Recently, we have been receiving an increasing number of enquiries from foreign companies that supply industrial products – such as machinery, batteries, etc. – to Bulgaria and assemble them there. This raises complex legal and tax issues, which we will address here.
A supply and installation contract with a foreign company is a complex undertaking. It combines the purchase and sale of goods with the provision of a service. Key steps include determining the place of performance and the tax treatment under the Bulgarian Value Added Tax Act, as well as choosing the applicable law to avoid disputes.
I. Characteristics of the Contract
When investing in new production facilities, specialised machinery or complex technological systems, the purchase is rarely concluded simply by the unloading of the goods. As a rule, the process involves installation, testing and commissioning by staff of the manufacturer or a subcontractor appointed by the manufacturer. In practice, this type of transaction is governed by what is known as a supply and installation contract. This is a complex contract of significant commercial importance, combining elements of a contract of sale with those of a contract for services (the installation work). In this context, there are a number of specific aspects which we will address in this article.
Why do the FAT and SAT tests determine the outcome of the deal?
When purchasing production equipment, signing the contract and the physical arrival of the goods at the company’s premises are only half the process. The deal is only truly finalised once the machine has demonstrated that it functions exactly as promised. In international practice, this is governed by two crucial technical tests – FAT and SAT. These are not merely a technical formality – payments, the warranty and the taxes for the project all depend on them.
1. FAT (Factory Acceptance Test) – The test at the manufacturer’s factory.
This is the ‘dress rehearsal’. Before the machine is dismantled, packed and loaded onto lorries, the engineers must visit the foreign supplier’s factory. There, the machine is assembled and commissioned in test mode. If the machine has a manufacturing defect or an important component is missing, this must be identified at the manufacturer’s factory. If this test is skipped and the defect is only discovered in Bulgaria, the project comes to a standstill. Returning parts abroad for rectification takes months, incurs enormous transport costs and leads to disputes over who must bear the cost of the delay. A successful FAT test is the ‘green light’ for the payment of the instalment prior to dispatch.
2. SAT (Site Acceptance Test) – Acceptance test carried out by the buyer
Once the plant has arrived in Bulgaria and been assembled by the foreign specialists, the final test – the SAT – takes place. This test is carried out under real production conditions using the buyer’s (customer’s) raw materials and staff, in order to demonstrate that the machine achieves the contractually agreed capacity (e.g. number of parts per minute). Successful completion of the SAT test is confirmed by a final acceptance report signed by both parties. This document is the most important one in the project, as three key events are automatically triggered from its date:
The tax event under the Value Added Tax Act: This is the date on which the supply is officially deemed to have taken place.
Start of the warranty period: The commercial warranty begins on the day after the SAT report is signed, not from the date of purchase.
The signing of the SAT report marks the official end of the project in Bulgaria. To ensure that the foreign company does not remain in the country for too long and establish a permanent establishment (which would subject it to a 10 per cent Bulgarian corporation tax), the entire process – from the team’s arrival to the final SAT test – must take place within the short timeframe stipulated by the relevant double taxation agreement.
II. Treatment under the Bulgarian Value Added Tax Act
With the recent amendments to the Bulgarian Value Added Tax Act (VAT Act) coming into force, it has become more important than ever to draft contracts for supply and installation correctly.
As the installation takes place in Bulgaria, the place of supply is always deemed to be within the country in accordance with Section 17(4) of the VAT Act. This means that the transaction is subject to 20 per cent Bulgarian VAT. The transaction is not treated as an intra-Community acquisition at all, even if the goods originate from the European Union. The provision for ‘supplies involving installation’ under Section 17(4) completely replaces the provision for intra-Community acquisitions. In this case, the dispatch of goods from the EU to Bulgaria constitutes what is known as a ‘technical transfer’ for the purposes of installation by the supplier.
With the legislative amendments, the provision in Section 82(2)(2) of the Value Added Tax Act has been definitively repealed. This means that the reverse-charge mechanism (self-assessment with a protocol in accordance with Section 117) no longer applies to ‘supplies involving installation’ from the EU. The foreign company from the EU is obliged to register in Bulgaria in accordance with the Value Added Tax Act before carrying out the supply. It must submit an application for registration to the National Revenue Agency (NAP) at least 7 days before the date on which the tax on the supply becomes due.
If the contract provides for an advance payment, the tax becomes due on the date of the advance payment. The foreign company must already have a Bulgarian VAT registration number before transferring the advance payment so that it can issue an advance payment invoice showing 20 per cent VAT.
Breaking the contract down into separate items for the supply and separate items for the installation does not alter the general tax treatment under the Value Added Tax Act. The Bulgarian National Revenue Agency (NAP) and case law regard such transactions as a single, complex supply of ‘goods with installation’ in accordance with Article 17(4) of the Value Added Tax Act. Should you attempt to treat the supply of the equipment as a standard intra-Community acquisition (ICA) exempt from VAT and the installation as a separate service, the Bulgarian National Revenue Agency (NRA) will reclassify the transaction during an audit. There is no problem in dividing the contract into payment phases to facilitate the cash flow. However, the tax treatment follows a strict timetable that depends on when payment is made: as this payment is made prior to final installation, it essentially constitutes an advance payment for the entire supply. The foreign company must already be registered for VAT in Bulgaria. It issues an invoice for this stage with 20% Bulgarian VAT. To avoid tax risks, the contract must expressly state that the division of the price into stages is for payment purposes only, but that the transaction constitutes a single supply of goods with installation within the meaning of the VAT Act.
For this reason, whilst entering into two separate contracts – one for the purchase of the goods and one for their installation – is a classic tax planning tool, it carries a significant risk of reclassification by the Bulgarian National Revenue Agency (NAP). The tax authorities and the Court of Justice of the European Union (CJEU) apply the principle that substance takes precedence over form. If the two transactions are economically and logically linked, they are regarded as a single complex supply of goods with installation pursuant to Section 17(4) of the Bulgarian Value Added Tax Act (VAT Act). When will the Bulgarian National Revenue Agency (NAP) treat the two contracts as one?
The auditors assume that this constitutes an artificial splitting of a single transaction if the following criteria are met:
- The same supplier: Both contracts were concluded with one and the same foreign company (or related parties).
- Functional link: The goods (e.g. a machine or a production line) cannot function without professional installation carried out by the supplier.
- Temporal link: The two contracts were signed at the same time or within a short period of time, and installation takes place immediately after delivery.
III. Installation by a subcontractor from another Member State
If the contract includes an obligation to carry out the installation, this may be subcontracted. If the subcontractor is based in another EU Member State, the same VAT registration rules apply to them as to the original contractor under the contract.
IV. Place of economic activity under double taxation agreements
In the case of supply and installation contracts with foreign companies, the question of the place of economic activity (permanent establishment) under double taxation agreements (DTAs) represents the second major challenge after the Value Added Tax Act.
Under international tax law (and the OECD Model Tax Convention, on which most double taxation agreements are based), a construction site, or a construction or installation project, constitutes a place of business only if its duration exceeds a certain period. Depending on the country of origin of the foreign company, the time limit agreed in the DTA varies, but is usually between 6 and 12 months.
If the installation work lasts longer than the period permitted under the DTA, the foreign company in Bulgaria is subject to the following obligations:
- Registration with Bulstat: Registration of business activities locally with the registration authority.
- Accounting: Reporting of income and expenditure relating to the Bulgarian project in a separate balance sheet
- Corporation tax: The profit generated from the activity in Bulgaria (income from the installation work less the costs of salaries, business travel and materials) is subject to a 10% corporation tax.