Luxembourg: New VAT rules on transactions between related parties

Interactions between Transfer Pricing ("TP") rules and Value Added Tax ("VAT") is one of the recurrent topics of debate and concern for both businesses and tax authorities.
Globalisation and growing intragroup cross-border trading (goods, services, intangibles, financial instruments, among others), affect both the enterprises’ tax policy  as well as the way tax authorities treat international tax matters across borders. Specific rules are being set in order to prevent tax avoidance and enhance sound competition.
Due to a lack of guidance, businesses aren’t always aware if TP rules have VAT implications or vice versa. Luxembourg recently implemented Article 80 of the EU VAT Directive and the tax authorities issued guidance in January 2019.

I. Concept of “open market value” for VAT purposes introduced in the VAT law

a) In the VAT directive

Article 80 of the EU VAT Directive is a “may” provision which means that Member States have the option to implement it or not, as opposed to a “shall” provision which they are compelled to apply. This article aims at preventing VAT loss for Member States in specific situations between related parties where the price of a supply of goods or services has been overstated or understated.

When implemented by a Member State, the tax authorities can disregard the consideration (or price) agreed between related parties, retaining instead the open market value, which would be determined between unrelated parties.

b) In the Luxembourg VAT law

Article 80 of the Directive has been transposed by Article 28.3 of the Luxembourg VAT Law. This measure applies to local and cross border transactions taking place between related parties (e.g. management, ownership, membership and financial, legal, personal or family ties).

Since 31 July 2018, the date the provision entered into force, there are three situations where taxpayers must ensure to apply the “normal value” to their transactions:

  • Case n°1 - the price for a supply is lower than the open market value while the purchaser has a limited recovery right;
  • Case n°2 - the price for an exempt supply is lower than the open market value while the supplier has a limited recovery right;
  • Case n°3 - the price for a supply is higher than the open market value while the supplier has a limited recovery right.

When a transaction falls within one of the above scenarios, the consideration (price) of the supply (good or service) that must be applied by the parties is either:

  • the open market value that would be applicable under conditions of fair competition for comparable supplies; or
  • the purchase/cost price of the goods or the total expenses incurred by the supplier to supply the service, in the absence of comparables.

c) Guidance provided by a circular letter

The Luxembourg VAT authorities published the circular letter n°790 on 18 January 2019 to provide guidance on the application of this provision.

Case n°1 where the price for a supply is lower than the open market value while the purchaser has a limited recovery right:

This situation is targeting the purchaser who will suffer a lower VAT cost.

What are the sanctions applicable in case of non-compliance?

  • The taxable basis of the supply will be increased to be in line with the open market value and the VAT due will be computed on that amount;
  • The purchaser will not be entitled to recover any input VAT until a corrective invoice reflecting the open market value is issued by the supplier.

Case n°2 where the price for an exempt supply is lower than the open market value while the supplier has a limited recovery right:

This situation is targeting the supplier who will increase the VAT recovery right.

What are the sanctions applicable in case of non-compliance?

  • The taxable basis of the transaction that will be taken into account for the computation of the supplier’s VAT recovery right will be the open market value.

Case n°3 where the price for a supply is higher than the open market value while the supplier has a limited recovery right:

This situation is targeting the supplier who will increase the VAT recovery right but will also impact the purchaser.

What are the sanctions applicable in case of non-compliance?

  • The taxable basis of the transaction that will be taken into account for the computation of the supplier’s VAT recovery right will be the open market value.
  • The supplier will be liable for the VAT amount mentioned on the invoice until it issues a corrective invoice reflecting the open market value.
  • The purchaser will not be entitled to recover the input VAT on the transaction until the supplier issues a valid invoice reflecting the open market value.

In the three situations mentioned above, a fine ranging from € 250 to € 10,000 could, in principle, be decided by the Luxembourg VAT authorities.

II. Interactions between TP and VAT: discussion at EU level

If a transaction between associated enterprises is not at arm’s length, adjustments must be made in order to replicate the conditions of that transaction had it been carried out between independent parties.

In general, TP adjustments can be made either by:

  • the tax authorities (i.e. in case of an audit); or
  • the taxpayers (businesses) themselves (e.g. implementation of a new intra-group TP policy).

One of the latest papers of the VAT Expert Group, published on 18 April 2018, welcomes the possibility to discuss the interactions between TP and VAT following an initiative of the EU commission, which shared its views in working paper n°923 in February 2017.

a) Can a TP adjustment made by the direct tax authorities lead to VAT pitfalls?

A TP adjustment made by the direct tax authorities amend the transfer price or margin applied and ultimately affects the corporate income tax results. Different categories of adjustment exist:

  • Primary Adjustments: “An adjustment that a tax administration in a first jurisdiction makes to a company’s taxable profits as a result of applying the arm’s length principle to transactions involving an associated enterprise in a second tax jurisdiction” (OECD Transfer Pricing Guidelines, Glossary).
  • Corresponding Adjustment: “An adjustment to the tax liability of the associated enterprise in a second jurisdiction made by the tax administration of that jurisdiction, corresponding to a primary adjustment made by the tax administration in a first tax jurisdiction, so that the allocation of profits by the two jurisdictions is consistent”. A corresponding adjustment can mitigate or eliminate double taxation and ensure that allocation of profits between the two jurisdictions is consistent.
  • Secondary Adjustments: is “an adjustment that arises from imposing tax on a secondary transaction”. A secondary transaction is defined as “constructive transaction that some countries will assert under their domestic legislation after having proposed a primary adjustment. Secondary transactions may take the form of constructive dividends, constructive equity contributions, or constructive loans.”(OECD Transfer Pricing Guidelines, Glossary).

In the past, such adjustment did not have any VAT implications whatsoever. Since the implementation of Article 28.3 in the Luxembourg VAT law stating that taxpayers must ensure to retain the “open market value” for their transactions, it remains to be seen whether such adjustments could lead to potential VAT audits. It follows that taxpayers involved in group transactions should be able to support the valuation of their flows from a TP and VAT perspective.

b) How a taxpayer TP adjustment may influence its VAT costs?

 A TP adjustment could trigger VAT implications when the adjustment is made by the taxpayer himself. This is called a compensating adjustment[1].

The compensating adjustment “is an adjustment in which the taxpayer reports a transfer price for tax purposes that is, in the taxpayer’s opinion, an arm’s length price for a controlled transaction, even though this price differs from the amount actually charged between the associated enterprises[2]”.

In short, when the TP adjustment could be seen as a consideration given in exchange for a supply of goods or services already made, leading to a change of the taxable amount, it should lead to VAT implications under specific conditions (i.e. existence of a consideration, existence of a supply and a direct link between the consideration and the supply).

III. Other areas of interactions between TP and VAT: TP analysis

A TP analysis identifies, among other things, the substance of the commercial and/or financial relations between related parties and should delineate the actual transaction by analysing its economically relevant characteristics.

At the beginning of a TP analysis, the functional analysis seeks to identify how the economically significant activities are performed, in which legal entity, with what resources and risks assumed.  This will in turn inform the practitioner in the determination of the transfer pricing method to apply.

The Functional Analysis as part of the overall TP Analysis, by identifying the functions performed, the assets used and the risks assumed by the parties involved in a transaction, provides for the factual substance of the financial or commercial relations[1]. This might lead to the reclassification of the underlying transaction or even to the non–recognition of a certain transaction. In that context, there is a direct interaction with VAT as the VAT treatment directly depends on the economic nature of the transaction.

Function can for instance dictate a VAT-exemption. For example, some intermediation services in the financial area are VAT-exempt. But they need to pass some tests like for instance the active placement of financial products with investors, as opposed to mere administrative or marketing support. Some TP methods may also reveal the absence of the conditions to apply VAT on a particular intra-group flow. When the method is not transactional, like residual profit splits, there may be no direct link between a payment and a supply of goods or services, and hence no VAT triggering event.

Practical Implications

Considering the complexity of the current global business environment, the companies confronted to TP adjustments should organise their business in a holistic way to avoid mismatches stemming from different tax considerations. An isolated view of VAT or TP, divorced from each other, and more generally from the overall business structure, could lead to important financial impacts.

We would be happy to help you navigate smoothly in this complex international tax requirement process with our TP and VAT teams, who have joined forces to help you succeed in your day-to-day tax-related work. We will focus on a holistic review of legal documentation when performing functional analysis, determining TP adjustments and checking if results lead to VAT implications.

References:

1. Working paper n°923, 28 February 2017, page 10
2. OECD Transfer Pricing Guidelines, Glossary.
3. OECD Transfer Pricing Guidelines, D.1.2 Functional analysis, paragraph 1.51

1. PwC Luxembourg (www.pwc.lu) is the largest professional services firm in Luxembourg with 2,870 people employed from 76 different countries. PwC Luxembourg provides audit, tax and advisory services including management consulting, transaction, financing and regulatory advice. The firm provides advice to a wide variety of clients from local and middle market entrepreneurs to large multinational companies operating from Luxembourg and the Greater Region. The firm helps its clients create the value they are looking for by contributing to the smooth operation of the capital markets and providing advice through an industry-focused approach.

2. The PwC global network is the largest provider of professional services in the audit, tax and management consultancy sectors. We are a network of independent firms based in 158 countries and employing over 250,000 people. Talk to us about your concerns and find out more by visiting us at www.pwc.comand www.pwc.lu.

Contact us

Frédéric Wersand

VAT Partner, PwC Luxembourg

Tel: +352 49 48 48 3111

Marie-Isabelle Richardin

VAT Partner, PwC Luxembourg

Tel: +352 49 48 48 3009

Christophe Hillion

Partner, Transfer Pricing

Tel: +352 49 48 48 2031