SERVICE PROVIDER'S PERSPECTIVE
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The primary risks to the service provider’s tax authority as far as intra-group services are concerned are either that services that have been provided have not been identified and charged for or that services have been identified but inadequately charged for.
Y has apparently identified and will charge its associated companies for a wide range of services that will be provided during the year. This is an important first step since management companies might fail to identify the services that are being provided to associated companies or to charge for such services.
This failure may be the result of a lack of awareness or attention to transfer pricing requirements. However, the failure to identify or charge for services provided may also be an attempt to arbitrage the differences between withholding taxes in the recipient jurisdiction and taxation in the provider's jurisdiction in respect of the repatriation of funds by way of service fees or dividends.
Y has set its service fees so that it will recover the estimated costs, including associated overheads, in respect of the services provided together with a margin of just over 10%.
These two steps may lead to the initial conclusion that Y poses a low risk of inappropriate transfer pricing in the service area. However, a number of factors undermine this conclusion. Some of the most readily apparent are the fact that:
- Recoveries have been based on expected costs and sales and there is no indication of whether or not an adjustment will be made to take account of actual costs and sales.
- Costs for which a direct charge may be possible and a CUP ascertainable are included in the indirect allocation of costs.
- A single allocation key has been used for a wide range of services.
- There is no indication that shareholder activity costs, which may be included in audit and accounting costs or company secretarial services costs, have been excluded from the recovery.
- Advertising, marketing, and branding costs have been allocated to group contract manufacturers, which have no influence over sales but merely produce products to specification.
These factors affect the total amount charged for the services provided by Y to its associated companies and the allocation of the amount, both of which may lead to the setting of inappropriate transfer prices. Accordingly, it seems appropriate to proceed to a detailed review of Y's transfer pricing policies in respect of intra-group services.
The detailed review of Y's transfer pricing policies in respect of intra-group services would require significantly more detail than is available in the example but would:
- Identify any services that are provided to associated companies that are not covered by the costs listed. As an example, it is not clear that the legal and consulting costs include the provision of Y staff to group companies to consult on the managerial or technical issues.
- Identify shareholder costs that should not be recovered or costs in respect of services that were not actually provided to recipients. In this regard it should be noted that, in addition to acting as the central management company, Y is the owner of the group’s manufacturing and marketing intangibles and is an active distributor. It is therefore not clear why trademark protection and litigation costs should be charged to group companies or to what extent the overhead costs, such as office supplies, rental, etc., incurred by Y relate to its own operations and not to group operations.
- Explore the opportunity for substituting a direct charge for services; such as legal, audit, accounting and insurance; for which a CUP could be found. This would depend heavily on the materiality of the amounts involved and the availability of records to support the identification of the services provided to each associated company.
- Consider the impact of extraordinary service requirements on the validity of any indirect key selected. There may be occasions, particularly on start-up or where disaster strikes, when the services provided to a particular group member far exceed those normally provided. Under these circumstances it may be appropriate to exclude the extraordinary services from the indirect allocation and utilise a direct allocation for that particular project.
- Consider the use of more than one allocation key since a number of the services provided do not appear to be dependent on sales. Examples of alternative keys would be group assets and risks insured for insurance, group personnel costs for staff travel and deployment, and debt funded by third parties for corporate finance costs, bankers’ charges, and credit line negotiation costs. The last key would have the advantage of eliminating the recovery of costs relating to any of Y’s debts in respect of the acquisition of group members.
- Although group sales may remain the most practical allocation key for several costs, A and B should be excluded from allocations that relate to advertising. On the other hand, X serves as both a specialist manufacturer, presumably taking full responsibility for its products, and as a distributor of group products and should therefore be allocated its share of these costs.
- Review the margin added in the cost plus computation to ensure that it is market related. This would be facilitated by the use of multiple allocation keys, which would allow for more specific comparisons to be drawn.
- Ensure that balancing adjustments for actual costs and allocation keys are made, bearing in mind the point made in 4 above.
The detailed review may still not result in fees that can be considered to be set at arm’s length in the recipient’s hands since the services provided to the recipient may not be necessary to it, As an example, they may simply represent a duplication of services obtained locally by the recipient. The tax authority in the recipient’s jurisdiction will be best placed to evaluate this aspect of the transactions.
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