By Luís Aires, EMEA Indirect Tax Advisor | Ph.D. Candidate | Author | Researcher on VAT Policy/Case Law and Tax Technology | Lecturer
According to the efficiency argument for profit maximisation, companies seek to maximise their own profits as it leads to economic efficiencies and welfare maximising outcomes. This statement however does not necessarily have to be true from the taxation perspective if there is a link between trading enterprises. The intention behind arm´s length is to ensure fairness of the price based on allocated risks, functions performed, used assets and compare those factors to the price that would be achieved between unrelated parties for similar goods or services. The concept behind ALP is to value transactions and tax profits between associated enterprises as if they were conducted between independent enterprises, taking into account conditions of the market, financial and commercial reality.
It is important to remember that the search of a comparable data is not only related to the type of goods and services, but it also includes a ‘functional analysis’ of assets, risk and functions performed.
The principle is endorsed by the OECD and applied in Art 9 (the Associated Enterprises) of the OECD Model Tax Convention on Income and Capital, however it is introduced in more detail in Chapter 1 of the OECD Guidelines. As specified in the Guidelines, “when associated enterprises transact with each other, their commercial and financial relations may not be directly affected in the same way by external forces (…), however there may be a genuine difficulty in accurately determining a market price in the absence of market forces or when adopting a particular commercial strategy. It is important to further adjustment to approximate arm’s length, irrespective of any intention of the parties to minimise tax. Thus, tax adjustment may be appropriate even where there is no intent to minimize or avoid tax”.
The underlying purpose therefore is to provide the parity of treatment between associated and independent enterprises as it makes them more equal for tax purposes. The application of the ALP faces difficulties and often requires adjustments, especially when:
- there are no comparable transactions available (e.g. when highly specialised or innovative goods are involved),
- when independent parties would not conclude transaction in question (e.g. licensing of intangibles is more probable to occur between related parties),
- when justification of the price is done many years after the actual transaction took place.
The list is not exhaustive and the above represents only few, most common examples. The first one, which focuses on the lack of comparability criterion, is crucial for the overall methodology used in transfer pricing. Regardless of valuation methods used or types of transaction, comparability is a lasting value for the entire transfer pricing system. It is argued that the comparability ensures the objective element in the valuation, while VAT (as will be explained in more detail in the further part) is based on the subjective valuation. The comparability covers multiple factors, inter alia, characteristics of types of transactions, whether they cover tangibles, intangibles or service transactions (quality, quantity), functional analysis, terms of the agreement, economic circumstances (overall economic conditions, labour costs, size of the market and competitiveness, etc.) or business strategies (expected expenses for the initial business developments, expectations of profits).
Certain areas might be more difficult to identify and characterise than others, for instance when dealing with service transactions, as often there is no physical transfer that could prove the existence of a transaction (with an exception of travelling professionals) and even the OECD Guidelines definition of a service is not definitive and only specifies types of potential services (e.g. administrative, technical, financial, management, control functions). This specific difficulty occurs also in VAT, as service has only a negative definition of being ‘not-goods’ (Article 24 of the VAT Directive).
Supply of goods or services
Article 73 of the VAT Directive establishes the taxable amount for a supply of goods or services: “In respect of the supply of goods or services (…) 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”.
It is not generally required for VAT purposes that the consideration which must be present in order for a transaction to be qualified as taxable, has to reflect the market value of the goods or services supplied. In fact, as to the concept of “consideration”, it is settled case-law of the ECJ that the taxable amount for the supply of goods or services is represented by the consideration actually received for them. That consideration is thus the “subjective value, that is to say, the value actually received, and not a value estimated according to objective criteria” (amongst others, ECJ: C-230/87, Naturally Yours, 23/11/1988, para.16; C-40/09, Astra Zeneca, 29/07/2010, para.28).
The ECJ has often dealt with cases where the consideration is lower than the cost price of the goods or services supplied. In Gåsabäck, where the VAT treatment of food supplied by a hotel to its personnel for a consideration below cost price was examined, the ECJ stated that “the fact that the price paid for an economic transaction is higher or lower than the cost price is irrelevant to the question whether a transaction is to be regarded as a ‘transaction effected for consideration’. The latter concept requires only that there be a direct link between the supply of goods or the provision of services and the consideration actually received by the taxable person…” (C- C-412/03, Gåsabäck, 20/01/2005, paras.22 and 36). In Campsa Estaciones de Servicio, the ECJ confirmed that “the possibility of classifying a transaction as ‘a transaction for consideration’ requires only that there be a direct link between the supply of goods or the provision of services and the consideration actually received by the taxable person. Thus, the fact that the price paid for an economic transaction is higher or lower than the cost price (…) is irrelevant as regards that classification” (C-285/10, Campsa Estaciones de Servicio, 9/06/2011, para.25).
In Weald Leasing Limited the ECJ regarded “rentals that were set at levels which were unusually low or did not reflect any economic reality” (C-103/09, Weald Leasing Limited, 22/12/2010, para.39), as being potentially contrary to the VAT Directive. However, this case refers to a situation of abusive practice with an artificial low consideration that runs against economic reality, whereas in Gåsabäck and Campsa Estaciones de Servicio the low consideration was fully justified in economic terms and did not have any abusive purpose.
It may be useful to also refer to the opinion of the Advocate General in Argos, which clarified the fact that VAT relies on the subjective valuation of transactions: “… the word ‘subjective’ is not used here in its normal sense, but rather to describe the value placed by the parties on key elements in a transaction; a meaning which is equally capable of being characterized as ‘objective’. The effect of these cases is to distinguish and exclude, for the purpose of assessing the consideration for a sale, any supposed independent valuation, different from that adopted by the parties”(Opinion of the Advocate General Fennelly, C-288/94, Argos, 27/06/1996, point 21).
Still, the VAT Directive does contain in Article 80 an anti-avoidance rule which allows Member States to levy VAT on a transaction based on its open market value rather than the consideration actually paid, provided that certain conditions are met:
“1. In order to prevent tax evasion or avoidance, Member States may in any of the following cases take measures to ensure that, in respect of the supply of goods or services involving family or other close personal ties, management, ownership, membership, financial or legal ties as defined by the Member State, the taxable amount is to be the open market value:
(a) where the consideration is lower than the open market value and the recipient of the supply does not have a full right of deduction under Articles 167 to 171 and Articles 173 to 177;
(b) where the consideration is lower than the open market value and the supplier does not have a full right of deduction under Articles 167 to 171 and Articles 173 to 177 and the supply is subject to an exemption under Articles 132, 135, 136, 371, 375, 376, 377, 378(2), 379(2) or Articles 380 to 390;
(c) where the consideration is higher than the open market value and the supplier does not have a full right of deduction under Articles 167 to 171 and Articles 173 to 177 (…)”.
This rule is however applicable only in the case of transactions between persons with close ties, which could be reminiscent of the concept of “associated enterprises” set out for the purposes of the above transfer pricing rules.
In turn, Article 72 of the VAT Directive defines “open market value” as follows: “For the purposes of this Directive, ‘open market value’ shall mean the full amount that, in order to obtain the goods or services in question at that time, a customer at the same marketing stage at which the supply of goods or services takes place, would have to pay, under conditions of fair competition, to a supplier at arm’s length within the territory of the Member State in which the supply is subject to tax (…)”.
Although Articles 72 and 80 of the VAT Directive could indeed be seen as reflecting the arm’s length principle for VAT purposes, there is one fundamental difference between the scope of application of those provisions and that of the transfer pricing rules: while the arm’s length principle must be generally observed in all intra-group transactions under the transfer pricing rules used for the purposes of direct taxation, the scope of the arm’s length principle set out under the VAT Directive seems much narrower. In fact, this rule is optional for Member States to apply, and it can only be used in order to prevent tax evasion or avoidance in a set of well-defined circumstances.
Existence of the arm’s length principle in the VAT Directive
The legislator has already introduced the arm’s length principle in the VAT Directive where it seemed relevant, that is, in the scenarios envisaged under Articles 72 and 80 of the VAT Directive. The determination of the taxable amount of a transaction according to the open market value deviates from the general rule laid down in Article 73 of the VAT Directive, which is based on the price actually paid (subjective value).
If all transfer pricing 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 and the open market value would “de facto” end up becoming the norm. In this respect, the ECJ 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.
This was also pointed out in the past by the Commission, notably in regard to the costsharing exemption laid down in Article 132(1)(f) of the VAT Directive. For instance, the impact assessment of the proposal put forward by the Commission in 2007 as regards the VAT treatment of insurance and financial services, which was recently withdrawn, referred to the tension between transfer pricing rules (requiring an open market mark-up) and the cost-sharing exemption (where one of the requirements for services supplied by the cost-sharing group to be exempt is that they are remunerated at cost). In the proposal, the wording of the condition concerning the reimbursement of costsharing services aimed at reconciling this requirement with transfer pricing rules: “the group claims from its members only the exact reimbursement of their share of the joint expenses, excluding any transfer-pricing adjustments made for the purposes of direct taxation” (Article 137b(5) of the Proposal for a Council Directive amending the VAT Directive as regards the treatment of insurance and financial services (COM(2007) 747).
As regards the cost-sharing exemption, the document produced by the Commission services for the discussion in the 91st meeting of the VAT Committee (Working paper No 654), held in May 2010, also indicated that: “It is conceivable that the group may become liable for direct tax by virtue of the transfer pricing rules of the Member State in which it is established. In such circumstances the direct tax consequences which may flow from the pricing policy imposed by the VAT Directive should have no impact on the VAT treatment of the services provided by the group”.