Uncertain tax positions, provisions, estimates, principal risks and uncertainties

Koninklijke Philips N.V. – Annual report – 31 December 2022

Industry: manufacturing

6 Risk management (extract)

6.5 Financial risks (extract)

Philips is exposed to tax risks which could have a significant adverse financial impact

Philips is exposed to tax risks which could result in double taxation, penalties and interest payments. The source of the risks could originate from local tax rules and regulations as well as international and EU regulatory frameworks. These include transfer pricing risks on internal cross-border deliveries of goods and services, as well as tax risks relating to changes in the transfer pricing model. Examples of initiatives that may result in changing tax rules and regulations include, but are not limited to, the OECD/G20 Inclusive Framework to address the allocation of income to user markets (“Pillar One”) and a 15 per cent. Minimum income tax rate (“Pillar Two”). The formal adoption of Directive (EU) 2022/2523 (the “Pillar Two Directive”) in December 2022 aims to achieve a coordinated implementation of Pillar Two in EU Member States and is expected to have an effect on the draft Dutch legislative proposal for the proposed Minimum Tax Rate Act 2024 (the “MTR Act”) Philips is closely monitoring these developments, but does not currently expect that it will be affected by Pillar One implementing measures (subject to clarity on final regulations). However, Philips may be affected by the “MTR Act” following its implementation, which is expected to occur on 1 January 2024, and other regulations and rules that have been, or will be, enacted to implement Pillar Two (for example, any implementing acts in EU Member States in respect of the “Pillar Two Directive”). This may impose an additional tax burden and increase Philips’ tax compliance requirements. Furthermore, Philips is exposed to tax risks related to acquisitions and divestments, permanent establishments, tax loss, interest and tax credits carried forward, and potential changes in tax law that could result in higher tax expenses and payments. The risks may have a significant impact on local financial tax results, which, in turn, could adversely affect Philips’ financial condition and operating results. The value of the deferred tax assets, such as tax losses carried forward, is subject to the availability of sufficient taxable income within the tax loss-carry-forward period. It is also subject to the availability of sufficient taxable income within the foreseeable future, in the case of tax losses carried forward with an indefinite carry-forward period. The ultimate realization of the company’s deferred tax assets is uncertain. Accordingly, there can be no absolute assurance that all deferred tax assets, such as (net) tax losses and credits carried forward, will be realized.

Risk response: Philips’ tax policy, strategy and planning provides overarching governance. The Philips global tax organization designs and implements this and provides tax advice, ensures tax compliance, including accounting and reporting, and deploys our tax risk management and control framework to ensure adherence to up-to-date tax policies. The Group Tax department is in charge of establishing, maintaining and overseeing the tax policies. Potential risks are carefully monitored and dealt with by tax specialists from relevant areas (e.g., corporate income tax, transfer pricing, indirect taxes, wage tax and tax accounting). In monthly reviews, a group of Market Tax Managers helps manage the risks and overall tax governance by applying their knowledge of local markets (e.g., introduction of new tax law), among others.

Please also refer to the disclosure in the Note Income taxes, starting on page 168 and the Country Activity and Tax Report.

10.9 Notes to the Consolidated financial statements (extract)

1 General information to the Consolidated financial statements (extract)

Accounting estimates and judgments

The preparation of financial statements requires management to make a number of estimates and judgments that affect the application of accounting policies and the reporting amounts of assets and liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities. Amounts recognized are based on factors that are by default associated with uncertainty. Actual results may therefore differ from estimates. Estimates and underlying assumptions are reviewed on an ongoing basis. Revision to estimates are recognized prospectively. Where applicable, the estimates and judgments of specific financial statement items are described in the respective note to the consolidated financial statements.

The areas involving a higher degree of judgment and complexity in applying accounting principles and for which changes in the assumptions and estimates could result in significantly different results than those recorded in the consolidated financial statements are the following:

  • Assessment of control (below paragraph Basis of consolidation and Interests in entities, starting on page 161)
  • Revenue recognition (Income from operations, starting on page 162)
  • For acquisitions, the identification and valuation of acquired assets and liabilities including contingent considerations provisions (Acquisitions and divestments, starting on page 158, Provisions, starting on page 193)
  • Determination of deferred tax assets for losses carried forward and uncertain tax positions (Income taxes, starting on page 168)
  • Assumptions used for impairment testing (Property, plant and equipment, starting on page 173, Goodwill, starting on page 176, Intangible assets excluding goodwill, starting on page 181)
  • Assessments of exposure to credit risk of financial instruments (Note Other financial assets, starting on page 184, Receivables, starting on page 186, Debt, starting on page 191, Fair value of financial assets and liabilities, starting on page 214, Details of treasury and other financial risks, starting on page 218)
  • Assumptions used to determine the net realizable value of inventories (Inventories, starting on page 186)
  • Actuarial assumptions of future events that are used in calculating post-employment benefit expenses and liabilities (Post-employment benefits, starting on page 198)
  • Estimating the likelihood of a potential outflow of resources, as well as the ability to make a reliable estimate of the obligation relating to provisions and contingent liabilities (Provisions, starting on page 193, Contingencies, starting on page 204)

The company regularly updates its significant assumptions and estimates to support the reported amounts of assets, liabilities, income and expenses. In relation to areas of judgment and estimates as disclosed in the accounting policies, those which are primarily impacted by the macroeconomic environment include impairment testing, valuation of inventories, valuation of deferred tax balances, measurement of financial instruments and the determination of fair values (for example fair values of acquired identifiable intangible assets, contingent considerations and certain investments).

In preparing the consolidated financial statements management has considered the impact of climate change, specifically the financial impact of Philips meeting its internal and external climate related aims, the potential impact of climate related risks and the costs incurred to pro-actively manage such risks. These considerations did not have a material impact on the financial reporting judgments, estimates or assumptions. The specific financial impacts considered include, for example: specific climate mitigation measures, such as the use of lower carbon energy sources, the costs of developing more sustainable product offerings and expenses incurred to mitigate against the impact of extreme weather conditions.

8 Income taxes (extract)

Tax risks

Philips is exposed to tax risks and uncertainty over tax treatments. For particular tax treatments that are not expected to be accepted by tax authorities, Philips either recognizes a liability or reflects the uncertainty in the recognition and measurement of its current and deferred tax assets and tax attributes. For the measurement of the uncertainty, Philips uses the most likely amount or the expected value of the tax treatment. The expected liabilities resulting from the uncertain tax treatments are included in non-current tax liabilities (2022: EUR 435 million, 2021: EUR 544 million, decrease due to release of liabilities, in combination with higher tax losses or similar tax carryforwards that can be used if uncertain tax treatments were settled for the presumed amount at balance sheet date). The positions include, among others, the following:

Transfer pricing risks

Philips has issued transfer pricing directives, which are in accordance with international guidelines such as those of the Organization of Economic Co-operation and Development. In order to reduce the transfer pricing uncertainties, monitoring procedures are carried out by Group Tax to safeguard the correct implementation of the transfer pricing directives. However, tax disputes can arise due to inconsistent transfer pricing regimes and different views on “at arm’s length” pricing.

Tax risks on general and specific service agreements and licensing agreements

Due to the centralization of certain activities (such as research and development, IT and group functions), costs are also centralized. As a consequence, these costs and/or revenues must be allocated to the beneficiaries, i.e. the various Philips entities. For that purpose, service contracts such as intra-group service agreements and licensing agreements are signed with a large number of group entities. Tax authorities review these intra-group service and licensing agreements, and may reject the implemented intra-group charges. Furthermore, buy in/out situations in the case of (de)mergers could affect the cost allocation resulting from the intragroup service agreements between countries. The same applies to the specific service agreements.

Tax risks due to disentanglements and acquisitions

When a subsidiary of Philips is disentangled, or a new company is acquired, tax risks may arise. Philips creates merger and acquisition (M&A) teams for these disentanglements or acquisitions. In addition to representatives from the involved business, these teams consist of specialists from various group functions and are formed, among other things, to identify tax risks and to reduce potential tax claims.

Tax risks due to permanent establishments

A permanent establishment may arise when a Philips entity has activities in another country, tax claims could arise in both countries on the same income.