Transfer Pricing Adjustments and VAT Implications: Navigating the Complexities

Transfer Pricing Adjustments and VAT Implications: Navigating the Complexities

Transfer pricing policies are typically established at the commencement of the fiscal year, grounded in prospective financial forecasts and benchmarking analyses designed to uphold the arm’s length principle. These policies aim to ensure that profits are allocated fairly among related entities based on economic substance. However, the inherent unpredictability of economic conditions—driven by market volatility, currency fluctuations, and operational variances—often results in actual outcomes diverging from initial projections.

While multinational enterprises (MNEs) may implement internal year-end adjustments to align with target margins, it is critical to recognize that transfer pricing adjustments frequently originate from tax authorities during audits or assessments. These adjustments are intended to correct misalignments and enforce compliance with the arm’s length standard.

The OECD Transfer Pricing Guidelines outline two key categories of adjustments that tax authorities may impose[1]:

• Primary Adjustment:

This is the initial correction made by a tax authority to align the taxable income of an entity with the arm’s length principle. For example, if a subsidiary undercharged its related party for services, the authority may increase its taxable income to reflect an arm’s length price.

• Secondary Adjustment:

Following a primary adjustment, tax authorities may require a corresponding adjustment to reflect the economic reality of the transaction. This often involves treating the difference as a deemed dividend, loan, or capital contribution, which can have additional tax and regulatory implications.

These adjustments are not merely accounting entries—they can trigger cash flow consequences and impact other tax obligations, including Value Added Tax (VAT).

A core VAT issue is determining whether a transfer pricing adjustment forms part of a supply of goods or services. Under VAT rules, a supply exists where goods or services are provided in exchange for consideration during a business[2]. If the adjustment relates to an actual underlying service—such as management support, financial oversight, IT services, or administrative activities—the adjustment may be considered a supply for VAT purposes.

Where the payment between group entities can be linked to identifiable services, VAT will generally apply, unless the supply falls under a specific exemption, such as certain financial services[3].

This brings us to the critical next step in understanding VAT implications: the value of the supply. The value of supply for VAT purposes refers to the amount of consideration (or its equivalent) that is paid or payable for the supply of goods or services[4]. Year-end transfer pricing adjustments can increase or decrease this value.

• An upward adjustment may require issuing an additional tax invoice and paying additional VAT.
• A downward adjustment may require issuing a tax credit note and reducing previously declared VAT.

As transfer pricing studies often incorporate both forecasted and actual results, the final transfer price can vary from the initial invoiced amount. Whenever the transfer price is adjusted, VAT reporting may need to be updated to reflect the finalize value of the supply. This may require corrections to previously filed VAT returns, to be made through the appropriate mechanism such as a Voluntary Disclosure[5].

Alongside the impact on output VAT, businesses must assess how transfer pricing adjustments influence their input VAT recovery. Input VAT may only be recovered to the extent that costs are used to make taxable supplies[6].

• If the adjustment relates to taxable supplies, input VAT on related costs may be recovered.
• If the adjustment relates to exempt supplies, input VAT recovery may be limited or entirely disallowed.

This analysis becomes particularly important where the intercompany service provider incurs significant costs—such as payroll, overheads, or outsourced support—because the recoverability of VAT on these costs depends on the nature of the supply to the related party.

If the underlying transaction forms part of exempt business activities, the ability to recover input VAT can be significantly reduced. Businesses must therefore analyse the nature of each transfer pricing adjustment to understand how it affects both output VAT and input VAT recovery.

In the UAE, where a business makes both taxable and exempt supplies, the Federal Tax Authority (FTA) requires that input VAT be recovered only to the extent that costs relate to taxable activities. 

Transfer pricing adjustments can directly influence these apportionment calculations, particularly where they alter the value of taxable or exempt supplies between related parties.

Under UAE VAT rules, partially exempt businesses must use an input VAT apportionment method—typically the standard method based on the proportion of taxable to total supplies—unless an alternative method is approved by the FTA[7].

A transfer pricing adjustment that increases taxable revenue (for example, additional charges for management services or head office support) may improve the taxable proportion and therefore increase recoverable input VAT. Conversely, an adjustment linked to exempt activities (such as financial services) may reduce the recovery ratio and trigger input VAT disallowance.

The FTA also mandates an annual wash-up calculation to reconcile the initial recovery rate applied during the year with the actual ratio determined using full-year figures[8].

Where transfer pricing adjustments are recorded at year-end—common for MNEs aligning intercompany margins—the resulting changes in turnover must be reflected in the annual wash-up calculation. This ensures the final input VAT recovery aligns with actual business activities rather than provisional estimates.

Given the FTA’s increasing scrutiny of intragroup transactions and input VAT claims, it is essential that businesses document how transfer pricing adjustments were treated in their apportionment calculations and ensure consistency between financial, transfer pricing, and VAT records.

In conclusion, transfer pricing adjustments carry significant VAT implications that must be carefully managed to ensure compliance with both transfer pricing and VAT regulations. The key considerations include determining whether a taxable or exempt supply exists, accurately establishing the value of that supply, managing any changes to the supply’s value, maintaining appropriate documentation, and considering the VAT treatment in the case of exempt supplies. MNEs should approach transfer pricing adjustments with a comprehensive understanding of both tax and VAT requirements to minimize compliance risks and ensure the correct VAT treatment of such adjustments.

By maintaining robust documentation and applying the arm's length principle, companies can avoid costly errors, such as double taxation or failure to properly recover input VAT. As VAT authorities continue to scrutinize intercompany transactions, proper handling of transfer pricing adjustments remains an essential part of tax compliances.

[1] OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, 2022, Chapter IV – Administrative Approaches to Avoiding and Resolving Transfer Pricing Disputes

[2] Article 1 of the Federal Decree-Law No. 8 of 2017 and its amendments (UAE VAT Decree Law)

[3] Article 46 of the UAE VAT Decree Law

[4] Article 34 of the UAE VAT Decree Law

[5] Article 10 of the Federal Decree-Law No. 28 of 2022 and its amendments (UAE Tax Procedures Law)

[6] Article 54 of the UAE VAT Decree Law

[7] Article 55(13) of the UAE VAT Executive Regulations

[8] Article 55(9) of the UAE VAT Executive Regulations