Once businesses expand internationally, it makes sense to centralize certain management, administrative, and technical services in one location. Centralized services can substantially reduce costs and allow companies to standardize processes and procedures. However, companies expanding internationally may not prioritize what is often considered a tax-only issue.
From a high-level, intercompany service fees can be charged on a cross-border basis when the assistance benefits the commercial position of the recipient company. Services can include everything from technical services to back-office support, but there are certain restrictions in both US and international transfer pricing rules that govern when charges are permissible.
Tax authorities around the globe certainly have concerns about multinational companies charging for intercompany services. Intercompany service charges reduce the amount of taxable income in the recipient country and increase taxable profits for the entity rendering the services. No wonder auditors cast a suspicious eye toward management fee payments disclosed on a company’s tax return.
It should be noted: there is just as significant a risk from not charging for services in the first place. A tax authority auditing a parent company can certainly make substantial transfer pricing adjustments for services rendered. Tax authorities do expect service companies to be remunerated for services provided.
While tax authorities do audit intercompany service payments, we find many companies are well placed to improve global cashflow with a fresh look at cross-border charges.
How Can Service Charges Improve Cashflow?
A benefit that may be missed occurs where service charges have an impact on the cash and taxable income position of each entity within a multinational company. Service companies earn taxable income and receive cash from related subsidiaries. This cash and income infusion can help pay off debt and optimize effective tax rates within a company. The following examples help illustrate this approach.
Many parent companies incur substantial debt to fund acquisitions resulting in substantial tax losses at home. For a parent company, implementing a charge for bona fide services can facilitate payment of debt and reduce tax net operating losses at home. The service recipient would consequently pay lower income taxes. The net result is the company pays lower taxes and improves cashflow on a global basis.
Another common scenario is where a parent company operating in a lower tax jurisdiction supplies services to related companies in high tax countries. This regularly occurs when overseas parents support subsidiaries in the US or other high-tax jurisdictions. For a company earning profits in both countries, the tax benefit would normally be the service fee payment times the differential in tax rates.
For certain industries with high duty rates, companies may be including ancillary services in the cost of products shipped on a cross border basis. Taxpayers may be able to reduce the dutiable value of goods by charging for services separately. In other words, reducing the goods price and charging a separate management charge could result in a lower duty payment.
Each of these scenarios could result in substantial tax savings and global cashflow improvements through service charge outs.
Managing Tax Risks
While companies can benefit from intercompany service charges, managing tax risks are a key concern.
The IRS or any other tax authority can certainly question the validity of any intercompany service fee payments paid on a cross-border basis. Taxpayers must prove, among other tests, that:
- The recipient benefitted from the service provided;
- The charge was reasonable; and
- The services were not duplicative or “stewardship.”
One typical arument is that without the service supplier, the recipient company would be required to pay someone else for the services.
There are tax risks from implementing a service charge-out system, especially when implementing the first time. Tax authorities can, and regularly do, disallow deductions for cross-border service charges. If a company is unable to substantiate the benefits of services provided or the amount charged, taxpayers face an uphill battle to appeal. While a multinational can provide supporting documents to defend its position during an audit, quite often these materials are dismissed as insufficient when gathered well after the charges are paid.
In our experience, companies are better positioned when taking the time to:
- Identify and document services provided on a contemporaneous basis;
- Develop a charge-out mechanism based upon fully-loaded costs;
- Implement an intercompany contract; and
- Provide clear explanations on intercompany invoices.
Where possible, companies should utilize a direct-charge method. If management and administrative staff do track their time spent on supporting each company’s operations, the taxpayers are best placed to demonstrate what benefits are provided on a day-to-day basis. Indirect allocations of service fees on a pro-rata basis, such as sales, are less convincing to tax auditors, especially with limited background support. Authorities in recipient companies can challenge the allocation methodology as unreliable, and in fact, some countries disallow indirect charging methods altogether.
Intercompany services are an essential component of multinational companies’ day-to-day global operations, but the implications for both cash and effective tax rate management can be a substantial bonus. With increasing scrutiny of transfer pricing issues, all multinational taxpayers should be ready to explain how services are provided on a cross-border basis.