The question arises as to whether a profit markup should be added to the costs in calculating a service charge. Nearly all tax authorities expect a group service company to render charges to affiliated enterprises in accordance with the cost-plus method and therefore to add a profit markup to the allocable cost. On the other hand, double taxation is avoided only if the tax authorities of the country in which the recipient company is resident allow a deduction, and not all countries accept the markup element of the charge as deductible.
In an arm’s-length situation, an independent enterprise would normally charge for its services to third parties in such a way as to recover not only its costs but also an element of profit. Consequently, any enterprise that is engaged solely in the business of providing such services should seek to make a profit. This is particularly true in the following three situations:
1. Where the service company’s only business activity is rendering services;
2. Where service costs are a material element in the cost structure of the service provider; and
3. Where the service costs represent a material part of the cost structure of the service recipient.
Most tax authorities in developed countries accept these conditions as relevant in reviewing the application of a markup to service costs. However, a more formalised approach is taken in certain instances, particularly in the US. As noted in chapter 71 of this book, the US temporary regulations on services require the addition of profit margin to the intragroup charge for services rendered where the services provided are not considered low-margin services or the median arm’s-length markup for such services exceeds 7%.
When it is appropriate to include a profit element on service charges, arm’s-length markups are determined by reference to comparables where possible. Once the service is identified, the cost of providing the service is determined and comparables are sought to determine the arm’s-length markup for those costs. In practice, many tax authorities expect to see certain levels of profit margin as the norm, typically between 5% and 10% of costs for most support services. However, as global competition gears up, companies should take care to ensure that the higher historical norms are not allowed to prevail in inappropriate circumstances, or the internal service provider may prove to be a cost-creating mechanism rather than a vehicle to enhance efficiency.
Furthermore, great care must be taken in deciding which costs should be marked up. It is the service function for which a charge is being made. If the service provider incurs third-party expense (for instance arranging for advertising space to be made available for its client), then it may well be correct to evaluate the advertising costs as an expense reimbursement (covering disbursements, financing and handling charges).
It will invoice for the service of arranging it (labour, phone, office costs, etc.) on a cost-plus basis. The total costs recharged would be the same, but the profit recognised in the service provider would differ significantly.
511. The determination of an arm’s-length service charge
The following example sets out how an arm’s-length service charge might be determined.
Example
Continuing the example in section 506, it has been determined that three services have been provided for, which it is appropriate to make inter-company charges:
• Assistance with the determination of arm’s-length service fees;
• Provision of marketing assistance in the form of sales brochures; and
• Accounting assistance.
The next step is to determine the fully loaded cost of providing those services. The costs of providing transfer pricing assistance consist of the external adviser’s fee plus the costs of the company’s tax department personnel involved in the study. The cost of providing tax personnel and the accounting assistance can be determined by reference to the amount of time the relevant individuals have spent in providing the services and the departmental costs in terms of salaries and overhead expenses. Once the time devoted to the pricing study has been identified, this can be expressed as a percentage of the total resources used by the relevant department during the year. Looking at the accounting support, for example, suppose one person was involved and spent 50% of the year on the project. There are three people in the accounting department.
Therefore, the cost of providing the service is one-half of the affected person’s salary and benefits plus one-sixth of the overhead expenses of the accounting department.
If we assume that a markup is deductible in each of the countries to which charges should be made, comparables must be identified for tax consulting (for the service fee project) and for accounting assistance. An obvious comparable is the markup the external adviser earned on the project. However, this information may not be publicly available, so other benchmarks must be used. Likewise, for accounting assistance, companies that provide accounting services and for which publicly available financial information exists may be identified. Once this is known, the inter-company charge can be determined. In practice this process may not be necessary, as many tax authorities accept that a margin of 5% to 10% on cost is prima facie acceptable. Nevertheless, a properly recorded and documented margin always offers a stronger position. For charges relating to the creation and printing of the sales brochures, one could allocate the departmental costs involved in the developing the brochures as well as any external printing costs. The charges could be allocated on the relative basis of brochures shipped or other allocation keys deemed more appropriate.
512. Documentation
Documentation in the area of management fees is every bit as important as in the case of the sale of inventory or the transfer of intangibles. At a minimum, it is necessary to provide documentation regarding the services that are provided, the costs of rendering those services and support for the appropriateness of any markup. It is imperative to have an inter-company agreement that sets out the circumstances under which services will be provided as well as the charges that will be made.
The support that might be needed to document each of these types of items could include the following:
• A written description of the different services provided, summarising the type (specialist skills, seniority, etc.) and number of employees involved, any reports or other end products of the services, and a statement of the aims of the services (to save costs, increase sales, etc.);
• A full analysis of the cost base, including explanations of allocation formulae, how they apply and why they are appropriate; a detailed list of the expenses to be allocated (salaries, overhead expenses, etc.); and invoices from other entities where they substantiate expenses suffered;
• A detailed computation of the amount of each invoice submitted to the recipient entities – it should be possible for a computer to produce this relatively easily once the cost base and allocation formulae have been established; and
• A justification of the markup applied referring to comparables or market practice.
In a Canadian case, the court gave detailed consideration to the subject of documentation of management fees and concluded that the following items of evidence would be of key significance:
• Evidence of bargaining between the parties in respect of the amount to refute any inference that the taxpayer “passively acquiesced” to the charge;
• Working papers supporting the expenses charged;
• Details explaining how the charges were calculated, including support for the apportionment of employee work performed or other expenses such as allocations of rental costs;
• A written agreement for the management charge; and
• Evidence that the expenses relate to the period of charge rather than a prior period.
The above comments are based on a 1991 case that predates the detailed OECD Guidelines chapter on Intra-Group Services. Today, most tax authorities’ expectations are likely to mirror the OECD Guidelines.
Contract services and shared service centres
Multinationals are increasingly looking for ways to achieve efficiency to improve their competitive position in the global marketplace. The traditional model for expansion, whereby the parent sets up one or more new companies for each new country of operation, has been successful in a number of ways. However, it has also encouraged bureaucratic and territorial approaches to business, which carries with it significant hidden costs. For instance, does each company really need its own personnel director, marketing director, finance department, inventory warehouse and buffer stocks, etc. or can these functions be fulfilled from a central point? With respect to strategic approaches to the market, the parent will want to encourage a global market view,
while the old “country company” model tends to narrow horizons to a very local level.
All these pressures and others are driving the creation of shared service centres which fulfil a wide variety of support functions for companies in many countries.
Another way in which multinationals are seeking to improve is through building on best-in-class techniques. If one of their operations appears to be particularly skilful in performing an activity, perhaps this entity should provide this service to others, rather than allow the latter to continue to operate at less than optimal standards.
Finally, the search for access to the best resources for a task at the lowest price is leading to the creation of contract research and development (R&D) centres and contract manufacturing activities. The idea here is that the multinational can tap into what it requires without impacting its strategy for managing intellectual property or manufacturing, while tightly controlling the costs. The best-known example of contract R&D comes from the US case, Westreco, in which the Swiss group Nestlè was involved.
Nestlè wanted to conduct research into the US market in order to design successful products for that market. If this research had been financed by Nestlè’s US operation, any intangibles created would have belonged in the US and subsequent profits derived would have been taxable there. Instead, Nestlè established a contract research operation that sold its services to the Swiss operation, which thereby owned the resultant intangibles. Subsequent exploitation by way of licence was therefore possible.
The key to the establishment of a successful contract R&D activity (or contract
manufacturing operation, which is a similar concept) is to draw up a service agreement that sets out clearly the activities required to be performed, service quality standard, timelines, etc. The service provider’s remuneration should be set by reference to appropriate comparables and is typically a cost-plus approach. Capital risk is a particularly important area to monitor, however. If the service provider needs to make significant investment in order to fulfil the contract, will the purchaser cover the financing costs and risk of disposal at this end of the contract? This question can be answered in many ways, but the answer will materially affect the profit, which it will be appropriate for the service provider to earn. As usual, risk should be compensated by the prospect of future reward.