What methods are used to analyze intracompany outsourcing? In conversation on the ‘Fiona Show’ podcast, XBS transfer pricing experts Adam Sandford and Andrei Enoiu talk about why service transactions are so important – and how to prove these complex arrangements are arm’s length.
Andrei Enoiu: So Adam, let’s start with what is a service transaction, and specifically, an intercompany service transaction?
Adam Sandford: These are transactions offered intercompany by one entity to another. And they could be back office support, which could include human resources; also admin activities or admin services; technical services, which are usually it related; and also management services. And that can include strategic management, finance, also accounting services.
Andrei Enoiu: Why would multinational corporations ever want to have these intercompany service?
Adam Sandford: There’s transactions primarily to centralize the services in one location and maximize the efficiencies and minimize the cost. I’m sure as these companies create synergies, they find those efficiencies. You wouldn’t want different services providing accounting to the group, the which were in the same region when you can find those efficiencies and just provide one service and centralize those in one location.
Andrei Enoiu: To that end though, is it fair to say that the first thing you need to do is to prove that you’re actually providing a benefit to your affiliates through these services?
Adam Sandrod: Correct. Tax authorities would want to know if there was a true benefit being provided and they will potentially question the validity of the service in a benefit test analysis.
Andrei Enoiu: So what does that benefit test analysis look like, Adam?
Adam Sandford: In a benefit test analysis, the service recipient has to be able to prove the economic value of the service they’ve received. Additionally, they have to prove that they would have been willing to pay an independent party for that same service
Andrei Enoiu: By going through this analysis and outlining or they would have been willing to pay for the services, what is the recipient of the transaction – and for that matter, that renderer of the transaction – what are they accomplishing?
Adam Sandford: They would be able to show a tax authority that the service is, that they’re engaged to provide or receive from their counter party are of value. And they would be able to pay a similar price for a similar service to a third party out in the market.
Andrei Enoiu: And essentially by doing so, they’re able to justify that truly they should charge for that service. Because we hear all the time about different types of services that don’t provide that direct benefit, or what have you. Things like shareholder activities come to mind. Tell us a little bit about those.
Adam Sandford: Sure. Those are services performed by a parent company or regional holding company because of its ownership interest in one or more group members. And the cost is normally incurred by the parent company.
Andrei Enoiu: So basically shareholder activities don’t really provide any benefit to the recipient.
Adam Sandford: Correct. Group members don’t require the activity and they would not be willing to pay a third party for it by any means. And so what, what kinds of services fall into this shareholder activity category?
Adam Sandford: These could be cost related to the admin structure of the parent company, like the meetings of the shareholders issuing of shares of the parent company, the stock exchange listing of the parent company, and even potentially the cost of the supervisory board.
Andrei Enoiu: Okay. And what about financial reporting, putting together their annual reports or potentially even transfer pricing documentation at the group level – not necessarily at the country level –would those be shareholder activities?
Adam Sandford: Yes. Those are costs related to compliance of the parent company. And they can include reporting requirements, a consolidation of reports, even their transfer pricing. A tax documentation could be included as well.
Andrei Enoiu: So it sounds like if we’re looking at, if we’re a multinational and we’ve got the shareholder activities, we’re not going to pass the benefit tests, then that means we shouldn’t really charge for these services at all.
Adam Sandford: Right, exactly. And those could be some of those factors that could interfere in passing the benefits test could be duplicated services. If the service already exists within the group. I mentioned earlier that if it already existed, most companies find those efficiencies and consolidate it into one. But it could also refer to a service that the group is performing inside the group or with a third party.
Andrei Enoiu: Interesting. So it’s not only about the type of service, but then it’s also about being duplicated elsewhere.
Adam Sandford: Correct.
Andrei Enoiu: And so are there, are there any exemptions to this duplication rule?
Adam Sandford: Only if the duplicated service is considered temporary.
Andrei Enoiu: In what sense?
Adam Sandford: For instance, if it was a service that wasn’t going to last more than a couple months and you had an agreement in place that this was going to be a one-off, maybe it’s an audit service from a related party. And that’s not something that was going to last year, or over a year, that could be considered temporary and then maybe not considered duplicated.
Andrei Enoiu: Okay. And what about something like a second opinion from a legal advisor, or if you went out to a third party but you had also gotten an opinion from your in-house counsel?
Adam Sandford: Yeah, that would be okay. If a duplicated service is undertaken to reduce the risk of a wrong business decision, like a second legal opinion, it counts as an exception. You can still count it as an intergroup service. So there is some flexibility.
Andrei Enoiu: It sounds like there is some flexibility.
Adam Sandford: There’s always flexibility in transfer pricing.
Andrei Enoiu: Yeah, that’s the beauty of it. So are there any other times where you wouldn’t treat the service as a, uh, a clickable charge that you wouldn’t want to charge out for it?
Adam Sandford: Absolutely. There’s the case of incidental benefits. When entire group service is performed for certain group members, but benefits other group members by chance, these incidental benefits would not cause these other group members to be treated as though they were receiving an intergroup service.
Andrei Enoiu: Interesting. Okay so more or less, if I’m providing a service to you as an affiliate and then we have another affiliate that also benefits by that… well then clearly I can’t charge them for the service I’m providing you.
Adam Sandford: Correct. It would have to be determined that they were only benefiting by chance, or indirectly.
Andrei Enoiu: I think it’s probably worth noting too, for our audience that, you know, all of this stuff we’ve been talking about with the benefits test and, and all this justification, it’s not sufficient to, um, simply think about it.
I’m assuming in your documentation you want to, you need to actually mention it, that you’ve thought about these things and that and justify the decisions you’ve made, um, that lead to you being able to charge your affiliate for that service.
Adam Sandford: Correct. And then all the documentation that we provide it when a service is part of one of the transactions that we’re covering we do the Service Benefits Test and that’s clearly defined for any audience that chooses to read the report.
Andrei Enoiu: So Adam – once you go through this benefits testing, you’ve validated that your intercompany transaction meets all these criteria, and in fact you can charge for it legitimately – what do you do next?
Adam Sandford: Well, next we would have to determine that the price of the service is in accordance with the arm’s length principle. You would want to make sure that the intergroup charges are the same as they would be if they were between independent parties. And additionally, if the service provider renders similar services to both independent and related parties, that would be extremely helpful for the firm documenting your, your services.
Matthew DeMello: And if I could interrupt just very quickly for the folks at home, Fiona, which types of transfer pricing methods can you use to prove service transactions are arm’s length?
Fiona: You can use transactional methods, profit-based methods for services, the services cost method, and the OECD simplified approach for intercompany services. For unique transactions, you can also apply other methods if the selected method is the best method.
Andrei Enoiu: Thank you, Fiona. So Adam given all of these methods exist, which one’s the direct?
Adam Sandford: The most direct would be the transactional analysis.
Andrei Enoiu: Okay. And you kind of alluded to it, right? If you provide the same service to a third party as you do to an affiliate, you could potentially use that transactional analysis. What does that look like in a service transaction?
Adam Sandford: The transactional analysis will compare the controlled transactions to uncontrolled transactions. So one would have to be able to identify situations where the service provider also provides similar types of services to third parties. Normally, we have agreements to analyze when covering these types of transactions.
Matthew DeMello: And Fiona, if I can ask once more, what are the transactional service methods?
Fiona: There’s the comparable uncontrolled service price method or CUSP. There’s the gross services margin method or the GSMM, and then there’s the cost service plus method or the CSPM.
Andrei Enoiu: Oh. Very interesting, Fiona.
So Adam, let’s talk a little bit about these transactional service methods. What is the comparable uncontrolled service price method? Or CUSP, as we tend to abbreviate…
Adam Sandford: So let’s say for legal services, you would pay $100 for an hour to controlled parties and uncontrolled parties. We could use that $100 an hour in attempt to benchmark that across different observations that we would search for.
Andrei Enoiu: And what about the gross service margin method or GSMM.
Adam Sandford: The GSMM compares controlled and uncontrolled transactions by their profit margin.
Andrei Enoiu: And so similarly rather than using an hourly rate, if you will, for doing your legal service example, sounds like here we would use some sort of gross margin percentage as the comparison.
Adam Sandford: Correct. We could take the gross margin percentage of our tested party and also when we identify similar observations on the market, we could calculate their gross margin as well. And build a benchmark.
Andrei Enoiu: All right. And what about the cost of service plus method?
Adam Sandford: Well, this method compares the gross service profit markup between controlled and uncontrolled transactions. The markup is measured by the percentage of profit markup.
Andrei Enoiu: So theory similar to the gross margin.
Adam Sandford: in some ways very similar. In this case we’re only taking the profit markup, whereas on the other one we were taking the profit margin.
Andrei Enoiu: All right, so you know all of these sound like a very reasonable way to determine your arm’s length pricing, but we don’t see them too often. So what are some of the challenges in using transaction-based analyses?
Adam Sandford: Well Andrei, true comparables are hard to find and a lot of times we have to go with the best available. But comparing apples-to-apples does prove to be difficult when searching for comparables.
Andrei Enoiu: And and so why isn’t that? Why or why are transactional analysis comparables so hard to find?
Adam Sandford: So let’s take a law firm, for instance. A law firm provides legal services to many customers, but data from their contracts is not readily available. It’s not public knowledge from a transfer pricing perspective, we would need to identify specific transactions that are observed in the market and we can’t rely on the going rate, let’s say.
Additionally, we have to identify true uncontrolled transactions, which does prove to be a challenge, but a challenge that we are up to day in and day out.
Andrei Enoiu: It’s very interesting that you mentioned the going rate.
So I think what you’re saying is: If the law firm has a bill rate of $100 an hour, you can’t necessarily just go by that bill rate, can you? You have to actually show an invoice of $100 an hour because chances are they might discount it.
They might charge you more depending on the complexity of the work and the situation at hand.
Adam Sandford: Correct, correct. So I think first we would need to look at what were those legal services provided. One could be for a merger and acquisition, some legal device that they got. And another could be for an audit that they have and they need legal advice for that. So just because we have these two different situations and they were charged the same, that doesn’t mean that they’re exactly comparable. Now that being said, if we don’t have any other observations available to us, we might have to use it, but we need to search out in the marketplace first.
Andrei Enoiu: And so these comparability factors are super important, especially with transactional methods. We’ve learned about transactional methods in past episodes, so we know just how strict they they are.
Is there anything you can do If you don’t have, I’ll call them “perfect comparables”?
Adam Sandford: You can adjust the results. Depending on what services we’re covering and the similarity of the comps that we found, we can potentially adjust their profitability to bring them closer to the tested party.
Andrei Enoiu: So Adam, what happens next? Right? Let’s say that you can’t confidently apply a transactional analysis. Either you can’t find any comparables whatsoever or the comparables that you find just truly don’t meet that compatibility standard. What do you do next?
Adam Sandford: We would potentially then consider a profit based where the most common type is where we’re looking into the profits of each individual comp that we locate.
Andrei Enoiu: Okay. And so what does that look like? Just as a recap for listeners from when we covered profit-based analyses in more broad terms…
Adam Sandford: Sure. Well, first we would establish a search for comparable companies engaged in the same type of services for benchmarking. Because most jurisdictions want to transfer pricing analysis to construct an InterQual tile range. We would need at least four comparables. We like to have more than that so that our analysis end up being more robust. But four you would need to calculate that range.
Andrei Enoiu: And so what, what are the profit-based methods called for service transactions?
Adam Sandford: The comparable profits method, which is used in the U.S. and Taiwan, it compares the profits between related and unrelated parties. There is additionally the TNMM, which is the OECD equivalent or the transactional net margin method, which compares net margins between controlled and uncontrolled transactions.
Andrei Enoiu: That’s a good point. So with these profit-based analyses, you’re looking at the profitability. And what you’re trying to test is really the markup on the cost of the service that leads to that profit margin.
What about the cost base itself? Can you speak a little bit to that?
Adam Sandford: Right. So many times, if we’re testing a transaction that’s worth $80,000, we might not want to compare that to a transaction or a company that generates billions of dollars a year. What we’re looking for, when we’re attempting to identify similar companies, we want to make sure that they’re similar in every possible way. And one of those ways is their income, the size of their transactions, and the size of their operations. So that does have a play in it as well.
Andrei Enoiu: And what about, as a multinational, if I’m looking to charge my affiliate for service that I’m doing for them, that’s benefiting them and I’ve validated all of that. How do I figure out how much to actually charged them, just as far as my cost goes?
Adam Sandford: I know that I’m going to have to do a CPM or a TNMM to figure out what markup to charge on top of that cost.
Andrei Enoiu: But what about the cost itself? What are some of the ways that we can determine that?
Adam Sandford: So in many times we can use allocations to look for recuperating that cost and some companies go based on the amount of revenue. Some companies still go based on the amount of head count. I’ve seen, for instance say, a European group allocate their cost out and depending on who utilize their services the most, that’s how they allocated the costs. But there are many different ways to do this across a group of companies in a just way, and it’s not difficult for us to benchmark and document that in our analyses.
Andrei Enoiu: And I would say it depends on the function itself, doesn’t it? Because to your point, whether it’s revenue or whether it’s if you’re allocating out IT charges, you might even look at how many laptops or workstations are in each location, and you can allocate based on that or potentially how many clicks they received in that local jurisdiction tickets or what have you.
So there’s a lot of different drivers that you can use.
Adam Sandford: Right.
Andrei Enoiu: A key of course being like you said: You have to justify that it’s fair way of charging out for that service. Let’s talk a little bit about these profit based methods as they are the most common. What are some of the reasons for that?
Adam Sandford: Well, they’re most often used in practice because data is available and the profitability of similarly natured services where the product compatibility is less strict than the unit price comparison analysis. What we’re primarily looking at is what the margins would be on such services.
Andrei Enoiu: And what about with multinationals, where they perform more than one service transaction or more than one type of service transaction?
Adam Sandford: Most companies are engaged in more than one activity. You can evaluate several types of service transactions all at once, not only on a case-by-case basis. For example, a lot can be bucketed under management services, general types of shared services transactions include management services, accounting, payroll, tax support, and IT related services. Our clients depending on how they want to to document these, they can bucket all of these together or carve them out. And we’ll talk a little bit about that later in terms of the white listed services.
Andrei Enoiu: Yeah. So actually that’s a good segue, right?
What are some other methods that can be used for service transactions? Because we know that there are times if you have a low-value added service then you don’t necessarily need to go A to Z in terms of analyzing it. But what do those methods look like?
Adam Sandford: The most common one would be the services cost method…
Andrei Enoiu: Which is an IRS specific method, correct?
Adam Sandford: Correct. This was introduced by the IRS in 2007 it has no specific regulations about the treatment of services and it’s intended to minimize the compliance burden of common intercompany services that weren’t low markups, like we mentioned before. So it might be the accounting, the payroll, the, the admin services.
This allows taxpayers to compare cost without comparing profit.
Andrei Enoiu: And so does the IRS allow you to use it for any type of service?
Adam Sandford: No, it can’t be applied for any type of service. There are specific services the IRRS listed as acceptable for this type of method. Most of those services will be considered low value added services. There’s extensive documentation listing out these services and if you fall into one of those buckets, you can consider yourself for the SCM or the services cost method.
If it’s a high value added service and you can imagine the strategic management research and development, you will not be eligible for the SCM.