Within the framework of their attributions, tax administrations can reclassify transactions with the consequent adjustment to market values, as long as these determine that companies did not correctly credit their transactions after the tax audit process due to lack or insufficient support.
Nevertheless, what is the analysis of these actions and the support to perform them?
In section “D” of the OECD Guidelines in Actions 8 – 10 of the BEPS Plan, which aims to ensure the alignment of Transfer Pricing and the value-creating activities by the Economic Group members, the OECD states the following:
(…) “These reviews focus on the importance of an accurate definition of an effective related-party transaction, supplementing, if necessary, the terms of any contract evidencing the conduct of the parties in practice. The transaction is not only defined by the entered into in a contract.”[1]
Tax administrations aim to ensure that transfer prices for transactions performed in the Economic Group – including transactions performed in low or null taxation countries or territories within the scope – are under the contractual arrangements, as well as the economic reality of the transaction to prevent the tax base erosion and profit shifting.
In other words, the assumed risks must be supported by the decision-making, given that these may significantly affect the price of the transaction, according to the Arm’s Length Principle.
When tax administrations start a tax audit process for intragroup services, if there is a possible tax loss case, they request the accreditation of:
- The nature of the service.
- The effective rendering of the service.
- The real need for the service.
- The place and time covered by the rendering of the services.
- The costs and expenses incurred by the renderer, as well as the allocation criteria of such costs and expenses employed for the segmentation.
Among the requested details, the tax authority also requests to identify deliverables associated with services, name identification – the function of the personnel in charge of the rendering of the service, details of the activities carried out in the rendering of the services, income, costs, and related expenses.
The information requested by the authority allows for a partial contrast of the reality of the transaction along with the attributions stipulated in the contracts.
The following explains some transactions the tax authority may not be aware of.
Let us suppose some examples:
- An administrative service (low-value service) received from a related party was declared when this indeed involved executive management personnel.
- A transaction was declared as expense reimbursement, which actually is a service rendered for a Fee of 0% and not the re-invoicing for an expense incurred with an independent third party.
In the first case, the positions of the personnel actually rendering the service, the risk assumed by the decisions resulting from these services, as well as the time covered in the rendering thereof, the tax administration can reclassify the service as high value with the consequent adjustment of market values for senior management services, whose margins of transactions associated with functions, assets, and risks required by the position generate a higher added value.
In the second case, given that a re-invoicing for expenses incurred with independent third parties was not configured and the rendering of a service to a third party should be carried out with a profit margin despite the compliance with the Arm’s Length Principle, this service would be below the market values, which may be a lower collection for the tax authority 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 services rendered, these adjustments can be significant and lead to lengthy and tiresome litigation with the tax administration.
Therefore, the performance, along with external advice, can avoid or reduce possible drawbacks for misperformances of services.
Preventively, the preparation of contracts and/or others may be advised, as well as the evaluation of the margins to be agreed upon by related companies and adjust them at market values, if necessary, before the accounting closing, or calculate the adjustments to be directly added in the income tax return.
Due to the trend of tax administrations to be aligned with the OECD Guidelines, the companies operating in an Economic Group must take preventive actions from experts in the area, considering the organization’s standards:
