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Introduction of transfer-pricing for VAT Back  
Amendments to the Sixth VAT Directive may lead to increased costs for financial services companies that receive VAT taxable services from connected parties in Ireland or abroad. Businesses should review transfer pricing arrangements on transactions with related entities that are not in the same VAT group.
The pace of change in VAT doesn’t show much sign of slowing down. This article focuses on a recent amendment to rules relating to ‘market value’ in the context of transactions between connected parties (i.e. transfer pricing).
John McGlone

Many taxes have a general ‘market value’ rule where the amount subjected to tax is deemed to be market value in certain circumstances. Up to now VAT did not have a general market-value rule. A fundamental principle of the common EU system of VAT has been that the taxable amount is the subjective consideration agreed between the parties. This has been the case even where the price agreed is less or more than the market value. VAT was applied to the consideration actually received by the supplier rather than what the supplier might or could otherwise have achieved.

In July this year, the EU Council of Ministers approved amendments to the Sixth VAT Directive allowing Member States introduce ‘market-value’ rules. Broadly, Member States are now authorised to apply market value as the basis of taxation for VAT purposes in the case of a supply of goods or services to a connected party. The definition of who is considered connected is wide and includes persons connected by ‘family or other close personal ties, management, ownership, membership, financial or legal ties as defined by Member States.’ In this context, legal ties can include the relationship between an employer and an employee (or the employee’s family or any other closely connected person).
Irish VAT law already contained rules which seek to impose market value in specific circumstances. For example, market value is applied where non-monetary consideration is received. Market value is also applied where for a ‘non-business reason’ the amount received by the supplies is less than market value. However, these special provisions of Irish VAT law do not appear to have a basis in terms of the Sixth VAT Directive (with which Irish VAT law is required to comply), and would probably not have survived a legal challenge. However, Ireland is now free to introduce ‘market-value’ rules as set out in the revised Directive.

According to the Commission, the background to the introduction of the new rules is that old favourite ‘prevention of tax evasion or avoidance’. The Commission, encouraged by several Member States, felt that the pre-existing rules may have been applied to reduce the VAT liability of businesses providing goods or services to related business entities or to family members, in cases where the recipient was not entitled to full VAT recovery.

The impact for financial services businesses will depend on whether VAT grouping is available. VAT grouping eliminates the need to charge VAT on the provision of goods or services between the VAT group members. To qualify for VAT grouping it is not necessary that both entities are registered for VAT or that one directly controls the other (indirect control by a common ultimate parent is usually sufficient). However it is necessary that both entities are ‘established’ in Ireland for VAT purposes. In other words, both entities must have an office, branch or other permanent presence in Ireland and (in VAT terminology) have at that location ‘sufficient presence of human and technical resources’ necessary to carry out the particular business activity. If only one (or neither) entity is ‘established’ in Ireland, VAT grouping between the entities is not possible.

It is expected that the Revenue Commissioners will seek to amend Irish VAT law to introduce new market value provisions along the lines outlined above. Were this to be the case, businesses that cannot form an Irish VAT group are likely to have to consider the ‘transfer-price’ of goods and services supplied between connected entities. Most financial services business suffer some level of restriction of input VAT costs. Any increase in the level of charge which has to be recognised for VAT purposes would have a cost impact for those businesses.

It is likely that any change in Irish VAT law would apply both to domestic transactions and to cross-border supplies. The rules may therefore become relevant for services that are received from abroad i.e. ‘Fourth Schedule’ services which give rise to an obligation on the recipient to self-account for VAT on the ‘reverse-charge’ basis. Where such services are received from a connected party based outside of Ireland, the new rules may be applied to require the recipient entity account for VAT on the market-value of the services received (and not necessarily the amount charged by the related-party supplier). In effect this would be the introduction of a transfer-price rule for VAT on cross-border transactions.

The Commission has also sought to introduce rules to prevent transfer pricing being used as a mechanism for increasing the level of input VAT reclaimable by businesses that supply VAT exempt services. Generally speaking, VAT recovery is based on the use to which the cost input is applied. If the cost relates to VATable activity, full VAT recovery is allowed. Where the cost relates to VAT exempt activity, recovery is disallowed. Where the cost relates to both VATable and exempt activities (e.g. overhead), an apportionment is allowed. Many Member States allow that apportionment to be made on the basis of relative turnover from the activities. The Commission was apparently concerned that businesses that transact with connected parties may have sought to apply a reduced consideration to the exempt supplies or an increased consideration to the taxable supplies in an effort to improve the overall percentage value of taxable activities for the purposes of VAT recovery. The new rules contain provisions allowing Member States to apply an increased or reduced consideration for VAT purposes in such circumstances.

It is not known when Irish VAT law might be changed to take account of the facility now available to Member States to apply these new rules. It is expected that some changes are likely and these could be as early as Finance Bill 2007. Businesses should therefore prepare by examining the transfer pricing applied to related party transactions and determine what action may be necessary to be taken in advance of any new rules applying.

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