Keeping intra-group services at arm’s length

With fiscal deficits on the rise, governments around the world are closely policing the tax base, and have been challenging inter-company transfer pricing arrangements with greater vigour. In recent years, the compensation paid for intra-group services to related entities has attracted the attention of Indian tax authorities during a transfer pricing audit.

Multinationals are increasingly looking for ways to achieve greater efficiency to improve their market position, and it is common for them to arrange for a wide scope of services for group members on a centralised basis.

Such services typically include management, coordination, and control functions. Indian taxpayers who are a part of the multinational group make payments for such centralised services, mostly with an element of mark-up. From a transfer pricing perspective, these services should be shown to be at arm’s length.

Under the arm’s length principle, a service is considered to be rendered when the activity provides economic or commercial value to the recipient.

However, issues arise when justifying that a ‘benefit’ is anticipated, or has been obtained, from the payment for such services, and determining what amount would be appropriate as ‘arm’s length’.

Tax authorities have been vigorously scrutinising intra-group service transactions, and have challenged taxpayers to justify such payments. The authority’s approach has been to make a detailed enquiry into the nature of the services, organisational structure of the Indian entity, value of the services, determination of costs, benefit received by the Indian affiliate, allocation key adopted, and methodology chosen to defend the payment.

Taxpayers are typically asked to describe the activities undertaken by the foreign affiliates, and also quantify the time spent in India. The information requested suggests that the tax authorities expect a taxpayer to demonstrate that a service has been rendered by an overseas affiliate, resulting in an economic or commercial benefit.

The authorities also expect the taxpayer to demonstrate that the benefits received are not remote or incidental, that the activities are not shareholder activities, or that the services cannot be duplicated.

Given the breadth and depth of the enquiry, compiling the necessary information has been an onerous and time-consuming task for the taxpayers, and it has been compounded by the short time-frame given for responses.

While payments for direct charge mechanism may be easily substantiated, challenges arise in demonstrating benefits for services based on indirect charge mechanism.

In the absence of adequate documentation, tax authorities have contended that no benefit is received by the Indian entity, and have disallowed the entire payment charge by determining the transaction value as ‘nil’.

The challenges facing taxpayers in meeting the authorities’ demand for information have made such transactions easy pickings for making significant transfer pricing adjustments in recent years.

According to Ernst & Young’s survey in 2010, documentation of service transactions has often lagged documentation for tangible goods. Accordingly, taxpayers need to prepare for audits in advance by building a robust transfer pricing defence file, based on the information or data requests made in recent audits, and adopt a proactive approach to transfer pricing dispute resolution early in the audit cycle.

Rajendra Nayak is Tax Partner, Ernst & Young

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