VAT Considerations in Toll Manufacturing: Classification of Supplies

The VAT treatment of manufacturing arrangements continues to present significant challenges for businesses operating across borders. In particular, toll manufacturing raises complex questions regarding whether the activities performed constitute a supply of goods or a supply of services. Misclassification can have far-reaching consequences, including incorrect VAT reporting, exposure to penalties, and disruption to supply chains.

Definition and Scope of Toll Manufacturing

Toll manufacturing refers to an arrangement whereby the principal company dispatches goods to a third-party manufacturer, often established in another EU jurisdiction, for the purpose of processing, or conversion into finished products. Following completion of the manufacturing process, the finished goods may:

• be returned to the principal company’s warehouse,
• be sold directly from the manufacturer’s location, or
• be transferred to storage facilities in another Member State.

Throughout this process, the principal company retains ownership of the goods, while the toll manufacturer performs services on the goods.

VAT Characterisation: Goods or Services?

The main VAT issue in toll manufacturing lies in determining whether the activities performed by the manufacturer constitute a supply of services or a supply of goods.

• In the classical toll manufacturing model, the manufacturer provides a processing service, and the principal company acquires a service while retaining ownership of the goods.
• In practice, contractual arrangements, packing lists, and invoicing methods may create the appearance of a purchase of finished goods, potentially leading to an incorrect classification.

Incorrect classification may result in:

• Misreporting of intra-Community acquisitions by the principal.
• Incorrect identification of the Member State in which the transactions should be taxed, and associated VAT obligations leading to a potential underpayment of VAT with exposure to interest and penalties.
• Potential assessments and penalties by tax authorities due to inaccurate VAT returns.

Accurate classification is therefore critical to ensure the correct VAT treatment and avoid unnecessary compliance risks.

System Challenges and Solutions

For ERP systems like SAP, VAT determination is often complicated by the way purchase orders (PO’s) and invoices are structured. Standard system configurations may treat toll manufacturing arrangements as purchases of finished goods, triggering acquisition VAT codes inappropriately,  and potentially leading to a sale of goods in the wrong EU Member State.

To mitigate these issues, a VAT determination solution for SAP can provide functionality that can be leveraged to reflect the correct VAT treatment. For example:

• Item categories: By correctly assigning subcontracting as the item category, the system can distinguish between goods purchases and service supplies.
• Additional parameters: Other system fields such as account assignment or GL accounts can be configured to further refine VAT determination logic.

Enhanced VAT determination solutions, such as Meridian’s SAP-integrated functionality, utilise these parameters to ensure that VAT treatment aligns with the underlying legal characterisation of the transaction. This enables businesses to apply the correct VAT codes automatically, reducing the risk of misreporting.

Conclusion

Toll manufacturing shows the complexities inherent in cross-border VAT compliance. The determination of whether a supply constitutes goods or services is fundamental to accurate VAT reporting, yet in practice it is often obscured by contractual and system related factors.

Businesses engaged in toll manufacturing should ensure that:

• arrangements are reviewed carefully to determine the correct VAT classification,
• ERP systems are configured to reflect the legal and commercial substance of the transaction, and
• robust VAT determination tools are implemented to manage reporting obligations consistently across jurisdictions.

By addressing these issues proactively, businesses can minimise compliance risks, ensure accurate VAT reporting, and achieve greater certainty in their cross-border supply chains.