Transfer pricing of sale of services
Related parties may offer a broad range of different services between them, such as administrative services or services related to their actual business. From the perspective of transfer pricing, the parties involved must ensure that the terms and conditions for the service-related intra-group transactions correspond to the terms and conditions that would have been applied by independent enterprises. The accrued profit of the group company rendering the services must be equivalent to the profit that would accrue to an independent enterprise in similar circumstances.
Sale of services must be priced at arm’s length
Intra-group services usually mean services related to the multinational enterprise`s (MNE`s) actual business, such as sales, manufacturing and research and development services, as well as services supporting the actual business such as financial management services, technical services and legal services.
The objective of transfer pricing of sale of services is that the service charges between related parties correspond to the charges that would have been agreed on between independent enterprises in similar situation. From the perspective of the related party providing the service, this means that the company must receive an arm's length compensation for the service provided. From the perspective of the company acquiring the service, the charge should correspond to the charge that an independent enterprise would have been willing to pay.
Transfer pricing of sale of service is influenced by the nature of the service
When the parties involved agree on service charges and other contractual terms and conditions, it is essential to consider the functions and risks related to the provision of the services. For example, the intra-group services may generate substantial added value for the group's business operations or they may be routine support services. Research and development services are an example of services generating substantial added value. The functions and risks have an impact on how an independent enterprise would be expected to perform financially in a similar situation.
In practice, in the transfer pricing of intra-group sale of services the situation is usually assessed from the perspective of the service provider, especially when the provision of the services does not involve significant intangibles or special expertise. Generally, the service recipients conduct the group's actual business operations and are responsible for the most significant functions and risks involved. When performing the services related to the business operations and supporting them, the risks are merely limited to the provision of the services.
In practice, the functions between related parties may involve a broad range of different functions for supporting the operations. Then it is important to identify the forms of cooperation in which independent enterprises would have agreed on a payment of compensation. However, within the groups there are also activities related to other group companies that, from the perspective of transfer pricing, are not services chargeable to other group companies. Such activities include among other things the so-called shareholder activities benefitting merely the shareholders. The services belonging within the scope of transfer pricing are such that group companies can concretely utilize in their daily business operations.
Determining the arm's length price for sale of services
There are number of different methods for verifying that transfer pricing is at arm's length. The different methods are described in the transfer pricing guidelines of the OECD. The OECD guidelines are internationally accepted and an important source of interpretation when the arm's length principle is applied.
OECD Transfer Pricing Guidelines (www.oecd.org)
As a rule, the arm's length pricing of the fees charged relating to the intra-group services is indicated by means of comparable prices. Comparable prices are prices that are applied in the sale of services between independent enterprises. This method is called the comparable uncontrolled price method (CUP). The CUP method is the most suitable method when a company purchases similar services from third parties or a company providing services sells the same service to independent and comparable parties.
There are rarely any direct comparables for intra-group services available in the market, unless the company sells similar services also to parties outside the group. Therefore, the intra-group services are usually priced by determining the costs arising from providing the service and adding a mark-up on the said costs. Typically, the ratio of the operating profit to operating costs is assessed. This method is called the transactional net margin method (TNMM).
The cost base comprises the direct and indirect costs arising from providing the service. The mark-up is determined in accordance with the services provided. Usually, the arm's length mark-up is indicated based on the operating profit calculated for the costs incurred by independent enterprises providing similar services.
The levels of operating profit of independent enterprises can be examined using commercial databases (such as the Amadeus database of Bureau van Dijk). When making searches for comparables in the database, it is important to use refined search criteria so that the companies displayed are comparable in terms of their functions, risks and, for example, utilization of valuable intangibles. The comparability of the individual comparables must also be carefully assessed in relation to the company to be compared, which in service transactions is usually the company providing the service.
Other matters to be considered in transfer pricing of sale of services
The following matters should also be considered in the transfer pricing of sale of services:
Generally, as the business expands, the intra-group services are centralized to be carried out by a particular group company. If, for example, the parent company provides the same service to a large number of group companies, the costs arising from the provision of the services and a mark-up should be allocated to the group companies in proportion of how extensively they have been using the services.
If it is not possible to track the use of the services in a reliable manner, the allocation of the charges may have to be based on a more general allocation key. The ratio of the companies’ turnover is the most common, but not necessarily the most reliable, allocation key. This indirect way of charging the services is usually well-suited for low-risk and low-value-adding services such as administrative services.
Maintaining a service activity
A group may have to maintain a particular service even if it is not used on a regular basis. As a rule, charging for maintaining such stand-by services is justified if the availability of such service benefits the group companies considering the long term.
Restructurings in the operating model of the group
When the operating model of the group is restructured, some of the functions and risks of the company providing services may be transferred from one group company to another. For the company providing the services, the changes in functions and risks practically mean that there will be changes in the mark-up in the service charges. In every restructuring the company must revise its transfer pricing model and update the changes in the transfer pricing documentation. It must also be evaluated whether the company providing the services should receive a separate compensation for the transferred functions and risks. Such a situation may arise when, for example, the transferred functions constitute an activity connected with substantial profit expectations.