EU VAT Expert Group 2017 Working Paper

The tension between TP and VAT rules was discussed in 2017 by the EU VAT Expert Group and resulted in a recommendation to the EU member states ("Paper"). Although this Paper is not binding, it is taken into consideration by many EU tax authorities, and the comments mentioned in the Paper provide guidance to determine the correct approach. 

The EU VAT Expert Group agreed in the Paper that in order for TP adjustments to have VAT implications, "it is necessary for there not only to be a supply for consideration pursuant to Article 2(1) of the VAT Directive but also for the consideration to be directly linked to that supply. This should be assessed on a case-by-case basis."

They highlighted the following aspects to be considered:

1. Interaction between direct and indirect taxation: Reference is made to CJEU rulings², which state that the tax authorities should not charge an amount exceeding the tax paid by the final consumer (in this case a related entity), which is in conflict with TP rules that do not require a real payment to be made. In other words, in a situation where there is no real payment made between the related entities (i.e., the final customer does not pay the VAT in fact), charging the VAT on a TP adjustment may be in conflict with CJEU VAT case law. And this deviation between TP and VAT rules should be taken into consideration when determining the direct link between the supply and the remuneration and when analyzing whether the TP adjustment should be considered for VAT purposes or not.   
2. Existence of the ALP in the VAT Directive: VAT legislation already includes a provision relating to arm's length prices charged between related parties³, which is a special provision derogating from the basic rule, set out in Article 73 of the VAT Directive, that the taxable amount is everything of subjective value actually received. If all TP adjustments led to a modification of the VAT taxable amount, the general principle laid down in Article 73 of the VAT Directive could be undermined. Consequently, and similar to point 1 above, the provisions of the VAT Directive should be considered when determining whether a particular TP adjustment should lead to VAT charges or not.
3. Existence of consideration: The TP adjustment should not simply be an adjustment for tax purposes; in order for there to be a supply for consideration under VAT rules, there has to be an element that could be identified as (extra) consideration in return for the supply (which may already have been made) in order for the TP adjustment to lead to the recognition of a supply for VAT purposes.
4. Existence of supply: As mentioned above, a payment can be viewed as consideration where it is given in return for a supply of goods or services. Therefore, it must be possible to link that payment to a specific transaction. Where transfer pricing adjustments are made on the basis of aggregated amounts, it should be possible to allocate them to individual transactions in order for them to have VAT implications.
5. Existence of a direct link between supply and consideration: To fall within the scope of VAT, there must be a direct link between such payment and the goods or services received.

Czech Republic and UK approach

The approach outlined by the EU is generally accepted by many EU member states. For example, the Czech Republic does not have any special rules or guidance relating to the VAT treatment of TP adjustments. The Czech tax authorities issued an opinion answering questions raised in relation to TP adjustment in 2006 that effectively corresponds to the CJEU case law. In general, the approach of the Czech authorities in this respect is to follow the approach of the CJEU.

Similarly, the UK does not adopt clear rules with respect to the treatment of transfer pricing adjustments, and the recommendation is to apply general principles such as those set out above. In short, it is necessary to consider whether the TP adjustment reflects a reallocation of costs or represents an adjustment to consideration for an underlying supply or import, or remuneration for a service provided.

Italian approach to TP adjustments

The Italian VAT legislation does not expressly govern the impact of TP adjustments for VAT purposes. As a result, the topic has been subject to debates for the Tax Administration and authors over the years. This situation has created uncertainty for taxpayers. Indeed, the inaccurate VAT treatment of TP adjustments — especially upward TP adjustments granted by an Italian company — could expose taxpayers to adverse consequences in case of a tax audit and, in the worst case, to criminal implications, due to the severe VAT penalty system existing in Italy.

In this regard, there is no prudential approach that could be followed by taxpayers in doubt about how to treat such TP adjustments. Indeed, if the tax auditors disagree with the choice to give relevance to the TP adjustments for VAT purposes or to consider them outside the scope of VAT, they could, in both cases, levy penalties against the taxpayer. In particular, in case the TP adjustments triggered the application of VAT while the tax auditors considered them outside the scope of VAT, there could be adverse consequences, such as an assessment arising from the incorrect application of the domestic reverse charge, or denial of the right of deduction of VAT by the company receiving the TP adjustment.

In case, instead, the TP adjustment is deemed by the taxpayer to be outside the scope of VAT and the tax auditors disagree with such a conclusion, they might take action against the company granting the TP adjustment for the non-issue of a relevant VAT invoice and the unfaithful filing of the relevant VAT return. Moreover, they could also take action against the company receiving the TP adjustment for the omitted application of the reverse-charge mechanism. In any of the above cases, the penalties levied could range from 90% to 180% of the VAT amount incorrectly levied.

The Italian tax legislation provides that penalties cannot apply in case of uncertainty of the legal provision allegedly violated. This means that, when the VAT treatment of TP adjustments is challenged and the above penalties actually applied, there is a good chance that taxpayers may ultimately have them overturned by the tax court due to the fact that the legislation could be considered as uncertain, lacking any specific provision on the VAT treatment of TP adjustments. However, having the correctness of the position adopted acknowledged by a tax court requires taxpayers to deal with a tax court proceeding, which in Italy might be a very lengthy and resource-heavy process.

In order to avoid the above-described situation, taxpayers often file preliminary ruling requests with the Tax Administration to obtain confirmation on the envisaged VAT treatment, or, alternatively, an express indication on the correct way of handling TP adjustments for VAT purposes.

So far, there are three answers to such preliminary ruling requests which have been rendered publically by the Italian Tax Administration. They were issued in November 2018, August 2021 and December 2021, respectively. All these answers were in accordance with the principles set forth in the Paper.

In the last answer issued, the Tax Administration considered an upward TP adjustment granted by an Italian company to its foreign affiliates. The adjustment was made in order to increase the cost of the goods sold and decrease their operating margin to align it with the group's overall TP policy. The Tax Administration was asked to clarify whether this TP adjustment was relevant for VAT purposes or not. In such a case, the Tax Administration clarified that such TP adjustments are relevant for VAT purposes, provided that one of the following alternative conditions is met:

1. The adjustment represents the consideration for a new supply.
2. The adjustment represents an increase to the taxable amount of the original supply.

With respect to the first condition, the Tax Administration acknowledged that, in the absence of a direct link between the payment of the adjustment and a new obligation for the recipient receiving the adjustment to perform any new activity, such adjustment could not be deemed to be a consideration for a new supply. Indeed, in case of TP adjustments, such as those granted in the case under examination, the adjustments were exclusively aimed at aligning the controlled company's operating margin to the group's overall TP policy. It also did not lead to the undertaking of any obligation on the latter company's side. The qualification of the TP adjustment as a remuneration for a supply was therefore excluded.

As to the second condition, the Tax Administration evaluated whether the TP adjustment granted in the circumstances under examination could actually have a VAT effect, namely, increasing the VAT taxable amount of the original transaction. In this regard, the Tax Administration, mirroring the principles set forth in the Paper, concluded that the taxable amount is affected provided that there is a 'direct link' between the TP adjustment and the supply of goods or services. In the case under examination, the Tax Administration deemed such a link to be nonexistent and, therefore, the TP adjustment was not relevant for VAT purposes.

The recent Tax Administration position, which sets forth principles applicable to the majority of TP adjustment situations, is a further step toward a situation in which — in the absence of express law provisions — taxpayers may have more certainty on the VAT treatment of such TP adjustments.

Recommended actions

When faced with a TP adjustment, or cost allocation, taxpayers are primarily focused on the corporate income tax impact. However, corporate taxpayers must not lose sight of the possible VAT impact of such TP adjustments, as the incorrect VAT treatment of these adjustments may have significant consequences. The incorrect treatment for VAT may give rise to interest and penalties in many EU member states. If in doubt, please reach out to your local Baker McKenzie contact so we can review the potential VAT impact for the relevant TP adjustment.