What happens when transfer pricing and VAT worlds don’t align?

Understanding transfer pricing adjustments

Multinational groups commonly use transfer pricing adjustments to ensure that profit outcomes for their affiliates are at arm's length. However, not all transfer pricing adjustments are the same from a direct or indirect tax perspective.

Tax authorities may require adjustments, but from a VAT perspective, these adjustments typically do not constitute consideration for the provisions of any services. As such, they are not subject to VAT.

Taxpayers also frequently make their own adjustments, either impacting their financial results or being explicitly reported on their tax return. A typical example is where a subsidiary company's ("SubCo") profitability is set to target a particular operating margin (or range of margins), often guided by a benchmark of comparable data. To achieve this net profitability, the principal company ("PrincipalCo") may make a payment to increase SubCo's profitability, or a charge to decrease it.

It is not always made clear on invoices or accounting adjustments, in intercompany agreements or in transfer pricing documentation what these payments are for. For example, when PrincipalCo issues an invoice to SubCo to reduce SubCo's net margin to within a benchmarked range, SubCo could be paying for:

• Services provided by PrincipalCo to SubCo.
• Valuable intellectual property owned by PrincipalCo that benefits SubCo.
• A "top-up" to the price of products purchased by SubCo from PrincipalCo during the year.
• Other less specifically defined transactions.

In addition, payments can flow the other way, ie PrincipalCo can make a payment to increase SubCo's profitability.

Each of these types of payment may have different VAT and with-holding tax (WHT) treatments, so they should be carefully considered from a direct and indirect tax perspective.

The Arcomet case

In the pending tax case of SC Arcomet Towercranes SRL ("Arcomet Romania", or SubCo in our previous example), Arcomet Romania received invoices from its Belgian related party ("Arcomet Belgium", PrincipalCo). These invoices reduced the profitability of Arcomet Romania to an arm's length level, applying the transactional net margin method.

A recent legal opinion by the European Court of Justice’s Advocate General (AG) aimed to clarify whether these invoices relate to the provision of a supply under the EU VAT Directive. Post-Brexit, determining if this case will influence the UK’s position remains a complex matter and deserves a separate discussion.

The AG considered it was unreasonable to answer this question purely using general principles. Instead, the AG recommended a case-by-case assessment, including:

• Whether there is a legal relationship between the service provider and recipient under which services are exchanged for remuneration.
• Whether there is an individualisable service and remuneration, ie does the PrincipalCo provide an identifiable service to SubCo?
• Whether there is a direct link between the service and the consideration received.

This will often, but not necessarily always, be the case for transfer pricing adjustments calculated using the transactional net margin method.

In the case of Arcomet Romania, the AG noted that the management of the crane fleet by Arcomet Belgium and its negotiations of framework contracts with suppliers could reasonably be considered an identifiable service, indicating a VAT charge (or adjustment) must also follow.

Burden of proof for VAT deductions

Making a VAT adjustment then leads onto the question of whether the recipient of the service can reclaim the VAT due. The AG noted that the taxable person claiming the VAT deduction must establish that they meet the conditions for benefiting from it. In particular, they should maintain evidence that goods or services were actually supplied.

An invoice alone may not always suffice. Further evidence may need to demonstrate that services are provided to the taxable person, the business and contractual relationship between them. This should ideally be covered in transfer pricing documentation, intercompany legal agreements and supporting paperwork.

Risks of ignoring VAT adjustments

This is a complex area and transfer pricing adjustments can often be significant. We often find transfer pricing adjustments can be done in isolation with parties neglecting to think about any corresponding VAT corrections. In the UK, if there are any oversights, HMRC may seek to levy penalties for non-declared VAT or potentially refuse a right of deduction. This creates a financial risk and one that should be taken seriously.

What should you do next?

The full court decision remains pending and should be kept as a watching brief for many businesses. This is also an area where businesses and their tax advisers (both transfer pricing and VAT) should be working together to gain a consensus. Depending on the conclusions, businesses should note if VAT is due and ideally raise it through an invoice reflecting the correct tax points.

If you have any uncertainties or questions, please contact Scott Harwood.