Another Look at Transfer Pricing Risk and Intra-Group Services

Following his earlier article on transfer pricing risk and the disallowing of intra-group services, Christos Theophilou of Taxand takes a further look at specific examples of intra-group services that aren’t chargeable, as provided in the OECD Transfer Pricing Guidelines.

As multinational enterprises would normally have intra-group services of some kind, tax authorities around the world typically start their audits from these services. MNEs should have adequate documentation in place for the tax audit to be closed quickly and not extended to other perhaps more important areas.

In an earlier article, we analyzed the general principle that intra-group services are disallowed (not chargeable)—that is, the benefit test. In this article, we analyze the specific examples provided by the 2022 OECD transfer pricing guidelines that intra-group services under certain circumstances aren’t charged, that is, a negative definition of the concept of a chargeable service:

• Shareholder activities (paragraphs 7.9-7.10)
• Duplicated activities (paragraph 7.11)
• Passive association or implicit support (paragraph 7.13)
• Incidental benefit—activity based (paragraph 7.12)
• Group synergies with no deliberate concerted group action (paragraph 1.177-1.180)
• On-call services provided that the need is remote (paragraph 7.16-7.17)

Shareholder Activities

Shareholder activities are a frequent area of disputes in tax audits and have their origins from both the 1979 Transfer Pricing and Multinational Enterprises and the 1984 Transfer Pricing and Multinational Enterprises—Three Taxation Issues. Shareholder activities are defined in the Organization for Economic Cooperation and Development guidelines as an activity performed by an associated company—typically by a parent company or a regional holding company—solely because of its ownership interest in one or more group members (that is, in its capacity as a shareholder). The service(s) provided don’t provide any benefit to the service recipient(s). Such activities are more likely to be found in centralized MNE structures; in decentralized structures the associated companies normally perform the functions themselves.

The EU Joint Transfer Pricing Forum provides for a benchmark test, that is, whether an activity only discharges a shareholder duty or also produces an additional benefit to the service recipient associated companies. The OECD guidelines provide specific examples of shareholder activities:

• Costs relating to the juridical structure of the parent company itself
• Costs relating to reporting requirements of the parent company
• Costs of raising funds for the acquisition of its participations and costs relating to the parent company’s investor relations
• Costs relating to compliance of the parent company with the relevant tax laws
• Costs which are ancillary to the corporate governance of the MNE as a whole.

More practical examples are included in annex 2 of the EU transfer pricing forum and in section 5.2.6.3 of the 2021 United Nations Practical Manual on Transfer Pricing.

There are gray areas, such as stewardship activities, that should be distinguished from shareholder activities. Stewardship activities, as used in the 1979 OECD report, benefit the service recipient associated companies somehow and therefore are chargeable. Stewardship activities include planning services, emergency management, technical advice, and day-to-day management.

Another area where the rules aren’t clear is fundraising activities. For example, when the parent company assists its subsidiary in raising funds for the subsidiary to invest in a new project, this would normally be considered a chargeable service. Care should be taken, however, on the recommendations of the 1984 OECD report that “costs of managerial and control (monitoring) activities related to the management and protection of the investment as such in participations” are in line with the “independent party test.”

To illustrate the above points with a practical case study, assume a parent company wishes to provide costly services to its foreign subsidiary due to the parent company’s high-quality standards. Although the benefit test is met, as the foreign subsidiary receives a high-quality service, the foreign subsidiary wouldn’t be willing to pay for such a high-quality but costly service; an independent party, arguably due to the local market conditions, wouldn’t be willing to pay for such a service. In this example, although the parent company’s needs are satisfied, the foreign subsidiary’s needs aren’t. Therefore, the tax authorities where the foreign subsidiary is located may fully disallow the costs, or partly disallow them up to the amount had the services been acquired locally.

Duplicated Activities

Duplicated activities occur where an associate company (the service provider) provides a service to another associated company (the service recipient). Normally the service recipient has the option to either perform such a service in-house or outsource to a third party. Therefore, an independent company that aims for profit optimization—either by increasing their revenues or minimizing costs—wouldn’t be willing to pay twice for the same service. The OECD guidelines provide for two exceptions:

• The duplication of services is only temporary, for example, where an MNE group is reorganizing to centralize its management functions; and
• The duplication is undertaken to reduce the risk of a wrong business decision, for example, by obtaining a second legal opinion on a subject.

In practice, tax authorities may challenge the fact that an intra-group service is provided at two different levels, as when marketing services are rendered to headquarters (strategic marketing) and to the associated companies (operational marketing). Another example would be when tax services are rendered to headquarters for implementing the MNE tax policy to its foreign associated companies, and for local tax compliance purposes. Duplications would be determined on a case-by-case basis, and the key question is whether intra-group services confer any additional benefit to the service recipients.

Incidental Benefit

There are two types of incidental benefit: the first type arises in situations where an associated company performs an activity (activity-based incidental benefit), and the second where the benefit obtained doesn’t arise from an activity (passive association or implicit support).

Incidental benefit—activity-based: Under the “separate entity” approach adopted by the OECD guidelines (paragraph 1.16), all associated companies of an MNE group are considered to be independent companies. Based on this premise, there would be situations, for example, in a group reorganization such as a restructuring or acquisition, where an associated company, typically the parent company, would render services only to some group members (primary beneficiary of the service) but incidentally provide benefits to other group members.

On one hand, such intra-group services normally would be chargeable for the particular group member involved (the primary beneficiary of the service). On the other hand, even though the group reorganization may also produce economic benefits for the other group members that aren’t directly involved in the potential decision, such intra-group services wouldn’t be chargeable (that is, disallowed). Put simply, the incidental spill-over effect can’t be remunerated because the incidental benefits enjoyed by the other group members wouldn’t be benefits for which independent companies would be willing to pay.

Group synergies: In practice, incidental benefits also may involve realizing synergies or achieving economies of scale. Where there is a deliberate concerted group action resulting in synergistic benefits—for example, an MNE may centralize purchasing in a regional headquarters company to take advantage of volume discounts—then such benefits should be allocated to the associated companies in proportion to their contribution to the creation of the synergy. However, if a supplier unilaterally offers one member of a group a favorable price in the hope of attracting business from other group members, no deliberate concerted group action would have occurred. Therefore, such benefits wouldn’t normally be allocated.

Passive association or implicit support—no specific activity performed: Passive association or implicit support arises when an associated company obtains incidental benefits attributable solely to its being part of a larger concern, and not to any specific activity being performed by other associated companies of an MNE. A key feature of this type of incidental benefit is that it is passive and can’t be attributed to an overt action. Importantly, implicit support should be distinguished from explicit guarantees or financial guarantees, as the latter would normally be chargeable. Explicit guarantees are legally binding commitments where the guarantor assumes the risks if the debtor defaults, and therefore service should be charged. For example, an intra-group service would usually exist where a higher credit rating was due to a guarantee by another group member.

On the other hand, implicit support or implicit guarantees provide no legally binding obligation towards the creditor, so the parent company might not always support the associated company in case of default. For example, no service would be received where an associated enterprise by reason of its affiliation alone has a credit rating higher than it would if it were unaffiliated. Notably, explicit guarantees relate to financing and are now covered under the OECD guidelines Chapter X, on transfer pricing aspects of financial transactions.

Finally, another practical example would be the simple recognition of group membership or the use of the group name merely to reflect the fact that group membership wouldn’t warrant a payment.

On-Call Services

On-call services are commonly found in centralized structures, where, for example, an MNE may decide to pull together certain back-office activities—such as IT, accounting, and HR—into a single shared service center. Such on-call services typically are scrutinized by tax authorities because by using such services it is easy to shift profits. There are three situations where such services would normally be disallowed:

• The potential need for the service was remote,
• The advantage of having services on-call was negligible, or
• The on-call services could be obtained promptly and readily from other sources without the need for stand-by arrangements.

Importantly, the EU transfer pricing forum notes that for on-call services to be recognized, an infrastructure has to be in place to offer and meet the commitments in an on-call arrangement.

Planning Points

Intra-group services are a significant target of tax audits, and MNEs should have sufficient documentation in place to defend their position, particularly centralized structured MNEs. Disputes that are open to challenge may arise, for example, on the different definitions of shareholder activities—what does “costs of the supervisory board” or “strategic management” mean? The complication is compounded depending on whether the tax audit is conducted from the perspective of the service provider or of the service recipient.

To avoid an intra-group service being disallowed, taxpayers need sufficient evidence to meet the guiding principle of the so-called benefit test, and the specific examples in the OECD guidelines. The following points are important:

• Is an intra-group service charge documentation justified?
• Does the documentation demonstrate whether a service has been rendered and/or that the service rendered provides benefits to the recipient?
• Is the advantage of having the intra-group service negligible?
• Is there a potential need for the intra-group service?
• Has an associated company received an unintended or intended benefit from being part of the group?
• Is a benefit more for the service provider than the service recipient?
• Does the service recipient require the service? If yes, would an independent party in similar circumstances be willing to pay for such a service?
• Does documentation justify that services aren’t duplicated, and if so, that it benefits the service recipient?

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

The article appears in Bloomberg Tax, published by Bloomberg BNA.

Christos Theophilou
T: +357 22 875 723
E: ctheophilou@cy.taxand.com