Andrew Hughes is an economist specializing in transfer pricing, valuation, and risk management. He is based in Brussels.
In this article, the author discusses how to handle coronavirus-related service expenses in an intercompany context, examining both OECD and IRS guidance.
Major effort has been undertaken in response to the COVID-19 crisis, including by multinationals scrambling to address supply chain concerns, enact crisis management measures, look for additional sources of financing, and revise company projections. This article examines how to handle pandemic-related service expenses in an intercompany context, using both OECD and IRS guidance.
I. Background on Services Guidance
A. IRC Section 482 and Regulations
Treas. reg. section 1.482-9 discusses intercompany services transactions. First, for a controlled services transaction to exist, an activity must be performed by one member of a group of controlled taxpayers that results in a benefit to at least one group member. What constitutes an activity is relatively straightforward, but the regs offer more detail on what is and is not a benefit. They state:
An activity is generally considered to confer a benefit if, taking into account the facts and circumstances, an uncontrolled taxpayer in circumstances comparable to those of the recipient would be willing to pay an uncontrolled party to perform the same or similar activity on either a fixed or contingent-payment basis, or if the recipient otherwise would have performed for itself the same activity or a similar activity.
The regs list four activities that do not give rise to a benefit. First, the activity must not provide an indirect or remote benefit — for example, an internal study that recommends changes in management structure and compensation of division heads located at Company X not necessarily having a direct effect on related party Company Y.
Second, the activity must not be a duplicative activity that does not provide any incremental benefit. For example, a treasury function at Company X should not be charged to Company Y if Y has its own treasury function that performs the same function without added benefits provided by X.
Those first two concepts are relatively straightforward.
Third, and most interesting from the perspective of COVID-19 responses, shareholder activities are not considered to provide a benefit. According to the regs, shareholder activities are those that solely “protect the renderer’s capital investment in the recipient or in other members of the controlled group, or facilitate compliance by the renderer with reporting, legal, or regulatory requirements applicable specifically to the renderer, or both.”
Finally, an activity does not provide a benefit if the benefit arises solely from the controlled taxpayer’s status as a member of a controlled group (passive association). That could happen, for example, when newly acquired Company Y wins a large client contract that it would not have won before its incorporation into Company X, even if X did not perform any specific marketing activities to assist Y in winning the contract.
B. OECD Transfer Pricing Guidelines
The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations also devote many pages to the concept of a benefit and when one would and would not be provided. They describe a benefit as “whether an independent enterprise in comparable circumstances would have been willing to pay for the activity if performed for it by an independent enterprise or would have performed the activity in-house for itself.”
The OECD offers three scenarios for when a benefit would not be deemed to occur. First, any activity providing incidental benefits would not be an activity for which intercompany services could be charged. The description of incidental benefits closely follows the concepts of indirect and remote benefit and passive association in the section 482 regulations. Specifically, the OECD guidelines describe an incidental benefit as one in which an activity is performed that benefits other group members not directly involved. They also point out that a related party would not be considered to receive a benefit warranting a service charge if it received an advantage solely for being part of a larger concern.
Second, the OECD guidelines include the section 482 regulations’ requirement for duplication. Specifically, no intragroup service “should be found for activities undertaken by one group member that merely duplicate a service that another group member is performing for itself.” The OECD does note several exceptions, such as when a group is reorganizing or centralizing management functions or duplication is done to reduce business risk (for example, getting a second legal opinion on a business topic).
Finally, the OECD guidelines specify that shareholder activities would not be activities that a related party would be willing to pay for, because they are performed by a related party only because there is a need to do so arising from a capacity as a shareholder.
The following section goes into more detail regarding shareholder versus non-shareholder activities, because those are the kinds of activities that are most often found in a gray area for taxpayers, and thus may be the most difficult to pinpoint during the COVID-19 crisis.
II. Shareholder Expense Examples
Shareholder activities generally cause substantial concerns for practitioners. When an intercompany activity that relates to multiple associated entities is performed, it is deemed a shareholder activity if an associated entity would not be willing to pay for the service if it were an independent enterprise. The costs for those activities should be borne by the group’s actual shareholders.
The IRC regulations and OECD guidelines provide some examples of what shareholder expenses may be, including:
costs related to the parent’s legal structure, such as shareholders’ meetings, issuance of publicly traded shares, and stock exchange compliance fees;
costs related to the parent’s financial reporting requirements, such as consolidating reports and preparing the group’s consolidated financial statements;
costs of raising funds for acquiring its participations in group members and costs related to investor relations; and
costs relating to the parent’s compliance with tax or other laws specific to the parent or its jurisdiction.
Those activities tend to be the most difficult to assess because it is unclear whether an independent company would pay for them. Although the examples above seem straightforward, imagine a U.S.-based multinational conducting an audit of its related parties’ compliance with U.S. anti-bribery and corruption laws. If the multinational has a French affiliate that must comply with France-specific SAPIN II anti-bribery laws, the question whether the audit is a shareholder activity becomes trickier. On the one hand, some of the audit results or recommendations could be partially leveraged to comply with SAPIN II regulations for the French affiliate — but all else being equal, the affiliate would likely not engage a third party to conduct a standalone audit of U.S. anti-bribery and corruption laws.
III. Treatment of COVID-19-Specific Activities
The first step in determining how to treat coronavirus-specific activities in an intercompany context is identifying all those activities and their costs. That should be done as soon as possible, while the information is readily accessible. Practitioners should also try to analyze each activity to determine how it interacts with the supply chain — a central question in determining the pricing of each activity.
The next step is determining whether the costs are direct or indirect and if the activities provide a benefit under the OECD or IRS guidance. Some COVID-19-specific activities that practitioners will want to consider are:
Rebudgeting, forecasting, and consolidating financial projections; specifically, any group-level reporting and consolidation should be investigated as potential shareholder activity.
Creating new investor reports in response to changing financial or earnings projections. This is likely to be investigated as potential shareholder activity.
Helping affiliates manage their response to COVID-19 from a legal, human resources, risk management, and communications perspective. This is likely to be a beneficial activity.
Finding alternative supply sources for the company’s traditional supply chain or procurement of health- and safety-related products necessary for the continuation of operations. This is likely to be a beneficial activity and could be investigated as a high-value-added activity.
Securing additional cash requirements for the group and its affiliates. Depending on which members will have access to cash, this could be considered a beneficial activity.
Reviewing insurance contracts, managing business interruption claims, and securing alternate forms of risk transfer. Again, depending on which members will benefit from the claims, whether group-level policies are involved, and if other forms of risk transfer will be available to group entities, this could be considered a beneficial activity.
Acquiring or divesting businesses or assets for strategic or cash purposes, closing stores, and shifting production toward products more resilient to the crisis. This will depend on whether the activity is beneficial to each related party at hand. There is likely a range of possible answers, depending on the facts and circumstances.
Finally, it is important to consider how to handle those costs under existing intercompany agreements. Not only will it be critical to document economic conditions to justify charges, procedures, and other facts and circumstances as they happen, but it will also be critical for companies operating traditional management service charge models to examine whether their contractual framework is broad enough to include pandemic response activities. When the contracts are not broad enough to include those expenses, practitioners should draft new intercompany agreements, or at least amend current agreements, as soon as possible to capture ongoing expenses.
IV. Subsidizing Routine Service Providers
The coronavirus pandemic raises another exceptional circumstance for determining how cash-strapped multinationals should compensate routine service providers traditionally receiving income on a cost-plus basis. For example, imagine a related party that operates as a shared service center for related-party customer service and data processing activities. For the past several months, operations at many companies have been extremely limited or nonexistent. Should MNEs continue to compensate those routine service providers? Most practitioners would say it depends on the contractual terms or on what unrelated parties would do.
Indeed, the problem becomes complex when examined from all sides, and several outcomes are possible. One angle is to examine the question using the contract terms. Do the contractual arrangements allow me to discontinue services for a period? How do third-party contractual arrangements handle similar issues in cases of business stoppage or supply chain interruption? Attention should be paid to the notice period, break, and force majeure clauses to determine how and if a party could contractually decide to diminish or end the relationship during crisis conditions.
Another angle for cash-strapped multinationals looking to optimize their intercompany pricing structures could be to look at comparable company returns. Do I expect the comparables to have decreasing returns in this fiscal year, and could I adjust compensation downward in the intercompany context of our multinational organization?
MNEs will face questions on whether they still need to compensate routine service providers, as well as whether they can continue to compensate those providers irrespective of whether they are providing services. Here, the answer will depend on both the contractual framework and fact-based questions, such as whether the service provider has cut or furloughed employees and what labor conditions are like for employees where the provider is located, to determine what potential options multinationals have.
V. Conclusion
The COVID-19 pandemic will certainly keep tax practitioners busy with unique intercompany challenges, especially when it comes to intercompany services. MNEs should start to identify, track, and examine the additional services being performed in an intercompany context and whether they can and should be charged to related parties. Specific difficulties will arise in determining whether activities constitute shareholder activity, beneficial and high-value-added activity, or something in between. Further, as companies shut down operations and unemployment soars, multinationals will need to consider whether there are potential transfer pricing opportunities for routine service providers in their multinational supply chain.