The draft mainly clarifies how existing principles apply in practice, with expanded guidance and 21 illustrative examples in a new annex to Chapter VII.
Accurate delineation incorporating the benefit test
The benefit test is one of the most problematic areas of the current services guidance. There can often be a mismatch between the expectations of the head office jurisdiction tax authority on what costs should be getting charged out as a service (see Management expenses: are you audit ready?) versus what foreign jurisdictions are willing to accept are deductible. Managing these challenges can involve a disproportionate level of effort for multinational groups.
The revisions clarify that:
- The benefit test should form part of accurate delineation. This is helpful because some tax authorities conflate the benefits test with pricing (i.e. view the test as being whether there is evidence the direct benefit received is more than the price charged); and
- It should be applied at the level of each service recipient, so a service may satisfy the test for one recipient but not another.
The guidance also stresses that intra-group services must be viewed in the context of the group’s wider activities, including asset ownership and economically significant risks. It adds commentary on aggregation and segregation where multiple services are provided, or services are linked to goods or intangibles.
Whilst some new examples are provided (most notably example 16 which is an attempt to illustrate how the provision of technology enabled healthcare services could involve a transfer of know-how), this remains an area where further explanation and examples would be useful.
Application of the benefits test
The core benefit test is unchanged: whether an independent enterprise in comparable circumstances would have paid for the activity or performed it in-house. What is new are four factors for assessing whether the benefits test is met:
- A benefit means any economic or commercial value derived by one or more associated enterprises from another group member’s activity;
- The benefit may arise during or after the period in which the activity occurs;
- The benefit must be identifiable and reasonably expected at the time of the transaction, and sufficiently direct for an independent party to be willing to pay for it; and
- The benefit must be factually possible and reasonably expected from the outset, even if not guaranteed.
The draft also confirms that a loss-making entity may still receive an intra-group service.
Shareholder costs, duplication and incidental benefits
The proposed revisions helpfully clarify that shareholder activities, duplicative activities and incidental benefits are examples of situations that will not satisfy the benefits test rather than separate tests.
There are some new examples illustrating scenarios involving shareholder activities and where head office activities may involve a service to reinforce the point that senior management activities (including ‘stewardship’ activities) are not automatically shareholder activities. The OECD has invited comments on examples of other activities not explicitly mentioned in the guidance which meet the definition of shareholder activities including activities which could come under “ancillary activities to the corporate governance of the MNE as a whole”.
The guidance on duplication and incidental benefits is reworked with a couple of illustrative examples in the annex but there are no material changes. In our experience, tax authorities’ concerns about duplication are usually a result of misunderstanding. There are no new examples of duplicative services provided and those given in the existing guidance relate to temporary duplication during a reorganisation, a second legal opinion to manage risk on a significant business decision and duplication of risk management functions to satisfy jurisdictional regulatory requirements. For each of these examples there should be an entity (or entities) which can meet the benefit test, and it would be helpful if this was more clearly articulated by developing the examples further. The question isn’t whether there is a service, it is a question of identifying the correct recipient(s).
Transfer pricing method selection
Read in isolation, the existing Chapter VII, particularly paragraph 7.31, suggests a cost plus paradigm for intra-group services where no directly comparable price (CUP) exists. This is something HMRC have strongly rejected in their guidance on the six-step risk control framework and pricing of contributions to the control of economically significant risks.
As expected, the guidance on selection of the most appropriate transfer pricing method has been significantly expanded with new guidance on the application of the profit split method added, alongside expansion in the guidance on application of the CUP method and cost-based methods.
The updates seek to rebut any default preference for cost-based methods and emphasise the importance of looking past any labels assigned to services and focusing on examining the economically relevant characteristics of the intra-group service. Specific reference is made to situations where services involve the use of unique and valuable intangibles and the relevance of understanding the risk profiles of the relevant entities based on accurate delineation of the transaction, when selecting the most appropriate method. The examples provided to illustrate application of the profit split method to services are carefully selected, steering away from more difficult issues including loss splits and the impact of capital at risk.
The expanded guidance on cost-based methods includes additional commentary supported by an illustrative example regarding pass-through costs, acknowledging that industry norms and practices may be relevant in identifying such costs. This should be welcomed by multinational groups as it is a common topic in audits.
One notable omission is any guidance on using revenue based profit level indicators for pricing services using the Transactional Net Margin Method (TNMM). In practice this can be a halfway house between cost-based methods and profit split for certain types of services whose value is most closely correlated to revenue generation (e.g. sales-related services performed by senior individuals accountable for achievement of sales targets and exercising control over customer pricing and key commercial terms).
Further guidance on implementing cost-based charging policies
There are some updates to the existing guidance on the indirect-charge approach emphasising the importance of consistency in approach to allocation keys across periods and recipients to prevent double counting, with particular care needed where multiple allocation keys are used for the same cost base. The OECD has invited views on whether further allocation key guidance for certain categories of services would be useful and for multinational groups to share what allocation keys they apply in practice for particular types of services.
There are no significant changes to the guidance on the simplified approach for low-value added intra-group services but there is a welcome clarification that the 5 percent mark-up applied under the simplification does not represent a floor level of mark-up for services more generally and, in practice, arm’s length mark-ups could be lower than 5 percent.
When cost-based methods are applied one of the most frequent questions that arises is how to treat share-based compensation.¹ This is a highly complex topic where an understanding of the specific features of the reward scheme and how it is accounted for by group entities is important before embarking on the tax and transfer pricing analysis. The views of the courts (see Share based reward: the transfer pricing cost conundrum) and tax authorities on this subject are continuing to evolve (the Inland Revenue Authority of Singapore issued new guidance this month).
At this stage the OECD has not provided any new guidance on how to approach this topic; instead, it has invited public comments on the challenges faced by taxpayers, the approaches multinationals have been taking and whether additional guidance would be beneficial. There is already a good starting point, as the OECD previously undertook a project looking at the impact of employee stock option plans on transfer pricing, which was published in 2004 without ever making it into the OECD Transfer Pricing Guidelines.
Documentation
The revisions include new guidance on transfer pricing documentation specific to intra-group services. The general theme here is the specificity and granularity of the evidence types referenced (IT helpdesk tickets, deliverables for services, internal communications between provider and recipient, contemporaneous evidence of expected benefit and costings). The reality for multinationals is that obtaining this type of information at scale is incredibly onerous and often unrealistic. Whilst there are references to proportionality and materiality and sample based approaches, the messaging could be stronger on this. More innovative thinking needs to be brought to the table to try to address risk in a more balanced way.
