The BRICS nations—Brazil, Russia, India, China and South Africa—play a key role in the global economy. The five countries collectively represent approximately 42% of the world’s population, 23% of global GDP and 18% of international trade. The BRICS nations are not members of the OECD, but they are represented at various international forums. While the bloc represents emerging economies and offers opportunities for global investment and trade, BRICs is not a homogeneous group—the tax policies of the individual countries is just one example of the diversity.
BRICS countries generally play an important part in the value chain for global organisations and, hence, transfer pricing is key to tax risk management and compliance in these countries. However, growing scrutiny of transfer pricing practices and evolving transfer pricing frameworks in BRICS countries drive the concerns of multinational entities (MNEs). Considering the unique economic and geographical factors of the BRICS countries, and to address the potential transfer pricing exposures, the local tax authorities closely monitor and conduct regular transfer pricing audits. For instance, audits by the Indian tax authorities have been focusing on issues such as location savings, marketing intangibles and supply chain structures. On the other hand, Brazil mandates the use of fixed profit margins (predetermined margins) and effectively ignores the arm's length principle. In South Africa, because of limited local comparable data, the tax authorities usually prefer/expect a geographical comparison during audits.
As in most jurisdictions, one of the most commonly litigated issues across the BRICS countries relates to intragroup and low-value-adding services. Tax authorities often challenge intragroup services—i.e., services provided by an MNE to its subsidiaries for a fee—because they are an easy target for transfer pricing adjustments when priced incorrectly. Taxpayers have been challenged on their documentation of the “benefits test,” the computation of the cost base considered for recharge, the appropriateness of the allocation keys and the arm’s length nature of the mark-up charged. Tax authorities take a pragmatic approach when evaluating intragroup service charges and in cases where there is a lack of commercial expediency or reasonableness for the charge, the payments may be challenged.
This article looks at the transfer pricing aspects of intragroup services in the BRICS nations and shares practical experience in this area.
The OECD transfer pricing guidelines address intragroup transactions and low-value-adding intragroup services. Intragroup services include a wide array of services, such as technical (research and development (R&D), engineering), financial (treasury, hedging), commercial (sales and marketing, sourcing) and management services (legal, administrative, back office, human resources (HR)). The concept of low-value-adding services, introduced in 2015 in the OECD’s final report on Actions 8-10 of the base erosion and profit shifting (BEPS) project, encompasses a subset of intragroup services, including services such as accounting and auditing, HR activities, information technology, legal and general services of an administrative or clerical nature.
Intragroup services and low-value-adding services are distinguished by the service provider’s risk profile. Some intragroup services, such as R&D services, may involve higher risk compared to routine service transactions such as accounting or bookkeeping services. Low-value-adding services do not involve substantial or significant risk.
None of the BRICS nations provide specific guidance on intragroup and low-value-adding services in their local rules; instead, they generally refer to the principles enunciated in the OECD transfer pricing guidelines. Notably, Brazil does not follow the OECD transfer pricing guidelines for intragroup services, and its transfer pricing rules apply to all controlled transactions, including those involving intragroup services. The Russian tax authorities, on the other hand, have focused on intragroup services transactions in the last few years and have issued two significant clarification letters on the treatment of expenses on intragroup services.
Generally, there are two major issues involved in assessing intragroup services across jurisdictions: were intragroup services rendered and, if so, were the expenses charged in accordance with the arm’s length principle?
The main issue to be determined in an intragroup service transaction is whether the services are in fact provided to the group companies. The following tests are used to make this determination:
To qualify as an intragroup service, the services must meet two criteria: (a) whether an independent enterprise in comparable circumstance would be willing to pay for similar services provided by another independent enterprise; and (b) whether an independent enterprise would have performed that service in-house. If the independent enterprise would not be willing to pay for or perform the activity, the transaction should not be treated as an intragroup service.
Following this principle, Russia’s clarification letters prescribe a “reality test” to ensure that the services were actually rendered to the extent the taxpayer claims. The taxpayer must be able to demonstrate the need to involve its associated enterprises in these processes and transactions.
The benefits test is used to establish that the intragroup services rendered have economic or commercial value resulting in some form of benefit to the group. Although most of the BRICS nations use the benefits test, there are certain deviations:
Services that do not qualify as intragroup services
While the service and benefits tests determine whether intragroup services have actually been rendered, the BRICS countries (with the exception of Brazil) have determined that some services are non-beneficial in nature and cannot be charged for. These services include shareholder activities (primarily rendered by a holding company and carried out solely by virtue of its ownership interest), duplicative activities and services resulting in incidental/passive association benefits.
China has perhaps the most stringent requirements regarding shareholder activities as compared to the OECD. Shareholder activities include financial, tax, HR and legal services provided for the management and operations of a group for the purpose of decision-making, monitoring, control and compliance. These services may not qualify under the benefit test in China. For example, a U.S. MNE may incur costs in ensuring that all its subsidiaries, including its Chinese subsidiary, comply with a particular U.S. regulation. In this case, the activities carried out and costs incurred by the MNE in ensuring that its Chinese subsidiary complies with the U.S. regulation are considered nonbeneficial services and would be treated as shareholder activities. Thus, MNEs should ensure that they understand the expansive scope of shareholder activities in China and clearly distinguish/eliminate the cost of such services.
Similarly, the clarifications issued by the Russian tax authorities list the types of shareholder activities (e.g., participation in profit distributions, receipt of information on the activities of the MNE group, participation in the general shareholder meetings, audit and preparation of consolidated statements, and the purchasing of shares/interests) that cannot be considered intragroup services.
Once intragroup services have been scrutinized and deemed to have met the substance test, the next issue taxpayers need to address is whether the transaction has been priced in accordance with the arm’s length principle.
Most BRICS countries generally follow the two-method charging system prescribed in the OECD transfer pricing guidelines, i.e., direct charging and indirect charging. Direct charging is used when a specific service is directly provided by one member of the group to another member and indirect charging is used when the costs are not directly attributable. Charging involves allocating costs that are commensurate with the benefits received and based on appropriate allocation keys. A mark-up is then added to this cost, the amount of which depends on the nature of the services, and a functional and economic analysis, and is generally in line with mark-ups charged in uncontrolled transactions (typically documented in a benchmarking study).
Some of the BRICS countries have adopted specific rules relating to charging:
While the above methods are followed for intragroup services, four of the five BRICS countries (excluding India) have not adopted the OECD’s simplified approach for low-value-adding intragroup services. India introduced a safe harbour rule in June 2017 for the receipt of low-value-adding intragroup services by an Indian taxpayer from its related entities, under which a mark-up of 5% is allowed on transactions of up to INR 100 million (including the mark-up). For other intragroup services, the Indian tax authorities scrutinize the cost base, allocation keys and mark-up charged to an Indian company.
Taxpayer documentation of intragroup services is crucial for establishing the legitimacy of the services and their charges (elaborating on the benefits test and the arm’s length price) before the tax authorities.
The BRICS countries, as most other jurisdictions, have enacted rules that require taxpayers to keep documentation that details the nature of the services provided, the rationale behind and expected benefits from those services, the cost base considered for recharge, the cost allocation keys, and a calculation of the mark-up charged. Depending on the tax authorities, such documentation could generally include intercompany agreements, invoices, presentations, email correspondence, calendar invites, phone call details, timesheets, meeting notes/minutes and passports to confirm stamps of dates of travel.
South Africa imposes additional requirements regarding intragroup services. For example, an inbound service invoice must be approved by the South African Reserve Bank (SARB). Hence, the SARB may request an audit approval letter before allowing the remittance of funds for service fees. SARB approval usually provides support for the arm’s length nature of the charge and more detail on the benefits received and requires two directors to sign a statement stating that the company has received the benefit.
The general audit trends in the BRICS countries are as follows:
As is evident from the above, intragroup services are examined closely in the BRICS countries and the key issues faced by taxpayers during transfer pricing audits are common across the jurisdictions.
As explained above, intragroup services have always been susceptible to litigation, but the COVID-19 pandemic has triggered a need to review and assess intragroup services in light of the new economic conditions. There have been discussions regarding the impact of the pandemic on intragroup services, but no specific guidance has been issued by the tax authorities in the BRICS countries. In Russia, however, the fact that the tax authorities have started to pay more attention to intragroup services cases since August 2020 (when the first of two clarifications were issued) could be construed to be a result of the pandemic.
Due to the lack of specific guidance, taxpayers should pay attention to the following:
There are numerous such considerations that will need to be thought of and acted upon. It is thus anticipated that taxpayers and the tax authorities will agree on a reasonable commercial judgment to estimate the arm’s length price for COVID-19-impacted periods for intragroup services.
As the growth of global businesses in the BRICS nations is placed on fast-track mode, the volume of intragroup services is also expected to grow significantly. Intragroup services, including low-value-adding services, will continue to be a hot topic of discussion and litigation for BRICS countries in the foreseeable future until the tax authorities formulate concrete guidelines for relevant issues. From a taxpayer perspective, remaining current with rules and regulations and having robust and comprehensive documentation is critical to justify the charges for intragroup services, with the benefits test continuing to be at the crux of that inquiry.
The economic impact of COVID-19 has added a fresh layer of complexity and heightened the risk of litigation for MNEs, especially in BRICS nations from an intragroup services perspective. Keeping all of the above in mind, MNEs will need to gear up and be prepared considering the potential for future litigation!