Businesses usually know what to look out for on the transfer of goods within a group, but what about services? This is an area of risk not only for multinationals with large Head Offices, but also for SMEs. For example, the French entrepreneur who expands into Belgium and centralises the bookkeeping or sets up a loan for the Belgian business should beware.

This article gives a basic outline of the principles and practice of transfer pricing as it applies to intergroup services. Ultimately, transfer pricing is a complex subject and professional advice is needed to avoid expensive surprises from the taxman.

Does your business model need transfer pricing?

Some groups use a decentralised model made up of self-contained subsidiaries with little interference from the parent. The shareholder acts as a financial investor in operating companies that are measured on their bottom line and behave almost like independent businesses. Here, the businesses share few services, making their transfer pricing less of an issue.

More commonly, international groups adopt a centralised model, because of economies of scale or concentration of expertise or know-how. Transfer pricing then becomes critical to a head office supplying services to its operating companies. While, for example, separate manufacturing companies and distribution subsidiaries may assume many of the normal risks associated with running a business, they may receive non-core services, such as IT, legal and HR support, from the head office. These services need to be charged and paid for. The nature of some industries demand centralisation of services: courier companies must use common systems, tech companies centralise research and development, as does the pharmaceutical sector.

OECD transfer pricing guidelines and the ‘arm’s length principle’

The guidelines look to establish two facts for intergroup services: whether a service has been provided and the price that should be paid for those services.

The price should conform to the ‘arm’s length principle’: looking at any transaction between related parties, would two unconnected third parties have entered the agreement under the same terms and conditions (assuming a willing buyer and a willing seller)? If not, then the taxman can adjust the profits from the transaction.

What is a service?

A service must confer an economic or commercial advantage to the recipient. Put another way, would an independent company be willing to pay for such a service? Examples of typical services include: administration, accountancy, marketing, recruitment, and training.

But just because a head office incurs a cost does not mean it provides a service.

Duplicated services seldom qualify because of the commercial benefit test. On the other hand, a group company should not be charged for incidental economic benefits; for example, a group acquisition that enhances sales, because they could not be sold to or by an unconnected third party. Equally, an advantage gained purely from being a subsidiary of a creditworthy owner should also fail the test, although tax authorities are developing policy around ‘affiliation benefit’ in interest rate pricing.

Methods of charging

There are two methods of charging for a service: direct or indirect.

A direct charge is the approach preferred in the OECD guidelines. This is straightforward when the service is quantifiable and you can point to a market rate of pricing. An example would be legal services where you can quantify the hours worked and charge a market hourly rate. This method is known as comparable uncontrolled price or CUP.

But what if it’s not that simple to quantify the service? Where a direct charge is not practicable, you may use an indirect charging method by allocating costs across group companies. However, you can’t just divide costs arbitrarily; the method must be sensible and the allocation key relevant.

Take, for example, marketing services: turnover is an acceptable key, as the larger the turnover the more support may be needed. By contrast, the main business driver for payroll services is headcount.

Risk management

Regular TP risk management helps avoid tax surprises resulting from profit adjustments or non-compliance penalties. The board and its advisers should review questions such as:

• Will your transfer pricing strategy pass audit?
• Will your transfer pricing pass investigation by local tax authorities?
• Is your documentation adequate?

Remember, with good documentation it is up to a tax inspector to prove your TP is wrong. Without it, you make it easy for an inspector to substitute different (usually disadvantageous) numbers for the related party transactions in the tax return.

Poor documentation poses the commonest risk of all. Contemporaneous documentation is a legal requirement in many countries; its absence often means a fine, sometimes monthly until the documentation is produced. Directors could even be committing a criminal offence if they sign a tax return without checking the TP position.