Article
1.0 Introduction :
One of the most widely contested issues by Indian tax
authorities during a transfer pricing audit is the amount paid for intra-group
services to group companies often referred to as management or intra-group
fees/charges. In fact, compensation for intra-group services has been one of the
important transfer pricing challenges globally for taxpayer and authorities
alike.
At the same time, management fees can be one of the more
important and legitimate tax planning tools for effectively lowering taxable
income in a particular tax jurisdiction, if it is structured in a proper manner.
Hence it is obvious that tax authorities look at this mechanism as a profit
extraction technique and adopt a strict posture while investigating the
inter-company affairs. Further it is imperative that the Multinational
Enterprise (MNE) group which is formulating an intra-group management fee
policy, must consider the tax implications in both the jurisdictions. It is also
equally important to consider other aspects such as withholding tax, indirect
tax levies, international tax and regulatory issues while formulating an
intra-group management fee policy.
This article (in two parts) seeks to outline certain key
aspects that need to be considered while formulating a management fee policy and
also the broad approach to be followed in this regard. The analysis here is
mainly from an Indian perspective (i.e., mainly with reference to a
foreign MNE proposing to charge management fees to its Indian group company to
which support services are rendered, and also with reference to an Indian MNE
proposing to charge management fees to its overseas group companies). At various
places, the article also highlights the practical approach currently being
followed by the Indian tax authorities and issues encountered by taxpayers based
on transfer pricing assessments recently completed.
There is no specific mention of intra-group services (though
there is for cost sharing arrangements) in Indian transfer pricing provisions [i.e.,
S. 92 of the Income-tax Act, 1961 (ITA)]. The law is still emerging in India and
therefore reliance is also placed on, and useful inferences have been drawn
from, the international tax practices followed in some other developed
countries, along with the OECD Transfer Pricing Guidelines (OECD Guidelines)1
and the Guidance Note of the Institute of Chartered Accountants of India on
transfer pricing.
2.0 Concept of intra-group services and management fees :
An intra-group service is a service performed by one member
of a multinational group for the benefit of one or more group companies. The
intra-group services may be performed by a parent company or a sister company
for any one or more of the group companies. In a transfer pricing context, such
intra-group services become significant when they are rendered to related
parties located in different tax jurisdictions.
The OECD Guidelines state that generally every MNE group
arranges for a broad range of services to be available to its members, in
particular, administrative, technical, financial and commercial services. Such
services may include management, coordination and control functions for the
entire group.2 In
essence, intra-group services encompass a broad range of services that can
potentially be provided by the parent/group company to another group company (or
across group companies). In general, the categories of services that could be
regarded as intra-group services include the following :
- coordination, control and administrative services;
- research and development;
- purchasing, marketing and distribution;
- staff & HR related matters, such as recruitment and training;
- other commercial services that typically can be provided with regard to the
nature of the MNE’s business.
Some of the intra-group services (basic administrative,
financial or support services) could be referred to as routine in nature. The
identification and treatment of these services are generally straightforward and
simple. However, the issue of charging for services may become complex as the
nature of services moves from routine to more sophisticated.
3.0 Broad parameters for designing a policy for charging for intra-group
services :
Considering the importance of charging arm’s-length management fees from the perspective of both the service provider and the service recipient, the basic principles involved in designing a management fee policy are discussed here. Broadly speaking, the OECD Guidelines” outline two main issues that should be addressed when evaluating intra-group services in the context of transfer pricing, namely:
- determining whether the activities undertaken by a parent company or group service centre genuinely constitute intra-group services (i.e., whether the payer is receiving a benefit); and
- how to determine an arm’s-length consideration for such services (in accordance with the benefit received).
3.1 Determining whether intra-group services have been rendered:
The OECD Guidelines provide a basis to determine whether a service has been rendered. The OECD Guidelines broadly state that when one group member performs an activity for one or more group members, it will be regarded as a service rendered if and only if the activity provides the respective group member with economic or commercial value that might conceivably enhance the recipient’s commercial position.’ It also provides another simple way to ensure that a legitimate service is being rendered by considering whether an independent enterprise in similar circumstances would be willing to pay for the same service conducted by another independent entity or whether it would perform that service in-house. In other words, the OECD Guidelines are based on the principle of willingness to pay for an activity from an independent enterprise vis-a-vis performing it in-house. Simply stated, if the activity is not one for which the independent enterprise would have been willing to payor perform for itself, the activity ordinarily should not be regarded as a chargeable intra-group service under the arm’s-length principle.
The US regulations u/ s.482 of the Internal Revenue Code (US regulations) are also based on the same lines. Similarly, the position of the Australian Tax Office (ATO) with regard to head office activities is that services are chargeable only when the activity has conferred a benefit to an assessee. The ATO also takes the view that where a benefit is provided to an entity by way of a service and there is a real connection between the entity’s operations and the associate, the entity would be expected to pay for the services.
This test involving a willingness to payor existence of a benefit (benefit rule), as enunciated above is, by far, the most important factor that determines whether a related-party service recipient would pay for an intra-group service and, therefore, in turn, whether the service provider can justify a charge for the provision of the intra-group services. The objec-tive of the benefit rule is not only to determine the quantum of benefit, but also the relative proximity of the benefit derived to the intra-group services rendered. Therefore, one should determine how direct or remote the benefits derived are in relation to the activity performed under the guise of intra-group services. A direct or perceived benefit from the service rendered must be identified. Conse-quently, allocations are not to be made if the prob-able benefit to other members is so indirect or re-mote that unrelated parties would not have ‘charged for similar services.
Further, such management fee charge is to be consistent and commensurate with the relevant benefits intended for the services, based on the facts known when the services were rendered, and not based on benefits realised later on. In other words, the use of hindsight is to be avoided.
Consequently at a practical level, with a view to determining whether intra-group services have been rendered, each service must be evaluated on the basis of whether it provides a group member with economic or commercial value that enhances its commercial position in the market where it operates.
This is also relevant because certain services are not chargeable at all. The OECD Guidelines identify certain services or activities that are deemed to be non-beneficial for the recipient. As a result, those activities cannot be regarded as chargeable intra-group services. The main categories of non-beneficial services identified in the OECD Guidelines are:
- shareholder/custodial activities;
- stewardship / duplicative services;
- services that provide incidental benefits;
- passive association benefits; and
- on-call services.
The same are briefly discussed hereunder:
3.1.1 Shareholder services/Custodial activities:
Shareholder activities are regarded as activities that a group member performs solely because of its ownership interest in one or more of the group members (in its capacity as a shareholder). Such an activity may be performed by one group member for related group members, even though those members do not need the activity and would not be willing to pay for it if it were performed by an independent enterprise. Consequently, under the OECD Guidelines, this type of shareholder activity would not justify a charge to the recipient company.
On reading of OECD Guidelines, the Canadian Regulations, and the US Regulations, an illustrative list of services/ costs that are regarded as share-holder activities are mentioned below :
- costs of activities relating to the legal structure of the parent company and include expenses associated with the issuance of stock and maintenance of shareholder relations (e.g., costs of issuing shares, share transfer expenses, meetings of shareholders and costs of the supervisory board);
- costs relating to the reporting and legal requirements of the parent company (e.g., consolidation of financial reports, maintenance of shareholder records, filings of prospectuses and income tax returns);
- costs incurred by a parent company to raise funds for acquisition of a new company in its own rights;
- costs of managerial and control (monitoring) activities related to the management and protection of the investment as such in participations;
- costs of visits and reviewing subsidiary performance on a regular basis; and
- costs of financing or refinancing the parent’s ownership participation in the subsidiary.
However, merely because an activity has been per-formed for the benefit of the owner does not, per se, mean that it is a shareholder activity for which an allocation is not warranted. This is because there may be activities performed for the interest of the owner, which conform to the shareholder activity definition provided in the OECD Guidelines, but which could nevertheless be regarded as chargeable based on surrounding facts and circumstances of the case. In such cases, the OECD Guidelines advise that whether the activities fall within the definition of shareholder activities as defined in the OECD Guidelines is to be determined based on whether under comparable facts and circumstances, the activity is one that an independent enterprise would have been willing to pay for or to perform for itself.
3.1.2 Duplicative Services:
Duplicative services or stewardship services are those that a group member offers to any other member, which can be considered duplicate in the sense that the service is already performed by the recipient or by a third, unrelated party on its behalf. In that case, no intra-group services should be considered to be rendered by the group member.
Such stewardship or duplicative expenses are illustrated in the US Regulations in the context of a financial analysis for a subsidiary’s borrowing needs. When the subsidiary does not have personnel qualified to make the analysis, and does not make the analysis, the cost of the financial analysis done by the parent is required to be allocated to the subsidiary. If, however, the subsidiary has qualified financial staff that makes the analysis, the review of the analysis by the parent’s financial staff is duplicative and an allocation of such costs is not to be made to the subsidiary in such cases.
However, at the same time, it is also recognised that there may be some exceptions, i.e., a temporary circumstance or an opportunity to eliminate critical business risk. The instances of elimination of critical business risk would come into play, for example, while taking a second legal opinion or performing an external audit to avoid a risky or wrong business decision. In other words, when a valid business reason exists, those duplicate services may be considered intra-group services eligible for a management fee payment.
3.1.3 Services that provide incidental benefits:
The OECD Guidelines highlight another set of services which do not warrant an allocation – namely, services that result in an ‘incidental benefit’. This refers to services performed by one group member, such as a shareholder or coordinating centre, for a particular group member or a set of group members, such that it also incidentally provides a benefit to other group members.
To illustrate, a situation of reorganisation decision or acquisition/ disinvestment deal being carried out by a parent or a sister company results in economies of scale or some other benefit for some other group member not directly involved in the process/deal. In this case, though there is a service element, the same cannot be charged for since it only provides indirect benefit.
3.1.4 Passive association benefit:
This is another category of activities that does not justify an allocation under the benefit test. A mere ‘status as a member of a controlled group’ in case of a taxpayer generally will not be considered as adequate to justify provision of a benefit to the tax-payer for which an arm’s-length charge or allocation will be required.. ,
For example, an enterprise deriving incidental benefits simply because of its affiliation with the parent or the group per se; like in the form of a higher credit rating cannot be said to be receiving a service and does not warrant a management fee payment. However, if the higher credit rating is due to a guarantee provided by a group member, then an intra-group service charge would be required”.
3.1.4 On-call services:
The OECD Guidelines refer to another category of services in the context of intra-group services, i.e., services provided ‘on-call”. The availability of those services generally requires the existence of a support group of some sort and an understanding between the group members about the nature of the assistance being provided in any field of operation whenever required and on an on-call basis. For example, a parent company or a group service centre may be on-hand (always ready/prepared) to provide assistance in matters of legal, finance, technicalor tax issues at any time.
The aspect that merits consideration here is whether the ‘availability’ of that service in itself is considered as a separate service (for chargeability) over and above the service fee compensation for the actual service rendered. The justification provided in the OECD Guidelines for considering such availability as a separate service rendered is that it is common knowledge that independent enterprises incur so-called ‘stand-by charges’ to ensure availability of those services when the need for them arises. An example of that service is the appointment of any legal, technical or financial service provider on a ‘retainer basis’.
These services are not necessarily a regular requirement and may vary in terms of frequency and importance from year to year. Therefore, one must ascertain the potential need of the stand-by service option for the recipient of the service. In cases in which the service requirement is remote or could be easily procured from other sources without an ‘on-call’ service option, the availability of that option is redundant and, hence, unjustified. Therefore, to evaluate whether an ‘on-call’ service is rendered, one must consider the benefit that the’ on-call’ arrangement offers to the group over a period of several years (given the sporadic nature of the occurrence of those service needs), rather than only for the year of taxation under consideration).
In sum, it would be necessary to justify intra-group services from the point of view of an independent enterprise and whether that enterprise would be willing to pay for the service in question or perform the same service in-house.
Also, special attention and close scrutiny should be paid to certain non-chargeable categories of services such as the shareholder activities, duplicative services, services providing incidental benefits, passive association benefits and on-call services as the OECD Guidelines (and perhaps even the laws of the overseas countries of the subsidiaries of Indian MNE) regard above-referred services as non-beneficial activities for the recipient entity, for which a charge is not justified.
Having discussed the nature of services for which the charge is required, the second aspect that is equally important is how to determine an arm’s-length consideration for such services (in accordance with the benefit received). This aspect would be discussed in detail in the second part of this article.
4.0 Documentation to justify that the services are rendered and benefits accrue to the service recipient:
The documentation process for intra-group services is vitally important to establish before the tax authorities the legitimacy of any intra-group service charges, including management fees. Even though the Indian regulation has prescribed detailed transfer pricing documentation requirements in general, no specific guidance has been given in the context of intra-group services. However, it would not be correct to assume that a taxpayer does not have to prepare the necessary documentation to substantiate any and all intra-group charges within an MNE. Further, it is pertinent to note that under the Indian regulations, the primary onus to prove that the international transactions are at arm’s length is on the taxpayer and the tax authorities have powers to make appropriate adjustments where such onus is not adequately discharged by the taxpayer.
Also, mere existence of services agreement or invoice would not be sufficient to justify the arm’s-length nature of management fee charge. Neither do the service agreement nor the invoice demonstrate that the services are actually rendered and the recipient has benefited from such services.
The most important and crucial aspect is the documentation of the fact that intra-group services were rendered by the service provider and the benefits were received by the service recipient. Thus, apart from documenting the aspects such as description of the business operations of the group and the tax-payer, detailed analysis of functions performed, assets employed and risk assumed, etc. which are mentioned in S. 92D read with Rule LOf), one must demonstrate that the service recipient benefited from the provision of the intra-group service and the same must be proved beyond reasonable doubt”.
The following documents would be useful in demonstrating that the services were actually rendered and benefits were received by the taxpayer:
- A written, binding service contract between the companies which shall include details of the group companies providing and receiving management services; detailed nature and extent of services to be provided; basis for determining the fees to be charged; etc. The description of the services in the service contract assumes significance. If the description of the services to be provided appears incomplete, unclear and dis-jointed in the contract or if the description is entirely missing, the tax authorities could dispute the arm’s-length nature of services.
- A detailed narrative of the services actually rendered during the year under consideration along with documents such as copies of time sheets or cost centre reports, etc. to demonstrate the services rendered. Other documentation could also include letters, manuals, instructions, proof of visits, written advice, periodic activity reports and any other documents or data which tend to confirm that the services were rendered for the benefit of the recipient and are justifiable on an ‘arm’s-length’ basis.
- A detailed narrative of benefits received; examples to illustrate those benefits; supporting documentation, to establish the existence of a benefit like correspondence, memoranda, manual, directives, etc., indicating a benefit to the recipient of the intra-group service; job descriptions of staff at the service provider and the recipient to identify services and to prove that there is no duplication of services, etc.
In fact, the Indian tax authorities are insisting on some of the above documents during the course of transfer pricing assessment in order to satisfy themselves of the arm’s-length nature of management fee charges. In cases where the taxpayer fails to furnish the requisite documentation, the tax authorities have been disallowing the entire management fee charge by treating the arm’s length value of the said management fee paid as Nil. In contrast, the US and Canadian IRS have adopted an increasingly proactive and more sophisticated approach towards examining transfer pricing policies in respect of intra-group support services.
Concluding remarks:
In the realm of transfer pricing, intra-group service transactions present as many challenges as opportunities to the multinational taxpayer. Needless to say, the management fee policy should be designed with the above background in mind such that it does not result in either overcharging or under-charging of management fees and also considering other tax and regulatory aspects. Any under or overcharging could result in adverse tax implications for the group as a whole. Further, as transfer of services is less obvious than transfer of goods, documentation of service transfer has to be robust. One of the major aspects that enable tax authorities to challenge the management fee charge is the lack of a comprehensive and thorough identification, evaluation, and documentation process that can effectively present the best possible arguments to justify any charges for intra-group services. In the context of an aggressive audit and litigation environment like the one that currently prevails in India, the best defense for a multinational with intra-group service transactions is a thorough evaluation process, with the help of transfer pricing experts that results in adequate documentation to present the most persuasive case to tax authorities.
In the next part of this article, we shall discuss how to determine and justify an arm’s-length consideration for such intra-group services.
