Within the framework of their faculties, tax administrations can reclassify transactions with the respective adjustments to market values as long as these conclude after the tax audit process that companies did not correctly credit their transactions due to insufficient support.
Conversely, what are the analysis of these actions and the performance reasons?
In section “D” of the OECD Guidelines in the framework of Actions 8-10 of the BEPS Plan, which are intended to ensure Transfer Pricing is according to the creating value activities performed by the Economic Group members, the OECD states:
(…) “These reviews focus on the importance of precisely defining the effective transactions among related companies by supplementing, where necessary, the terms of any contract with the evidence resulting from the proceedings of the parties. The transaction is not simply defined by the terms entered into a contract.”
Tax administrations aim to ensure that Transfer Pricing set in transactions performed within the Economic Group – including the transactions performed with low or null taxation countries/territories within the scope – are aligned with the contractual agreements, as well as the economic reality to prevent the tax base erosion and profit shifting.
Thus, the assumed risks must be supported by the decision-making, given that these can significantly affect the transaction price, according to the Arm’s Length Principle.
When tax administrations start a tax audit process for intragroup services, if possible tax damages, they will require the accreditation of:
- The nature of the service.
- The effective rendering of the service.
- The actual need for the service.
- The place and time covered by the rendering of such services.
- The costs and expenses incurred by the renderer, as well as the allocation criteria of such costs and expenses used for the segmentation.
Among the details requested, the tax authority also requests the identification of deliverables associated with the services, identification of the name/position of the personnel in charge of rendering the service, details of the activities performed in the rendering of services, as well as the associated income, costs, and expenses.
The information requested by the authority partially contrasts the operational reality with the faculties stipulated in the contracts.
The following is an exemplification of some transactions the tax authority may not be aware of.
Let us suppose in the following examples:
- An administrative service (low-value service) was declared as received from a related party when this actually involved senior management personnel.
- A transaction was declared as an expense reimbursement, which is really a service rendered at 0% Fee and not the re-invoicing for an expense incurred with an independent third party.
In the first case, by analyzing the positions of the personnel that actually rendered the service, the risks assumed by the decisions resulting from these services, and the time spent in rendering the service, the tax administration may reclassify the service as one of high value, with the effective adjustment to the market values for senior management services (such as those of management), whose operating margins associated with the functions, assets, and risks required by the position generate a higher added value.
In the second case, due to the lack of a re-invoicing for expenses incurred with independent third parties and that the rendering of a service to a third party should be along with a profit margin, according to the Arm’s Length Principle, such service would be below market values, which would represent a lower collection for the tax administration and, therefore, the corresponding adjustment to the taxable base would be requested after a reclassification of the analyzed transaction.
Depending on the materiality of the rendered services, these adjustments may be crucial and lead to long and tiresome litigation with the tax administration.
Therefore, these services externally advised can prevent or minimize the possible contingencies due to mischaracterization of services.
The preparation of contracts and/or addendums, as well as the evaluation of margins to be agreed upon by related companies, can be preventively advised, adjusting them to the market values, if necessary, before the accounting closing or calculating the adjustments to be directly added in the income tax return.
Given the trend of tax administrations to be aligned with the OECD Guidelines, companies operating within an Economic Group must take preventive actions along with experts, considering what the standards of the organization state:
“(…) In short, the reviews are due to the mandatory requirement to prevent the payment of an inadequate return on capital and the misallocation of risks by promoting rigor in determining the arrangements effectively in force among related companies, considering the valuation to the real contribution of these parties, including the risks effectively assumed and by the possibility of excluding transactions commercially meaningless.”
Source: ACTIONS 8-10 – Final Reports. Ensuring that the Transfer Pricing output agrees with the creating value. OECD and G-20 Project on Base Erosion and Profit Shifting