claim that the recharacterisation and non-recognition of transaction should not be common.

Reasons behind implementation of the recharacterisation and non-recognition of transaction

Given the reasons presented by the lawmakers and the explanatory memorandum to the amending act we can come up with the following examples to demonstrate when tax authorities could use the recharacterisation and/or non-recognition of transaction:


A company has a production plant in a flood risk area. The company buys insurance of its property from an associated enterprise and pays premiums. An analysis of the insurance market shows that an insurance contract could not be signed with an independent insurance company due to the high risk for the insurer.

In such a situation, tax authorities may decide not to recognise the transaction between the associated enterprises, claiming that the transaction would not be carried out on the free market because no insurance company would enter into a contract given such a high insurance risk. Then, tax authorities would assess the taxpayer's income excluding the payments for the transaction.


A company operating in the pharmaceutical industry produces intangible assets over a certain period. The beneficiary of those intangible assets is an associated enterprise which has to pay a pre-agreed flat fee on that account. The flat fee has been calculated using a wrong algorithm – one that independent enterprises would never agree on.

Tax authorities may regard the transaction as a loan and assess income using the transfer pricing method applicable to loans.

Reasons behind implementation of the recharacterisation and non-recognition of transaction

Generally, the changes reflect the rules added to the OECD Guidelines on the prevention of tax base erosion and shifting of profits (BEPS, Actions 8–10). In addition to the transaction price verification, Section D.2 of the Guidelines provides for reclassification or non-recognition of transactions. According to the recommendations in the guidelines, the above-mentioned tools are meant to determine if a transaction between associated enterprises would in fact be made between independent enterprises in similar economic circumstances.

In the explanatory memorandum to the amending act the lawmakers explain that Article 11c of the Corporate Income Tax merely "refines and confirms the availability of the above-mentioned tools" and "fine-tunes the existing right of tax authorities to consider the entirety of the terms and conditions of business between associated enterprises and to find that in certain circumstances a transaction would not be made or a different transaction would be made (derived from existing Article 11(1) of the Corporate Income Tax Act and Article 25(1) of the Personal Income Tax Act)." The lawmakers claim that the regulations had to be refined to clear uncertainties regarding the application of the tools and due to transactions where it would be difficult to prove the tax advantage.

This justification of the changes seems questionable because Article 11(1) of the Corporate Income Tax Act did not give any additional rights to tax authorities. Consequently, in a certain sense the new wording creates new law.

Implications of the changes

The new regulations fine-tune the tax authorities' rights in checking the arm's length nature of intra-group transactions and let them reclassify or refuse to recognise a transaction. The lawmakers emphasise that the ultimate purpose of the new tools is to penalise taxpayers who use non-arm's length mechanisms to reduce the taxable base. The new tools are supposed to radically tighten up the tax system. In practice, the analysis of the business rationale behind a transaction will be crucial and may often be the bone of contention between taxpayers and tax authorities. According to the OECD Guidelines, any verification of the compliance of a transaction's terms and conditions with the arm's length principle must start with an in-depth examination of the course of the transaction including a multilevel risk distribution analysis. However, it is difficult to tell if tax authorities will follow the OECD Guidelines and the ensuing practice also while using the recharacterisation and non-recognition tools.


In view of the legislative amendments discussed here we recommend having justification for transactions and their accounting (e.g. in transfer pricing documentation or some additional in-house documents). A functional analysis will be a particularly important component of transfer pricing documentation in the case of disputes with tax authorities. We also recommend documenting the buyer's benefits from the transaction, which may directly substantiate the taxpayer's business prudence.


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Daria Walkowiak-Dobner

Attorney at law (Poland)

Associate Partner

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