VAT and Transfer Pricing – CJEU Rules on the VAT Treatment of Compensating Transfer Pricing Adjustments
The Court of Justice of the European Union (CJEU) has issued a preliminary ruling clarifying the VAT treatment of transfer pricing adjustments. The Court held that a compensating (i.e. self-initiated) transfer pricing adjustment may, under certain conditions, fall within the scope of VAT. Such an adjustment is subject to VAT only if it constitutes consideration for an actual service supplied and if there is a direct link between the adjustment and that service.
The nature of transfer pricing adjustments and the criteria established in the judgment appear to give multinational entities considerable flexibility in determining whether such adjustments should be treated as subject to VAT or as transactions falling outside its scope. Despite the ruling, several questions concerning the VAT treatment of transfer pricing adjustments remain unresolved.
Background
In Case C-726/23 (Arcomet Towercranes), a Romanian subsidiary belonging to the Arcomet Group obtained cranes which it subsequently sold and leased to its customers. The Belgian parent company conducted negotiations with suppliers and determined the contractual terms applicable to the subsidiary. Under the framework agreement, the parent company bore most of the financial responsibility — including determining the overall business strategy, planning, financing, and supplier negotiations — whereas the subsidiary was responsible for acquiring the cranes and managing their sale and rental activities.
Based on a transfer pricing study carried out between the parent company and its subsidiaries, and applying the Transactional Net Margin Method (TNMM) in accordance with the OECD Transfer Pricing Guidelines, an arm’s-length operating profit margin for the subsidiaries was determined to fall within a range of –0.71% to 2.74%.
The agreed compensation was determined based on the operating profit margin. If, at the end of the year, a subsidiary’s profit margin exceeded 2.74%, the parent company invoiced the excess amount as remuneration for the services described in the agreement. Conversely, if the margin fell below –0.71%, the subsidiary invoiced the parent company accordingly. In practice, this constituted a compensating adjustment intended to ensure that the subsidiary’s profit remained at an arm’s-length level.
For several years, the profit margin exceeded the established range, and the parent company invoiced the subsidiary in accordance with the agreement. Some of these invoices were treated as subject to VAT, but the Romanian tax authorities denied the related input VAT deduction on the grounds that the subsidiary had not demonstrated that the services had been performed, nor that they were necessary for its taxable business activities.
Ruling
In its ruling the CJEU examined whether the aforementioned adjustment constituted consideration for a taxable supply of services and whether, in such a case, the tax authorities may require documentation other than the invoice itself to substantiate the right to deduct input VAT.
According to the CJEU, the adjustment constituted consideration for a taxable supply of services. The Court emphasized, in particular, the existence of a direct link between the service provided and the corresponding remuneration. Under the framework agreement, the parent and subsidiary companies had undertaken reciprocal obligations: the parent company committed to provide the services described above and to bear the financial risks associated with the subsidiary’s business, while the subsidiary committed to pay, at the end of each year, the portion of the profit margin exceeding 2.74%.
The services defined in the agreement were also capable of conferring tangible benefits on the subsidiary. They influenced the subsidiary’s final profit margin through the savings achieved and the improvement of services enabled by those activities.
The CJEU emphasized the importance of examining the economic and commercial reality, which is a key factor in assessing both the VAT treatment of a transfer pricing adjustment and the related right to deduct input VAT. Where the circumstances indicate the existence of a service supplied for consideration and a corresponding payment, such payment may constitute genuine remuneration for a taxable supply, even if it has been determined using a method based on the OECD Transfer Pricing Guidelines.
The fact that the compensation defined in the agreement varies in nature depending on future events, or that invoicing may also occur in the opposite direction – from the subsidiary to the parent company – does not break the direct link between the service and the corresponding remuneration.
The CJEU further held that, in order to establish the right to deduct input VAT, the tax authorities may require the taxable person to demonstrate that the parent company had actually supplied the services and that the subsidiary had used those services in its own taxable business activities. However, the scope of such a requirement extends only to verifying whether the company claiming the deduction has in fact received the services and subsequently used them for its taxable transactions.
Any such requirements must be necessary and proportionate for the purpose of assessing the right of deduction. The authorities may not, however, require the taxable person to prove that the services were necessary or appropriate for their taxable activities. This approach is consistent with the Weatherford judgment discussed in our earlier article.
Practical implications of the judgment – opportunity for corporate groups to influence the VAT treatment of their transfer pricing adjustments
The CJEU did not explicitly address the VAT treatment of primary (i.e. tax authority–initiated) transfer pricing adjustments in its ruling. However, based on the Court’s reasoning, it appears highly unlikely that such adjustments would fall within the scope of VAT. In a primary adjustment, no invoice is issued, and there is generally no agreement between the parties that would define the prices in accordance with the adjustment made by the authorities. However, disregarding a transaction may be possible in certain circumstances.
The economic and commercial reality highlighted by the CJEU can hardly support the view that a primary adjustment would constitute consideration for a service, or that there would be a direct and immediate link between the consideration and such a service. In our view, this interpretation is consistent with the current position of the Finnish Tax Administration, according to which a primary transfer pricing adjustment does not fall within the scope of VAT where the contractual terms or the prices paid between the parties are not altered.
In addition, a compensating adjustment made solely for income tax purposes – for example, by correcting a tax return or recording an accounting entry – without any invoice being issued or any agreement between the parties on the provision and pricing of services, would, based on the Court’s reasoning, likewise fall outside the scope of VAT.
Based on the above interpretations, corporate groups have a considerable ability to influence the VAT treatment of their transfer pricing adjustments. In groups where not all entities have full input VAT deduction rights, it is therefore essential to take VAT implications into account already when structuring transfer pricing policies and drafting related intercompany agreements. Doing so can, at best, help avoid significant additional costs – or, at worst, create them if VAT implications are not properly addressed. If this has not been done previously, the group should re-examine its transfer pricing arrangements also from a VAT perspective.
If VAT-related transfer pricing issues raise uncertainty within your organization, consulting an expert is advisable to ensure the correct VAT treatment of your transfer pricing policy before any complications arise.In our previously published article, we discussed issues related to VAT and transfer pricing.
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