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Transfer Pricing Considerations for Intercompany Services

It is common for multinational companies to look for services internally rather than from a third party. These services could be managerial in nature, related to research and development, customer service, administration, marketing, or any one of a number of activities. Sometime the services are provided internally for efficiency or simplicity, as is often the case with administrative or back-office services. Sometimes the services are provided internally almost out of necessity, as can be the case with certain types of management services. Often, an entity is setup solely for the purpose of providing a service to other group members, such as with customer service centers, sales and marketing entities, or research and development activities.

In all of these cases, a related party transaction is occurring, therefore transfer pricing rules and regulations apply. In the U.S., intercompany service transactions are governed by Section 482-9 of the Treasury Regulations. Like all intercompany transactions, service transactions must be priced in a manner consistent with the arm’s length standard. This means that the pricing between the related parties must be in line with what the pricing would have been if the parties were unrelated.

When intercompany service transactions are occurring, a number of factors must be considered to mitigate potential adjustments by tax authorities. Most countries have regulations within their transfer pricing rules that deal specifically with service transactions, as they are the most frequently-occurring type of related-party transaction. Among the factors to be considered is whether the recipient of intercompany services derives a benefit from the services. Certain services, such as those of a stewardship nature being provided by a parent company, may not result in a benefit. If no benefit is found, the transaction may not qualify for any charge between the parties.

When a benefit does exist, the next step is to determine what the pricing policy should be. Often, companies use a cost-plus policy in which the provider is reimbursed for its costs plus a profit markup. Taxpayers should always ensure such a policy is appropriate under the applicable transfer pricing rules. If it appropriate, two issues must be addressed: the determination of the cost base, and the value of the markup. A common pitfall occurs when taxpayers do not include or exclude the appropriate costs, both direct and indirect, in the cost base. Determining the cost base can be tricky when the provider of the services has other functions. In such cases, a method of allocation must be chosen that will provide an accurate breakdown of the costs.

When an entity’s sole or primary function is to provide services internally to the parent company or other related affiliates, the entity is referred to as a captive services provider. The IRS has a campaign focused on situations in which a captive services provider is located outside the U.S. and providing services to a related party located in the U.S. The IRS is concerned that U.S. taxpayers are overpaying their foreign captive service providers, which depletes the U.S. tax base.

It is important to carefully analyze intercompany service transactions from both sides of the transaction, considering the transfer pricing rules in each jurisdiction in which a party involved in the transaction in a tax resident. Transfer pricing rules differ from country to country, and often a balance must be struck to comply with all applicable rules.