Using Intercompany Service Charges To Share Losses
Posted by Sean Faulkner on May 12, 2020
Intercompany service charges, particularly headquarters or management services (referred to herein as “HQ services”), are one of the most common transactions for multinationals, but also can be one of the most difficult to successfully defend. Benchmarking an arm’s length cost-plus mark-up for this type of intercompany transaction is usually the easy part; supporting the cost base to which the mark-up is applied is often a more difficult task.
The COVID-19 crisis has not made the latter task any easier. As financial losses mount in businesses around the world, often it seems these losses are concentrated at the HQ level. Pricing HQ services is typically a subjective exercise, and it is the easiest to adjust by tax authorities. (Tweet this!)
In this article, we will address a question some clients have asked about how to account for this kind of intercompany transaction during COVID-19: Can HQ service fees potentially be adjusted upward to facilitate operating loss dispersion among subsidiaries of multinational entities?
Intercompany Transactions: Accounting For HQ Services During COVID-19
The ideal intercompany HQ services arrangement consists of a few key components, namely:
- Executed legal agreement between the related parties
- Reliable means to capture the relevant costs of providing services
- Regularly updated functional interviews with management of the groups providing services
- Detailed descriptions of the services being provided
- Thoughtful analysis of the nature of shareholder services
- Descriptions of the benefits of the services to the recipients
- Analysis of the most reliable means to allocate costs to the recipients based on the benefits of the services
- Benchmarking for the mark-up that is charged to determine the transfer price
- Detailed invoices for the charges
Given the skepticism with which tax authorities view HQ service charges from a recipient perspective, even having all of the above in place will not ensure audit safety if the charges are contested. Additional challenges often include tension between the service provider and service recipient as to the level of benefit of the services and the cost discrepancy when charging from a high-cost country to a low-cost country.
Before altering a fee arrangement for this type of intercompany transaction, accounting for a scenario like COVID-19, for example, it is best to view any potential changes through the lens of the aforementioned components. To determine whether increases for HQ services are warranted (and how they might be viewed by the tax authorities) ask the following questions:
- Does the intercompany legal agreement allow for changes to how the HQ service charges are calculated? Ideally, the agreement is flexible enough to allow for changes to the services provided, the capture and allocation of costs, and/or the mark-up applied.
- Has there been any change to the nature of the services that are being provided? Perhaps management is more involved in the day-to-day operations of the service recipients given COVID-19: the supply chain team may be taking a more active role in deciding where products are manufactured; health and safety teams could be designing specific responses for individual locations; or information technology teams may be providing additional services as more employees are working remotely, etc.
- Has there been any change to the benefits of the services provided to the service recipients? If service recipients have reduced headcount as a result of COVID-19, or certain employees are not able to work remotely, then more services may be required from HQ to support the business.
- Has anything changed that warrants an update to the allocation keys previously used to approximate the benefit received by the service recipients? Many companies use revenue as the primary allocation key for their HQ service charges. In an environment where revenue will likely be decreasing worldwide (at least in most industries) at different rates in different geographies, a revenue-based allocation key may no longer be reliable. Even single allocation keys may not be reliable, and an allocation that is based on a blended factor may be best. Charges are generally more supportable when allocation keys are specific to the service being performed.
These questions are by no means exhaustive, but if the short answer to all of these is no, then it may be difficult to support an increase in HQ service charges. As the financial situation of the service recipients becomes more uncertain, increasing charges to all recipients without sound economic reasoning will undoubtedly increase transfer pricing risk.
Any opinions expressed in this article are those of the author, and not necessarily those of Valentiam Group.
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We are pleased to announce that Josh Walls has joined the Valentiam Group as a transfer pricing partner in our Los Angeles office.