Use of Predefined Profit Margins in Intercompany Services
One of the key novelties introduced by the OECD’s action plan to combat tax evasion and profit shifting (the BEPS plan) is the proposal of a “safe harbor” for low-value-adding intercompany services. Under certain restrictions, this safe harbor would allow the transfer of specific support services (not in any way related to the recipient’s core business activities) at their total cost, plus a 5% profit margin. The use of the safe harbor by multinational groups could have tax implications in emerging economies, as the transfer of costs and expenses associated with a service, along with the aforementioned profit margin, does not necessarily equate to an arm’s length expenditure for the recipient. This could eventually lead to discrepancies with tax authorities.
Background
On October 5, 2015, the Organisation for Economic Co-operation and Development (OECD) published the final reports of its action plan to combat tax evasion and profit shifting (known as the BEPS plan, an acronym for Base Erosion and Profit Shifting). Action 10 of the BEPS plan (other high-risk transactions) introduced modifications to the transfer pricing treatment of certain categories of intragroup services, specifically low-value-adding services.
The OECD defines low-value-adding services as those that:
i) Administratively support the taxpayer’s operations and, therefore,
ii) Are not part of the recipient’s core business activities,
iii) Do not require or create unique and valuable intangibles, and
iv) Do not pose significant risks to the service provider.
By applying specific rules—such as identifying costs to be transferred and establishing common allocation methods for all beneficiaries—it is possible to transfer the total costs associated with these services, plus a 5% profit margin (provided that there are no internal comparables).
This simplified approach proposes the elimination of the “benefit test”—currently included in the OECD Transfer Pricing Guidelines—which requires taxpayers to demonstrate that the received services provide an economic benefit to the recipient, meaning that, without them, the recipient would either need to hire an independent third party or internalize the activity using its own resources.
Additionally, in a second phase, the OECD would set upper charge limits (still undefined) that would invalidate the use of the safe harbor if the service fees exceed those pre-established thresholds. For this rule to be attractive to emerging countries, these limits would likely take into account the administrative cost structures reported by independent third parties in the local economy.
The new rule was proposed to be adopted in two phases:
- The first phase involved incorporating it into as many countries as possible before 2018.
- The second phase involved developing the rule regarding the maximum allowable charge for intragroup services and addressing implementation issues to achieve the highest possible level of adherence to this proposal.
Given this background, does this measure have a chance of success in emerging economies?
The Opportunity Cost for the Charge Recipient
One of the most common sources of disputes between tax authorities and taxpayers arises from intragroup services. These transactions have a high incidence in emerging economies, and frequently, the service charges are entirely disconnected from the functional structure of the recipient. Additionally, when the service charge appears significantly higher than the alternative cost of the service in the domestic market, tax authorities are encouraged to reject the deduction of the intercompany service expense.
Given this, is the markup suggested by the safe harbor a problem? Not necessarily. The issue lies in the underlying service costs, not the markup itself. The following table shows the cost of the same position in different markets (based on data from Hays[3]):
| Position | UK | Canada | Japan | China | Mexico | Malaysia |
|---|---|---|---|---|---|---|
| Financial Accountant | 61,191.5 | 59,028.5 | 69,374.5 | 23,207 | 47,500 | 28,231 |
| Tax Accountant | 59,905.5 | 84,614.5 | 79,305.5 | 29,933.5 | 51,109.5 | 34,179 |
As seen above, the cost of the same positions varies significantly between developed and emerging economies, reaching differences of up to 60% in some cases (e.g., financial accountants in Japan vs. China). Evidently, each transaction must be evaluated on a case-by-case basis. However, if these low-value-adding services are, in principle, replaceable in the origin market, the recipient country’s absorption of the function at the origin cost would not be justified unless the cost were shared among multiple subsidiaries and the resulting charge was equal to or lower than the domestic market value. This would require multinational groups to conduct an in-depth analysis of their expense allocation mechanisms and distribution amounts, considering the alternative costs for recipient subsidiaries.
There are additional barriers to achieving widespread adoption of this rule in emerging economies. One critical issue is setting charge limits based on the substitute cost of the function in the local market. In highly competitive jurisdictions for support services—such as China, India, or Mexico—it seems unlikely that a rule disregarding the local economic dynamics would be adopted. Furthermore, the formal incorporation of this rule requires the issuance of national regulations, which is often a lengthy process. This delay can create discrepancies when multinational groups establish global transfer pricing policies.
Conclusion
The introduction of transfer pricing rules for low-value-adding services aims to reduce the administrative burden these transactions create for multinational groups. However, the success of this rule remains uncertain. Since there is no global consensus, the early adoption of this measure by multinationals from developed economies in relation to their subsidiaries in emerging economies could trigger double taxation issues.
Therefore, to avoid uncertain tax scenarios, multinational groups should carefully evaluate the adoption of this rule and remain aware of the potential implications of its use.
[1] OECD/G20 Base Erosion and Profit Shifting Project. Aligning transfer pricing outcomes with value creation. Actions 8-10: 2015 final reports, D.1. 7.45
