Transfer pricing rules on intragroup services
IN Filipino, the word "toka" is commonly uttered to assign a specific task, duty or responsibility to someone. In a family setting, it means one sibling's share of household chores. This term is also used in planning a family vacation, fiesta, outing, and even a group activity or school project.
This word is also present and relevant in the world of intercompany transactions and transfer pricing. It could be referred to as the equivalent of "intragroup services" which are those provided by one or more entities within a business group to other entities in the group that provide benefits for one or more other members. These may take the form of administrative, finance, human resources, information technology (IT), management, marketing, procurement, research and development, technical services, and others provided in connection with the nature of the group's business.
The services are usually performed within the group to improve processes, enable technology investment, generate profits, and reduce costs by standardizing practices and procedures.
The common practice by taxpayers is that the entity who provides these intragroup services is compensated or reimbursed at cost and without any mark-up or profit element. The question is whether this is a proper treatment. What do Philippine transfer pricing rules say about this arrangement? Let us discuss the relevant provisions in Revenue Audit Memorandum Order 1-2019.
Determine intragroup service
First, it is crucial to determine whether a particular transaction is considered intragroup service. The existence of delivery transactions of intragroup services is recognized if the service provides economic benefit or commercial value that improves the commercial position of the recipient company. This can be determined by considering whether an independent party in comparable conditions would be willing to pay another independent party or would the provision of the services itself.
The group should be able to ensure that a certain service from a related party was, in fact, performed and provided economic benefit to the other related party. To ensure that the service provided has an economic benefit, the taxpayer should match the function performed by the taxpayer with the type of intragroup services received, examine the details of the services charged and understand specifically how the services could provide or have provided economic benefit to the taxpayer.
As earlier mentioned, intragroup services include administrative, management, marketing, procurement and technical services, distribution and routine support services. Examples of routine support services include accounting and auditing, accounts receivable and accounts payable support, budgeting, computer and IT support, database administration, employee benefits administration, legal services, payroll, staffing and recruiting, and training and employee development, among others.
Needless to say, these types of services provide economic benefits to the other party.
On the other hand, the following activities are not considered intragroup services:
– Shareholder activity, which are services intended for activities of the parent company;
– Duplicative service, or those performed by a member that duplicate activities performed by the taxpayer itself or performed by a third party;
– Services that provide incidental benefit, which comprise activities performed by one member of a business group for certain members that also provide incidental benefit to the taxpayer in the group. (Generally, intragroup services will be performed to meet the needs of a particular beneficiary. Other members of the group may gain an incidental benefit. The cost charged for incidental benefits that are received is not a cost that can be charged as expense.);
– Passive association, which is service that is paid to a related company simply because the taxpayer is a member of the company group; and
– On-call services, or those provided by one member of a business group (usually the parent company) that are always available at any time when needed by the taxpayer. If provided by an independent party, there will be a special charge for such service to ensure its availability.
Determine the arm's length payment
Once the service is classified as intragroup service, the taxpayer should calculate the arm's length payment by performing the following steps:
– Review the basis for charging fees. The charging of fees for intragroup services should be based on the costs actually expended in providing the services. For example, a charge for management services should be based on the amount actually spent and not based on the taxpayer's turnover.
– Examine the components in the cost base actually expended by the service provider and their appropriateness to the service provided and the economic benefits for the taxpayer.
– Examine the method for charging for the services used. The methods consist of the direct charges method and the indirect charges method. The former is used in a situation where the service, recipient of the service, the fee that is charged and the basis for the charge can all be clearly identified. The charge can be allocated directly to the recipient. The latter, meanwhile, is used when the direct charges method cannot be applied or when the charge relating to the services provided is not easy to identify and attribute to the related company.
– Examine the basis for allocation of charges for services. The application of the arm's length principle to intragroup service transactions requires that the amount of expense allocated to group members is commensurate with the benefit expected. Allocation basis is acceptable if the taxpayer can explain the correlation between the particular basis and the cost that is expended.
– Examine whether there are comparables for the intragroup services and their mark-up and apply the transfer pricing method that is most appropriate to the conditions and facts. The methods that may be used in evaluating the arm's length nature of service fees include the comparable uncontrolled price method, cost plus method and the transactional net margin method.
Now that we know that intragroup services require an arm's length payment with mark-up element and not merely reimbursement at costs, the common practice of taxpayers mentioned earlier is improper and at risk of being assessed by the BIR (Bureau of Internal Revenue).
In the field of taxation, "toka" likewise applies. To the BIR, it refers to their duties and responsibilities in implementing and enforcing transfer pricing rules such that taxpayer noncompliance will merit tax assessment. To taxpayers, it means knowing the rules on intragroup services and proper charging of arm's length payment to avoid the risk of tax assessment.
Nikkolai F. Canceran is a partner from the Tax Advisory and Compliance Division of P&A Grant Thornton, the Philippine member firm of Grant Thornton International Ltd. For comments and inquiries, please email email@example.com.