The Arm’s Length Principle on specific intra-group services

The arm’s length principle (ALP) is the overarching standard considering the subject of Transfer Pricing (TP). ALP is currently the global norm for taxing transactions between associated/related entities and it is based on separate entity principle. The ALP states that the price charged in a controlled transaction between two related parties should be the same as that in a transaction between two unrelated parties on the open market.

The Organisation for Economic Co-operation and Development (OECD) adopted the ALP as an objective guideline for determining how transfer prices should be set in transactions between controlled parties. The increasing size and complexity of transactions among multinational enterprises (MNEs) has, however, made it more difficult to apply the ALP in a consistent manner and that which is accepted by tax authorities. This has led to a sharp increase in the amount of TP documentation requirements by tax authorities.

Zambia’s TP rules provide for the application of the ALP to controlled transactions. Section 97A of the Income Tax Act and the TP Regulations require that assessable (taxable) income of a person should calculated on the basis that the ALP is applied in relation to all controlled transactions.

In cases where the conditions of a controlled transaction are not in accordance with the ALP, then the taxpayer must make the appropriate adjustments to ensure that the assessable income of such a person is calculated in accordance with the ALP. ?

Special intra-group services

These services are very popular in company groups and they often arise because it is more efficient and economical to centralise certain activities. For instance, it is particularly common for various back-office services to be provided, including Accounting, Information Technology, Legal, Tax, Human Resources and so on. These are typically carried out by the parent company or by a group service centre.

This article will primarily focus on the main issues that arise in determining the arm’s length price for services that have been rendered as part of an intra-group transaction.

Some countries have specific legislation, regulations or guidelines on this, but in most cases the only guidance is the OECD Transfer Pricing Guide (TPG). These include a specific chapter, Chapter VII, dealing with intra-group services. The OECD TPG was published in 1995 and has been updated continuosly. Further guidance has been added on shareholder activities together with Section D on low value-adding services which provides for an elective 5% mark-up for such services.

In the analysis of transfer pricing for intra-group services, the OECD TPG mainly concentrate on two issues:

• First of all, it is important to understand whether a service has actually been rendered in the context of the intra-group transaction under analysis.
• Secondly, once it has been established that a service has been provided by an enterprise to one or more related parties, it is then crucial to assess what the charge should be, in accordance with the ALP.

Determining whether intra-group services have been rendered

In order to assess whether an intra-group service has been rendered one must consider whether the transaction in question provides a related party with economic or commercial value that enhances its commercial position. This can be tested by considering whether a third party enterprise in comparable circumstances would have been willing to pay for the activity or would have performed the activity in house for itself. If the answer is no, the service should not be considered an intra-group service under the ALP. Some intra-group services are carried out by one member of the group or related parties to fulfil an identified need and to the benefit of one or more affiliated members of the group. In such a case, it is clear that a service has been rendered.

The OECD TPG highlight several situations that may not be a service to a group company because there is no benefit to that company as detailed below:

????????i.???????????Shareholder activities

Some types of activities are performed by a company because of its ownership interest in other companies, i.e. in its capacity as shareholder. Ordinarily such activities do not provide an economically relevant value to the related parties. Such activities are referred to as shareholder activities. The OECD TPG provide the following examples of shareholder activities:

• Costs of activities relating to the juridical structure of the parent company itself, such as meetings of shareholders of the parent, issuing of shares in the parent company, stock exchange listing of the parent company and costs of the supervisory board.
• Costs relating to reporting requirements (including financial reporting and audit) of the parent company including the consolidation of reports. Costs relating to the parent company’s audit of the subsidiary’s accounts carried out exclusively in the interest of the parent company and costs related to the preparation of the consolidated financial statements of the group (however in practice costs incurred locally by the subsidiaries may not need to be passed on to the parent or holding company where it is disproportionately onerous to identify and isolate those costs).
• Costs of raising funds for the acquisition of its participations and costs relating to the parent company’s investor relations such as communications strategy with shareholders of the parent company, financial analysists, funds and other stakeholders in the parent company.
• Costs relating to compliance of the parent company with the relevant tax laws.
• Costs which are ancillary to the corporate governance of the group as a whole.·

??????ii.???????????Duplicative activities

The OECD TPG also state that there will generally be no intra-group service arising from activities undertaken by one group member for another group member that merely duplicate an activity that the other group member is performing for itself, or that is being performed for such other group member by a third party. This principle is clearly correct, but in practice it is rare for activities to be duplicative, because most multinationals go to some effort to ensure that their activities are planned and controlled in a holistic, coherent manner in order to achieve maximum efficiency and effectiveness. If the same activity is truly being duplicated, the multinational is being wasteful, so apparent duplication should be treated with some skepticism. The mere fact that more than one entity carries out an activity that is labelled with the same description does not mean that there is necessarily duplication.

A duplicative activity can sometimes constitute a valid service if it is only temporary, for instance when the group is reorganising to centralise its management functions and there is temporary overlap.

????iii.???????????Incidental benefits

There are some cases where an intra-group service performed by a group member relates only to some of the group members but incidentally provides benefits to other group members. When a parent company is looking to reorganise the group, acquire a new company, or to terminate a division, these activities could possibly constitute an intra-group service to the particular members of the group involved. For instance, a member of the group might be the appropriate entity to acquire a new business in the same country and might therefore be charged for the costs of acquiring the new business.

These activities may produce economic benefits for other group members not involved as parties in the transactions, by increasing efficiencies, economies of scale or other synergies. The commercial position of the other group members could be more valuable after the transaction has been entered into, but the OECD TPG take the view that the incidental benefit would not cause the other group member to receive an intra-group service, because an independent enterprise would not be willing to pay for it.

Determining an Arm’s Length Charge

Once it is determined that an intra-group service has been rendered, the second step is to determine the appropriate quantum of the charge that is consistent with the ALP. This means that the charge for intra-group services should be that which would have been made and accepted between independent enterprises in comparable circumstances. In general, companies can use either a direct or an indirect method for charging for services.

????????i.???????????Direct charge method

The direct charge method is where each associated enterprise receiving the service is charged directly for that service. Direct charging is most likely to be possible and appropriate in cases where a company is providing an intra-group service that it also provides to third parties, which means it will have put in place a mechanism for determining an appropriate charge.

??????ii.???????????Indirect charge methods

A direct charge method for charging for intra-group services can be difficult to apply in practice. Consequently, some companies resort to indirect methods for charging for services provided by related entities. The indirect charge method is where the charge is based on an apportionment amongst various associated enterprises. The apportionment will involve the use of allocation concept.

Calculating the arm’s length compensation

The method to be used to determine arm’s length transfer pricing for intra-group services should be determined according to the guidelines in Chapters I, II, and III of the OECD TPG. Often, the application of these guidelines will lead to use of the Comparable Uncontrolled Price (CUP) or a cost-based method for pricing intra-group services. A CUP method is likely to be the most appropriate method where there is a comparable service provided between independent enterprises in the recipient’s market, or by the associated enterprise providing the services to an independent enterprise in comparable circumstances.

Conclusion

Most MNEs that are operating in Zambia are net recipients of service transactions from their foreign affiliates. Similarly, most Zambian headquartered companies (that are related) are also conducting significant service transactions amongst themselves. It is therefore very likely that Zambia Revenue Authority (ZRA) will review intercompany service transactions in great detail to ensure that the transactions are consistent with the ALP. It is therefore important for companies to ensure that intra-group service transactions comply with the ALP.?

NB: THIS ARTICLE WAS PREVIOUSLY PUBLISHED BY HLB ZAMBIA IN THE NOVEMBER 2021 ISSUE OF THE MONTHLY TAX FLASH.