Simplifying the Rules. A Bit.

Last week the OECD released a discussion draft about how “low value-adding intra-group services” should be treated for transfer pricing purposes (pdf). This document is part of the OECD’s ongoing BEPS project, and represents a substantial piece of output by the group working on action item #10 (out of 15 total): “high risk transactions”.

8161291_sBy way of background, it’s important to understand what is meant by the term “intra-group services”. Nearly all multinational groups have entities that perform services that benefit entities in other countries. Perhaps the group has an R&D center in a country that helps to develop new products for the entire company. Or maybe a local affiliate helps to develop marketing materials for a parent company. Even the performance of order processing, call center, logistics, or other “back-office” type functions by an entity in one country to assist a related entity in another country count as intra-group services. Given the complex web of functions distributed around the world in today’s typical multinational, the scale and scope of such intra-group services are enormous.

Since such transactions are between related parties, they are subject to transfer pricing rules. That means that every time a company or facility in one country performs a function that benefits a member of the corporate group in another country, the service must be paid for in a manner consistent with the arm’s length standard – i.e. as if the transaction had happened between two unrelated companies.  The associated administrative burden to calculate and substantiate that can be substantial.

That’s where the OECD’s latest draft document comes in.  While the primary aim of the BEPS project is to make it harder for multinationals to shift their worldwide income to low-tax jurisdictions and thus reduce their tax bills in ways that are perceived as being unfair, this document actually takes a step toward making life a tiny bit easier for multinationals to meet their transfer pricing regulatory requirements.  The document proposes that there be a simplified way for multinationals to calculate the correct prices to apply to certain intra-group service transactions.

The proposed simplified approach will be very familiar to transfer pricing practitioners in the US, as it is substantially the same as the Services Cost Method (“SCM”) that has been a part of US transfer pricing regulations for several years. The essence of both the SCM and the OECD’s proposed simplified method is to pool the cost of the center providing services, allocate those costs in a reasonable way among the various entities that benefit from the provision of those services, and then possibly add a small markup (in the case of the OECD proposal) or no markup at all (in the case of the US’s SCM).  Importantly, this simplified method is only applicable to services that are considered “routine” and not central to the company’s business.

From my perspective, this makes all kinds of sense. I don’t see any reason for companies to waste time and resources to perform extensive economic analyses supporting their transfer pricing on routine services.  Transfer pricing practitioners have seen so many of these intra-group services (after all, pretty much every multinational company has them) that we can usually tell you exactly what transfer prices the economic research will support even before we’ve crunched the first number.

But this also touches on a couple of larger interesting issues.  First, I think that this marks another step on the path of simplifying transfer pricing by focusing more on outcomes rather than individual transactions. In other words, to me this seems consistent with the continued ascendancy of profits-based approaches over transaction-based approaches to verifying that a company is adhering to the arm’s length standard.

Second, it puts renewed attention where it really should be: on the role and treatment of intangible assets (including their creation, maintenance, and management) when it comes to tax strategies employed by multinational companies.  After all, when you think about today’s most profitable companies, what is the ultimate source of their profitability?  It usually lies with their IP. Most other intra-group transactions are little more than a sideshow and distraction by comparison.

Finally, it’s interesting to note that this may be yet another way in which the US’s transfer pricing rules appear to have foreshadowed developments around the world. The US was one of the first adopters of formal transfer pricing regulations. The US began emphasizing profits-based approaches over transaction-based approaches before most other countries. And now the US’s simplified approach toward low-value intra-group transactions seems to be earning wide-spread acceptance as well.

I think this is simply a reflection of the fact that the US started regulating transfer pricing before most other countries. As a result, the US has had over 20 years to slowly build up a cadre of transfer pricing professionals and a body of institutional knowledge among the IRS, taxpayers, and consulting firms. And with that has come a gradual improvement in our understanding of what works and what doesn’t from a practical point of view.  So it’s worth thinking about how this latest product from the BEPS project may be another small but positive step in the gradual convergence of transfer pricing rules around the world… and to consider that the end result may end up looking more like the US’s transfer pricing rules than one might have expected.

2 comments

  1. Harold McClure says:

    I tell clients with centralized services benefitting the operating affiliates around the world that the key issues are whether these affiliates benefit from the activity (include a charge or not) and how to allocate these expenses. What the profit element should be (if any) turns out to be a tertiary issue. While the OECD safe harbor (markup from 2% to 5%) is a bit different from the US safe harbor (zero), this issue has never been a real driver of income allocation as long as the service is indeed routine. Of course, multinationals still need to address the allocation issue. And this document itemizes a lot of services that are not considered routine.

  2. Kash says:

    Agreed. The difference in taxable income between applying a 0%, 2%, or 5% markup is trivial compared to the differences that can arise from getting the base allocation wrong. That’s why I’m all in favor of allowing companies to simply apply a low statutory markup to these transactions – it lets them spend their time and energy on getting the much more important pieces of the puzzle right.

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