INTM464050 - Transfer pricing: types of transactions: Transactions involving services

As well as tangible goods, the transfer pricing legislation applies to services provided between connected persons. The term 'services' is not defined in the legislation. A common sense approach, based on a complete review of the facts, is necessary in deciding whether a service has been performed and what the arm’s length price for the service would have been.

The guidance in this chapter covers the following issues:

• OECD Transfer Pricing Guidelines 
• Have intra-group services been provided? 
• Would an independent company pay for the service? 
• Are the activities shareholder activities? 
• Services combined with other transactions 
• What is the arm’s length price of a service? 
• Group treasury companies 
• Procurement services 
• UK deductions for recharged expenditure 

OECD Transfer Pricing Guidelines

Chapter 7 of the OECD Transfer Pricing Guidelines considers particular issues related to the provision of intra-group services. The two main points are:-

• Whether intra-group services have been provided,
• That the transfer price for any such service should be calculated in accordance with the arm’s length principle i.e. the price which would have been charged between independents.

The Guidelines consider that the best way of charging an intra-group service is for the service providing company to operate a direct charge method. An example would be translating a legal document, which would generally be priced (in the manner that an independent would calculate a fee) according to the time taken for translation. However this method can be difficult to operate in practice because of the complexity of some intra-group services.

The Guidelines therefore sanction using an indirect charging method. This will involve using cost allocations and apportionments, often involving some degree of estimation or approximation. This is acceptable provided the price does take account of the benefit of the service to the recipients and the extent to which comparable services are provided between independent parties.

When calculating the arm’s length price, the Guidelines say that the price for the service should be calculated by reference to the perspective of both the provider and the recipient. The service must be of value to the recipient and the price must be one that an independent party would be prepared to pay. The service provider would take account of the cost of providing the services, but this is not necessarily a determining factor in every case. All the facts and circumstances must be considered.

Comparable uncontrolled price ('CUP') and cost-plus are considered the preferred methods for valuing the transfer price of intra-group services in many cases. The Guidelines also consider the circumstances in which a service provider might expect to make a profit on the transaction (from Para 7.5 onwards).

The Guidelines give some examples of intra-group services (some are duplicated)

• Legal, accounting, auditing, financing advice, training of personnel (OECD Guidelines 7.2)
• Marketing (OECD Guidelines 7.3)
• Planning operations, emergency management, technical advice or trouble shooting (OECD Guidelines 7.9)
• Administrative services such as planning, co-ordination, budgetary control, financial advice, accounting, auditing, legal, computer services; assistance in the fields of production, buying, distribution and marketing; services in staff matters such as recruitment and training; administration and protection of intangible property for all or part of the MNE group; research and development (OECD Guidelines 7.14)
• In certain circumstances it may be appropriate to make a charge for 'on-call' services in addition to a charge for actual usage of the service (OECD Guidelines 7.16 and 7.17)

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Have intra-group services been provided?

Review all of the facts to ascertain whether a service has been carried out.

Consider whether a company has received (or extended) a service or the use of intangible property. The OECD Guidelines recognise that in some cases it can be very difficult to determine where the exact border lies between the licensing of intangible property and the provision of services. The distinction can be very important, as generally services would be priced in relation to their associated costs, whereas intellectual property may be paid for by way of royalty or other turnover-based fee. The difference between the two can be significant. This distinction may affect both the arm’s length price and the manner in which it would be calculated.

For example, a large multinational enterprise provides management services to third parties. The business is conducted in each geographical market by wholly owned subsidiaries. The parent company provides a number of auxiliary services to the subsidiaries, including use of the brand name, for which the subsidiaries pay a royalty/fee of 5% of their gross turnover under a licence agreement with the parent. In 2001, the UK subsidiary has a turnover of £200 million, and pays a royalty/fee of £10 million. A full review of all of the facts establishes that the actual cost to the parent of these services (excluding use of brand name) to the UK in 2001 was £2 million and that the UK company attracts most of its business because of the reputation of its own consultants. The business derived from the use of the brand name is not significant because the brand name is unknown in the UK and so the turnover fee is in reality charged in return for the auxiliary services. It is very unlikely that an independent party would be prepared to pay for this bundle of rights and services under a licence agreement involving a turnover-based fee. A cost-plus mechanism is on the facts of this case a better way of calculating the arm’s length price.

In cases where it is established that the point at issue is the provision of services, the OECD Guidelines indicate it is not automatic that those services should necessarily be recharged. Even if an activity is carried out, or cost incurred; it does not naturally follow that intra-group services have been provided that should be recharged. It is it necessary to review what would happen at arm’s length. There are two main points to consider:

• Does the service provide the recipient with something of an economic or commercial value - something it would be prepared to buy from someone else?
• Are the activities shareholder activities?

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Would an independent company pay for the service?

Sometimes it will be easily apparent from the facts that a service has been performed which would be paid for at arm’s length. This will often be the case where the outcome of a service is easily identifiable. There will be other cases where the nature of the service is more difficult to ascertain, and the outcome not so easily defined.

For example, a UK subsidiary uses the services of senior personnel from its US parent to provide expertise on general market direction. The subsidiary is unlikely to be able to point to a particular outcome and say 'that is where they added value'. Any review would need to ascertain the facts and to ask whether an independent would have paid for what was actually received. There is a possibility that the facts might indicate that such a general service forms part of general shareholder activity - see below.

Such cases can get more difficult to assess when the service is provided to a number of different subsidiaries, or to the group as a whole. Some instances will be fairly straightforward - for example a group may have contracted independent IT personnel to review the group’s computer system as part of a plan of anti-virus protection. The parent alone may have been charged by the third party. Since each subsidiary had actually received a review of its IT, a re-charge of the cost would appear appropriate. This recharge would amount to what an independent company would pay for the service.

However, the arm’s length price becomes more difficult to judge if the facts show that a subsidiary had also paid a separate third party for a review of IT, or carried out one internally, and had no need of the service paid for by the parent.

Where such complexities become apparent, review the facts with these points in mind:

• What is being paid for?
• Would an independent pay for this?

Group companies will also obtain incidental benefits of belonging to a group, for example the cost of reporting finance, etc, data. These benefits should not generally be recharged; they arise as the result of the subsidiary belonging to a larger group, not because a service has actually been provided.

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Are the activities shareholder activities?

A group will be obliged to carry out particular activities and incur some expenses because of its responsibilities to its shareholders, or because of the parent company’s role as a shareholder in the subsidiaries. This type of expenditure should not be recharged. A third party would not require such services and so would not be prepared to pay for them. Examples quoted by the OECD Transfer Pricing Guidelines (at Para 7.10) include the cost of the juridical structure of the parent company (such as AGM’s, issuing shares and any supervisory board); costs relating to the reporting requirements of the parent (such as producing consolidated accounts or other reports for shareholders); and raising funds to invest in its subsidiaries.

Any system put in place to facilitate the reporting requirements for shareholders will fall within the definition of shareholder costs. There can be difficult borderline cases within what the OECD Guidelines refer to as the 'costs of managerial and control (monitoring) activities related to the management and protection of the investment as such in participations' (participations being, in this context, subsidiaries). Such systems might perform more than just the shareholder reporting function, although these other benefits may be just incidental.

The test in such circumstances is whether the activity is one that an independent party, under comparable circumstances, would have paid for. This will always depend on the facts and circumstances of a case. The original 1979 Guidelines referred to 'stewardship' activities, as opposed to 'shareholder' activities. Stewardship is a broader term and would have included some activities that are now accepted as being rechargeable intra-group services (e.g. emergency management or technical advice).

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Services combined with other transactions

The facts may indicate that certain intra-group services are linked with the transfer of valuable intangible assets. For example, the grant of a licence agreement, under which valuable patent and know-how rights are made available to a subsidiary, may involve the provision of technical services, such as helping to set up a new manufacturing process. Such services would generally be covered under the payment of royalties. However licence agreements concluded between independent parties may put a limit on the services provided (e.g. by way of number of hours or man-days); any additional services would be subject to a separate charge.

There is a distinction to be drawn between services that might be provided under a licence agreement (and calculated by reference to turnover), and services that would be provided under some other form of contract, as discussed under the section 'Have intra-group services been provided?' above. One would have to review all of the evidence and decide what would happen at arm’s length.

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What is the arm’s length price of a service?

A review of the evidence should indicate what price would be charged between independents for the service. A whole range of commercial factors would influence the price. A transfer pricing methodology is unlikely to reflect these complexities; it should be applied using common sense and judgement, without being formulaic or prescriptive.

The enquiry should be predicated on the basis that the arm’s length price should be charged for any service. Between independents, a complex interaction of commercial factors combine to determine the price. These factors might include:

• The costs of providing the service
• The costs of an alternative
• The expected benefit
• The state of the market
• The financial position of the provider or recipient.

The price will depend on the nature of services provided and the businesses of the companies providing and receiving the services. The examples below however give an indication of the possible criteria that might be used in different situations.

1. A company provides services that are integral to the group’s business as a whole. For example a firm of civil engineers may have specialists in a particular field based in the UK. The firm’s subsidiary in South Africa wins a contract to design and oversee the construction of a new power station. The UK supplies specialist employees critical to the success of the project. A suitable method of valuation of the services provided by the UK might be an independent firm providing similar services.
2. A group company provides services only to other group companies. For example a group manufactures and sells electrical equipment. It established a subsidiary whose business is to provide legal, accountancy, human resources and IT services to all the group companies. A review of the facts might lead to the conclusion that this service provision falls within the scope of the guidance on centrally provided services at INTM464055, and so a cost-plus method can be applied.

In all enquiries, the facts must be established to show the exact nature of the service, the functions and costs involved in supplying it and the extent of the benefit to the recipient. The arm’s length price would be influenced by all of these factors.

The costs themselves will consist of direct and indirect costs. The direct costs will include employee costs such as salaries, bonuses, pension provision, travel and subsistence costs, support costs such as secretaries, broadly costs that relate directly to the service being provided (which usually is the services provided by a person, or group of persons). Indirect costs will include for example office accommodation and a share of utilities and other overheads.

These costs would affect the price charged between independents.

When applying the cost-plus method, the OECD Transfer Pricing Guidelines (at para 7.35) recommend that when looking at comparable transactions or independent companies supplying comparable services, one should be aware of differences in overhead (indirect) costs between the case under review and the comparables. Adjustments to the cost base may be needed .

The OECD Transfer Pricing Guidelines also consider when it would be appropriate for the service provider to make a profit (paras 7.33 to 7.36). There may be occasions when a service provider is content only to cover costs although, in the normal way of business, companies intend to make a profit, and charge accordingly. Review the full facts and consider what would happen at arm’s length. In such a situation the recharge should not exceed what an independent would pay. Where a group company has acted as an agent or intermediary in incurring expenditure on behalf of someone else, it may be appropriate to just recharge the expenditure without a profit margin (para 7.36).

Any charge should equal that which would have arisen between independents. While cost-plus may be the method that has to be used in the majority of cases, there should be evidence to demonstrate the benefit of the service to the recipient.

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Group treasury companies

A group treasury company may provide a number of services to group companies, e.g. finance, hedging, debt factoring, etc. To the extent that the company is only providing expertise, a fee-based reward might be appropriate. For example a subsidiary may decide to hedge an upcoming purchase of goods, the price being in US dollars. The subsidiary faces a number of ways of hedging the transaction such as a forward currency contract. It asks the group treasury company to advise on the best method of hedging and to arrange the purchase of the appropriate financial instrument on its behalf.

Between independents this fee might be built into the cost of the instrument. Where the cost of the instrument and any financial risk is borne by a company, they may have already paid in part for the provision of the service. In this case, the group treasury company would be justified in charging a fee for advising and arranging the financial instrument, based on the fee a broker would charge.

The provision of services such as loan finance, leasing and debt factoring, and underwriting or providing financial instruments can be complex and is considered in more detail in the chapter on Intra-group funding at INTM500000 onwards.

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Procurement services

Procurement services might include a fee for negotiating contracts or a charge for providing the facility to buy products at a discount.

Consider how a similar function would be rewarded at arm’s length. The evidence might reveal that it was the bulk buying power of the distribution companies which dictated any discount, not the negotiating skills of the procurement company. This would limit its reward accordingly.

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UK deductions for recharged expenditure

There may be an apparent tension between an arm’s length payment for the benefit of a service and another part of the UK tax code which prohibits a tax deduction for a particular class of expenditure. An obvious example is a company being recharged particular costs that are deemed to be entertaining.

A particular issue that has arisen in recent years is the recharge of the cost of share-based remuneration, in particular share options. Employees of a subsidiary may receive share options through a group scheme run by, or on behalf of, the parent company - instructions on dealing with this are dealt with under INTM464140. Here however the concern is with the recharge of employee costs where those employees are providing services to different group members. In some cases (particularly US groups) the service fee charged to subsidiaries includes a charge to cover share options.

	Salary	£1,000,000
	Retirement provision	£2,000,000
	Share options	£6,000,000
	Direct support costs	£1,000,000
	Total	£10,000,000

For accounting periods ending before 31 December 2002, a recharge of such costs, based on the difference between the option and exercise price (£6 million) would not be considered arm’s length. A recharge based on a reasonable hedging strategy will be acceptable. For a discussion of hedging strategies please see INTM464140.

For accounting periods ending after 31 December 2002, a recharge based on the full spread would still not be arm’s length, notwithstanding the new legislation governing deductions for share options. The statutory deduction is given as part of the Government's policy of encouraging the use of share options. There is no suggestion that it is simultaneously representing an arm's length price.

Where a company is providing services using employees who have received options, that company will receive a statutory deduction when the employees exercise the options. In pricing the services to its affiliate, however, the treatment of the deduction is not relevant. Instead a hedged cost should be recharged. If the services being provided are those that it would be proper for the company to charge at a mark-up, then the hedged costs should marked up as well.

Businesses that trade by providing services do not generally set their prices solely by reference to the cost of those services. They will take these costs into account, but will price the services by reference to many factors: what the market will bear, or at a discount in order to attract business.

However, the provision of share options is a valuable service, which at arm's length a third party would pay for, and the logical method is to recharge the costs. Where employees are remunerated by share options there may be no actual cost to the parent company. However services provided by employees who are paid £100 cash plus 100 options are likely to be more valuable than services provided by employees who are paid simply £100 cash. The price paid should therefore reflect the existence of share options, and the question remains as to how to price the options. As explained in INTM464140 the arm's length price will rarely be the profit made by the employee.

There is unlikely to be any actual physical cost to the parent company (whether based in UK or not). It may simply issue new shares to cover the options granted. The fact that a country has a domestic tax code which permits deductions based on the profit made by employees on exercising the options cannot be used as justification for effectively passing on that deduction to another country. A distinction needs to be drawn between statutory deductions (whether in the UK or in other countries) and the arm's length price. Failure to make the distinction can result in the importation of a non-arm's length price into another tax jurisdiction; and that can be resisted on general transfer pricing principles.