Transfer pricing: Types of transactions: centrally provided services
Companies operating within a group will often provide services to other members of the group, for instance to gain economies of scale through the concentration of activities. Examples include centralised administrative functions and group payroll services. The provision of these services is subject to the same transfer pricing rules and principles as apply to any transaction between connected businesses. General guidance on transfer pricing for transactions involving services is given in INTM440060.
This specific guidance on centrally provided services complements the more general guidance. It aims to help businesses identify more readily the circumstances where it is clear that it is appropriate to use a cost-plus method (see INTM421060) to establish the arm’s length provision for some such services, in preference to the application of other transfer pricing methods where the simplified approach in respect of low value-adding services described at INTM440071 is either not appropriate or not adopted.
Where a cost-plus method is used, businesses will need to consider what mark up to apply to relevant costs. The extent of work done to establish an appropriate mark up should relate to the level of risk (as assessed by reference to guidance on risk assessment in INTM482020). If the tax risk is low, then businesses are not expected to devote significant time to this, and it is not anticipated that HMRC will seek to make marginal changes where a reasonable mark up is used and applied to an appropriate cost base.
Scope of this guidance
The basic premise of this guidance is that cost-plus methodology is particularly appropriate for routine low risk activity. It follows that only if all the following points are relevant to the case in question can this guidance be applied in respect of a particular transaction:
- Is a service being provided?
- If so is it a service that would be taken up if offered at arm’s length?
- Would the service receive a return at arm’s length?
- (For example, these conditions would not be satisfied if a service is routinely provided by a parent company to its subsidiaries, but is of limited benefit to a particular subsidiary, which would not have paid to obtain it in that form from a third party if the parent had not supplied the service.)
- If the service were provided by a third party, would it involve relatively low commercial risk and be likely to generate relatively modest margins of up to around 10%?
- (For example routine, administrative business support functions, such as payroll administration, which could be purchased as a “commodity” from an independent provider? High risk activities can not be added in and averaged out.)
- Is the service of a routine and administrative nature, very much ancillary, to the main business of the recipient?
- (i.e. the service assists the delivery of the service recipient’s business activity)
- The transaction is not a financial transaction - i.e. does not involve the provision of finance or financial instruments.
- (This condition is not intended to exclude, for example, administrative work relating to financial management or protection, for instance a group service operation providing accounts administration for group members.)
- The transaction is not an intellectual property transaction - i.e. it does not involve the creation, enhancement or transfer of intellectual property.
- (But this condition is not intended to exclude, for example, administrative work relating to the management of intellectual property, for instance a group service operation administering payment of trademark registration / renewal fees for group members).
- The transaction does not involve intra-group service provision made in relation to the long-term insurance fund of an insurance company in the circumstances described in paragraph 3.59 of the Life Assurance Manual (to which that guidance applies instead).
If the service provider supplies the service or similar services to independent third parties, it would be important to consider the potential applicability of the Comparable Uncontrolled Price method based on the price charged to third parties).
Use of the guidance
For transactions within its scope, this guidance can be used to establish an appropriate arm’s length result for the purposes of applying transfer pricing rules. However, the guidance is not meant to be prescriptive. Businesses may also use other appropriate approaches to establish an arm’s length result, drawing on the more general guidance on applying transfer pricing to the provision of services set out in INTM440060 and the OECD Transfer Pricing Guidelines referred to there.
Methods for estimating an arm’s length result
The service provider may either buy in the service supplied to the service recipient, or deliver it “in-house”. Methods that can be used to establish an arm’s length result in each of these circumstances are set out below.
For the purposes of applying the cost-plus method outlined in this guidance, the cost of supplying a service used should be the full cost including overheads, calculated on an absorption cost basis (not marginal cost). Where employees of the service provider deliver the service or part of it, the cost of their work should include an appropriate amount to cover overheads such as accommodation, staff management, personnel services, information technology services, etc.
Where one member of a group of companies (the service provider) buys in a service and supplies it to other members of the group (the service recipient), then there are two components of the service cost, the cost of purchasing the service from the independent third party, and the service provider’s own costs (eg to manage the contract with the third party and administer provision of the service to the service recipients).
In calculating an arm’s length result, it should not generally be necessary to add a mark up to the element of overall cost relating to the cost of purchasing the service from the independent party, if the service is provided on a basis that is representative, in commercial terms, of the original purchase. (This is because the original purchase will have been made on an arm’s length basis and the independent third party can be expected to have already included a profit element in their prices).
Where significant work is undertaken by the service provider to commission the supply of the service from the independent party and oversee the delivery of the service to the service recipient, then the arm’s length result should also take account of this work. This part of the provision can be calculated on a cost-plus basis, taking the cost of undertaking this work as the starting point, and adding an appropriate, modest, mark up to reflect the profit that an independent third party could be expected to earn undertaking this work for the service recipient.
“In-house” service delivery
The provision for “in-house” work to deliver services within the scope of this guidance can be based on a cost-plus method, taking the cost of providing the service as the starting point with an appropriate, modest, mark up to reflect the profit that an independent party could be expected to earn for delivering a comparable service to the service recipient.
Allocation between multiple service recipients
Where more than one recipient is receiving a service, the arm’s length result for the supply of the service may need to be arrived at by allocating an overall amount between the recipients (for example where a parent company buys in a service and provides it to a number of subsidiaries). Any service provision that would not, or could not be provided between independent parties should be disregarded for this purpose (e.g. superfluous service provision that the recipient does not need or derive business benefit from)
If possible, a direct charge method should be used, relating to the provision of the service to each recipient.
If this is not practicable, then it may be necessary to use an indirect charge method, i.e. to use an allocation key that provides a reasonable proxy for the sharing out the value of the service. For example, if the level, intensity, type and quality of service delivered to different recipients is similar and the volume of service correlates relatively well with the benefit derived by the service recipients, then each recipient’s share of the volume of service delivery could be used to allocate the total cost and mark up between service recipients.
The aim is for the allocation to relate as closely as is reasonable to the relative benefit derived by each service recipient. If the tax risk is low, then businesses are not expected to devote significant time to this, and it is not anticipated that HMRC will seek to make marginal changes where a reasonable allocation is made.
Cost contribution arrangements
These types of arrangements can be extremely varied and as such fall outside the scope of this particular guidance. The OECD Transfer Pricing Guidelines give detailed guidance on cost contribution agreements and transfer pricing (see INTM421090).
Continuity and consistency
Where a cost-plus method is used on the basis of this guidance, the same approach, including the same mark up, can be used from year to year, unless there is a significant change in circumstances.
The basis on which an arm’s length result is calculated should be consistent across all intra-group supply of a service, and for the supply of services in both directions between two members of a group. For example, where a cost-plus method is used, any difference in the mark up applied in relation to the supply of the service to two different members of a group would need to be justified by reference differences that would exist if the service provider was an independent third party.
Separate guidance on risk assessment in INTM482000 onwards sets out the general principles that will guide HMRC when considering whether to initiate a transfer pricing enquiry. In relation to use of this guidance, specific factors that could influence decisions on initiating enquiries where significant tax is at stake include: quoting this guidance in respect of the supply of services outside the scope of the guidance; inconsistent application of the guidance within a group; and use of mark ups that are clearly inappropriate.
The guidance on transfer pricing documentation at INTM483030 that a business “should prepare and retain such documentation as is reasonable given the nature, size and complexity of the business”.
For the supply of services within the scope of this guidance, application of this guidance would generally constitute a “reasonable attempt” to demonstrate an “arm’s length” result, providing that where a cost-plus method is applied there is a reasonable basis for setting the mark up used and making any allocation between multiple service recipients.