Even intercompany management fees have complex tax rules
Most U.S.-based businesses with international operations perform centralized or shared service functions at their company headquarters. This can include services such as accounting, human resources, information technology, legal services, marketing and other back-office services.
Companies regularly centralize these functions in order to generate cost efficiencies, leverage centralize expertise and maintain consistency throughout the company. In order to justify these headquarter costs, an intercompany charge commonly referred to as a management fee or intercompany service charge is billed to the foreign subsidiary or other foreign entity for their share of the expenses.
Too often, though, some companies may be performing these services but not charging anything out to their foreign subsidiaries or other foreign entities. The costs associated with these supporting services stays on the U.S. books. By not allocating a portion of the costs to any foreign subsidiaries, the company is understating income subject to U.S. taxation and overstating foreign taxable income.
Since the intercompany charges are cross-border, this results in a permanent reduction to the U.S. tax base. If caught by the IRS, the taxpayer could be exposed to severe penalties for noncompliance. Penalties generally run either 20% or 40% of the increase in tax due to improper cost sharing, depending upon the magnitude of the tax understatement.
The Arms-Length Standard: How Would Unrelated Taxpayers Behave?
The current U.S. tax regulations governing intercompany services between related parties can be found under Treas. Reg. Sec. 1.482.9. Under these regulations, the U.S. entity should be charging an arms-length management fee for the services it provides.
The situation can become exacerbated for tax purposes if the foreign subsidiaries are profitable in their home country while the U.S. business is reflecting losses. It is possible that the expenses in the U.S. are really supporting the foreign operations. Under Sec. 482, the IRS has the power to reallocate income and deductions between related party taxpayers in order to reflect what it believes to be the true economic nature of the cross-border activity.
Section 482 deals with related party transactions, and is commonly known as transfer pricing. The purpose of Section 482 is to allow the IRS to make reallocations and adjustments to income and deductions as needed to prevent tax evasion and to reflect the true income of related taxpayers involved in a transaction.
The U.S. transfer pricing rules require that the arm’s-length standard be the basis for determining which transfer pricing methods would provide the most reliable results. The arm’s-length standard requires the controlled taxpayers to achieve the same results from their transactions as would uncontrolled taxpayers under the same circumstances.
If one member of a group of controlled entities provides services for the benefit of or on behalf of another group member without charge or at a non-arm's–length charge, IRS can make appropriate reallocations under IRS regulations to reflect an arm's–length charge for those services. If the services benefit more than one group member, IRS bases the allocation on the relative benefit intended for each group member when the services are performed. Under IRS guidance, the taxpayer can price services rendered by a group member by using one of the following methods:
- the service cost method (SCM);
- the comparable uncontrolled services price method (CUSP);
- the gross services margin method;
- the cost of service plus method;
- the comparable profits method; and
- the profit split method.
Unspecified methods are also permitted, provided that (as with any of the above six methods) the taxpayer can demonstrate that the method used gives the most reliable measure of an arm's-length result under the best method rule as described in the regulations.
The Taxpayer as the Burden of Proof
The burden of proof that a company has its transfer pricing in line rests with the taxpayer, not the IRS. This is based on the principle that the income tax system relies on self-assessment and that as a consequence the burden of proof is on the taxpayer. A Section 482 adjustment can be made regardless of taxpayer motive or even if the tax effect of the original pricing was unintentional. Special transfer pricing tax penalties can be asserted as part of an IRS transfer pricing adjustment.
A penalty can be imposed on an underpayment of taxes that results from improper intercompany transfer pricing as follows:
The penalty is 20% of the underpayment of tax when:
- The price claimed on the tax return is 200% or more than the arm's length price; or
- The price claimed on the tax return is 50% or less than the arm's length price; or
- The net Section 482 adjustment exceeds the lesser of: $5 million or 10% of gross receipts.
The penalty is 40% of the underpayment of tax when:
- The price claimed on the tax return is 400% or more than the arm's length price; or
- The price claimed on the tax return is 25% or less than the arm's length price; or
- The net Section 482 adjustment exceeds the lesser of: $20 million or 20% of gross receipts.
The IRS requires contemporaneous documentation to be in place at the time the return is filed in order to obtain penalty protection.
The arm's-length amount charged in a “controlled services transaction” must be determined under a method described above. A controlled services transaction includes any activity (see below) by one member of a controlled group (the renderer) that results in a benefit to one or more other members of the controlled group (the recipient(s).
An activity is not considered to provide a benefit to the recipient if, as provided, the benefit:
- is indirect or remote ,
- is duplicative,
- arises solely in a shareholder activity, or
- results from membership in the controlled group.
The services cost method (SCM) evaluates if the amount charged for covered services is arm's-length by reference to the “total services costs” with no markup. If the taxpayer applies the SCM under these rules, then it is considered the best method and the IRS is limited to adjusting the amount charged for the services to reflect the properly determined services costs. Thus, the taxpayer controls whether the SCM applies.
Lower Value Services can be Handled More Expeditiously
Low margin covered services is one of two categories of covered services eligible for the SCM, are services for which the median comparable markup on total services costs is less than or equal to 7%. The other category is specified covered services as listed in Rev. Proc. 2007-13. This revenue procedure identifies specified covered services.
The activities identified in this revenue procedure are support services common among taxpayers in a variety of industry sectors, and generally do not involve a significant arm’s length markup on total services costs. Such services include costs related to payroll, accounting, G&A functions, Meeting coordination and travel planning, tax, environmental, budgeting, treasury, recruiting, employee development, I.T. and insurance claims management.
Higher Value Services do not Come Under SCM
Some intercompany services have to be handled separately, because they are of higher value. Excluded services include:
- Extraction, exploration or processing of natural resources;
- Reselling, distribution, acting as a sales or purchasing agent, or acting under a commission or other similar arrangement;
- Research, development, or experimentation;
- Engineering or scientific;
- Financial transactions, including guarantees; and
- Insurance or reinsurance.
Typically intercompany support services are compensated based on cost or a cost plus method. Not all costs are required to be marked up.
Establishing the value of the true benefit that is flowing cross-border is the key to avoiding a Section 482 adjustment by the IRS, and is the primary support for its deductibility in the local country. Of course, the deductibility of management fees in local countries will be contentious if there is not adequate documentation justifying such charges. Transfer pricing documentation is required by law in about 100 countries. Additionally, some countries have their own particular limitations on the deductibility of such charges.
Written Documentation is Key
The take-away is that management fees need to reflect economic reality, be based on an arm’s length standard as provided in the Section 482 regulations and be documented in writing. This may entail analysis of all the activities being performed, interviewing personnel and coming up with the proper cost drivers so that the fully loaded cost of providing these type of services can be derived. The cost drivers can be based on costs of certain departments, headcount, relative sales or cost of sales, or other cost drivers.
It is also important to distinguish management fees from payments for the use of intangible property. Providing company know-how, processes, customer lists or other intangible property may be viewed as an outbound transfer of intangible property for which royalties are due, and they are often subject to withholding at source.
The formula for intercompany charges needs to memorialized and formalized in an intercompany services agreement. The charges should be invoiced on a regular basis and not made by mere journal entry or intercompany account offset. In order for the management fee deduction to be deductible in the local country, the management fee needs to be reasonable and necessary and based on the services actually performed (as opposed to what the management agreement said it would perform).
The lesson to be learned here is obvious. Documentation is key. The arrangement needs to be real and must have a valid business and economic propose. The documentation should be in place before the tax return is filed.
There is no one size fits all formula. Considerable judgment has to be exercised in crafting such agreements. Obviously materiality is a factor, while a transfer pricing study may be warranted for a seven-digit annual management fee, the same would not apply to a $50,000 management fee. Your tax advisor knows this, and can advise you on best practices for your type of industry and situation. Contact us with any questions you may have.