Avoiding tax pitfalls: Understanding the interaction between transfer pricing adjustments and taxes in Egypt

This article outlines the effect of transfer pricing adjustments administered before year end on direct and indirect taxes in light of recent tax audits.

Types of adjustment implementation

Companies may administer transfer pricing adjustments in a number of ways to achieve a desired arm’s length outcome. They can be grouped based on their effect on a company’s profit and loss account as follows:

• Profit adjustments, which for the purposes of this article refers to adjustments made at the operating profit level. Their objective is for the company to achieve a margin that is within an arm’s length range of comparable companies. Profit adjustments are often recorded as separate line items such as other revenues/other expenses. These adjustments may not be linked to a particular product or service and are focused on adjusting the overall results of a company. Profit adjustments may also occur within the revenues/cost of goods or services sold; however, for simplicity, these will be considered within the following type of adjustment.
• Price adjustments, which adjust the price charged for particular goods or services transferred between related parties. The main drivers for price adjustments are usually errors, or changes in the cost of production or market prices. Price adjustments are typically recorded directly within the revenues/cost of goods or services sold.

These adjustments can be made as upward adjustments, increasing the taxable income of the company, or as downward adjustments.

Impact of TP adjustments

Transfer pricing adjustments are often cause for debate as they can materially change the amount of taxable income that a company reports. Accordingly, the impact of an adjustment must be evaluated from a number of angles, most importantly:

• Transfer pricing audit outcomes – given there is no specific guidance on the treatment of transfer pricing adjustments within Egyptian tax law or transfer pricing guidelines (with the exception of those made in an advance pricing agreement context), adjustments are cause for attention, and tax authority assessments are made on a case-by-case basis;
• Possible deductibility challenges – Egyptian tax law specifies conditions for deductibility and a deduction of cost is denied for tax purposes if these are not met;
• Triggers for withholding tax – usually correlated with the characterisation of the payment made and whether it may be classified as dividends, interest, a royalty, or services; and
  Indirect taxes – while companies typically consider transfer pricing adjustments as primarily a corporate income tax issue, such adjustments can also have a large impact on VAT and customs.

The impact is different depending on the nature of the adjustment and its direction; upwards or downwards. Accordingly, it is important for companies to evaluate the possible scenarios prior to administering an adjustment.

Upward adjustments

Upward adjustments increase the profit of the company. An upward price adjustment results in an increase in revenue or a decrease in cost of goods or services sold, while an upward profit adjustment results in an additional revenue line item in the income statement of the company, beyond gross profit, such as support payments or subsidies.

From an Egyptian perspective, the impact of an upward adjustment may have an effect on the transfer pricing assessment made upon audit, and on indirect taxes – depending on the characterisation of the adjustment.

TP audit outcomes

In cases where the upward adjustment is not clearly linked to the core operations of the company or its goods or services,, the tax authority may initially dismiss the adjustments from the operating profit calculation, and then may offset them later (depending on the case) against profit adjustments calculated by the tax authority at the time of the audit. This essentially means that, if not carefully characterised, there is a risk that company results would fall out of range despite the presence of the upward adjustment, which may still result in an added tax liability.

VAT and customs

Where the upward adjustment has caused a decrease in cost of goods sold, this may mean that the company is entitled to a customs and/or VAT refund.

Where the upward adjustment has caused the introduction of additional revenue, the company may be considered to have exported a service. Ordinarily, an exported service is subject to a 0% VAT post meeting certain service classification requirements. The most relevant requirement is where the services are deemed to be ultimately benefiting the Egyptian market, in which case the upward adjustment may be subject to VAT.

Downward adjustments

Downward adjustments decrease the profit of the company. A downward price adjustment results in a decrease in revenue or an increase in costs of goods or services sold, while a downward profit adjustment results in an additional cost line item in the income statement of the company, beyond gross profit, such as a residual payment. From an Egyptian perspective, the impact of a downward adjustment may have an effect on the transfer pricing assessment made upon audit, as well as on deductibility, withholding tax, and indirect taxes – depending on the characterisation of the adjustment.

TP audit outcome

A downward adjustment is consistently challenged, particularly when not clearly linked to a good or service that is provided by the overseas counterpart. It is generally regarded by the authorities as a reduction in profits generated in the Egyptian market and facilitated by its conditions.

Deductibility

The Egyptian income tax law has conditions for approving the deductibility of costs for corporate tax purposes, as follows:

• The necessity of the cost for the performance of the company’s activities; and
• The costs being real, and supported by documents.

On that basis, downward price adjustments that are more directly linked to certain services/goods, and are therefore regarded as real, are easier to justify for deductibility. On the other hand, downward profit adjustments are more difficult to justify if not characterised and linked to the core operations of the business.

VAT and customs

The VAT and customs impact may differ depending on the way the downward adjustments are booked within the income statement. Where the downward adjustment has caused an increase in cost of goods sold, this may mean that the VAT or customs originally paid will be impacted and the company may need to settle additional taxes.

With downward profit adjustments which would result in documentation of the adjustments as separate cost line items, the downward adjustment could be subject to VAT depending on the nature/characterisation. The invoice received by the Egyptian company may be considered an imported service benefiting the Egyptian market and subject to VAT. Payments that may have an intellectual property component may be subject to customs as well as VAT.

Withholding tax

In most instances, true down adjustments will not explicitly represent dividends, interest, services, or royalties. However, practically speaking, it is likely that in a tax audit the authorities would still seek to impose withholding tax on those payments with the purpose of retaining taxing rights on exit from Egypt.

Key takeaways

Regardless of the driver to perform transfer pricing adjustments, companies need to take into consideration the impacts they might have from the transfer pricing, indirect tax, deductibility, and withholding tax angles to avoid pitfalls, such as recharacterisation, disallowance, and adjustments during audit.

Transfer pricing adjustments can be complex to navigate; however, by carefully considering the potential impacts and by accurately documenting and supporting the adjustments, companies can mitigate a large number of risks and remain consistent with their global policies.