Iceland: Transfer pricing adjustment and penalty upheld (Reykjavik District Court decision)

The Reykjavík District Court upheld the tax authority´s transfer pricing adjustment and 25% penalty surcharge in the country’s first transfer pricing court case.

The case is: Icelandic Calcite Algae Company Ltd v. The Icelandic State

Background

The taxpayer operates a processing plant in Iceland where it harvests, cleans, and dries calcite algae for its Irish parent company.  The taxpayer sells nearly all this raw material to the parent company, which specializes in the development, manufacturing, and marketing of marine plant ingredients to fortify food, beverage, and supplement products. All further processing of the raw material takes place in Ireland.

In the assessment years under dispute, 2016 through 2020, the taxpayer reported losses but prepared no contemporaneous documentation. In August 2020, the Director of Internal Revenue (DIR) issued a formal request to submit the documentation of the taxpayer´s related-party transactions in 2018, pursuant to Article 57(5) of the Income Tax Act No. 90/2003 and Article 3 of Regulation No. 1180/2014. The taxpayer submitted the documentation in October 2020, detailing its transfer pricing methodology. Specifically, the taxpayer had applied the cost-plus method (CPM) under the OECD Transfer Pricing Guidelines, with a 50% gross markup over variable production costs such as materials, packaging and freight, electricity, and cultivation costs. Labor expenses and depreciation were excluded. The benchmarking analysis submitted by the taxpayer was based on the transactional net margin method (TNMM) of the OECD Guidelines and estimated a range of profit margins from 4.8% to 93.8% earned by comparable companies.

In December 2021, the DIR imposed a transfer pricing adjustment on the taxpayer, increasing its taxable income for 2016 by ISK 488 million (approximately USD 3.6 million). This eliminated a previously unused carryforward tax loss of ISK 132 million, bringing the net adjustment down to ISK 356 million. The DIR also imposed a 25% surcharge on the increased tax base pursuant to Article 108(2) of the Income Tax Act. The DIR justified this reassessment by arguing that the parent company had structured the financial operations of the group to ensure that no taxable profit was generated in Iceland. Instead, all profits were attributed to the parent company in Ireland, leaving the Icelandic subsidiary with minimal or zero taxable income. The DIR contended that the CPM was applied incorrectly, particularly in the calculation of production costs, which led to an understatement of the taxable base. Accordingly, the DIR concluded that the transfer pricing methodology did not comply with the arm´s-length principle, as outlined in Article 57(3) of the Income Tax Act. The DIR recalculated the transfer price retaining the 50% gross markup but expanding the cost base to include all labor costs and depreciation expenses of production.

The taxpayer appealed the ruling, arguing that the parent company bore the primary financial and commercial risks, and had made significant investments in specialized manufacturing facilities. The taxpayer asserted that raw material sourcing and operating licenses were not unique and that the group´s success depended on research and development conducted by the parent. In December 2022, the Appeals Committee for Tax Matters rejected all of the taxpayer´s claims and upheld the DIR´s reassessment. The taxpayer initiated the court case in June 2023.

Legal arguments

The taxpayer asserted that the DIR and Appeals Committee rulings must be overturned due to procedural and substantive errors. The main procedural errors were:

• Imposing adjustments without conducting any subsequent analysis per the investigative principle of Article 10 of the Administrative Procedures Act no. 37/1993, if the DIR believed the taxpayer´s documentation was inadequate
• Violating the principle of proportionality under Article 12 of the Administrative Procedure Act by arbitrarily increasing the cost base without making a corresponding adjustment to the markup percentage

The substantive errors were:

• Failing to provide a benchmarking analysis demonstrating that the taxpayer´s pricing was not at arm´s length
• Mischaracterizing the parent company as a mere distributor rather than a significant risk-bearing entity
• Overemphasizing the importance of labor and depreciation costs and imposing an economically unviable pricing structure
• Ignoring relevant comparative data, as the profit margins among comparable companies are highly variable

Based on the above, the taxpayer demanded a full refund of the additional tax, plus accrued interest and penalties. At a minimum, the taxpayer requested that the 25% surcharge be revoked because it had acted in good faith.

In defense against the above claims, the Icelandic State pointed out that:

• The taxpayer had ample opportunity to provide additional documentation and clarify its methodology but failed to do so. They were granted an extended deadline to submit supporting documents, but the taxpayer did not avail of this extension.
• The taxpayer´s failure to submit complete data does not constitute a procedural violation by the tax authority.
• The tax authority did not violate the proportionality principle because it merely corrected errors in the cost basis. Moreover, it acted within its legal authority as the Income Tax Act explicitly permits the tax authority to adjust the tax base of companies engaged in non-arm´s length transactions.
• The tax authority conducted a functional analysis and concluded that the Icelandic subsidiary played a more significant role in the value creation; that the parent did not bear most of the financial risk; and that the economic reality of the transactions indicated that a greater share of profits should be allocated to the subsidiary.

Based on the above, the Icelandic State demanded a full dismissal of the taxpayer´s claims.

Court´s decision

In its decision issued in February 2025, the court dismissed all procedural claims brought by the taxpayer, agreeing with all the points raised by the tax authority in its defense against these claims. The court found that the tax authority applied the same methodology as the taxpayer (i.e., CPM) but corrected a misclassification of production costs. The court further noted that the taxpayer did not propose an alternative markup rate during administrative proceedings, nor did it provide comparative benchmarks for a different cost allocation method. Thus, the court ruled that the tax authority's approach was not disproportionate.

The court denied the taxpayer´s substantive claim for a full refund of the additional tax, asserting that the taxpayer played a crucial role in the initial extraction and processing of raw materials, which warranted a fairer allocation of profits to the Icelandic entity. Further, the court upheld the 25% penalty surcharge, noting that there were deficiencies in the tax returns of the taxpayer. Thus, the tax authority was acquitted of all claims made by the taxpayer.

KPMG observation

The court decision is worrisome in its approach to the allocation of burden of proof in transfer pricing matters. It suggests that if the tax authority considers a taxpayer´s data to be insufficient, it can impose an income adjustment without demonstrating that the reassessment leads to an arm´s length result. The decision shifts the burden of proof almost entirely on the taxpayer. This approach presumably conflicts with the investigative principle of Article 10 of the Administrative Procedure Act:  the more onerous the administrative decision, the more stringent the requirements placed on the administrative authority to ensure that the information underlying the decision is correct.

The case also highlights the crucial role of careful documentation and implementation of transfer pricing policy in shifting the burden of proof. It appears that  the taxpayer missed more than one opportunity to shift this burden to the tax authority: in the first instance, by not having contemporaneous documentation, and failing to ensure that its profit outcomes are consistent with its characterization as a routine entity; and in the second instance, by providing a benchmarking analysis with incomplete data and a range of results so broad that it was rendered useless. The taxpayer could likely have obtained a better outcome by adopting a more reasonable strategy rather than aggressively defending an incorrect transfer pricing policy, for example, by ceding to the increase in cost base but proposing a much lower net cost-plus markup.

For more information, contact a KPMG tax professional:

Veena Parrikar | veenaparrikar@kpmg.is

Ágúst K. Guðmundsson | akgudmundsson@kpmg.is