TP adjustments can add value to a supply - worth VAT consideration

There has been a lot of attention lately on the interaction between TP and customs valuations and now the interplay of VAT and TP has come into sharper focus following a landmark judgment by the CJEU in the SC Arcomet Towercranes SRL case (C-726/23).

Arcomet Romania is part of the Arcomet Group, an independent global group in the crane rental sector. In the course of its activity, Arcomet Romania purchases or rents cranes in order to resell or rent them to its customers in Romania. Arcomet Belgium seeks suppliers for all its subsidiaries, including Arcomet Romania, and negotiates with those suppliers the contractual terms to be applied to its subsidiaries. However, the sales and rental contracts are, in respect of the activity carried out in Romania, concluded by Arcomet Romania both with its suppliers and with its customers.

A contract was concluded between Arcomet Belgium and Arcomet Romania, under which Arcomet Belgium was responsible for performing a wide range of commercial functions such as strategy and planning, negotiating (framework) contracts with third-party suppliers, negotiating the terms and conditions of financing contracts, engineering, finance, crane fleet management at central level, and quality and safety management. On the other hand, Arcomet Romania undertook to purchase and hold all the goods necessary for the exercise of its activity and to be responsible for the sale and rental of those goods and for the provision of services. 

According to the contractual terms, the way in which Arcomet Belgium and Arcomet Romania were to be remunerated for their activities (and risks assumed in relation to those activities) was subject to a year-end cap and collar pricing mechanism. This was detailed in an annex to the contract. Arcomet Romania’s operating margin was to be tested annually and if it exceeded 2.74 percent, then Arcomet Belgium was to issue an additional invoice as reward for its activities under the contract. If Arcomet Romania’s operating margin was below -0.71 percent, then any excess losses were to be covered by Arcomet Belgium reflecting its greater control and accountability for managing risk. The cap and collar rates were based on a TP benchmarking study, the reliability of which was not in dispute. As it turned out, Arcomet Romania earned over the cap and therefore Arcomet Belgium issued invoices for the contractually stipulated TP adjustments. The contract specified that Arcomet Romania would bear any VAT relating to the remuneration received by Arcomet Belgium.

Arcomet Romania accounted for VAT under the reverse charge mechanism on certain of the year-end price adjustment invoices issued by Arcomet Belgium. Arcomet Romania was later subject to a tax inspection and assessed by the authorities to disallow recovery of the reverse charge VAT due on the payment to Belgium, together with interest and penalties. The right of deduction was refused on the ground that Arcomet Romania had not demonstrated that the services invoiced had actually been supplied and that those services were necessary for the purposes of Arcomet Romania’s taxable transactions.

The dispute made its way to the CJEU which has ruled that TP adjustments which aim to limit the profits of a group company to a target operating margin are capable of being subject to VAT. The judgment follows the Advocate General’s Opinion which had also concluded the same.

In considering the facts of the case, the Court found the following factors to be relevant in arriving at its decision:

• There was an agreement in place between the parties which documented the services to be provided by the former and received by the latter (including the former limiting the latter’s economic risk); and
• The agreement specified the consideration that was to be paid by the recipient in return for the services (by way of the Romanian entity having to pay its excess profits above a benchmark to its Belgian parent). This was sufficient for the Court to rule that the key VAT test of ‘reciprocal performance’ was met.

This is a significant decision because there have been differing opinions as to whether there is a sufficiently clear link between the supplies received and the consideration given in cases where year-end TP adjustments are invoiced to bring the profit margin of one party within an expected range (intended to represent arm’s length returns for that party’s contributions).

In Arcomet, the Court did not agree that there was insufficient linkage, concluding the consideration payable was “neither voluntary nor uncertain” as it was clearly documented in an agreement. It is worth noting that the CJEU decision differs from the VAT Expert Group (VEG) opinion published in 2018 which stated that TP adjustments should be treated as outside the scope of VAT unless the parties are partially exempt (i.e. not entitled to reclaim VAT in full). The VEG also opined that adjustments to reach a guaranteed profit margin (the Arcomet scenario) should not be subject to VAT and again this is different from the CJEU’s view.

With December year-end soon approaching we are recommending that groups review the VAT treatment of intra-group charging mechanisms in light of the contractual arrangements and associated TP policies. Groups reviewing their procedures ready for year-end should turn to their contracts first and assess these in light of Arcomet, including whether they should be amended going forwards to provide greater clarity from a VAT perspective.

This will be a priority for groups which are making (or have made in the past) TP adjustments (balancing payments) treated as outside the scope of VAT, either in the UK or in the EU. It will be important to consider whether this continues to be the correct VAT treatment post­-Arcomet. Despite the UK having left the EU, in our experience HMRC continue to closely monitor CJEU decisions and consider their application under UK VAT law.

An additional VAT liability may arise in a number of scenarios, including (but not limited to) under-declared reverse charge VAT which may not be reclaimable if the recipient entity:

• Carries out activities which do not entitle it to full or partial VAT recovery (including some in-house financing or treasury functions); and/or
• Does not retain the appropriate evidence required for input tax deduction (also a topic in Arcomet).

Reverse charge input VAT cannot be viewed as directly attributable to the reverse charge output tax.

We have also come across cases where charges between UK VAT-registered foreign group companies and local UK companies have been questioned by HMRC, even though an additional VAT liability in one group company would be fully recoverable in another.

Last but not least, whilst this case centres on a target margin pricing model, there may also be situations where a contract defines the adjustment as being required to give effect to an agreed split of profits. This is another area where we would recommend specialist advice is sought to ensure the correct VAT treatment is being adopted and that the arguments which underlie the corporate tax position (e.g. why the payment is arm’s length and deductible for the payer as an expense of earning the profits of the trade rather than a payment out of the profits of the trade) are consistent with those underpinning the VAT treatment.

For further information please contact:

• Phil Roper
• Karen Killington