The valuation framework: Key considerations for your business

Valuing transactions between international related parties is one of the most scrutinised areas of international tax. As that landscape evolves, what has traditionally been a direct tax issue that has focused on corporate tax and transfer pricing, now has significant implications for indirect taxes like VAT (value-added tax), GST (goods and services tax), and customs duties.

Businesses must navigate these different areas of tax, each with its own rules, methods, and objectives. This complexity can create significant challenges. If you are unsure where to start or how it all connects, do not worry—we will guide you through the key considerations.

The divergence of price and value

A common misconception among corporate executives is that the price applied under transfer pricing principles when dealing with international related parties is automatically the correct value for goods at import or export. This assumption is the source of most risks and problems. The words 'price' and 'value' themselves have fundamentally different meanings. Price is what you pay; value is relative.

• VAT perspective: The key principle is 'consideration' – how much is paid for goods and services. For affiliated companies, this should reflect the true value, but this is not always the same as a transfer pricing analysis or a customs valuation.
• Transfer pricing perspective: The focus is typically on the function of an entity, not the specific product or service. For example, a distributor's profit margin is benchmarked against third parties with similar functions to determine an 'arm's length' return. Adjustments are often made as a single, year-end entry to align the entity's overall profit with this benchmark.
• Customs perspective: The starting point is the price paid or payable, but this is not the final destination. The World Trade Organisation's (WTO) Agreement on Customs Valuation provides the framework, not the OECD's transfer pricing rules. This agreement, signed by over 160 countries, sets the standard for arriving at a value to declare on import. Inconsistent implementation and enforcement by member countries add another layer of complexity.

These differing objectives create a landscape where a single transaction can have multiple 'correct' values. The question is, how do you align them?

Key valuation considerations for your business

To navigate this intricate framework, we have identified four key areas that demand your attention. By focusing on these elements, you can build a robust and defensible valuation strategy.

1.The role of legal agreements

Legal agreements are the foundation of your transactional relationships with international related parties. They are the first-place tax authorities and courts will look to understand the intentions of the parties involved.

From a transfer pricing viewpoint, intercompany agreements must align with what unrelated parties would agree. These agreements often include pricing clauses that either set a specific price (e.g., cost-plus 10%) or simply state an 'arm's length price' to be determined periodically. It is prudent to include clauses that allow for the consideration of customs and VAT duties when making adjustments. This provides the legal form to connect substance with the transaction.

For customs, a well-structured contract is critical. It clarifies terms of sale and any additional payments, such as royalties or licence fees. Properly worded agreements create certainty and support a defensible position. Vaguely worded contracts, however, can lead to disruptions and costly failures. The recent victory for PepsiCo over the Australian Taxation Office (ATO) highlighted the importance of properly constructed legal agreements in a tax dispute.

From a VAT perspective, the legal agreement is vital. If agreements are ambiguously worded, they are likely to fail the 'direct link' test between services provided and payment received. A UK case involving JP Morgan demonstrated this, where inconsistencies in a global services agreement undermined the company's VAT position.

2.Clarity in invoicing

Invoicing is a natural extension of the legal agreement. The invoice is the primary document the recipient uses to evidence its entitlement to recover input tax.

Clarity is essential. If the documentation does not sufficiently justify the supplies made, VAT may not be recoverable. This was a key point in the recent Court of Justice of the European Union (CJEU) judgment in the Arcomet Tower Cranes case. The court confirmed that remuneration based on transfer pricing can constitute a supply for VAT purposes, provided there is a direct link between the services and the payment.

3.Managing year-end adjustments

One of the biggest challenges businesses face is the year-end adjustment. The way an adjustment is handled for transfer pricing is not always aligned with customs or VAT requirements.

For transfer pricing, a year-end adjustment is often a one-off accounting entry to ensure the entity's profitability is at arm's length. This lump-sum approach is less concerned with individual transactions.

For customs, however, each cross-border transaction must be at arm's length. Reconciling a period-end lump-sum adjustment across all underlying transactions can be problematic. Authorities will often require the adjustment to be applied to the individual transactions, a process that varies tremendously by country. This also applies in the context of VAT - for example, to determine the place of supply. Even within the EU, where a framework exists, each customs administration has different rules and allowances.

4.International considerations

A transaction always has two sides, which means appeasing at least two tax authorities.

Transfer pricing is based on global OECD principles, so if a transaction is considered arm's length on one side, it is usually considered arm's length on the other. Processes like the Mutual Agreement Procedure (MAP) exist to resolve instances of double taxation.

For VAT and customs, differing views between authorities are more common. This brings us back to the importance of clarity and consistency in your legal and commercial arrangements. You must also consider the structure of the transaction itself. For example, supplying goods on consignment rather than as a direct sale can create problems for customs valuation, as there is no 'price paid or payable' at the time of import. This invalidates the primary valuation method and forces the use of alternative, often more complex, methodologies.

Lessons from recent case law

Recent court rulings provide valuable insights. In the case of Swedish company Högkullen AB, the CJEU examined the valuation of support services provided to subsidiaries. The company used transfer pricing to set charges but excluded significant shareholder-related costs from the value. The CJEU concluded that the services were separate and distinct, which was helpful to the taxpayer as they could be benchmarked against third-party services. A non-specific combined charge would have given more weight to the tax authority’s preference for a full cost-based approach.

This case, and others like it, underscore a critical point: where activities are exempt from VAT (common in sectors like finance, insurance, and health), the value of the supply becomes critical. Any VAT charged between connected businesses may not be fully recoverable, creating a real cost.

Moving forward with confidence

Navigating the valuation of intercompany transactions requires a holistic and integrated approach. It is not enough to solve for transfer pricing and hope the other pieces fall into place.

Your business must ensure that legal agreements, invoicing practices, and year-end adjustments are designed with transfer pricing, VAT, and customs in mind from the outset. This requires collaboration between your internal tax, legal, and finance teams, as well as your external advisors.

By understanding the distinct principles of each regime and building a cohesive framework, you can manage risk, ensure compliance, and gain the confidence to thrive in a changing world.