Transfer Pricing and VAT: Why Economic Substance Matters More Than Ever
Understanding Transfer Pricing
Transfer Pricing governs how related entities within a multinational group price transaction between themselves. These transactions may include the sale of goods, provision of services, licensing of intellectual property, or financing arrangements. The objective, rooted in the OECD’s arm’s length principle, is to ensure that intra-group transactions reflect prices that independent parties would have agreed upon under comparable circumstances. This principle serves to allocate profits fairly for corporate income tax purposes based on functions performed, risks assumed, and assets employed by each entity.
The Role of Transfer Pricing Adjustments
Transfer Pricing adjustments serve as corrective mechanisms to ensure that intra-group transactions comply with arm’s length standards. Such adjustments may arise proactively by taxpayers through compensating adjustments prior to filing tax returns or retroactively by tax authorities through primary, secondary, or corresponding adjustments following audits. In some cases, adjustments are built contractually into profit equalization mechanisms. While their primary purpose is to realign profits for income tax, these adjustments may raise VAT questions when they involve actual financial flows or re-invoicing.
The VAT Framework: Defining the Scope
The scope of VAT is governed by Article 2(1) of the VAT Directive, which applies VAT to supplies of goods or services for consideration by a taxable person acting as such. While Transfer Pricing focuses on market comparability, VAT operates differently, relying on the actual consideration paid, known as the subjective value principle. In other words, VAT typically taxes what is paid, not what might have been paid under arm’s length conditions. Nonetheless, where Transfer Pricing adjustments lead to actual payments; the question arises whether these payments constitute taxable consideration for VAT purposes. The issue has been extensively discussed by EU bodies, including the VAT Committee and the VAT Expert Group. Their consistent message is that there is no universal rule: each transaction must be analysed on a case-by-case basis, focusing on its economic and contractual substance.
Determining the Taxable Amount: Articles 73 and 80 of the VAT Directive
The taxable amount for VAT purposes is primarily determined by Article 73 of the VAT Directive, which states that VAT is due on everything received as consideration for the supply of goods or services. This subjective approach forms the foundation of VAT. However, Article 80 of the VAT Directive introduces an anti-abuse mechanism allowing Member States, under narrowly defined circumstances, to substitute open market value in cases involving related parties where tax evasion or avoidance is suspected. Outside these limited exceptions, the VAT system remains firmly rooted in the principle of taxing actual consideration rather than hypothetical market-based adjustments.
When Do Transfer Pricing Adjustments Affect VAT?
The VAT consequences of Transfer Pricing adjustments depend on several interrelated factors. Critical aspects include the existence of a contractual obligation to make adjustments, whether the payments can be clearly allocated to specific supplies, whether financial records reflect these adjustments, and whether the adjustments constitute additional consideration for goods or services already supplied. If adjustments are solely designed to align profit levels for corporate income tax, without altering agreed consideration or triggering payments linked to specific supplies, they generally remain outside the scope of VAT. Conversely, where adjustments involve actual payments directly linked to prior or ongoing supplies, VAT implications may arise.
The CJEU’s Current Focus: The Pending Arcomet Towercranes Case
The pending Arcomet Towercranes case (C-726/23) before the Court of Justice of the European Union (CJEU) provides a direct examination of these questions. In that case, intra group payments calculated under the Transactional Net Margin Method (“TNMM”) following the OECD Transfer Pricing Guidelines were scrutinised for VAT purposes. Advocate General Richard de la Tour has proposed that where intra-group services are identifiable, contractually agreed, and actually performed, the resulting payments should be regarded as consideration for supplies of services subject to VAT. This approach emphasises that contractual clarity, economic substance, and real financial flows are the determining factors in assessing VAT liability, not the mere application of Transfer Pricing methodologies.
A Careful Path Forward
The interplay between Transfer Pricing and VAT demands careful legal and commercial assessment. Transfer Pricing adjustments do not automatically trigger VAT consequences. Instead, each scenario must be analysed individually, considering the contractual agreements, financial flows, and economic realities of the transactions involved. As the CJEU continues to clarify this complex relationship, businesses and VAT professionals must remain attentive, ensuring that Transfer Pricing compliance aligns not only with direct tax obligations but also with VAT requirements.
