This is an area which has often been disregarded by taxpayers despite the potential of VAT implications following any Transfer Pricing (TP) adjustments. It has been discussed by the VAT Expert Group in the past at an EU level where only non-binding recommendations (i.e., Working Paper 923 taxud.c.1(2016)1280928 - 28.02.2017) have been agreed offering little guidance to taxpayers in determining the correct approach in this field. Each Member State may decide to follow these guidelines or implement other measures.

Before looking into the possible VAT implications of TP adjustments we need to define what TP represents. In a nutshell, TP is the collection of international tax laws that compel businesses to apply the open market or “arm’s length” principle on transactions between related entities, which establishes that the conditions of a transaction between associated enterprises must not differ from those which would have governed a transaction between independent enterprises under similar circumstances. Where a transaction between associated parties is not at arm’s length then adjustments must be made to replicate the conditions of that transaction, had it been carried out between independent parties.

It seems that the key point which should be examined first is whether TP adjustments could be seen as consideration given in exchange for a supply of goods or services by a taxable person acting as such, that person being, any person carrying out an economic activity, whatever the purpose or results of that activity (articles 2(1) and 9 of the VAT Directive). Furthermore, a supply of goods or services is considered to be taxable only if there is a direct link between the services or goods provided and the consideration received (Apple and Pear Development Council - C-102/86). Such a direct link is established if there is a legal relationship between the provider of the service and the recipient pursuant to which there is reciprocal performance, the remuneration received by the provider of the service constituting the actual consideration given in return for the service supplied to the recipient (Tolsma, C-16/93).

In general, the concept of consideration does not need to reflect the market value of the goods or services supplied, but rather it is construed as a subjective value which reflects the value actually received and not the value estimated according to objective criteria. However, the VAT Directive does contain an anti-avoidance rule in article 80 which allows Member States to levy VAT on a transaction based on its open market value rather than the consideration actually paid. Basically, article 80 is aimed only at preventing potential situations regarded as tax evasion or avoidance by each Member State (i.e. it is an optional measure) where the supply of goods or services is carried out between persons closely related (family or other close personal ties, management, ownership, membership, financial or legal ties) who do not have a full right of VAT deduction and where the consideration is either lower (to the recipient or supplier of those goods and services) or higher (to the supplier of those goods and services) than the open market value. Therefore, the general rule is that the taxable amount is everything that constitutes consideration understood as the subjective value (i.e., the price actually paid) whereas the objective criteria (i.e., open market value) is to be applied only to tackle tax avoidance or evasion and it is at the discretion of each Member State. In fact, the CJEU recalled that the use of the open market value as a taxable amount for VAT purposes is an exception to the general rule, and that the use of such exception is limited to the cases envisaged by Article 80 of the VAT Directive.

The Commission opinion in Working Paper 923 lays out the points that should be reviewed when dealing with TP adjustments that may have an impact from a VAT perspective.

• Interaction between Direct and Indirect taxation: the CJEU has limited in the past the potential correlation between Transfer Pricing rules and the rules introduced in the VAT Directive. For instance, in FCE Bank (C-210/04, EU:C:2006:196, paragraph 39) it was stated that "the OECD Convention is irrelevant since it concerns direct taxation whereas VAT is an indirect tax".
• Existence of the arm's length principle in the VAT Directive: The VAT Directive in Article 80 includes the option to use the arm's length principle under certain conditions to determine the taxable amount of a supply of goods or services based on the open market value. However, in general, the taxable amount is everything which constitutes consideration (i.e., subjective value - the price actually paid).
• Existence of consideration: there must be consideration received (i.e., payment, either in money or in kind) made in return for a taxable supply of goods or services. In other words, there must be an actual element which can be identified as extra consideration for the supply already made. In that regard, the notion of consideration cannot be restricted to that of "payment” (as payments do not constitute taxable supplies) but must be taken also to include other forms (e.g., goods or services supplied in exchange for other supplies). Therefore, based on existing case law of the CJEU, it would also seem possible to consider as ‘more’ or ‘less’ consideration for a previous supply other transactions not just the monetary payments (e.g., other supplies of goods or services, or the offsetting of mutual debts between the associated enterprises).
  Therefore, it must be possible to link a payment to a specific transaction and it must be made to another identifiable party in return for a taxable supply of goods and/or services. 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.
• 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. 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.
  According to the CJEU, such a direct link is established if there is a legal relationship between the provider of the service and the recipient pursuant to which there is reciprocal performance, the remuneration received by the provider of the service constituting the actual consideration given in return for the service supplied to the recipient. Based on the existing case law of the CJEU as regards the existence of a direct link, it is unclear whether transfer pricing adjustments would always meet this requirement.

At an EU level, we are seeing some Member States taking the lead and issuing tax rulings in respect of the VAT treatment of Transfer Pricing adjustments carried out by businesses established in their territories in an attempt to shed some light and establish their position on this matter.

For instance, the Italian Revenue Agency (“ITA”) has already issued two tax rulings in respect of Transfer Pricing adjustments and potential considerations from a VAT perspective. In the first tax ruling (No. 60, issued on 2 November 2018), the ITA was presented with a situation where a multinational group consisting of a non-EU entity (Principal) and two Italian resident entities (Assembler and Manufacturer) raised a question in regards to whether a compensation adjustment agreed between the Principal and the Assembler which guarantees matching the Assembler’s remuneration on an arm’s length basis to cover for any unexpected production cost falls within the scope of Italian VAT.

The ITA confirmed that the adjustment cannot be deemed to represent remuneration paid in respect of a specific supply of services from the Assembler to the Principal in addition to any other supply of goods, there were no additional obligations for the Assembler towards the Principal in respect of which the adjustment could represent the relevant compensation but rather it represented a remuneration for a financial risk assumed. In addition, the ITA went on to consider whether the adjustment could imply a change in the consideration paid for the supply of goods which would entail a modification in the VAT taxable base.

The ITA confirmed that TP adjustments may have an impact on the VAT taxable base when the following conditions are met:

1. There must be a consideration received because of the TP adjustment (i.e., monetary payment or in kind for such adjustment).
2. That payment must be linked to a specific supply of goods or services to which the consideration refers; and
3. There must be a direct link between the transactions (i.e., supply of goods or services) and the consideration received (i.e., payment).

The ITA concluded that as none of the conditions highlighted above were met by the applicant, the TP adjustments had to be regarded as out of scope transactions for Italian VAT purposes.

Likewise, in the second tax ruling (No. 884, issued on 30 December 2021), the ITA was presented with a situation where it had to determine whether financial adjustments carried out as part of the TP adjustments policy of a group of companies was regarded as consideration received for an independent supply of goods and/or services subject to VAT.

The appellant, an Italian company within the fashion industry, is part of a multinational group with subsidiaries located in other EU Member States. The Italian company sells finished products to its subsidiaries which subsequently resell those products in each EU Member State.

The group’s intercompany transactions are based on the ‘CUP’ (comparable uncontrolled price) internal method. However, at the end of year, the group carries out a corroborative analysis (“sanity check”) by way of using the TNMN (Transactional Net Margin Method) which is aimed at ensuring that the application of the intra-group prices identified according to the CUP method as well as the margins of the foreign subsidiaries are consistent with the functional profile assumed by the group and fall within the interquartile range of the specific benchmark developed.

In line with this, the sanity check showed that the foreign subsidiaries had a higher marginality compared to the upper interquartile range of the group which required the foreign profitability to be adjusted by way of raising adjustment invoices which would mean these foreign subsidiaries entering an extra cost that will decrease their Earnings Before Interest and Taxes (EBIT) and therefore the relative return on sales (ROS) revenue.

In accordance with the previous case, the ITA deemed it necessary to first prove the legal relationship between the applicant and its foreign subsidiaries and, if in that context, there is a direct link between the transfers made by way of TP adjustments and the supply of goods and/or services by the appellant. For that purpose, it is required to answer the following:

1. Are the year-end adjustments carried out by the appellant consideration for an independent and autonomous supply of goods and /or services?
2. If not, do these year-end adjustments represent an increase in the taxable amount of the original supply of goods?

The ITA answered the first question negatively on the basis that it is not possible to link such adjustments to the consideration received for an independent and autonomous transaction since the whole purpose of the adjustments is to bring the foreign subsidiaries marginality within the interquartile range of the group. Therefore, the ITA focused on the second question to ascertain whether those price adjustments would affect the VAT taxable base.

The ITA highlights in their decision that the consideration is the price actually paid for a supply of goods or services (subjective criteria) which is reinforced by Article 73 of the VAT Directive which reads as follows: “In respect of the supply of goods or services, other than as referred to in Articles 74 to 77, the taxable amount shall include everything which constitutes consideration obtained or to be obtained by the supplier, in return for the supply, from the customer or a third party, including subsidies directly linked to the price of the supply.” Furthermore, the ITA states that in agreement with the relevant ECJ case law, Article 73 of the VAT directive “constitutes the expression of a fundamental principle, the corollary of which is that the tax authorities may not charge more VAT than the amount received by the taxable person.”

The ITA reaffirmed that to evaluate if these adjustments have an impact in the VAT taxable base of the supplies of goods between the appellant and its foreign subsidiaries, a direct link must exist between the adjustments and the supply of goods, a consideration is paid, the supplies of goods and/or services can be identified and there must be a direct link between the supply of goods and/or services and that consideration received.

The ITA concluded that the adjustments were not “directly related to the original supplies of finished products made by the petitioner” and consequently it is understood that the financial adjustments made following the TP adjustments in question, carried out in implementation of the TP policy of the Group are regarded as outside the scope of VAT.

As we can see there is a clear tension between the Transfer Pricing rules that seek to arrive at the arm’s length principle for the valuation of a transaction (i.e., open market value) and the VAT rules that are based on the existence of a supply for consideration (i.e., the price actually paid).

In conclusion, TP adjustments may have VAT consequences when such adjustments are seen as consideration received for a supply of goods or services already made. If such adjustment constitutes consideration for a supply and there is a direct link between that supply and the consideration it could be argued that this would give rise to an increase or decrease in the VAT taxable amount of that transaction. However, given the complexities involved it is recommended that each TP adjustment should be assessed on a case-by-case basis.