BENCHMARKING INTRA-GROUP SERVICES USING INDIRECT CHARGE METHOD

BENCHMARKING INTRA-GROUP SERVICES USING INDIRECT CHARGE METHOD

In a global business environment, multinational companies provide services group widely. These services need to be remunerated in line with the arm’s length principle. Tax authorities worldwide have been challenging intercompany charging arrangements. The reason for this is that such charges can potentially result in erosion of the local country tax base. The approach to deal with transfer pricing (TP) aspects of such arrangements has also been discussed in the OECD/ G20 BEPS project under Actions 8-10 in the context of “low value-adding intra-group services”.

In recent years, the appropriate treatment of the intra group provision of services has become a critical transfer pricing issue in India. Recent TP audit experiences have shown an increased and intense focus by the Indian tax authority on TP aspects of intra group services. The approach of the tax authority has been to make a detailed enquiry into the nature of the services, the organizational structure of the Indian entity, the value of the services, the determination of costs, the benefit received by the Indian affiliate, the allocation key adopted and the methodology chosen to defend the payment. Taxpayers are typically asked to describe the activities undertaken by the foreign affiliates and are also asked to quantify the time spent in India. The nature and extent of enquiry is likely to put an onerous burden on most taxpayers, as documentation of these categories of transactions often lags behind documentation for tangible goods transactions. This has resulted in making the already challenging Indian TP audit process even more difficult to manage. Absence of specific TP rules in India dealing with intra group services and the controversial nature of some of the issues is likely to result in complex and monetarily significant TP disputes and risks of double taxation.

An issue which arises in the context of allocation of intra group services relates to the use of direct v indirect charge method. The OECD TP Guidelines recommends a direct charging mechanism wherever possible. that is all services rendered to group companies being directly attributable should be charged based on a service-level agreement that specifically defines the service provider, the service recipient, the nature of the services provided, the risks involved and the remuneration scheme applied. However, in many cases a direct charging mechanism is not possible or may result in extreme administrative costs. In such cases, an indirect charging method maybe applied. Before applying an indirect service charge, all other direct services must be identified and excluded from the cost base. The remaining (residual) costs are then allocated to the group companies under the management service fee scheme. However, the indirect charging method may be accompanied by some significant tax risks.

The OECD Guidelines work fine for groups consisting of more or less homogeneous service recipients. Assuming a headquarters having a manufacturing plant and sales hubs (subsidiaries) all over Asia, a charging mechanism following the OECD guidance should be defensible.

In contrast, many problems occur with heterogeneous groups and different business structures in many countries. Assume a group having different operating plants, trading/ distribution centres, procurement offices of varying maturity all over Asia. In such case, the charging mechanism might lead to some difficulties due to the fact that the range of services rendered to the entities may range from no services required to providing full support services. An allocation key that is feasible for one part of the business may not fit other parts of the business. In the example with plants and trading activities, an allocation key such as net operating assets would result in a significant charge to the plants but lead to a reduced charge for trading activities. To cover all the different business lines and structures in the various countries, an even more sophisticated set of allocation keys will likely have to be considered. This results from residual costs being allocated indirectly via different allocation keys.

Problems arise from a local perspective for the receiving entity. Only some services have been rendered due to the business structure, but all services have been invoiced on a pro rata basis. In this case the tax authorities could argue that the services have not been effectively rendered and therefore are not tax deductible at the level of the receiving entity. There is a significant risk of ending up with non-deductible costs locally, as well as the accompanying potential double taxation at the group level, as local tax authorities usually call for a so-called “benefit test” at the level of the receiving entity.

In a recent ruling, the Kolkata Bench of the Income-tax Appellate Tribunal in the case of Nalco India Ltd deleted a TP adjustment in respect of intra group service payments made by the taxpayer to its Singapore based Associated Enterprise (AE) at 2% of net sales for each calendar year. In this case, the Singapore AE operated as the regional headquarters company in relation to the group of companies, including the taxpayer. The intra-group service charge was calculated at a fixed percentage of sales of the taxpayer, irrespective of which services were actually received by taxpayer or whether any services were received by it or not. The Tribunal upheld the method of allocation as akin to the indirect charge mechanism approved under the OECD guidelines.

While the Tribunal’s acceptance of the indirect charge method and reliance on the OECD guidelines is welcome, the ruling raises a question on appropriate compensation mechanism under the indirect charge method. The arm’s length charge for services (including centralised services) is often determined by using the cost plus method. However, where the service provider has unique skills or special expertise that is made available to group members, and the value of that expertise is not fully reflected in the cost of providing services, one might often need to consider a mechanism which reflects the expected value to the recipient of the specialised services.

There may be cost savings to be made by a group in centralizing some functions. In such cases, the charge mechanism may need to consider the service provider’s ability to retain the benefit of the cost savings. While upholding the indirect charge method the Tribunal seems to have implicitly recognised the concept of a “value based service fee” and that the indirect charge method can also include such a fee. In the taxpayer’s case the service charge was linked to the net sales made by the service recipient of each year, regardless of the costs incurred by the service provider in performing the service. The Tribunal decision does not however address the crucial question on the comparability analysis which is required to support the arm’s length nature of the “value-based” charge. In case a taxpayer is not able to identify comparable uncontrolled transactions to support a value based charge, a more complex methodology such as contribution analysis may be required.

Global business includes significant cross-border transactions. This also covers intra-group services which in many cases cannot be charged directly to the service recipients. The OECD provides some guidance regarding how to handle these indirect charging schemes. However, the OECD guidance does not address the necessary details. When an indirect charge method is used, the relationship between the charge and the services provided may be obscured and it may be difficult to evaluate the benefit provided. Indeed, it may mean that the enterprise being charged for a service itself has not related the charge to the service. There is a conflict between the general acceptance of an indirect charging method and the request from local tax authorities to provide evidence on a single-service basis. As always in TP, intercompany dealings must be considered from both sides of the transaction. Taxpayers may need to tailor their global TP platform for analysis of intra group service transactions to local requirements in view of the higher risk of scrutiny. Taxpayers should look at developing an integrated global and local approach to documentation, prepare for an intensive TP audit on these types of transactions in advance by building a TP defense file based on the information/documents that may be requested during an audit and consider a more proactive approach to controversy management and dispute resolution early in the life cycle of an audit.