Transfer pricing: Types of transactions: Services: introduction
As well as tangible goods (see INTM440020 onwards), the transfer pricing legislation applies to services provided between connected persons. A complete review of the facts is necessary when deciding whether a service has been performed and what the arm’s length price for the service would have been.
OECD Transfer Pricing Guidelines
Chapter 7 of the OECD Transfer Pricing Guidelines considers particular issues related to the provision of intra-group services. The main points are:-
- Whether intra-group services have been provided, and
- What is the arm’s length price for those services
The Guidelines say that the arm’s length price for the service should be determined taking into consideration the perspectives of both the provider and the recipient. The service must be of value to the recipient and the price must be one that an independent party would be prepared to pay. The service provider would take account of the cost of providing the services, but this is not necessarily a determining factor in every case. All the facts and circumstances must be considered.
Comparable uncontrolled price (‘CUP’) or cost-plus (see INTM421030 onwards) are often likely to be the most appropriate method, determined in accordance with the guidance given in Chapters I-III of the OECD Guidelines, for testing the transfer pricing of intra-group services.
Have intra-group services been provided?
Consider whether a company has received (or extended) a service or the use of intangible property. The OECD Guidelines recognise that in some cases it can be very difficult to determine where the exact border lies between the licensing of intangible property and the provision of services. The distinction can be very important, as generally services would be priced in relation to their associated costs, whereas intellectual property may be paid for by way of royalty or other turnover-based fee. This may affect both the arm’s length price and the manner in which it would be calculated.
For example, a large multinational enterprise provides management services to third parties. The business is conducted in each geographical market by wholly owned subsidiaries. The parent company provides a number of auxiliary services to the subsidiaries, including use of the trade name, for which the subsidiaries pay a royalty/fee of 5% of their gross turnover under a licence agreement with the parent. In 2012, the UK subsidiary has a turnover of £200 million, and pays a royalty/fee of £10 million. A full review of all of the facts establishes that the actual cost to the parent of these services (excluding use of brand name) to the UK in 2012 was £2 million and that the UK company attracts most of its business because of the reputation of its own consultants. The business derived from the use of the trade name is not significant because the trade name is unknown in the UK and so the turnover fee is in reality charged in return for the auxiliary services. It is very unlikely that an independent party would be prepared to pay for this bundle of rights and services under a licence agreement involving a turnover-based fee. A cost-plus mechanism is on the facts of this case a better way of calculating the arm’s length price.
In cases where it’s established that the point at issue is the provision of services, the OECD Guidelines indicate it is not automatic that those services should necessarily be recharged. Even if an activity is carried out, or cost incurred; it does not naturally follow that intra-group services have been provided that should be recharged. It is it necessary to consider whether the service is one that provides the recipient with something of an economic or commercial value - which it would be prepared to pay for at arm’s length.
Would an independent company pay for the service?
Sometimes it will be easily apparent from the facts that a service has been performed which would be paid for at arm’s length. This will often be the case where the outcome of a service is easily identifiable. There will be other cases where the nature of the service is more difficult to ascertain, and the outcome not so easily defined.
Such cases can get more difficult to assess when the service is provided to a number of different subsidiaries, or to the group as a whole. Some instances will be fairly straightforward - for example a group may have contracted independent IT personnel to review the group’s computer system as part of a plan of anti-virus protection. The parent alone may have been charged by the third party. Since each subsidiary had actually received a review of its IT, a re-charge of the cost would appear appropriate. This recharge would amount to what an independent would pay for the service.
However, the arm’s length price becomes more difficult to judge if the facts show that a subsidiary had also paid a separate third party for a review of IT, or carried out one internally, and had no need of the service paid for by the parent.
Where such complexities become apparent, review the facts with these points in mind:
- What is being paid for?
- Would an independent pay for this?
Group companies will also obtain incidental benefits of belonging to a group such as, for example, a credit rating higher than it would otherwise have solely as a result of its affiliation (rather than due to a specific guarantee from another group member). Such benefits should not generally be recharged; they arise as the result of the subsidiary belonging to a larger group, not because a service has actually been provided.
Are the activities shareholder activities?
A business will be obliged to carry out particular activities and incur some expenses because of its responsibilities to its shareholders, or because of the parent company’s role as a shareholder in the subsidiaries. This type of expenditure should not be recharged. A third party would not require such services and so would not be prepared to pay for them. Examples quoted by the OECD Guidelines (at paragraph 7.10) include the cost of the juridical structure of the parent company (such as meetings of shareholders of the parent, issuing of shares in the parent and costs of the supervisory board); costs relating to the reporting requirements of the parent (such as producing consolidated accounts or other reports for shareholders); and raising funds to invest in its subsidiaries.
Any system put in place to facilitate the reporting requirements for shareholders will fall within the definition of shareholder costs. There can be difficult borderline cases within what the OECD Guidelines refer to as the ‘costs of managerial and control (monitoring) activities related to the management and protection of the investment as such in participations’ (participations being, in this context, subsidiaries). Such systems might perform more than just the shareholder reporting function, although these other benefits may be just incidental.
The test in all circumstances is whether the activity is one that an independent party, under comparable circumstances, would have paid for. This will always depend on the facts and circumstances of a case.
Incidental benefit or Deliberate concerted action?
The concepts of:
- ‘incidental benefit’ (paragraphs 1.158 and 7.12-7.13 of the Guidelines) or
- benefits arising to group members as a result of what is termed ‘deliberate concerted action’ (paragraphs 1.158-1.159 of the Guidelines)
are used in the Guidelines to distinguish between:
- benefits arising from the mere fact of group membership and, consequently, in respect of which no payment would be due from the group member or members benefitting to any other group member, or
- benefits arising to a group member or members from functions performed, assets used or risks assumed by another group member for which compensation would be paid at arm’s length
An example of ‘deliberate concerted action’ is where a group centralises purchasing in a single group company to take advantage of volume discounts derived from the combined purchasing power of all relevant group members. The centralisation of the purchasing might be structured in a number of different ways. For example, the company undertaking the negotiations with suppliers might either take legal title and/ or physical possession of the goods supplied and then transfer them to the relevant group members or, alternatively, might arrange for legal title to be passed and physical delivery to be made directly to the group members using the goods.
In both circumstances deliberate steps have been taken and the central purchasing company would be due an appropriate reward for the services it provides (which would be greater where it takes legal and physical possession of the goods given the greater functions and associated risks it thereby assumes). The balance of the volume discount achieved should be shared amongst the group members using the acquired goods in proportion to their contribution to achieving the volume discount (e.g., depending on the exact facts, by proportion to the relative volume of the goods they take).
Conversely, if a supplier offers a discount on purchases to a group member in the hope of attracting further business from the group, there would be no ‘deliberate concerted action’ but rather the group member concerned would have derived an incidental benefit from its group membership in respect of which no payment would be due to another group member.
The existence of synergistic benefits arising from deliberate concerted action and the quantification of such benefit arising to a particular group member plus the amount it would pay at arm’s length to the party or parties taking or co-pordinating that action can only be determined through a thorough comparability analysis (see INTM485021)
Services combined with other transactions
The facts may indicate that certain intra-group services are linked with the transfer of valuable intangible assets. For example, the grant of a licence agreement, under which valuable patent and know-how rights are made available to a subsidiary, may involve the provision of technical services, such as helping to set up a new manufacturing process. Such services would generally be covered under the payment of royalties. However licence agreements concluded between independent parties may put a limit on the services provided (e.g. by way of number of hours or man-days); any additional services would be subject to a separate charge.