VAT and Transfer Pricing – A Topical Issue Under Scrutiny by the CJEU
Transfer pricing refers to the pricing of transactions between related parties in accordance with the arm’s length principle. In particular, retrospective adjustments to pricing (transfer pricing adjustments) may often create uncertainty regarding their VAT treatment.
Value-added taxation fundamentally differs from corporate income taxation in nature, which may lead to the perception that a transfer pricing-related adjustment does not meet the VAT requirements of a consideration-based supply made in the course of business and, therefore, should not be subject to VAT. However, this assumption may not necessarily be always correct.
The VAT treatment applied to transfer pricing is currently under detailed scrutiny by the Court of Justice of the European Union (CJEU). Accordingly, multinational entities should likewise pay equally close attention to this issue.
Current Court Cases
A notable case for the VAT treatment of transfer pricing is the CJEU ruling in Case C-527/23 (Weatherford) issued in December, which held that the right to deduct input VAT paid should not be restricted on the grounds that the intended business transaction related to the purchase turns out to be unprofitable or is not completed. In addition, the CJEU is currently reviewing three cases directly concerning the VAT implications of transfer pricing. Given the ongoing scrutiny by the CJEU, multinational entities should place particular focus on this issue.
Previously, there has been no uniform approach across the EU to the VAT treatment of transfer pricing. National legislation and interpretations of the VAT Directive have varied significantly, sometimes resulting in the same adjustment being treated differently across jurisdictions. The CJEU’s forthcoming rulings are expected to clarify and harmonize VAT practices concerning the matter.
Potential VAT Risks Associated with Transfer Pricing Adjustments
A transfer pricing adjustment ensures that intra-group transactions reflect the arm’s length principle, facilitating the appropriate allocation of taxable income between jurisdictions. Typically, operational transfer pricing is based on budgeted figures, leading to discrepancies between projected and actual financial performance. Consequently, adjustments are often necessary, for instance, at the end of the financial year.
VAT risks may emerge if the adjustment affects an entity that does not have a full right to deduct input VAT. If adjustments were previously treated as being outside the scope of VAT but are subsequently deemed taxable, this could create significant complications. Conversely, if adjustments have been treated as VAT-liable, documentation requirements may become a critical compliance issue. A key question before the CJEU is the extent to which the right to deduct input VAT is contingent upon documentation that aligns with transfer pricing rules. A new interpretative approach could result in situations where documentation fails to substantiate that an adjustment constitutes consideration for a taxable supply or has a direct and immediate link to the company’s VAT-liable business activities.
In some EU Member States, courts have issued rulings that take a strict stance, classifying adjustments as subject to VAT while simultaneously denying the right to deduct input VAT. In the most severe scenario, insufficient documentation of adjustments may therefore lead to substantial VAT liabilities, even where both parties would otherwise have full right to deduct input VAT. At the very least, this could trigger a burdensome process, requiring retrospective changes or additional documentation to ensure the right of deduction.
For example, if a parent entity charges a year-end transfer pricing adjustment as a management fee to its subsidiary, this could present a significant VAT risk. If the VAT practice regarding transfer pricing adjustments were to change in such a way that the adjustment is subject to VAT, but the service characterized as management is not considered to benefit the subsidiary’s VAT-liable activities, the associated VAT could result in a loss for the group.
Minimizing Risks Through Proactive Measures
As the CJEU reviews multiple cases concerning transfer pricing and VAT, tax authorities are also likely to increase scrutiny on this issue. Multinational entities should therefore anticipate potential audits and developments in tax practice by proactively addressing VAT implications in their transfer pricing strategies – particularly if this has not been a key consideration previously.
It is essential to ensure that agreements and economic and commercial conditions of the transactions support the VAT policy adopted in transfer pricing. Determining the extent to which services are actually provided and whether they benefit the VAT-liable activities of the recipient entity is crucial. Additionally, the transfer pricing method used should establish a justifiable consideration for the supply. A proactive VAT analysis and well-timed measures can help mitigate risks related to VAT implications of transfer pricing, thereby preventing unexpected tax liabilities.
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.
