European court harmonises VAT and transfer pricing valuation

What’s the case about?

A Swedish holding company, Hogkullen, provided management services to its subsidiaries for a fee which was based on a cost base at a fraction of the total costs that it had incurred on the basis that for transfer pricing purposes, Hogkullen would be expected to retain certain costs and not recharge those to subsidiaries via a management fee. Hogkullen recovered all the VAT it paid to its suppliers, but its subsidiaries were not entitled to reclaim the VAT charged by Hogkullen. The Swedish tax authority argued that the value assigned to the services by Hogkullen was below the open market value and sought to increase the fee so that it matched the business’s costs. If the tax authority had been successful, the additional VAT on Hogkullen’s services would have significantly increased the group’s costs.

How does it affect the UK?

Swedish and UK VAT legislation on valuation rules for services between related companies bear many similarities. Indeed, the UK courts have considered this VAT point in the past, albeit in slightly different circumstances. In addition, both countries adopt the same principles to examine the transfer pricing arrangements between related companies, adopting the “arm’s length principle” in their domestic transfer pricing legislation. 

The reason that the topic of VAT valuation crops up so often across the UK and the EU is that both VAT systems share a common principle. Holding companies can’t reclaim VAT unless they charge related or third-party companies for the goods or services. In response, many holding companies have begun to charge subsidiaries for management services to ensure VAT doesn’t become an unnecessary cost to the group. 

Valuation and VAT

HMRC’s view is that some of the charges that holding companies levy on their subsidiaries do not justify VAT recovery, or alternatively, the value of those charges is less than it should be. As a consequence, there are several cases in the UK where the efficacy of these management services arrangements has been tested. The only arrangements which are considered immune from challenge are those where all holding company costs are recharged in the period in which they are incurred. Of course, for commercial (and transfer pricing) purposes, a routine cost-plus arrangement, with an allocation of costs and a profit mark-up on those costs, may be too simplistic to reflect an open market or arm’s length price, and more sophisticated approaches may be required. 

Open market equals arm’s length?

EU VAT legislation, which still forms the basis of UK VAT law (and, of course, Swedish law), allows member states to enact legislation that overrides the valuation assigned by related parties to a transaction. Despite these powers, HMRC is not able to assign any value to a transaction, instead it must apply an open market value. Transfer pricing refers to a similar concept, the arm’s length principle, and in the process of calculating the value of an intra-group transaction to align with the arm’s length principle, they will seek comparable services available on the open market. 

Hogkullen relied upon a valuation based on the value that it argues would be assigned to a comparable service being provided between unrelated third parties. It first established that the services that were being provided by Hogkullen could and would be sourced by its subsidiaries from a third-party service provider. It then calculated a price for the services based on an appropriate cost base and mark up derived from a benchmarking study that identified unrelated third parties performing comparable services. Importantly, in considering whether the services would be sourced from third parties by the subsidiaries, Hogkullen applied transfer pricing guidance around the identification of an appropriate cost base, excluding certain costs incurred by Hogkullen in its role as a holding company (referred to in a transfer pricing context as “shareholder costs”) from the calculation of the charge.

In their opinion, which is not binding, the Advocate General concluded that the open market value for each of Hogkullen’s individual services must be determined separately based on comparable prices. This was contrary to the approach adopted by the Swedish Tax Authority.

What next?

The Court of Justice of the European Union (“CJEU”) will in due course deliver the final ruling for the Swedish Court to implement. If the CJEU agrees with the Advocate General this may represent a significant setback for member state tax authorities. It may transpire that Hogkullen achieves a VAT saving by incurring VAT bearing costs in the holding company then charging its subsidiaries a lower fee than the costs borne. This is one of several cases that could have a significant effect on the interplay of VAT and transfer pricing in the years to come, not only in the EU but also in the UK. We expect tax authorities to consider these cases very carefully when considering their policy in this area.