1. Background : The previous article specified the criteria to determine whether an intra-group service has been rendered by a related entity. Once it has been concluded that a service has been rendered, the second of the two primary issues pertaining to intra-group services needs to be addressed, namely, the amount to be charged for the service rendered. This is in line with the fundamental concept of transfer pricing (i.e., the arm’s-length principle). In other words, a charge for intra-group services between related parties should reflect the charge that would have been made and accepted between independent enterprises in comparable circumstances.
2. Benchmarking the intra-group management fee charge:
As regards the selection of the most appropriate method for benchmarking an intra-group management fee charge, it may be noted that the OECD Guidelines indicate that the transfer pricing methods which can be used to determine an arm’s-length transfer price for intra-group services could include the comparable uncontrolled price (CUP) method and the cost-plus method.2 Sub-classifications of the cost-plus method are the direct charge method and the indirect charge method.
2.1 Comparable uncontrolled price method3 :
The CUP method compares the price charged for services rendered in a controlled transaction with the price charged for similar services rendered in a comparable uncontrolled transaction under comparable circumstances.4
In practice, services in the nature of intra-group support services generally may not be rendered by the group service provider to any third parties in India or abroad, nor would similar services under similar circumstances be procured by the group service recipient from any third parties in India or abroad. This is mainly because of the very nature of intra-group services, in that they are in the nature of support services which the group service provider would render only to the entities within the group. Consequently, in general, no internal comparables may be available in practice.
Moreover, regard being had to the nature of intra-group services generally provided, it might also be difficult to procure external comparables from the public domain. Also in the context of intra-group services, as services rendered by the overseas parent are generally in the nature of support services, the CUP method would not be the most appropriate method. Consequently, in the absence of internal or external comparables, the CUP method is generally not selected as the most appropriate method from a transfer pricing perspective for analysing the arm’s-length nature of transactions involving intra-group services.
2.2 Cost-plus method5 :
The cost plus method tests the arm’s-length nature of a transfer price in a controlled transaction by reference to the gross profit mark-up (e.g., gross profits divided by cost of rendering services) realised in a comparable uncontrolled transaction.
Given the facts that details about internal or external transactions may not be available for the application of the CUP method, and the costs incurred by the parent/group service provider inasmuch as are attributable to its subsidiary/service recipient may be easily identified or computed, and given the fact that details of margins of comparable companies from transfer pricing databases would generally be available, the total cost-plus method would, in practice, be the most appropriate method to benchmark intra-group service transactions.
As mentioned earlier, there are two variants of the cost-plus method — the direct charge method and the indirect charge method.
2.2.1 Direct charge method :
Under the direct charge method, associated enterprises are charged for specific services. For example, the overseas subsidiary may be directly charged for a two-day visit of a software engineer who is on the roll of the parent company and who may have visited the overseas subsidiary’s site at the latter’s request to render certain consultancy or advisory services. In such a case, the parent company can charge the specific costs for these consulting services with or without a profit mark-up (as the case may be), directly to the overseas subsidiary. A third party would also, in all probability, proceed in this way under similar conditions and circumstances.
The direct charge method is applicable primarily when services can be specifically identified for cost attribution. In such circumstances, the expenses of the specific support group responsible for the service rendered can be directly attributed to the services rendered (for example, in terms of hours, travel expenses, etc.).
2.2.2 Indirect charge method :
The indirect charge method is appropriate when the services provided and the costs attributable thereto relate to a number of different entities. For example, there may be situations when an MNE cannot attribute direct costs either because the associated costs of a service rendered are not easily identifiable or the costs are incorporated into other transactions between the related entities. In those circumstances, a cost allocation or apportionment method is used which often necessitates a degree of estimation or approximation. Essentially, the relevant controlled transactions may be aggregated if it is impractical to analyse the pricing or profits of each individual transaction, or if such transactions are so interrelated that this is the most reliable method of benchmark-ing the transactions against the arm’s-length outcome. An appropriate allocation and apportionment of costs incurred by the group member in rendering the service to a specific affiliate should be commensurate with the quantum of the service rendered.
2.2.3 Which method is appropriate — direct charge or indirect charge ?
From the above, it can be inferred that the direct charge method should be preferred over the indirect charge method in cases where the services rendered by the taxpayer to other group members :
- are the same or similar to those rendered to unrelated parties; or
- can be reasonably identified and quantified.
However, in cases where a particular service has been provided to a number of non-arm’s-length parties and the portion of the value of the service directly attributable to each of the parties cannot be determined, it is possible to use the indirect charge method.
2.2.4 Identifying the cost base for the indirect charge method :
For application of the indirect charge method, it becomes necessary to ascertain the chargeable cost base. In this regard, it is necessary to take all costs directly or indirectly related to the services performed.
2.2.5 Apportioning expenses included in the cost base and selecting the appropriate allocation key :
Having identified the cost base, the next issue to be addressed is that of apportioning the cost among various service recipients.
There is no specific method or formula specified for allocating the centralised costs incurred. Therefore, if the portion of the value of the service directly attributable to each of the service recipients cannot be determined (e.g., where global advertisement campaign is intended to benefit all the related entities), an appropriate allocation key is used to allocate the costs. Charges for services rendered are determined by allocating those costs across all potential beneficiaries using an appropriate allocation key. Even the tax authorities would be interested in assessing the arm’s-length nature of the allocation criterion, since the indirect allocation method is open to possible manipulation and is highly dependent on the nature and usage of the intra-group services. Hence, it becomes imperative to select the proper allocation key.
The choice of the allocation key should be made by giving due consideration to the nature of the service involved and the use to which it is put. Some examples of allocation keys are as under :
- allocation of department costs based on sales of the group;
- time spent by employees performing intra-group services;
- units produced or sold;
- number of employees;
- total expenses;
- space used;
- capital invested;
- asset quantum; and
- a combination of the above.
When choosing an allocation key, the taxpayer should consider the nature of the services and the use to which the services are put. For example, if the services relate to human resource activities, the proportionate number of employees may be the best measure of the benefit to each group member.
2.3 Mark-up on costs :
2.3.1 Generally :
Having identified the cost base and the basis of allocation to various group companies, the issue of marking up costs is the next issue in any transfer pricing analysis for intra-group services. This is because, depending on the facts and circumstances, the tax authorities in the foreign subsidiary’s country of residence may not allow a mark-up on costs unless it is adequately substantiated. Similarly, there may be issues in the home country of the service provider if no mark up is charged on value added services. Therefore, the costs incurred for the provision of intra-group services needs to be properly examined with a view to determining whether a mark-up on the cost base is justifiable.
Based on the international tax practice generally followed, it may be noted that determining whether a mark-up is appropriate and, where appropriate, what should be the quantum of the mark-up, require careful consideration of factors such as :
- the nature of the activity and the services rendered;
- the significance of the activity to the group;
- the functional profiling and the characterisation of the intra-group transactions involved;
- the relative efficiency of the service supplier; and
- any advantage that the activity creates for the group.
Mark-ups on costs should be applied, if at all, only after taking into account all the facts and circumstances surrounding the provision of intra-group services. Wherever the mark-up is applicable, it must be substantiated as being at arm’s length with a thorough analysis of arm’s-length comparables.
2.3.2 Benchmarking the mark-up :
In the case of certain value-added activities where a mark-up needs to be charged, the question arises as to how to compute the mark-up on such services. Determining whether a mark-up is appropriate and, where applicable, the quantum of the mark-up requires careful consideration of the factors referred above.
To determine the mark-up, one would have to run a search on a transfer pricing database that deals with financial details of potentially comparable companies. The objective of the search is to identify potentially comparable companies that render similar services and to ascertain the margins of such comparable companies. Such comparable margins could then be used as a benchmark for the mark-up on the intra-group services within an MNE. Generally, the appropriate comparables for such inter-company services should be third parties that offer services with similar risk profile and intangibles.
However, it may also be noted that transfer pricing is not an exact science and therefore, more often than not, the application of the most appropriate method or methods and the database search would produce a range of figures, all of which are relatively equally reliable. Therefore, the actual determination of the arm’s-length price based on arm’s-length margins would necessarily require exercise of good judgment.
3. Documentation :
In addition to the documentation requirement discussed in the earlier issue of this article (which primarily dealt with the documentation required to demonstrate the actual rendition/receipt of intra-group services and fulfilment of the benefit test), additional documentation which must be maintained to demonstrate the arm’s-length nature of the intra-group service charge is discussed hereunder.
Although the documentation to be maintained in each specific case must be determined based on all the facts and circumstances, at a minimum, it is generally advisable that the following documentation be maintained on file in relation to the arm’s-length nature of the management fee charge :
- the documentation that the service provider undertakes to supply in support of justification of the fee for the services rendered, e.g., copies of time sheets or cost centre reports;
- detailed fee accounts or invoices from the payee which include (1) full details of services rendered over the period covered by the charge, (2) confirmation that the fee calculation agrees with the service contract, and (3) any other documents supplied by the payee, which support the amount of the charge. In particular, any substantiating documentation which must be tendered in accordance with the contract of services;
- a certificate from a CPA, if possible, certifying (1) the viability of the method for allocation and apportionment of costs among subsidiaries, and (2) the authenticity of the cost apportioned to each entity;
- as noted above, where a fixed key is used under the indirect charge method, it is important to substantiate the cost basis and to have details on file to show which costs have been included/ excluded with a fixed-key method;
- where a mark-up has been charged by the service provider, and a benchmarking search has been carried out on the transfer pricing databases for finding potentially comparable companies, the following should form part of the documentation maintained :
- description of the database, along with the limitations of the database, if any;
- detailed description of the process used to search for potentially comparable companies on the database;
- details of filters, qualitative or quantitative, applied to shortlist closely comparable companies;
- criteria used to accept/reject potentially comparable companies found on the database;
- precise reasons for accepting/rejecting the comparable companies;
- adjustments, if any, made to account for differences between the functions performed, risks borne and assets employed by the comparable companies and the margins earned by the entity providing intra-group management services;
- sensitivity analysis, if any, carried out in respect of these margins; and
- actual workings of the margins of comparable companies, and the application of the margins of comparable companies to the transaction in question.
All in all, it can be noted that robust documentation is a pre-requisite for demonstrating the arm’s-length nature of the intra-group service charge.
4. Other issues impacting management fee policies in an international context :
Besides the above transfer pricing-related issues, there are also other issues which merit consideration while designing management fees policy from an international tax perspective. These include :
- Applicability of Service Tax on the management fee charge
- Applicability of VAT on the management fee charge in the foreign country
- Constitution of a ‘Service PE’ under the tax treaty by virtue of services being rendered by employees or other personnel beyond a certain threshold (or even irrespective of a threshold in some of India’s tax treaties)
- Withholding tax implications.
5. Conclusion :
Globally, tax authorities have adopted an increasingly proactive and more sophisticated approach to examining transfer pricing policies in respect of intra-group support services. The Indian tax authorities have already taken a cue from them and are following a similar and aggressive approach while examining intra-group services, especially when an Indian company is the recipient of services and management fee charge. Accordingly, Indian MNEs with subsidiaries abroad, and more importantly, foreign MNEs operating in India, are well advised to contemporaneously document their intra-group arrangements and practices in respect of support services, so as to prepare in advance for an inevitable transfer pricing examination. Because intra-group services are regarded by many as one of the most likely areas to be examined by the transfer pricing authorities, taxpayers that have not performed the necessary analysis and maintained adequate documentation run the definite risk of being audited (with the possible result that their income will be reassessed by those same authorities).
Experience shows that while formulating an intra-group transfer pricing strategy, many MNEs fail to work out the overall business strategy in tandem with various other pertinent international tax planning considerations. Formulating a comprehensive transfer pricing strategy for intra-group service transactions also requires a well-founded understanding of various international tax planning principles, detailed knowledge of applicable tax treaties, as well as a thorough understanding of the laws and practices in the home and host countries. The overall message is that it is imperative to consider all of these factors in the course of designing a proper intra-group management policy.
All in all, the best strategy for any MNE having intra-group service transactions is to formulate the intra-group management fee policy (with the help of transfer pricing experts) in sync with the overall objectives of the group, taking into account various tax and non-tax considerations; and maintaining adequate documentation to present the best possible defence before tax and transfer pricing authorities of the home and host countries !
Author/s : Maulik Doshi, Gaurav Shah
Chartered Accountants
Very well explained. Good Job.