Share based reward: the transfer pricing cost conundrum
Irish Tax Appeals Commission rules taxpayer correct to exclude notional cost of shares from intra-group service fee cost base
Transfer pricing treatment of share based compensation
This case was the first determination by the Tax Appeals Commission (TAC) in Ireland on a transfer pricing matter. It concerned the correct cost base to be used to calculate service fees charged by an Irish subsidiary (IrishCo) to its US parent company (Parent). Contractually, the fees were calculated by marking up IrishCo’s costs, and it was common ground that this general methodology was consistent with the arm’s length principle. However, the main issue in dispute was whether the cost base should include the notional accounting expense booked by IrishCo for share-based awards (SBAs) granted by Parent to IrishCo’s employees. This decision is important for multinational groups with groupwide SBA schemes and highlights the importance of considering the specific facts of each case when determining the appropriate cost base for transfer pricing purposes.
IrishCo did not include anything in its service fee cost base for the SBAs, arguing firstly that the intra-group service agreement expressly provided that this cost should be excluded from the cost base used to price the services; and, importantly, that this was appropriate as there was no actual cost to IrishCo because Parent did not recharge anything to IrishCo in relation to the SBAs. The position of the Irish Revenue Commissioners was that, applying the arm’s length principle, the accounting expense should have been included notwithstanding that there would never be a cash outlay by IrishCo. The result would have been a greater taxable service fee in the hands of IrishCo.
Similar to the UK, Ireland’s transfer pricing legislation requires related-party transactions (such as the services provided by IrishCo to Parent) to be priced at arm’s length in accordance with Article 9 of the OECD Model Tax Convention (Article 9) and the OECD Transfer Pricing Guidelines (TPG). Interpreting these in light of the taxpayer’s facts and circumstances, the Irish Tax Appeals Commissioner ruled in favour of IrishCo. The Commissioner’s reasoning was extensive and detailed, but the basic principle was that the notional SBA accounting expense did not represent an ‘economic cost’ to IrishCo and hence there was no economic basis for IrishCo to receive service fees or operating profits associated with the SBAs. Particular emphasis was placed on the absence of a recharge by Parent to IrishCo, and on the absence of any involvement by IrishCo in the decision-making and administration of the SBA scheme.
An important aspect of this case was that Parent was the sole customer of IrishCo and this was used to justify the commercial rationale for why no recharge was made by Parent. The Tax Appeals Commission were presented with an analogy of a mill owner providing flour, free of charge, to a baker who provided the baking services to produce goods for supply to the mill owner. It was rational that the mill owner would not require the baker to pay for the flour if this would only inflate the price charged back to them.
Another important aspect of the case was the link between recharging and corporation tax relief for share based compensation in Ireland. As there was no recharge, IrishCo had added back the expense for Irish corporation tax purposes. This differs from the position in the UK and US where relief is not conditional on there being a cash cost (ultimately) to the employing company
The Commissioner interpreted the Irish transfer pricing legislation (in light of Article 9 and the TPG) as requiring an adjustment to taxable profits/losses rather than an adjustment to the actual consideration for the transaction. It follows that had an adjustment been required (which it wasn’t in this case) the Commissioner would only have expected an increase in the profits of IrishCo for the mark-up on the share-based compensation expense, rather than the amount of the accounting expense plus the mark-up.
Whilst the TAC determination does not create binding precedent in relation to the operation of tax law in Ireland, the decision was informed by extensive expert testimony and is based on the application of the OECD Transfer Pricing Guidelines so we expect it will attract the attention of other tax administrations including HMRC. Current HMRC guidance at INTM421060 does not suggest HMRC will accept the exclusion of SBA costs from the cost base for services priced on a net cost plus basis which is consistent with our practical experience.
Multinational groups with SBA schemes may wish to review their existing transfer pricing policies and current approach to parent company recharges in light of the decision.
It will be interesting to see if the Irish tax authorities seek to pursue this further in due course.
