Christos Theophilou of Taxand explains that multinational enterprises need to have adequate preparation in place to satisfy the scrutiny of intra-group services by tax authorities, and he provides a practical example and case study to illustrate the issues.
Intra-group services are regularly scrutinized by the tax authorities, particularly in recent years, when globalization changed the way multinational enterprises operate in a more integrated manner. Specifically, this would be the case in a centralized MNE group, whereas in a decentralized MNE structure, the group companies would normally perform functions among themselves. (A list of intra-group services is provided in Annex 1 of the EU Joint Transfer Pricing Forum Guidelines on low value adding intra-group services.)
Typically, in accordance with the 2022 OECD transfer pricing guidelines, a four-step analysis can be applied in order to price an intra-group service:
This article focuses on considering the accurately delineated transaction (steps 1 and 2 above) that will identify whether an intra-group service will be recognized—that is, chargeable or deductible, or not recognized—that is, disallowed. (For completeness purposes, steps 3 and 4 deal with the arm’s-length compensation of intra-group services.)
To answer the question of whether an intra-group service has been provided, the Organization for Economic Cooperation and Development transfer pricing guidelines provide two tests, applied on a case-by-case basis. First, the so-called benefit test (guidelines paragraph 7.6) considers whether the services rendered provide “economic or commercial value to enhance or maintain its business position” to the service recipient. Second, in applying the benefit test, the guidelines recommend a willingness to pay/perform for itself test, that is, whether “an independent enterprise in comparable circumstances would have been willing to pay for the activity if performed for it by an independent enterprise or would have performed the activity in-house for itself.”
Therefore, an intra-group service will be recognized when both tests are fulfilled, and when one of the two tests is not fulfilled, such an intra-group service would normally be disallowed. The two tests should be performed using the two-sided approach, from the perspective of both:
Further, the OECD guidelines provide specific examples that intra-group services under certain circumstances are not charged (that is, a negative definition of the concept of a chargeable service):
It is worth mentioning that all five examples above do not meet the benefit test, that is, they do not benefit the service recipient and are therefore not chargeable for transfer pricing purposes.
A point to note is that the “benefit” does not necessarily need to materialize, but rather it can be “expected.” For example, in the case of marketing activities, for an MNE that provides intra-group marketing services, such activities might be realized not in the same year but rather in the following years, or might fail and not be realized completely. Such “expected benefit” would normally be chargeable. (This is implicitly stated in the OECD guidelines at paragraph 7.32 and explicitly stated in the UN TP Manual at B.4.2.5. and B.4.2.6.)
In practice, a transfer pricing study needs to include a benefit analysis to support whether an intra-group service has been provided in case of a tax audit. Such a benefit analysis should demonstrate, for example, the costs savings, administrative efficiencies, better quality control, and the non-monetary benefits of centralized services, such as consistency, ease of management and monitoring, or better data protection. In this context, the transfer pricing study should specify the responsible employees that are in charge of the intra-group services and link such employees with a list of their responsibilities.
As discussed above, an intra-group service would normally be disallowed (i.e., not recognized or not charged) if one of the two tests is not fulfilled.
Assume, for example, that in 2020, a company resident in a state R with a corporate tax rate of 2.5% (Low-tax Co.) enters into an agreement to provide consultancy services to a company resident in state S with a corporate tax rate of 12.5% (High-tax Co.). Assume further that during the year 2020, Low-tax Co. rendered services amounting to 1 million to High-tax Co., and the latter settled the outstanding amount via bank transfer. Thus, for the tax year 2020, Low-tax Co. paid 25,000 tax (1 million at 2.5%) and High-tax Co. had a tax deduction from its taxable income amounting to 125,000 (1 million at 12.5%).
Assume further that during a transfer pricing audit of High-tax Co. in the year 2022, the tax authorities of state S commenced their review first from the perspective of the service provider, Low-Tax Co., and second from the perspective of the service recipient, High-tax Co. During their analysis, the tax authorities identified that Low-tax Co. staff properly provided consultancy services to High-tax Co. However, such consultancy services have not satisfied an identified need from the perspective of High-tax Co., and an independent enterprise in comparable circumstances would not have performed the activity in-house, nor had the activity performed by a third party.
As a consequence, the tax authorities in state S disallowed the consultancy expenses of High-tax Co. amounting to 1 million, and thereby increased the taxable income of High-tax Co. by the same amount, resulting in an additional tax amount of 125,000.
To avoid double taxation, assuming there is a double tax treaty concluded between state S and state R that follows either the OECD or the UN Model, then under Article 9 paragraph 2, a corresponding adjustment is possible. Such corresponding adjustment will be provided if the tax authorities of state R agree with the primary adjustment of not recognizing the service performed by the tax authorities of state S. If the tax authorities do not agree wholly or partly to reduce the revenue of Low-Tax Co. then double taxation would arise.
Another area that tax authorities scrutinize with respect to the benefit test and disallowing intra-group services is management services. This is because MNEs might be inclined to charge management services to a jurisdiction with a high tax rate. In the case Italy vs Alfa Gomma Sud s.r.l., July 2014, Supreme Court 16480, the Italian tax authorities disallowed the management services (a contract for the provision of general management services such as marketing, telephone, and legal, accounting, and tax consultancy) provided by the parent company, Alfa Gomma S.p.A., to the taxpayer (the Italian company). This was because the taxpayer did not provide sufficient proof of the benefits of the management services received. The Supreme Court’s judgment was in favor of the tax administration and it dismissed the taxpayer’s appeal.
The Supreme Court, among other points, noted the following:
The main reasons the Supreme Court ruled in favor of the tax authorities were because the taxpayer’s documentation was insufficient, and further failed to prove that there was a direct link between the activities and costs incurred by the parent company, and the benefit received by the taxpayer. The deduction of management costs was therefore disallowed.
In light of the above, it is apparent that there are difficulties in applying the benefit test in practice. This is because it requires detailed documentation and a breakdown analysis of the benefit for each service recipient. Further, in case of dispute, MNEs would normally not initiate the mutual agreement procedure to resolve the conflict, as this would be time-consuming, expensive, and therefore very burdensome, possibly outweighing any potential benefit. Thus, a detailed functional analysis is required in order to reduce the number of controversies.
Moreover, in the post-Covid era, the above complications are compounded, and more disputes may arise with respect to activities performed remotely or by personnel who are seconded within an MNE group to perform work for an associate enterprise. Unfortunately, the OECD transfer pricing guidelines do not provide detailed guidance on this issue. Interestingly, the OECD is considering revising the guidance in Chapter VII (intra-group services) of the guidelines, as the original text of Chapter VII was included in 1995, and since then has remained largely unchanged.
Bearing in mind that intra-group services are considered to be a significant target of tax audits, normally tax authorities will first challenge whether such a service will be chargeable and, if so, will then challenge whether such a charge is sufficient, that is, at arm’s length. As a consequence, to avoid non-deductibility of intra-group services, MNEs need to have adequate documentation in place to support the two tests (benefit test and willingness to pay/perform for itself test) from both perspectives:
Such transfer pricing documentation should include the following:
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.