VOLUME 16, NUMBER 5 >>> May 2015

Transfer PriceAdjustments—whatyou need to Considerfrom an Indirect TaxPerspectiveMichaela Merz and Zsolt TenczerPwC Switzerland

Compared to the global focus on BEPS, indirect tax issues relatingto transfer pricing have received little attention, but businesses areas vulnerable to the VAT and GST implications of cross-bordertransactions as to transfer pricing adjustments themselves. Thefollowing article considers this in more detail.

The International VAT/GST Guidelines of theOECD, published in 2014, qualify the overar-ching purpose of a value added tax (VAT) as a

broad-based tax on consumption, primarily targetingfinal household consumption. Consequently, theburden of VAT should not rest on the businesses.

However, VAT and similar multi-stage taxes, knownby other names such as GST, are levied not only on thesupply to households upon final consumption, butalso on business transactions throughout the supplychain, and are paid by the businesses involved. In gen-eral, a business can recover local VAT payable on itspurchases, including VAT on intra-group transactions.However, there is a risk that treating business transac-tions incorrectly, including—among others—relatedparty transactions, will lead to indirect tax shortfalls.Even if VAT can be charged further in the supply chainand recovered by the other party, the assessed penal-ties could still significantly affect the financial resultsof the group.

Although the current worldwide debate aroundBEPS focuses primarily on direct taxes and on the fair

distribution of taxes amongst the jurisdictions in-volved, in practice, related-party transactions arechallenged from an indirect tax perspective time andtime again by various tax authorities. Besides the VATqualification, for the cross-border transfer of goodsthe customs treatment is also frequently challenged.

In order to generate additional revenues, assessingan indirect tax shortfall might be the easier approachfor many tax authorities in the present environment.Due to a lower level of harmonization and the fact thatindirect tax issues rarely get resolved across borders,businesses are much more at the mercy of local taxauthorities. So, even if incorrectly handled related-party transactions do not result in a loss of indirect taxrevenue for the treasury, non-compliance with formalrequirements can still be penalized heavily.

I. Key Indirect Tax Issues to be Clarified in Relationto Transfer Price Adjustments

As a precaution, tax managers and transfer pricingspecialists alike should be aware of the indirect tax

Michaela Merz isLeader IndirectTax and ZsoltTenczer is IndirectTax Senior Man-ager, PwC Switzer-land

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implications of transfer price (TP) adjustments. Takea common scenario in which a company has to makea TP correction for transactions performed with a re-lated party in the previous year. All of the following as-pects need to be analyzed:s Is the retroactive TP adjustment subject to value

added tax (VAT) or a similar multi-stage consump-tion tax in a given country?

s If yes, the adjustment may have to be invoiced andthe way this is done can be critical for the indirecttax assessment.

s In which reporting period should the adjustment betaken into account?

s In case of cross-border trade of goods, the customsvalue may also be impacted. What are the possibili-ties of modifying customs declarations, and arethere any related risks?

In some cases, the answers might be straightfor-ward; but investigating those questions for a given ju-risdiction might necessitate a thorough review, whereinternational tax treaties cannot provide any guid-ance.

To give a real-life example: during a tax audit, a mul-tinational client of ours was challenged for a VATshortfall of several million U.S. dollars with regard toa TP adjustment made for only one business year, witha linearly proportionate risk for a further five yearsopen for future tax audits. The reason was a disputethe client had had with the tax authority as to whetheror not a downward TP adjustment should have beensubject to VAT in this given country. Instead of charg-ing VAT, which the company had done, the tax author-ity argued that the client must credit the invoices andrebill the customer without VAT. Even if the client’scustomer in turn could also correct its VAT liabilities,the interest and penalties related to this dispute couldstill have a significant impact on the client’s P&L.

II. The Relevant Indirect Tax Principles

In the following, we would like to provide you withsome food for thought about how TP adjustments canaffect your indirect tax liabilities. Tax practitionersshould be able to recognize that implementing the re-sults of a TP analysis in practice could lead to differ-ing indirect tax treatments depending on theapplicable consumption tax (VAT/GST) and customsregimes. If the prices are modified retroactively, eitherupwards or downwards, the indirect tax implicationsof these changes should be taken into account.

From an indirect tax point of view, a TP adjustmentmay be treated in various ways. It may be treated (1)as part of the previous supply, modifying its value, (2)as consideration for a different supply (usually a typeof service), (3) as an indemnity that is not subject toVAT, or even (4) as a payment without an underlyingsupply that should be fully disregarded. Even whenthe TP adjustment relates to previous supplies, thereare still various questions that need to be answered toidentify the correct tax treatment.

From an indirect tax perspective, in order to illus-trate potential pitfalls at a very high level, three basicscenarios need to be analyzed, depending on where

the underlying transaction to which the TP adjust-ments relate is deemed to have taken take place. Forthe supply of goods, the location will be determinedbased on the physical route of delivery, i.e. the ques-tion is whether or not the goods are sold and deliveredto another country. In the case of services, however,the location of either of the contracting parties willmost likely be relevant.

III. Scenario 1: Local Supplies Within the SameJurisdiction

In order to determine where a transaction takes placefrom a VAT perspective, specific local rules should betaken into account. It should not be forgotten thateven transactions between two related parties that arelocated in different countries might qualify as localtransactions within one country for indirect tax pur-poses. For example, a US company supplying goods ina European country could be registered for VAT there,and the supplies to its related party subject to localVAT. Consequently, even if the TP adjustment takesplace between companies from two countries, for VATpurposes, the local rules of the European country inwhich the supply takes place would apply.

Without a cross-border element in the transaction,you might think that risks and potential challengeswould be limited. However, even if the transactionsoccur within one country, you should considerwhether or not TP adjustments are taxable at all underthe local consumption tax regime.s In case of a retroactive TP correction, do any of the

parties need to issue invoices, credit or debit notesand;

s what are the exact rules governing the contents ofthese documents?

In many countries, issuing/obtaining formally in-correct invoices could lead to a denial of VAT recovery.This risk, combined with ever-increasing consump-tion tax rates, could result in tax costs higher than theassociated direct tax effect of the whole TP adjust-ment. We should also not forget that transactionswithin one country, but between different federalstates, may be subject to different indirect tax rules.

For related-party transactions, there is a furtherrisk if one of the parties is not entitled to a full recov-ery of input taxes according to the applicable indirecttax regime (e.g. in the case of financial institutions). Insuch cases, when the applied prices are not at arm’slength, they will not only affect the corporate tax li-abilities, but also the indirect tax liabilities of the par-ties involved. This may lead to a situation in whichone of the parties would have to increase its total indi-rect tax liabilities—for example its output VAT—without the other party realizing a correspondingreduction of its tax liabilities by increasing the inputVAT. This situation would increase the tax-relatedcosts of the corporate group to which the related par-ties belong.

At this point, it should be mentioned that in indirecttaxation, the principles determining the price to beapplied between related parties may differ from thosein a direct tax approach. Modification of the price and

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the taxable base for VAT might be required by law onlyif one of the parties is not fully entitled to VAT recov-ery.

IV. Scenario 2: Transactions Within one CustomsTerritory, but Between Differing VAT Regimes

If related-party transactions are made across nationalborders, the easier scenario is for the underlyingtransactions to still take place in a single marketwithin one customs territory, such as within the EU.In this case, customs considerations are not relevantfor TP issues concerning the trading of goods. Onlythe two countries’ regulations relating to VAT (orother similar consumption taxes) are relevant.

Most likely, cross-border trading of goods will betaxed in the country of destination and be exemptfrom taxes in the country of supply. Services are usu-ally taxed at the customer’s location. Provided that theparties, being taxable businesses, can recover the pay-able indirect taxes, the questions which arise arerather of an administrative nature, such as:s How should the TP adjustment for cross-border

transactions in the respective countries bereported?

s Besides the relevant indirect tax aspects, tax profes-sionals should not forget that TP adjustments mayaffect other reporting requirements. For example,regarding the trade of goods, other statistical re-porting requirements, such as Intrastat reporting inthe EU, may arise.

With regard to TP adjustments, it is worth mention-ing the theoretical ‘‘challenge’’ that prices may only bemodified within the EU VAT regime if the modifica-tions can be directly linked to the original transac-tions. Most likely, this requirement would be fulfilledby most TP adjustments, because the modificationsaffect prices of the supply of goods and services in pre-vious periods, such as in a preceding fiscal year orquarter—but the direct link to the original transactioncould still be difficult to establish.

If transfer prices are modified based on functions orprofitability and not on comparable third-party pricesof specific products, they cannot be necessarily linkedor allocated to specific transactions in the past. Evenif we accept that a TP adjustment would be subject toVAT, as it is applied in most EU countries, the questionremains as to what the correction invoice would looklike:s Is summary invoicing for such a modification viable

at all in a given jurisdiction?s If countries with differing interpretations are in-

volved, how could we fulfil these contradictoryrequirements?

V. Scenario 3: Transactions Across CustomsBorders

Customs duties are generally imposed on the importa-tion of goods from other customs territories. How-ever, we should also consider the customs

implications for other types of intercompany transac-tions, since trademarks and royalties could affect thecustoms value of goods as well. In order to identifyand act on such customs implications, the responsibledepartments within a multinational organisationmust maintain the necessary internal connections andcommunication.

In contrast to the rather long-term approach oftransfer pricing, customs focuses on individual trans-actions at a specific time. In principle, import dutiesand taxes are assessed at the very moment the goodscross customs borders. Even in cases, where customsclearances may be modified retroactively, this is arather cumbersome administrative exercise in manyjurisdictions and is usually not well received by theauthorities.

Customs focuses on the transaction value, i.e., theprice actually paid or payable for the goods (with cer-tain adjustments). This encompasses everything (bothmonetary and non-monetary) that constitutes theconsideration from the purchaser when the goods aresold for export to the country of importation. If thisoriginally assessed value was not correct and the im-porting entity subsequently states that the TP assess-ment will influence this customs value, the customsauthorities of some countries could even consider thischange as fraud. By increasing the value (and relatedduties) retroactively, the importer of goods risks incur-ring high penalties or even criminal prosecution.

Furthermore, it is not simply a question of whetheror not it is necessary to retroactively modify theimport value; such a modification may not even bepossible, particularly if a price adjustment results in areduction of customs duties. Such cases may lead toan overpayment of duties, which would result in addi-tional costs.

VI. Conclusion

We suggest that you identify and analyze these indi-rect tax-related risks thoroughly in connection withTP adjustments. Involving indirect tax specialists witha thorough understanding of local regulations earlyon might be a well-founded approach. In order toensure that intra-group prices are not challenged bylocal authorities, preparing a defendable TP docu-mentation is not enough; it is equally crucial to clarifythe invoicing of the necessary price adjustments.

Especially with regard to possible customs implica-tions, it is essential to build strong internal channelsof communication with all other stakeholders withinthe organization, especially with those who sit outsideof the tax function, such as in the logistics or supplychain departments.Michaela Merz is Leader Indirect Tax and Zsolt Tenczer isIndirect Tax Senior Manager, PwC Switzerland. They can becontacted atmichaela.merz@ch.pwc.com; andzsolt.tenczer@ch.pwc.comwww.pwc.ch

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