Intragroup and low-value-adding services: A BRICS perspective
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.
Understanding intragroup and low-value-adding services
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?
Were intragroup services rendered?
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:
- Brazil - Every expense booked in Brazil (including intragroup service charges) must be necessary and related to the recipient company’s activity or to support the business. The tax authorities may request evidence demonstrating that the services were actually performed by the foreign entity.
- Russia – The clarifications issued by the tax authorities provide guidance to taxpayers as to how to meet the benefit test. There is no “one direction” practice on how to meet this test; it depends on the nature of the services in question. However, Russia’s tax authorities are starting to use investigative methods, including the questioning of staff.
- India – The tax authorities require that the taxpayer demonstrate a need for the services and that the services actually be rendered, in addition to meeting the benefits test. If the taxpayer is unable to provide supporting documentation or evidence to the satisfaction of the tax authorities, they may disallow the expense and make a transfer pricing adjustment.
- China – The tax authorities determine the arm’s length price of intragroup services by applying a six-part “beneficial test:” a benefit test, a necessity test, a duplication test, a value creation test, a remuneration test and an authenticity test. If services fail one of these tests, the taxpayer may not be allowed to deduct the payments related to such services for corporate income tax purposes.
- South Africa – Taxpayers are required to provide a description of the benefit received from the services in question. Although proof does not have to be documented, the tax authorities may request proof during audits. Apart from the local file requirements, any transaction over SAR 5 million must be supported with documentation demonstrating that the benefit test was met, as well as benchmarking and financial analysis/support.
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.
Are the intragroup services charged for in accordance with the arm’s length principle?
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:
- Brazil - Only costs/expenses directly attributable to the provision of services are taken into account in Brazil; Brazil does not take into consideration a functional or economic analysis or a benchmarking approach. Instead, the tax authorities make a calculation following established rules, using fixed profit margins to determine the maximum tax-deductible price for imported services and the minimum taxable price for exported services.
- Russia - Cost-sharing arrangements generally are examined closely in Russia. If a taxpayer cannot produce evidence of a clear link between the type of service procured, why the service is necessary for the Russian entity and evidence that the service was provided directly to the Russian entity, it may not be deductible for tax purposes. In most cases, the cost of a service is justified under a cost-plus basis with a comparison to the service provider’s actual mark-up on total costs, with a market range identified by the results of a benchmarking study.
- China - In addition to assessing the cost base, the allocation key and the mark-up rate from the foreign service provider’s perspective, the Chinese tax authorities also tend to look at the bottom-line profits of the Chinese service recipient. If these profits fall outside a reasonable profit range, such as the interquartile range established by comparable companies undertaking similar functions, assuming similar risks and owning similar assets as the Chinese entity, the tax authorities may view the profit as having been shifted out of China by means of the service fees. To manage the potential transfer pricing risk in China, taxpayers should consider preparing a benchmarking study to assess the appropriate return for the Chinese entity to arrive at a reasonable amount of service fees paid out of China.
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.
Documentation requirements and other audit issues
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:
- Brazil – The tax authorities generally require supporting documentation for every amount/line item that has been included/considered in the transfer pricing calculations.
- Russia - The tax authorities have prescribed a “documentation test” in which they provide examples of supporting documents that are currently requested with respect to intragroup services. This list is open-ended, but it discourages the tax authorities from using a formalistic approach when requesting and analysing documents. In practice, the approach of tax authorities is not yet entirely established and clear, as they have only recently (since 2020) begun transfer pricing audits for intragroup services.
- India - In many cases, the tax authorities have rejected taxpayers’ benefits test/benchmarking approach and determination of the arm’s length pricing of intragroup transactions as nil. However, transfer pricing practice has evolved and there have been several recent rulings where the taxpayer’s submission of documentary evidence to support the benefit test has been accepted and the arm’s length pricing of these intragroup transactions have been accepted.
- China - One of the major issues under inspection in China is the remittance of cross-border service fees, especially for Chinese subsidiaries incurring continuous losses. In cases where there are large cross-border service fee payments, the Chinese tax authorities tend to suspect that the payment is one of the major reasons causing the losses and they will request supporting documentation to demonstrate the nature of the services and the arm’s length nature of the payments. As mentioned above, if a taxpayer does not pass the six-part test, the service fees will be disallowed as deduction for corporate tax purposes. Further, as China does not have a safe harbour rule for the service fee mark-up rate, the arm’s length nature, even for low-value adding services, has to be supported by an economic analysis from transfer pricing perspective. These challenges/inspections could arise even after the service fees are remitted, since the Chinese authorities have discretion to request information going back 10 years.
- South Africa - The tax authorities’ usual practice is to disallow the full-service expense in the South African entity’s account and to require the taxpayer to provide supporting documents to render it acceptable. The tax authorities may be less concerned about mark-up but are more concerned about the costs being charged, which should be fair/beneficial and allocated to the South African entity appropriately.
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.
Assessing the Impact of the COVID-19 pandemic
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:
- Intragroup services that the tax authorities previously would have accepted may now be questioned. For example, services received from a parent entity during the pandemic may not pass the benefit test and may be classified as a shareholder activity.
- Considering that the pandemic has resulted in changes or shifts in the supply chain, with a corresponding impact on profitability, MNEs should review the functional and risk profile of such transactions and in turn their transfer pricing policies.
- Due consideration will need to be given to exceptional/non-recurring operating costs that may be part of the cost base of intragroup services. It will be necessary to perform a detailed analysis of the costs to be considered operating costs and their allocation. Although MNEs may look to attribute losses to even low-value-adding/limited risk entities, considering the pandemic, the reasons will need to be documented appropriately because they may be challenged by tax authorities in the future.
- The impact of the COVID-19 pandemic will be evident in the margins of comparable companies and, therefore, on the usual mark-up charged for intragroup services. MNEs may consider amending their transfer pricing policies, if required, depending on the impact. However, the lack of public data for the COVID-19-impacted period will pose additional challenges when an MNE group is affected by the pandemic and is looking to reduce the margin, which may not be backed by an appropriate benchmarking analysis.
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!