Getting ready for VAT in the GCC? Don’t forget about your TP! August 2017

Written by Mohamed Serokh & Patrick Oparah of PwC, a shortened version of this article first appeared in Forbes Middle East in August 2017

In brief

The introduction of Value Added Tax (VAT) is at the forefront of tax reforms that are being enacted in the Middle East and is expected to soon become a reality for many business operating in the Gulf Cooperation Council (GCC) countries[1], with the effective date for introduction anticipated to be 1st January 2018. This imminent date means that VAT has been high on the agenda for GCC based businesses in recent months and many businesses are now in various stages of preparation for the impact that VAT will have on them.

The primary focus for GCC based businesses is on operational aspects of the implementation of VAT such as the impact on systems, personnel, vendors and customers. However aside from these operational implications which businesses have to address, there are other tax implications which arise from the introduction of VAT and one of these is the interaction with direct taxes. 

It is important that VAT’s interactions with direct tax are not an afterthought as this is an aspect of VAT that can give rise to tax risks. So what is the interaction between VAT and direct taxes, and how is transfer pricing relevant and how should it be considered? Let's discuss...

[1] The GCC member states are Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates.

VAT refresher

VAT is an indirect tax that is applied on the consumption of most goods and services, though some supplies such as financial services, healthcare and education are typically exempt from VAT. As it is a consumption tax, in principle VAT is ultimately incurred and paid by the end consumer. However it is levied at each stage of the supply chain and collected by businesses on behalf of the government. Businesses are able to avoid the incidence of VAT because “input VAT” they incur on their purchases from suppliers can generally be claimed against “output VAT” collected from customers and remitted to the government. In some instances, businesses are unable to recover VAT because the input VAT incurred on purchases and other costs cannot be recovered via the VAT return. There can be various reasons why this VAT cannot be recovered. For example, the costs incurred by a business may relate directly to VAT exempt business activities or the costs are specifically disallowed for VAT purposes (e.g. VAT incurred on food and drinks) or relate to non-business activities or the VAT paid is foreign VAT, which may be irrecoverable.

VAT is expected to be introduced in all the GCC countries, including the UAE, with effect from 1st January 2018. The GCC countries have signed up to a unified framework which will form the basis of the domestic legislation that each country introduces to bring VAT into force. Several other countries in the wider region already have established indirect tax systems, such as Egypt and Lebanon.

Transfer pricing refresher

Transfer pricing refers to the setting of prices for transactions between related companies, and applies to tangible goods, services, intangibles and financing related transactions.

Many countries have introduced transfer pricing regulations because governments are concerned that transfer prices can be artificially set in order to reduce the amount of corporate tax that would otherwise be due. These rules require that transfer prices are set at “arm’s length”, i.e. at prices that would be charged between independent companies.

At a global level, the development of transfer pricing rules has been heavily influenced by the OECD[1], with the publication and updating of transfer pricing guidelines for multinational companies and tax administrations (“OECD Guidelines”). Individual countries typically have introduced their own domestic transfer pricing legislation, often linked to the OECD Guidelines, or deal with transfer pricing issues through domestic tax law provisions.

In the Middle East a number of countries either have transfer pricing rules or transfer pricing provisions in their tax laws, including Egypt, Saudi Arabia and Qatar among many others. Furthermore, because numerous countries around the world have some form of transfer pricing rules, Middle Eastern businesses engaging in transactions with foreign related parties are likely to be affected.

There is an increased focus on transfer pricing in the GCC and the Middle East, especially arising from the recent OECD / G20[2] recent OECD Base Erosion and Profit Shifting (BEPS) project. The BEPS project is a response to the perception that multinational companies avoid tax by engaging in significant shifting of profits out of jurisdictions where the profits are sourced. Transfer pricing is one of the areas that is prominently scrutinized in the BEPS project.

Transfer pricing has importance for many businesses that goes beyond ongoing tax compliance. It can be important that transfer pricing is at arm’s length for regulatory purposes, as well as statutory reporting and management reporting purposes, and also as a matter of good corporate governance and transparency. For example, for businesses that may be involved in mergers & acquisition activity either as targets, acquirers or when divesting operations, transfer pricing is typically a critical part of the associated due diligence processes.

[1] The Organization for Economic Cooperation and Development, is a unique forum where the governments of 35 countries with market economies work with each other, as well as with more than 70 non-member economies to promote economic growth, prosperity, and sustainable development.

[2] The G20 is an international forum for the governments from 20 major economies including Saudi Arabia.

VAT and TP interactions

VAT and transfer pricing interactions arise where related party transactions constitute “taxable supplies” on which VAT is levied. The absolute amount of VAT due depends on the value of the taxable supplies. The price charged for the transaction also affects the level of taxable profits in the entities involved. So both the amount of VAT due and the corporate tax due depend on the transaction value. Where transactions are between related parties, VAT rules may allow the tax authority to substitute market value for the transaction value for the purposes of calculating the VAT liability, if the pricing of the transaction is not arm’s length[1]. These set of principles are best illustrated in Figure 1 below:

[1] Article 26 of the Unified Agreements on VAT in the GCC refer to: 1) fair market value, i.e. an open market value between two independent parties and within competitive conditions specified by each member state. Next to this the Unified Agreement refers to “the supply value” which shall be the consideration value exclusive of VAT. It appears that the fair market value will in particular come into play where it concerns “deemed supplies” and “transport of own goods to another member state”. The value shall then be the purchase price at cost (and if this cannot be established the fair market value).

Figure 1 - Interaction between VAT and transfer pricing

This link between the value of taxable supplies for VAT purposes and the arm’s length transfer price for direct tax is important to consider both in the context of process design when VAT is embedded in existing supply chain transactions, and also if changes to the supply chain are contemplated as a result of VAT related considerations. We consider these aspects in more detail below.

Importance of process design: year-end adjustments

One example of the importance of process design when VAT applies to intercompany transactions is the implications for year-end transfer pricing adjustments.

The need for transfer pricing adjustments can arise when the actual prices charged for transactions during a financial year will not result in an arm’s length outcome from the perspective of the tax authorities. This can occur for several reasons. One example is where the transfer pricing policy for a distribution entity within a group is to target a particular operating margin (that has been supported by a benchmarking analysis) as being an arm’s length margin for the activity of the entity. The target operating margin has to be achieved by setting prices for the goods purchased from its related party supplier based on forecasts of revenue and operating costs. If actual revenue and operating costs differ significantly from the forecasts it may be necessary to adjust the transfer prices in order to achieve the arm’s length operating margin. 

As the value of the supplies for VAT purposes generally depends on the transaction value, any changes to the transaction value may have VAT consequences, as additional VAT may be due or excess VAT may have been remitted to the government. This example is best illustrated below:

Figure 2 - Impact of transfer pricing adjustments on VAT

Whether or not there are VAT consequences will depend on how the transfer pricing adjustments arise as well as tax rules in the relevant country. Transfer pricing adjustments can be initiated by the tax-payer on a prospective basis i.e. at some point during the financial year before the financial statements are closed. Adjustments could also be initiated by the tax-payer on a retrospective basis in its tax return. A third possibility is that adjustments are made by a tax authority following a tax audit of the company.

The VAT consequences of each of these scenarios need to be assessed in the context of domestic tax rules and practice. In particular where transfer pricing adjustments are made through the use of credit notes or additional invoices it will be important to understand and plan for the VAT impact to avoid potential non-compliance with VAT rules and the attendant penalties.

From the above example it can be seen that in redesigning systems and processes to take into account VAT, companies need to understand what the consequences may be in respect of their related party transactions. It will be important that there are good processes in place, firstly to reduce the likelihood of significant price adjustments being required and secondly to take the necessary steps to avoid exposures if such adjustments are unavoidable. The use of appropriate technology to provide timely information to tax departments is a critical part of such processes and system design.

Changes to the supply chain due to VAT

Introducing VAT considerations into the supply chain means that groups will be considering changes to their supply chains to address issues such as irrecoverable VAT, administrative and compliance costs, and cash flow implications of VAT, as well whether restructuring the supply chain could avoid the need to charge VAT to customers.

Whenever changes to the supply chain are contemplated it is important that they are assessed in a holistic manner that also considers direct taxes and transfer pricing, as well as many other tax and non-tax aspects, as illustrated in the figure below.

Figure 3 - Considerations in optimal supply chain design

It is critical that such supply chain changes are assessed from a transfer pricing perspective as well so that the outcome of the supply chain is aligned with substance and defensible from a direct tax perspective.

What about Customs Duties?

Where companies have cross border movements of goods, customs duties and transfer pricing interactions also arise. The issue of transfer pricing adjustments applies to customs duties in a similar way as it does to VAT. A further complication arises because customs authorities apply specific valuation methodologies which can give different outcomes compared to transfer pricing methods. There are also standards of substance in the supply chain that need to be meet for customs purposes, and so any tax assessment of the supply chain cannot be looked at from a purely direct or purely indirect tax perspective as this could give rise to a sub-optimal outcome from a tax perspective. Consider the following example illustrated below: 

Figure 4 – Importation: Customs duty, VAT and transfer pricing

Differences between transfer pricing and indirect tax perspectives on transactions

At the heart of the interaction between transfer pricing and VAT are a number of differences in the perspective on transactions.

For indirect taxes, the focus is on the price or value of individual transactions, because this is the basis on which taxation is applied. VAT returns can be submitted on a monthly basis, and customs duty is due prior to clearing goods through the point of importation.

From a VAT perspective, it is also critical to look at the fundamental nature of the supply in a transaction, as this will determine both the liability (what rate is applicable if there are different rates for different products) and place of supply (what jurisdiction is allowed to levy VAT).

In contrast, whilst transfer pricing is also ultimately about the pricing of transactions, the focus is generally on an annual basis in line with the completion of annual corporate tax returns and often is directed at assessing whether the profits generated by an aggregated group of transactions are consistent with the arm’s length principle. Because of this broader focus, transfer pricing rules generally consider a larger pool of methods that can be used to determine if intercompany prices are at arm’s length. These include both transactional based methods (such as the comparable uncontrolled price method, the resale price method and the cost plus method), as well as profit based methods (such as the transactional net margin method and the profit split method).

In contrast, for indirect tax purposes, valuation methods need to be transaction based, such as the rules recommended by the World Customs Organisation (WCO) for customs which recommend methods including transaction value, deductive value and computed value.

To ensure a consistent and defendable approach for both direct and indirect tax purposes, the broad reconciliation of these approaches is paramount as tax authorities around the world become increasingly harmonized at looking at taxpayers holistic tax positions. For example, under Action 13 of the BEPS project, the introduction of Country by Country reporting will now mean a greater sharing of information amongst the world’s tax authorities on tax payer positions.

Harmonization of tax authority approaches

The importance of not considering transfer pricing and VAT in isolation is heightened because increasingly tax authorities are looking to be more connected in their approaches to direct and indirect taxes.

Whilst historically many tax authorities around the world have had a separate approach to the collection of direct and indirect taxes, with in some cases different institutional bodies administering the taxes, the trend is now towards harmonization both at institutional level (a single authority dealing with both taxes) and of regulations. For example, the OECD and WCO have carried out a number of initiatives looking at harmonizing valuation approaches across transfer pricing, VAT and customs. 

However significant harmonization that will reduce uncertainties for taxpayers is still is a long way off and so for the present, taxpayers must take positions after careful analysis of the various regulations, and with adequate regard toh some of the risks that arising from the different approaches to valuation of transactions.

Aligning an approach to transfer pricing, direct and indirect tax

In order to carefully manage the interactions between transfer pricing, direct and indirect taxes, businesses that are preparing for the introduction of VAT in the GCC should include consideration of transfer pricing at certain critical points of their VAT implementation strategy. The figure below highlights some of the typical steps of a VAT implementation project that may require transfer pricing input.

Figure 5 – VAT implementation steps that may need transfer pricing input

Conclusion

As part of a VAT impact analysis and implementation strategy, GCC based businesses need to identify the specific intercompany transactions where VAT issues arise and put in place strategies that also take into account arm’s length pricing and direct taxation where applicable.

Where changes to supply are contemplated to address VAT concerns, it is critical that transfer pricing issues are also considered to ensure that the substance of the new supply chain is set up on an arm’s length basis and defendable from a direct tax perspective where relevant.

The interaction between VAT, transfer pricing and customs is becoming an increased area of focus as tax authorities seek to implement a more joined up approach to risk assessment and audit. By including transfer pricing considerations in their VAT implementation plans, businesses can proactively manage the risks.

So, in implementing VAT in the coming weeks and months, don't forget TP to ensure your organisation's holistic tax, reporting and regulatory position is where it needs to be!

Mohamed Serokh, PwC Partner and Middle East Transfer Pricing Leader

T: +971 (0) 4 304 3956

mohamed.serokh@pwc.com