What will the update to the OECD TP Guidelines bring in the area of intra-group services?
What will the update to the OECD TP Guidelines bring in the area of intra-group services?
In practice, we often encounter situations where a client approaches us with a request to prepare transfer pricing documentation for a group of companies in which the ultimate parent company strategically manages the entire group and, in addition to standard administrative services, also invoices the other companies for this strategic service, the amount of which is determined on the basis of the costs incurred plus a profit margin.
In the event of a tax audit of the company that received the strategic services, the tax administrator usually requires proof of the extent to which the service was provided and the submission of a comparative analysis on the basis of which the market rate of the profit margin applied was verified.
We have not yet encountered a situation where the tax administrator would dispute the net profit margin method applied on the basis of the traditional cost plus method used to determine the price for purchased strategic services, even in a situation where the recipient of the service is a routine entity reporting long-term losses.
One of the conditions for the tax deductibility of costs incurred for any services is the fulfilment of the so-called benefit test. This involves demonstrating the benefit that the service has brought to the recipient. When proving the tax deductibility of costs incurred for intra-group services, this test is very often confused with the arm's length test, which compares the reference price that an independent service provider would receive. However, these are two completely different tests.
In the benefit test for intra-group services, it is important to correctly identify the party that should be tested. This party is the recipient of the services, not the provider. It is essential for the benefit test to determine whether the services are low value-added services or high value-added services, such as science and research services.
If a low value-added service is provided, the Transfer Pricing Directive in its current wording clearly explains the allocation method, which can be used to determine the amount of remuneration for the service provider under certain conditions without the need for a complex benefit test on the part of the service recipient. This applies to situations where it is clear that the service was necessary and the recipient had to purchase it, for example, due to regulatory requirements and a lack of internal personnel capacity to provide it. There is no doubt that an independent company would also be willing to pay for the service, and only the amount of remuneration paid to the service provider is tested, regardless of the impact this remuneration will have on the recipient's profitability.
In practice, such a case can best be demonstrated by accounting services provided centrally to multiple companies within a group. If it were administratively burdensome to track the time spent on accounting work for each individual company in the group (e.g., some accounting operations involve multiple companies) The OECD guidelines allow for the possibility of determining the service provider's remuneration using an appropriately selected allocation key (e.g. the number of items in the accounting journal) as the sum of the costs incurred plus a surcharge, without the need to perform a benefit test on the part of the recipient. The cost plus method is based on the assumption that the remuneration of the service provider is directly proportional to the value of the costs incurred. The higher the cost base, the higher the absolute amount of remuneration.
In the case of strategically important services, high added value is often associated with the risk of high costs, which will be necessary to incur for the service. There is no assumption that service recipients will always be willing to pay for such a service if there is no clear positive direct link between the purchased service and the business performance indicators they monitor. If the recipient of the services had no control over the costs incurred and these costs were transferred to the recipient of the services using the cost plus method, the use of this method could mean that the market risk of business loss would be transferred to the recipient of the services.
It therefore seems entirely logical that the tax administrator would request proof of the benefit that the strategic service brought to the recipient of the service during a tax audit. However, it is not so obvious why the tax administrator does not question the method used.
How can the benefit of a strategic service be demonstrated? Can a service recipient benefit test be performed without taking into account the profitability of the service recipient? What adjustments should be made if the profitability of the recipient of strategic services is below the lower limit of the market margin?
Recently, we have increasingly encountered situations where remuneration for strategic services on the part of the recipient is not recognised as tax-effective and, at the same time, is included in the cost base of the service recipient (a routine entity) without any adjustment as a cost used to calculate the fictitious revenue of the service recipient from the end customer. The tax administrator thus, in complete contradiction to its conclusion that in the case of strategic services, these are not tax-deductible costs that were necessary to achieve the taxable income of the recipient of the services, constructs a hypothesis according to which the cost of strategic functions in a market environment is always covered by revenue from the end customer. All this in a situation where, in comparative analyses of the profitability of routine entities, companies that have suffered losses as a result of poor business strategy are excluded as comparable companies for the purposes of finding independent comparable companies. We consider this situation to be unfair double taxation of routine entities and a risk that, as a result of adjustments made by the tax administrator on the part of the service recipient, double taxation of the service provider will also occur.
A logical solution to the tax deductibility of strategic services for which no benefit to the recipient has been proven would be a subsequent price adjustment of the remuneration for strategic services. However, how should the tax deductibility of costs be approached on the part of the service provider if remuneration for strategic services cannot be claimed due to the unproven benefit on the part of the recipient? Will the costs incurred for strategic services on the part of the provider be tax-effective? The service was provided, the costs were incurred, and the amount of the provider's realizable market remuneration is directly linked to the actual benefit achieved by the recipient of the service, which may be achieved in subsequent periods.
Hopes that the forthcoming EU Transfer Pricing Directive, the draft of which was published at the end of September, would provide a solution to prevent double taxation of high-value services have proved futile. The draft EU Directive was withdrawn in October. The main objective of the EU Directive was to simplify the application of the arm's length principle and reduce the risk of double taxation.
We must therefore continue to rely on the rules enshrined in the OECD Directive, the expected update of which should be published in early 2026. The update should bring recommendations for the application of valuation methods other than cost-plus when remunerating high-value services.