When facing a potential dispute, there are many aspects and questions to consider. One item you should always include on your to-do list is tax. Different disputes and different ways of resolving the disputes lead to a variety of tax considerations. The key is to be aware of the tax consequences beforehand and to avoid any unpleasant surprises afterwards.
Understand the tax consequences as early as possible
As with all preparations for future disputes, when it comes to tax treatment, the best preparation is often done well before any dispute arises – when negotiating contracts or planning the business model.
At the latest when you anticipate, or know, that you will face a dispute, you should analyse what the claim that you are making, or that the counterparty is making, means from a tax perspective. In addition to understanding the tax consequences for your own business, it is beneficial to understand, at least to some extent, the tax consequences for the counterparty’s business.
“At the latest when you anticipate, or know, that you will face a dispute, you should analyse what the claim that you are making, or that the counterparty is making, means from a tax perspective.”
Types of tax questions to consider before the dispute
The first thing to think of is whether the claim is, from a tax perspective, considered damages, liquidated damages, purchase price adjustment, or possibly something else.
From a corporate income tax perspective, the main questions are whether the consideration paid is deductible in taxation and whether the consideration received is taxable income. In many cases, the answer to both questions is yes. Another relevant question that needs to be assessed case by case is the tax year to which the income or cost should be allocated – the tax year when the transaction subject to the dispute was carried out, or when the dispute was resolved, or some other year. The tax positions of different tax years may be different in terms of statute of limitations, tax losses, interest deductibility limitations, and so on, and changes to taxable income may have different consequences when taking the big picture into account. In longer disputes, the tax statute of limitation rules combined with rules on allocation of costs between tax years may even lead to an outcome that no tax deduction can be made at all unless appropriate measures are taken well in advance.
Liquidated damages are usually considered compensation for damages outside the scope of VAT, including when the amount is calculated based on an agreed formula and is thus not based on the actual amount of damages. On the other hand, purchase price adjustment usually leads to an adjustment of VAT. If both parties carry out business subject to VAT, neither of the alternatives leads to a final VAT cost. However, if the party making the claim does not carry out business subject to VAT (e.g., health care sector or financial sector) and bears VAT as a final cost, purchase price adjustment decreases the final VAT cost, whereas compensation for liquidated damages or damages does not.
The above are just some examples of tax questions that may be relevant. Other examples include transfer tax questions when the dispute relates to shares or real estate transactions, and the relevance of double tax treaties, transfer pricing, and the applicable tax rules in multiple jurisdictions in cross-border situations. Employment-related disputes often require an assessment of whether a consideration of any kind paid to an employee is considered salary income for tax and social security purposes.
“During the dispute, an understanding of your own tax treatment, as well as of the tax treatment of your counterparty, may be useful in negotiations.”
An understanding of tax issues is beneficial during dispute resolution
During the dispute, an understanding of your own tax treatment, as well as of the tax treatment of your counterparty, may be useful in negotiations. If the different alternatives for making a claim or proposing a settlement have different overall tax consequences, those should be taken into account when assessing how to structure the claim or proposal.
In the argumentation itself, the sources used in tax matters may sometimes come in handy. A good practical example is the use of OECD’s Transfer Pricing Guidelines, a well-established source for interpreting the arm’s length principle in tax cases and other transfer pricing principles when demonstrating market based pricing in a dispute resolution context.
When the dispute is resolved, there are still tax issues to consider
The tax treatment of different costs and income arising from the dispute needs to be analysed and included in the applicable tax returns. If, due to the outcome of the dispute, past taxation needs to be adjusted, claims for adjustment or appeals may need to be prepared. The transfer pricing model may also play a role when determining which entity within the group will ultimately bear the costs arising from the dispute, or benefit from the compensation received.
Due to the variety of types of disputes, there is no one-size-fits-all approach to the tax questions that need to be considered. It is important to involve tax experts – in-house and counsel’s tax team – in dispute resolution projects. The tax questions related to disputes are not always complex, but the key is to identify when there are potentially significant tax consequences that should be taken into account in one way or another.