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How the euro crisis is affecting indirect taxes and transfer pricing

COMMENT: Although the breakup of the eurozone is considered highly unlikely, companies should prepare for this possibility to reduce indirect tax risks.

Clearly, such a situation would have dramatic economic consequences in Europe and beyond, including, for example, the possibility of one or more countries leaving the euro or even a complete breakup of the currency union.

A lot has been said and written about the need to protect asset values and normal business transactions against new currency risks linked to a breakup of the euro. However, a euro breakup would affect many more business aspects, including the domain of indirect taxes and transfer pricing.

As for indirect taxes, the challenges of a currency fragmentation would be formidable for multinational enterprises (MNEs) with significant cross-border transactions in the eurozone. VAT is a chain of successive payments and refunds constantly being pumped through the economic system. Ensuring that IT systems dealing with VAT are effective, and that a company complies with all its obligations, is often a challenging job as it is. This task would become even more daunting if the software systems would have to deal with a sudden and significant increase in the number of intra-EU currencies.

In the run up to the introduction of the euro, it took companies years of often arduous labour to prepare for the transition of many currencies to the euro. In the case of a euro breakup, the task would be much more difficult. It is easier to change a system from many currencies to one, than from one currency to many. What’s more, a breakup could be sudden and chaotic, increasing the difficulties exponentially.

Check your systems

MNEs are therefore well advised to check on the robustness of their systems dealing with VAT payments and refunds. The importance of guaranteeing this effectiveness of systems is paramount. Even now, with the euro fortunately intact, errors in the way company software systems deal with VAT are more costly to companies than formal judgment errors in the way complicated transactions are classified for VAT purposes.

A possible breakup of the euro may also influence decisions of companies regarding the way they channel goods through different countries in the eurozone. Differences in the speed and ease of VAT refunds in different euro countries already inform these decisions. Possible currency risks may add to the mix of factors taken into account. This may be especially important in the decision of which port of entry to choose when goods are imported into the EU from outside the customs union.

Intra-group loans

International intra-group loans would also be affected profoundly by a euro breakup. Imagine, for example, a euro loan from a company in a core country of the eurozone to a subsidiary in a country in the periphery. If the subsidiary’s country were to leave the euro, chances are that its new currency would rapidly depreciate against the euro. If the loan were to be maintained in euro terms, this could cause the subsidiary to enter into technical bankruptcy. This situation, in turn, could force the holding company to inject extra capital into the subsidiary quickly. In some countries, after all, a technical bankruptcy can trigger adverse legal consequences if not remedied speedily. Therefore, it could be more appropriate to change the loan to the new currency of the subsidiary’s country. The question whether the resulting loss on the loan in the core country is tax deductible should also be taken into account. If the euro were to disappear completely, this denomination question might become even more complex.

One could argue that the euro crisis should already have consequences for the current transfer pricing of international intra-group transactions. The mere risk of a breakup of the euro for instance, could be considered a factor to be taken into account when establishing the arm’s-length interest rate that should be applied to the loan. This risk is not limited to the currency risk. Even a US dollar-denominated loan to a subsidiary in the euro periphery may be affected. After all, a euro exit may well lead to a deep depression in the subsidiary’s country. The resulting increase of the country risk, separate from the currency risk, could also severely impact the credit rating of this company itself. Obviously, the impact of a depreciating currency and a long and deep economic crisis will be very different for a subsidiary dedicated to, say, distribution and sales in the country itself, compared to a subsidiary that manufactures products that are exported back into the eurozone.

Avoiding the break up

These questions regarding intra-company loans may seem premature. However, over the last five years, tax authorities have rapidly increased the attention they are paying to interest rates on intra-group loans. That makes this question more than merely theoretical. For MNEs, the complicating factor – as often in transfer pricing issues – is that they should try to judge now how their current decisions will be interpreted by the tax authorities during an inspection that may take place three or four years from now, i.e., with the benefit of hindsight that companies lack.

Hopefully, a currency fragmentation of the eurozone can be avoided. It is in the best interest of MNEs that the currency union survives and emerges stronger from the current crisis. But MNEs should also prepare for the eventuality that one or more countries exit the euro, including the consequences for the management of indirect taxes and transfer pricing.

Alex Postma, EMEIA international tax services leader, Ernst & Young

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