What is a TP adjustment? This is an adjustment to the pricing of intercompany dealings between two (or more) related parties of a group that are made during the financial year (often at year-end) to ensure that the transfer pricing policy applied during the year indeed results in an arm’s length outcome. As, in practice, many transfer pricing policies are set on an ex ante basis based on projections (e.g. of sales, expenses, etc.), the arm’s length nature should in most tax jurisdictions be tested on an annual basis by applying the annuality principle. As projections in most cases deviate from reality, a transfer pricing adjustment is needed to align the actual operating result with the arm’s length principle.
How can a transfer pricing adjustment affect indirect taxes? Generally, customs duties are calculated as a percentage of the customs value. If the buyer and seller are related, then this customs value is often based on the applicable transfer pricing policy. Therefore, a TP adjustment between the importing company and the related supplier could result in a change of the customs value and therefore in an increase or decrease of customs duties.
Also, considerable thought should be given to the VAT aspects relating to TP adjustments. First, the taxable basis of import VAT always starts from the customs value. Therefore, a change in the customs value will automatically result in a change of import VAT. Second, even if no importation of goods is involved (e.g. only intra-EU supplies or services are involved), then TP adjustments, as such, can trigger VAT issues and result in cumbersome VAT correction obligations.
For these reasons, companies should always take indirect taxes into account when establishing their transfer pricing policy.
Simplified illustrative example: A US clothes design company operates as the principal company of a global group, i.e. it is responsible for all the key functions (design, manufacturing, branding, overall strategy, and pricing, etc.) and incurs the key risks (design risk if a collection is not successful, main market risk, foreign exchange risk, etc.) and owns all the important/valuable (intangible) assets, such as (trademarks, designs, specific technology, etc.). The US principal company sells finished clothing to its subsidiaries around the world, which in this example is to its Belgian subsidiary. The Belgian sales company performs so-called routine sales activities (towards local third party distributors or retailers) and incurs limited risks and does not own any valuable assets, and so - in transfer pricing language – is often called a Limited Risk Distributor (LRD).
In transfer pricing practice, in such a set-up, the sales company is often remunerated on a routine, stable operating margin level, by applying the Transactional Net Margin Method (with the operating margin as a Profit Level Indicator).
Suppose that at the start of 2020 the Belgian LRD projects sales of EUR 10.000 and operating expenses of EUR 2.500, and that the LRD’s transfer pricing policy is a target operating margin of 3%. The transfer price for the intercompany sales of goods would be set at EUR 7.200 to obtain an arm’s length operating result of EUR 300 (i.e. 3% of EUR 1000).
| FY 2020 (in EUR) | Belgian LRD (Budget) |
|---|---|
|
Revenue sales of clothing |
10.000 7.200 |
| Gross Result Operating expenses |
2.800 2.500 |
| Operating result (3% = target) | 300 |
At year-end, the group assesses it actual results. Due to the COVID-19 pandemic, the actual sales were not realised and were only EUR 7.500. Furthermore, the operating expenses have remained stable as budgeted. If no changes were/are made to the transfer prices, then this would result in the following outcome.
| FY 2020 (in EUR) | Belgian LRD (Actual) |
|---|---|
| Revenue sales of clothing Cost of clothing purchased from US Principal |
7.500 7.200 |
| Gross Result Operating expenses |
300 2.500 |
| Operating result (3% = target) | - 2.200 |
The outcome above results in an operating loss for the LRD and is not in line with the arm’s length principle. A TP adjustment is required. The costs of the clothing purchased by the Belgian LRD from the US Principal should decrease. Consequently, the US Principal should make a credit note of EUR 2.425. This results in the arm’s length result below, as the operating margin of 3% is realised.
| FY 2020 (in EUR) | Belgian LRD (Actual) |
|---|---|
| Revenue sales of clothing Cost of clothing purchased from US Principal |
7.500 4.775 |
| Gross Result Operating expenses |
2.800 2.500 |
| Operating result (3% = target) | 300 |
A few remarks: This simplified example illustrates that TP adjustments should be carefully assessed, and ideally on a more frequent basis than once a year (such as quarterly or monthly). In practice, an arm’s length range resulting from a benchmark is often used, which provides some more comfort compared to a fixed percentage (as any point within the range should be arm’s length). While the example above is for the intercompany sales of goods, a similar assessment could apply for other types of intercompany dealings, such as manufacturing activities, provision of services, etc.
Specific circumstances (local market conditions, exceptional circumstances, etc.) should be considered properly. Especially in a year in which the Covid-19 pandemic for many companies has caused a severe impact on overall profit levels, caution should be exercised. The functional profile of the companies involved should be assessed, as well as the options realistically available and what is third party behaviour in similar circumstances. Caution should be exercised when applying transfer pricing policies on “auto-pilot” or when routine entities will incur losses (as certain tax jurisdictions might argue that investments are made).
Finally, this simplified example also shows the impact of TP adjustments on customs duties and import VAT. After all, most probably, the Belgian LRD will have set the customs value of the clothing at EUR 7.200, since this amount was in accordance with its transfer pricing policy at the time of importation. Consequently, the LRD will have paid the applicable duty rate (e.g. 12%) on EUR 7.200. However, following the TP adjustment, it appears that the customs value should only have been EUR 4.775. Therefore, the LRD has paid too much customs duty and has calculated the import VAT on the wrong basis. If the LRD would like to recover the overpaid customs duty in such circumstances, then it definitely should confirm that its transfer pricing policy is checked with the competent customs administration in advance. Also, a corresponding correction must be made for the import VAT excess that will then be recovered as otherwise penalties and interest could be imposed.
For more information on this topic, please contact the authors of this article:
Tine Slaedts - Partner Tiberghien economics (tine.slaedts@tiberghien.com)
Ben Plessers - Senior Manager Tiberghien economics (ben.plessers@tiberghien.com)
Gert Vranckx - Senior Associate Tiberghien (gert.vranckx@tiberghien.com)
Ward Lietaert - Associate Tiberghien (ward.lietaert@tiberghien.com)
