The complex interplay between transfer pricing and VAT

In the realm of international taxation, transfer pricing (TP) and value added tax (VAT) are two pivotal components that often intersect in complex ways. Understanding their interplay is crucial for businesses operating across borders, particularly in the context of compliance and tax optimization. 

The pending case of SC Arcomet Towercranes SRL (ARO) underscores the intricate complexities surrounding TP and VAT, illustrating the challenges businesses face in complying with different tax regulations.

Context: The Arcomet case C-726/23 pending before the Court of Justice of the European Union (CJEU) deals with VAT issues related to transfer pricing within corporate groups. Arcomet Towercranes SRL, a Romanian subsidiary, received invoices from its Belgian parent company, Arcomet Service NV, to align profits according to OECD guidelines. The Romanian tax authorities classified these invoices as payments for services and applied VAT through the reverse charge mechanism, but they denied the subsidiary's right to deduct this VAT due to a lack of proof of actual services provided.

The parent company of the multinational Arcomet Group seeks suppliers for ARO (as well as for the other Group companies) and negotiates contractual terms with these suppliers. The contractual relationship with suppliers and end customers is then entered into by the ARO (or another Group company). As a result of the comparability analysis conducted within the scope of a transfer pricing study, it was assessed that the associated entities should record a specific financial result at market level (operating profit margin). The findings of the study were incorporated into a contract by which the parties assumed the responsibilities and risks for selling/purchasing and renting cranes. The contract provided for an equalization invoice to be issued each year.

The case thus centers on interpreting provisions of the Council Directive 2006/112/EC concerning the common system of VAT on two critical issues:

1. Whether amounts invoiced between affiliated companies to align profits, following OECD Transfer Pricing Guidelines, constitute payments for VAT-taxable services.
2. If tax authorities can mandate additional documentation, beyond invoices, to substantiate VAT deductions related to procured services for the taxable person's economic activities.

The relationship between TP and VAT is multifaceted, involving numerous regulatory guidelines and principles. While in general the taxable basis for VAT should be equal to the consideration paid (Article 2(1)(c) of the VAT Directive confirmed by various CJEU case law see, inter alia, Case C-16/93 Tolsma and C-285/10, Campsa Estaciones de Servicio SA), some exceptions to this rule exist. 

The VAT Directive, for instance, includes measures to prevent tax evasion or avoidance and defines taxable amounts based on the open market value and the arm's length principle in Article 80 of the EU VAT Directive. The principles in this article ensure that, under certain conditions, transactions between related parties are conducted as if they were between independent entities, thereby maintaining fair market conditions. It has nonetheless been established by the CJEU that the conditions of application of Article 80 of the VAT Directive are exhaustive and, consequently, national legislation cannot foresee that the taxable basis should be open market value in cases other than those listed (CJEU Joined Cases C-621/10 and C-129/11 Balkan and Sea Properties).

With the aim to strengthen its legislative frameworks to address the increasing concern of VAT fraud, the Luxembourg government introduced the EU principles in Article 28 3) of the Luxembourg VAT law in August 2018. 

The Luxembourg measures would only apply to transactions taking place between related parties with familiar or other close personal ties (including when they have management, ownership, membership, financial or legal links) and if one of the parties would have a limited input VAT recovery right.  It is also important to note that the anti-avoidance rule would apply to both local and cross border supplies. 

When a transaction falls within one of the above scenarios, the consideration (price) of the supply (good or service) would be either the open market value that would be applicable under conditions of fair competition for comparable supplies, or the cost price of the goods or the full costs incurred by the supplier to supply the service.

From a VAT perspective, TP adjustments can thus have significant implications. When tax authorities assess an increase in taxable profits following a TP audit, businesses must consider the corresponding VAT adjustments. This is particularly relevant for companies in the financial services industry, which often provide VAT-exempt services. These companies cannot claim back VAT incurred on goods and services purchased to carry out their activities, making VAT a final cost.

Entities within the same group or those with economic ties, often referred to as "related parties," frequently provide administrative or support services to each other. VAT is applicable to these services, and if the related parties cannot fully claim back VAT on their costs, this makes the VAT the final cost. To mitigate this, related parties may adjust the prices of their services compared to market prices. However, such adjustments can be challengeable and questionable if they aim to reduce VAT costs.

An essential aspect of managing TP and VAT compliance is thus maintaining thorough and well-documented TP documentation. Proper TP documentation ensures that intercompany transactions are appropriately justified and aligned with OECD guidelines. When tax authorities review VAT deductions or assess additional VAT liabilities, they often do so in lack of substantiating evidence that transactions were carried out at arm's length and for legitimate business purposes respectively due to inconsistencies between the TP documentation and Intra-Group Service Agreements signed. Failure to provide adequate TP documentation may thus lead to tax disputes, VAT reassessments, or even penalties. 

Emphasis should be placed on the importance of thorough documentation of cross-border relationships between all group companies. While VAT is generally harmonized within the EU, VAT authorities across Europe adhere to their respective State's internal guidelines regarding transfer pricing and VAT audit approaches.

As demonstrated by the Arcomet case, tax authorities may scrutinize TP adjustments and consider them as VAT-taxable transactions, reinforcing the necessity for businesses to maintain detailed and transparent documentation that supports their TP positions and VAT treatment.

Guidance to navigate the complex interplay between VAT and TP can be found in the VAT Expert Group (VEG) Discussion Paper NO 071 REV2. Therein the VEG provided some seemingly clear guidance on the VAT treatment of TP adjustments focusing on their nature and link to supplies. 

While in the said Paper, contracts defining adjustments to reach guaranteed profit margins are clearly considered as falling outside the scope, the Arcomet case adds the nuance of the parties assuming the responsibilities and risks for selling/purchasing and renting cranes as per the contract concluded further to the TP Study. The latter was interpreted by the respective tax authorities as constituting a supply of service and thus the TP adjustment to fall within the scope of VAT.

The Arcomet case raises the question of whether, and to what extent, input VAT deductions for transfer pricing adjustments need to be supported by documentation beyond invoices. This documentation is necessary to demonstrate that the costs from these adjustments are related to the company's economic activities.

The input VAT deduction is a fundamental right of the VAT mechanism which was emphasized by the VEG in its Discussion Paper and thus the VEG would not expect any non-deductible VAT to occur further to a TP adjustment. The said paper however focuses on VAT resulting from adjusted invoices i.e., such cases where further to a TP adjustment the taxable basis of an already existing supply of goods or services is adjusted and thus in principle the original invoices would require to be redacted. Consequently, the scenario in which further to a TP study an Intra-Group Agreement is concluded and further to this agreement the VAT authorities consider an independent supply of service to be executed between the group companies, has not been discussed by the VEG. Such scenario was omitted from the paper. Predominantly as in accordance with its arguments the VEG would not deem a TP adjustment to give raise to an individual supply of service following within the scope of VAT. 

It therefore remains to be analyzed by the CJEU in the Arcomet case whether and if so to which extent the existence of an intra-group agreement respectively invoice aiming to represent a TP adjustment further to a TP study could or should be interpreted as a supply of services against remuneration and if so whether any input VAT resulting from such TP adjustment would be deductible. 

While the hearing in the Arcomet case only took place recently, the judgement later this year is thus expected to clarify the specific case but also to provide more general guidance in the interpretation of the Paper of the VEG (opinion of the Advocate General Richard de la Tour scheduled for April 3, 2025).

Finally, in conclusion of the above, the interplay between TP and VAT is a complex but crucial aspect of international taxation. Businesses must navigate these intricacies to ensure compliance and optimize their tax positions. As governments continue to strengthen their legislative frameworks to combat tax avoidance and fraud, staying informed about these developments is essential for businesses operating in multiple jurisdictions. Understanding the principles and guidelines governing TP and VAT can help businesses make informed decisions and maintain fair market practices.