Multinational enterprises (MNEs) worldwide face complex challenges in an increasingly interconnected global economy, in particular with respect to the tax treatment of transactions (whether or not between related parties) and understanding the variety of tax obligations that can arise.
One key area that demands careful attention is the interplay between transfer pricing and value added tax/goods and services tax (VAT/GST). At first glance, it may appear that these two areas of tax — one affecting direct taxes and the other an indirect tax — are completely separate from each other, each with its own valuation system, methodologies, and compliance obligations. However, transfer pricing and VAT/GST both involve the treatment of transactions and supply chains between companies, and failure to consider the VAT/GST implications of a transaction can result in significant financial risks and increased costs for MNEs.
Since the U.S. has neither a VAT nor a GST, U.S. MNEs in particular should ensure that their non-U.S. operations are VAT- and GST-compliant.
Understanding Transfer Pricing and VAT/GST
Transfer pricing refers to the pricing of goods, services, or intangible assets transferred between entities within the same corporate group. It involves determining the prices at which transactions occur and ensuring they are in line with the arm's length standard, which requires that the results of transactions between related parties be consistent with the results that would have been realized if unrelated parties had engaged in the same transaction under the same circumstances.1 The goal of transfer pricing is to allocate income among different entities in different tax jurisdictions in accordance with the arm’s length standard.
VAT/GST, on the other hand, is a consumption tax levied on the value added at each stage of the supply chain. It is a transaction-based tax that is ultimately borne by the final consumer, with businesses acting as intermediaries responsible for collecting and remitting the tax to the tax authorities. While the overarching concept of VAT/GST is similar in each of the 173 countries that have implemented this type of tax, the way a VAT/GST system operates, the rates, and the approach of the tax authorities can vary considerably, potentially impacting the overall tax burden of MNEs.
The Link Between Transfer Pricing and VAT/GST
Many companies typically consider transfer prices to be primarily a corporate tax matter. However, transfer pricing decisions can have a direct impact on VAT/GST obligations and have costs for MNEs. When transactions take place between related entities, tax authorities typically scrutinize the pricing to ensure that it reflects the arm’s length standard. If the transfer prices are artificially inflated or deflated, the tax authorities may make transfer pricing adjustments, which in turn could affect the VAT/GST obligations of the entities involved.
Failure to align transfer prices with VAT/GST rules can have several adverse consequences. Understating the value of intragroup transactions may lead to underpaid VAT/GST liabilities, exposing companies to penalties, interest, and potential reputational damage. Conversely, for U.S. MNEs, overstating the value of a transaction may result in higher VAT/GST costs, eroding their profitability and reducing their competitiveness in foreign markets. In some jurisdictions, the mischaracterization of a transfer pricing adjustment can result in criminal charges, depending on the circumstances.
Importance for U.S. MNEs
Because the U.S. does not have a federal VAT/GST system, U.S. MNEs should be particularly cautious about VAT/GST implications. U.S. MNEs may not have the same level of familiarity or experience in dealing with VAT/GST as companies from jurisdictions that do have a VAT/GST system in place.
As U.S. MNEs expand into VAT/GST jurisdictions, they face the risk of increased costs and potential tax exposure. The VAT/GST burden can add significant complexity to business operations, requiring careful planning and compliance measures. For example:
- Transfer pricing and tax planning: Restructuring global supply chains (for example, in anticipation of Pillar Two) so that most international sales are carried out through a U.S.-established entity, can give rise to a VAT registration requirement for the U.S. entity in several countries, depending on how the supply chain is structured.
- Intercompany sales: When an MNE sells goods or services to its subsidiaries located in different countries, transfer pricing rules are used to determine the price at which the transaction occurs. This price can impact both the customs value of the goods and the VAT calculation in the exporting and importing countries, as customs duty and VAT are usually based on the transaction value.
- Intragroup services: MNEs often provide services, such as management, IT support, and marketing to their subsidiaries. Transfer pricing rules determine the price for these services, which can affect the VAT calculation. VAT may be applicable on the service charges, and the value of the services can impact the VAT liability. Furthermore, the intragroup provision of software could fall within the definition of electronically supplied services and could trigger a VAT registration obligation for the parent company in countries where the rules apply to B2B transactions.
- Cost sharing agreements: In some industries, companies enter into cost-sharing arrangements to jointly develop and share the costs of research and development activities. Transfer pricing rules allocate the costs among the participating entities. The VAT treatment of cost-sharing payments can vary, and it is essential to consider the applicable VAT rules for such arrangements.
Neglecting the VAT/GST implications that arise from intragroup activities can result in unexpected financial setbacks, damaging the bottom line and hindering growth opportunities in international markets.