This is mixing apples and oranges, is a reader’s first thought when reading about transfer prices and value added tax (“VAT”) in a single article. It is interesting to note that this area is becoming more and more popular since the interaction between direct and indirect taxes is only partially limited and is not always excluded. Can you imagine the significance of a potential change in the amount of VAT due if it were imposed on you for payment by the tax authority after making the adjustments for the transfer prices for the purpose of corporate income tax (“CIT”)?
Those engaging in goods imports have been informed of the fact that transfer prices can impact the value of goods for customs purposes. An adjustment of transfer prices results in a change of the value of goods for customs purposes and accordingly the basis for VAT accounting. Due to such adjustment, an importer can be bound to account and pay a higher VAT amount. In this respect, the Court of Justice of the European Union is currently examining a case in the framework of which it will decide whether the value of goods for customs purposes can be changed in case the related persons make an adjustment at the end of the year due to transfer prices, based on which the importer receives an invoice to pay an extra amount or a credit for a refund of a part of purchase amount. With an annual reconciliation, the related persons change the transaction values which can affect direct taxation or the basis for VAT accounting.
It will be interesting to follow the positions of the advocate general and the Court. Among other, the Court will answer the question of whether the effects of subsequent adjustments of transfer prices need to be recognised in a customs procedure of assessing VAT only when the value of a transaction is increased or also when a downward adjustment is made.
This also gives rise to important questions in other areas. As a rule, the VAT tax base is set on the basis of the amount of compensation received by a supplier for the goods supplied or services provided. This also applies in case the amount of the compensation is not equal to the market value of a transaction. It is namely difficult to imagine, from the point of VAT, that the rules could stipulate that an entity is required to pay a compensation not agreed upon. Such a position was adopted by the Court of Justice of the European Union in the case when a tax authority tried to impose VAT payment on a street musician from the voluntary contributions made by the passers-by. Based on the Court’s decision it was not possible to assume that a compensation has been made which would represent a basis for the payment of a service, since there was no legal relationship established between the supplier and the customer, which would impose obligations on them.
The situation in which one of the related persons in a transaction is not entitled to deduct the entire input VAT, is rather different. This usually involves situations in which an activity is performed that is exempt and applies e.g. to banks, insurance companies, persons performing an exempt healthcare activity, an activity of managing investment funds, gaming activities and similar. When a recipient of goods or services is unable to claim deduction for the entire input VAT, it could happen that in the event of a deviation from the market prices, the supplier would account and pay VAT in a lower amount than justified. If we take into account the principle that in the usual transactions VAT should not exceed the value an end consumer would be willing to pay we can, on the other hand, assume that a supplier in the above-described case should be obliged to charge at least the value that an end consumer would be willing to pay. In the event of a violation of the above principle, unjust VAT payment losses could be incurred by the state budget, resulting in significant tax consequences for the supplier.
The adjustment of transfer prices can also affect VAT in case when agreements exist between the related persons which can result in a change of the amount of compensation to which the supplier of goods or provider of services is entitled. For example, if there is an agreement based on which one of the related persons is obliged to pay an additional cash compensation to the other person after the adjustment of transfer prices, such payment can be considered a compensation that increases the base for VAT accounting. By increasing the liabilities to be paid by the recipient, the value of the compensation it is obliged to pay also increases. Consequently, the transaction value and the basis for VAT accounting are also increased. This also applies in the opposite case, i.e. in the event of a reduction of the recipient’s liabilities, the value of the paid compensation is also reduced.
In practice, there were cases when the recipient was obliged to perform a counter service instead of additional payment. From the economic point of view, such a fulfilment in kind is fully comparable with the fulfilment in cash; it is therefore necessary to consider, from the VAT point of view, that the transaction value is increased. Both parties to a transaction are obliged to pay VAT on such additional payment, namely, the supplier because of the increase in the value of the underlying transaction and the recipient because of providing a counter service which is also subject to taxation.
Before deciding on whether to account VAT because of the adjustment of the transfer prices, it is usually necessary to establish if all the criteria on the basis of which such an obligation had been incurred have been met. A supply must be made, an additional payment must be agreed upon, to be paid by the recipient, and what is most important, there must be a connection between the basic supply and the additional compensation. For example, an increase in the value of a transaction is not necessarily connected with the initial transaction if the reason for the increase is a subsequently agreed longer period of payment, because the substance of such an adjustment is the interest paid for the financing and does not increase the value of the initial transaction. The payment of additional compensation can affect the VAT account only in case it can be connected with the past supply, since there must exist a reciprocal relation between the supply performed and the subsequent payment received. If there is no such connection, the payment cannot be considered a compensation that is subject to VAT accounting in connection with the past transaction.
Those of you who are dealing with the above-described situations will most certainly wonder if the connection must be direct or if it can also be indirect. In general, direct connections are not a sufficient condition for considering an additional compensation as an increase in the compensation related to a past transaction; however, it is not possible to a priori exclude the situations in which a VAT accounting obligation could arise because of an increase in the value of the underlying supply also via an indirect connection. Each case must be carefully analysed so as to establish the reasons for the price adjustment or all economic circumstances that affected the value of the transaction.
In the above-described cases, the adjustment of the transfer prices can have a significant impact on VAT accounting which is why it is recommended that both the persons handling direct taxation (e.g. corporate income tax) as well as the persons handling indirect transactions, i.e. the VAT area, be informed of the transfer prices in the company.