Intragroup Transactions: What is The Profit Test?
There are related companies rendering services to each other. The services rendered between them are called intra-group services and are generally offered from the parent company to the branches.
As a result, some companies take advantage of these transactions to increase prices to justify a cost deduction. In order to prevent this kind of tax evasion, the contracted services, the preference of these from the related company instead of other offers in the market due to some economic or commercial benefit, must nowadays be justified.
In this regard, the first paragraph of the letter i) of Article 32-A of the Income Tax Law states that “Notwithstanding the requirements, limitations, and prohibitions provided by this Law, in the case of services subject to the application scope of paragraph a), the taxpayer must comply with the profit test and provide the documentation and information requested, as necessary conditions to deduct the cost or expenditure.”(emphasis added).
In this regard, paragraph a) of Article 32°- A refers to the Transfer Pricing rules to be applied to transactions carried out by taxpayers with their related parties or to those carried out from, to, or through countries or territories of low or no taxation.
Now, regarding the profit test, this is met when the rendered service provides economic or commercial value for the service recipient, improving or maintaining its commercial position, which occurs if independent parties have met the need for the service, performing it by themselves or through a third party.
It should also be noted that, for low value-added services, the deduction will be determined on the sum of the expenses and costs incurred by the renderer along with its profit margin, which should not exceed 5%.
Thus, according to the penultimate paragraph of section i) of Article 32-Aº of the Income Tax Law, low value-added services are those not forming part of the core business of the company, are of an auxiliary nature, do not require the use or creation of unique and valuable intangibles and: “do not entail assuming or controlling a high or significant level of risk, nor generate a significant level of risk for the renderer.”
Based on the aforementioned, the inclusion of the profit test in related company transactions avoids irregularities in the processes. This is due to the documentation entailing the profit test, in which the companies must justify the money transfers carried out through intra-group services.
Hence, a company must support the reason for choosing a related company instead of a non-related one, emphasizing the significance thereof for its choice.
In order to make a profit test acceptable as an argument, a company can start by wondering whether the services rendered to the business were indeed necessary, i.e., whether it was subject to the principle of causation. The profit test is also met if the rendered services add economic or commercial value to the business.
There is no support for inter-company transactions without the profit test. Therefore, these would not be valid to be deductible to determine the income tax.