The Hindu Business Line : Compensation for intra-group services

With the concept of `One World - One Economy' developing very fast, trade has crossed country borders. Multi-national enterprises (MNEs) are operating with the help of their subsidiaries in many countries. This has led to an increased quantum of intra-group transactions. More than 60 per cent of world trade takes place within MNEs. India, no exception to this, has, during the past decade, seen astonishing growth in intra-group international transactions. Among the prime contributors to this growth are the information technology and automobile sectors.

Among all the cross-border intra-group transactions of MNEs in India, the concept of intra-group services has achieved a pivotal position. Used effectively, an intra-group service charge/management fee is an important tax planning tool. Hence the compensation paid for intra-group services to related entities by way of intra-group fees specifically draws the attention of the Indian tax authorities during a transfer pricing audit. Every country would like to ensure that it gets its due share of taxes in cross-border transactions.

The Concept

An intra-group service is a service performed by one member of a multinational group for the benefit of one or more related members of the same group. The OECD Transfer Pricing Guidelines state that generally every MNE provides a range of services to its affiliates in order to benefit from economies of scale or to avoid duplication of services, or both. Typically, these intra-group services are technical, financial, administrative and commercial in nature.

They also include management, coordination and control functions within the group.

There can also be group-servicing centres, such as a shared service centre (SSC) or a centre of excellence (CoE) that provide these services to members of the group. In a transfer pricing context, such intra-group services become significant when they are rendered to related parties located in different tax jurisdictions.

It is important for any transfer pricing analysis to be consistent with international standards regarding the allocation of income among related parties. Otherwise, inconsistent approaches across countries could result in double taxation of the income of an MNE.

While the general transfer pricing provisions are contained in Chapter X of the Income Tax Act, 1961 (the Act), no specific provision governs intra-group services. The law is still emerging in India and, therefore, reliance may be placed on the international tax practices followed in developed countries such as the US, along with the OECD Guidelines.

OECD Guidelines

The Guidelines broadly state that while analysing any intra-group service, it has to be seen if, at all, the services were rendered and whether it fairly represents an "arms length charge". If a member of an MNE group is willing to pay to an outsider for the kind of service it used, then it is considered an intra-group service.

In other words, the OECD Guidelines are based on the principle of willingness to pay for an activity from an independent enterprise vis-…-vis performing it in-house.

This implies that such activity must provide some economic and commercial value to the receiving member; furthermore, the need for such a service has also to be justified.

Also, special attention and close scrutiny should be given to certain non-chargeable categories of services, such as shareholder (also known as stewardship) activities, duplicative services, services providing incidental benefits, passive association benefits and on-call services as the OECD Guidelines (and perhaps even the laws of the overseas countries of the subsidiaries of Indian MNE) regard above referred services as non-beneficial activities for the recipient entity, for which a charge is not justified.

Consequently, no allocation is to be made if the probable benefit to other members is so indirect or remote that unrelated parties would not have charged for similar services. Further, such intra-group service charges/management fee charge is to be consistent and commensurate with the relevant benefits intended for the services, based on the facts known when the services were rendered, and not based on benefits realised later on. In other words, the use of hindsight is to be avoided.

US - Temporary Services Regulations Overview

In the US, the Temporary Services Regulations (TSR) apply to "controlled services transactions," which are defined as any activity by one member of a group of controlled taxpayers (the renderer) that results in a benefit to one or more other members of the controlled group (the recipient).

As per the TSR, an activity generally is considered to provide a benefit to the recipient if the activity directly results in a reasonably identifiable increment of economic or commercial value that enhances the recipient's commercial position or may be reasonably anticipated to do so. This same standard of willingness to pay or perform the same activity for oneself is also the next criteria for whether an inter company service has produced a "benefit" for the recipient under the TSR.

However, the TSR excludes activities that produce indirect or remote benefits to the recipient or duplicate the activities of the recipient. Although the OECD Guidelines have no explicit provisions excluding services providing "remote benefits," paragraph 7.11 of the OECD Guidelines does exclude duplicative activities except where the duplication is temporary or necessary for business purposes. It is arguable whether or not a recipient entity would be willing to pay for an indirect or remote benefit.

One of the new areas that Indian MNEs are likely to encounter as they acquire overseas companies or organise overseas subsidiaries is the provision of headquarters services. Indian tax Authorities generally view non-Indian headquarters companies charging Indian subsidiaries as a reduction of income in India. This view could change as Indian companies go abroad. According to the Section 482 Regulations and the OECD Guidelines, Indian company may charge to its group company's management and/or service fees. In addition, depending on the type of services provided, a mark-up on costs may also be appropriate.

Importance of Documentation in Intra-group Services

The most important and crucial aspect is the documentation of the fact that intra-group services were rendered by the service provider and the benefits were received by the service recipient. Thus, apart from documenting the aspects such as description of the business operations of the group and the tax-payer, detailed analysis of functions performed, assets employed and risk assumed, etc, which are mentioned in section 92D read with Rule 10D, one must demonstrate that the service recipient is benefited from the provision of the intra-group service and the same must be proved beyond reasonable doubt.

Intra-Group services - a Planning Tool in Recession

Centralisation of services can reduce the cost of providing the services, gain economies of scale, and have further benefits in terms of securing better rates from suppliers (for example, when the central service involves the purchasing of raw materials, or even the procurement of bought-in services such as IT consulting, and the movement of raw materials and finished goods). Further, centralisation of services also reduces duplication of activities to be done by each group's entities.

Withholding tax implications:

Though Indian tax authorities allow a deduction from income on payments made for intra-group service charges to foreign invested enterprises operating in India, withholding tax implications on the same are unclear. Before withholding the taxes on such payments, it needs to be checked that services for which the payments are being made are chargeable to tax in India or not. Further, in certain judicial pronouncements it has been discussed to bring such payments out of the withholding tax net and provide relief to overseas companies having bona fide cost to cost recharge from their overseas group companies.

Recently, the Chennai Bench of the Income-tax Appellate Tribunal in the case of M/s. Cairn Energy India Pty Ltd held that the withholding tax provisions under section 195 of the Act cannot be applied to payments representing reimbursement of expenses having no element of income. However, there is a need for the taxpayers to maintain robust documentation to substantiate the reimbursements being free of any profit elements.

The matter is not free from further litigation. Until then, the taxpayers may go through the route of seeking a tax dispensation certificate under section 195(2) of the Act before remitting such sums to avoid unwarranted litigation at lower levels.

Other issues

Other issues that merit consideration while designing intra-group services from an international tax perspective are:

Applicability of Service Tax on the intra-group service charges/management fee charge

Applicability of VAT on the management fee charge in the foreign country

Global practices

Indian tax authorities must take the cue from the approach followed by tax authorities globally and follow a similar approach. Accordingly, MNEs are advised to perform the necessary analysis and contemporaneously document their intra-group arrangements and practices in respect of support services, so as to prepare in advance for an otherwise inevitable transfer pricing examination. While formulating an intra-group transfer pricing strategy, MNEs should make it a point to work out the overall business strategy in tandem with various other pertinent international tax planning considerations, such as intra-group services.