It was a hot October evening as Bevin Repko, CFO of the U.S.-based MNE group Soft Drink, was descending into Tampa International Airport. She had just attended a two-day tax conference in Mexico City to learn about current tax regulatory developments for multinational enterprises (MNEs). One presentation that had caught her attention addressed international transfer pricing. Specifically, the presenter – a transfer pricing consultant from Canada – had presented the new 2017 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations [herein cited ‘OECD Guidelines’]. Bevin Repko had only a vague understanding about international transfer pricing from a tax perspective. She knew from a tax course she took in college that MNEs must apply transfer prices in accordance with the ‘arm’s length principle’ when selling goods and services between affiliated entities. Specifically, they must use a transfer price that reflects the price independent parties would have agreed to under similar circumstances as set out in both the OECD Transfer Pricing Guidelines and the United States’ Internal Revenue Service (IRS) transfer pricing regulations.
Bevin Repko did not know how to apply the arm’s length principle to Soft Drink’s intra-group service transactions. This had bothered her because she knew that many of her CFO colleagues had already experienced audits by tax authorities in several countries and received significant adjustments to their tax returns for not applying transfer prices consistent with the arm’s length principle. In particular, Bevin Repko worried more after learning about OECDs Guidelines for intra-group services because Soft Drink had not paid much attention to international transfer pricing and tax compliance in the past. Instead the group had simply on occasion allocated some costs from headquarters service centers to subsidiaries to ensure that the service centers were at least reimbursed for some of their expenses. However, Soft Drink had no formal approach. Now, she realized that creating a more structured approach to transfer pricing allocations needed immediate attention to avoid trouble with several tax authorities.
In particular, Bevin Repko was afraid that various tax authorities would not agree with Soft Drink that the foreign subsidiaries’ tax deductions for these intra-group services performed by the U.S. headquarters were in accordance with the arm’s length principle and OECD Guidelines. Similarly, the IRS might argue that not enough costs were charged out to the subsidiaries and hence pre-tax profits reported at headquarters’ tax return were too low as well. Bevin Repko’s worries were further enhanced by the fact that starting in 2017, Soft Drink had restructured its group services. Specifically, instead of subsidiaries performing their own administrative services, Soft Drink decided that the MNE group could obtain significant cost reductions by having all administrative services performed at headquarters, within the same legal entity; therefore, subsidiaries were limited to perform only a very marginal number of day-to-day services. Thus, in 2017 the volume of Soft Drink’s intra-group services had dramatically increased, enhancing the transfer pricing tax risks facing the group. Based on the group’s general adherence to regulatory compliance, Soft Drink’s Board of Directors had provided Bevin Repko with specific instructions to ensure that all transfer pricing decisions were aligned with OECD Guidelines. While some minor differences exist between local transfer pricing regulation in many countries and the OECD Guidelines, the Board had decided that as of 2017, Soft Drinks approach to transfer pricing should be based in full on the OECD Guidelines regardless of the specific jurisdiction and its specific domestic tax regulation.
Soft Drink headquarters operates a total of 15 different service centers that service the Soft Drink group in a variety of countries. Bevin Repko has decided to focus on the three largest services namely ‘Accounting and Reporting’, ‘Information Technology’, and ‘Human Resources’. In addition, she will focus on the 2017 tax year, which recently ended. Her activities included making sure that the invoicing from each service center to the subsidiaries is adjusted in accordance with the arm’s length principle.
Accounting and Reporting Services (ARS) provide support to headquarters, as well as the subsidiaries, in the areas of bookkeeping and financial reporting. This service center also provides more complex non-routine financial transactions services, e.g. stock issuances on an ad hoc basis. The costs related to stock issuance are typically fees for external advisors with expertise in financial transactions.
Information Technology Services (ITS) is in charge of the group’s IT infrastructure. This includes purchasing, installment and maintenance of hardware throughout the group. Furthermore, this service center is in charge of setting up and maintaining servers for hosting the group’s increasing need for data storage capacity. In 2017, ITS also initiated a project where ITS staff were to assist the Australian subsidiary in implementing sophisticated online data analytics for tracking the behavior of local customers on Soft Drink’s Australian website. This project called ‘Aussie Track’ is a key part in the group’s strategic transition towards a more online-driven value chain and expansion of the current profit potential for the Australian subsidiary.
Human Resources Services (HRS) performs services related to the hiring and subsequent servicing of all managers at headquarters as well as subsidiary managers. ‘Subsequent servicing’ consists of e.g., assisting with personal tax returns, social security registration, and health insurance enrollment. HRS is also in charge of the annual employee evaluations that headquarter management has decided must be performed for all Soft Drink employees. Finally, HRS is in charge of all payroll-related matters within the group. However, HRS has hired an external firm ‘Pay Management Ltd.’ to perform the payroll function for Soft Drink’s UK subsidiary.
Table 1 provides accounting figures for 2017 for each of the three service centers.
Table 1. Accounting figures for service centers
Soft Drink’s organizational structure is outlined in Figure 1.
Figure 1. Organizational chart
Headquarters, based in the US, serves as the group’s parent company and owns 100% of the Soft Drink group’s subsidiaries around the world located in the UK, Australia and Canada. As mentioned, headquarters operates 15 service centers, including Accounting & Reporting Services, Information Technology Services and Human Resources Services. The remaining 12 service centers, (Legal, Logistics, Insurance, etc.) are not included in the group’s organizational chart and needs no further analysis for purposes of this case. All the subsidiaries are full-fledge distributors in charge of maximizing the sales volume of Soft Drink products to independent retail consumers in local markets. Conversely, headquarters is not involved in direct sales transactions of Soft Drink products. All product manufacturing has been outsourced to independent companies who deliver the products directly to the subsidiaries when inventory levels reach a certain minimum level.
It is further noted that direct market prices for the services performed by the service centers are not available. Exceptions are the payroll service performed by Payroll Management Ltd. and the stock issuance costs mentioned in Table 1. The service performed by Payroll Management Ltd. and the stock issuance costs is invoiced by the external service provider to HRS and ARS, respectively, but delivered directly to the relevant subsidiary. Furthermore, in cases where the TNMM method can potentially be used, top management has decided to follow OECD’s Guidelines for low value-adding service. For non-routine services considered part of Soft Drink’s core business, a commercial benchmark study suggests using a 15 percent markup on cost (given that the TNMM method applies). Finally, Table 2 provides various economic data related to headquarters and the three subsidiaries for 2017.
Table 2. Economic data
- REQUIRED VIDEO AND READINGS
In order to complete the case requirements below in Section 3, please start out by viewing the introductory video to international transfer pricing uploaded to Blackboard.
Then read the following two documents in the order which they appear:
- Appendix to the Soft Drink case. (located after Section 3 ‘Requirements’ in the case study document)
- Special Considerations for Intra-Group Services, pages 319-343, in the 2017 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, OECD: Paris. The link is available on Blackboard.
- Based on the OECD Guidelines, identify the specific service activities that headquarters can invoice to the subsidiaries. For each service identified, explain your reasoning.
- Which of the five OECD-recommended transfer pricing methods would you apply when determining the transfer price of each specific service provided to the subsidiaries? Explain your reasoning.
- How can the service centers determine the total arm’s length transfer price for each service activity that you identified in question 1 (i.e. the total transfer price to all the subsidiaries combined), given the method(s) selected for specific services in question 2?
- Please create a table that outlines the arm’s length transfer price for each specific service charged to each individual subsidiary and explain your underlying calculations.
- What implications do you see for management/cost accounting due to the legal requirement for arm’s length transfer pricing of services?
Multinational Enterprises (MNEs) often choose to centralize a wide range of services for supporting its subsidiaries around the world. Examples of such services are IT, legal, marketing, accounting, logistics, and R&D. Tax authorities are concerned with making sure that services delivered from a group service provider to one or more subsidiaries are priced in accordance with the arm’s length principle. While many countries have their own domestic transfer pricing rules and regulation, many MNEs choose to apply the OECD Guidelines on their intra-group transactions, including services. The main reason is that the OECD Guidelines are in practice recognized by most global tax authorities – including the IRS – despite minor differences in the way domestic transfer pricing rules are formulated.
OECD Guidelines for intra-group services
The OECD Guidelines for intra-group services can be found in Chapter VII. The chapter addresses two main issues for the purpose of determining arm’s length transfer prices for intra-group services in MNEs. The first one relates to determining if a service has in fact been provided to one or more group company, or not. If a service hasn’t been provided, there is no basis for charging a transfer price and no further action is needed. However, if a service has been provided, the second main issue addressed in the Chapter is how to determine an arm’s length price for the service.
Has a service been provided?
When evaluating if a service has been provided to one or more group subsidiaries, the OECD Guidelines recommend that the MNE applies the ‘benefit test’. The benefit test consists of evaluating if the service performed by a group service provider, e.g. a service center, has provided a benefit for one or more group subsidiaries. The criteria here is evaluating if the subsidiary/subsidiaries would be willing to pay an external party for the service, or alternatively have performed the service in-house itself. If the benefit test is not met, the service cannot be charged out by the service provider. Costs of services that do not meet the benefit test are broadly referred to as ‘shareholder costs’. Conversely, if the benefit test is met, the service provider needs to establish an arm’s length transfer price and charge it to the benefitting group company/companies.
Determining the transfer price
Assuming that the benefit test is met, a transfer price needs to be determined and charged to the benefitting subsidiary/subsidiaries. The charge can take two forms: ‘Direct charge’ or ‘indirect charge’.
Direct charge refers to the situation where there is no uncertainty as to how much of the service cost that belong to a particular subsidiary. For example, if a centralized R&D service center carries out a project for subsidiary X, the project benefits only subsidiary X and the service provider’s cost of performing the service (plus markup, see below) should therefore only be charged to X, but not Y and Z.
Conversely, indirect charge refers to a situation where there is uncertainty as to how much specific subsidiaries have used a particular service. For example, if an MNE operates a centralized marketing service center that carries out marketing services for subsidiary X and Y but has limited insights into how much of the service cost that belongs to X and Y, respectively, the service center need to apply an indirect charge approach for determining the transfer price. In this case, the service provider needs to determine an appropriate measure for the resources consumed by X and Y, and then charge them their respective portion of the total service cost.
In OECD Guidelines, such measure is referred to as an allocation key. This can be based on an accounting measure or some other measure related to organizational activity that provides a logical link to the how much the specific subsidiaries have likely consumed of the particular service. For purposes of allocating marketing cost (plus a markup, see below) the ‘turnover’ of the individual subsidiaries might serve as a good measure for how much marketing service cost they each consumed and hence how big a fraction of the service provider’s cost they each should be allocated. Another example would be a centralized service center that provides cleaning services to its foreign subsidiaries. In this case ‘number of square meters’ at the individual subsidiaries is typically used for allocating the total cleaning cost of the central service provider to the individual beneficiaries (i.e. subsidiaries). However, no standard list of allocation keys exists and each situation must be based on the specific facts and circumstances as well as economic data available.
Transfer pricing method
Regardless of whether the direct charge or indirect charge approach is used, the service center needs to determine an appropriate transfer pricing method for determining the transfer price. The OECD Guidelines put forward five accepted methods: Comparable Uncontrolled Price (CUP); Resale Price (RP); Cost-Plus (CP); Transactional Net Margin Method (TNMM) and Profit-Split (PS). In the case of intra-group services, however, the OECD recommends using either the CUP, or the TNMM based on costs.
The CUP can be used when direct market prices are available, in which case the market price serves as the arm’s length transfer price. For example, this would be the case when an MNE service center hires an external contractor to perform a service job for one or more of its subsidiaries and the contractor invoices the MNE service center that subsequently pass on the invoiced amount (i.e. the CUP) to the relevant subsidiary/subsidiaries. Note that the transaction between an MNE service provider and an external contractor is in fact a transaction between two independent parties, as they are not under common ownership. Another example would be the case where market prices for internally performed services can be directly verified from market transactions, e.g. where an MNE service provider assists a number of group subsidiaries and a market-based hourly rate for the service is available from external parties.
The TNMM takes the service provider’s in-house costs of providing the service and adds an appropriate markup, based on the return on costs earned by comparable independent parties. Hence, the TNMM for services works the same way as a Cost-Plus, except that the Cost-Plus only includes Cost of Goods Sold in the cost base. Conversely, the full cost base under the TNMM for intra-group services typically consists of the operating expenses (OPEX) for carrying out the service function. In case the TNMM is selected as transfer pricing method, the OECD Guidelines recommends that a markup is added to the internal cost of the service provider. The reason is that an independent party would generally not perform a job without receiving an economic return. In establishing the markup, OECD Guidelines put forward two different options, dependent on the nature of the service.
If the service can be considered a so-called ‘low value-adding service’ a safe-harbor markup of five percent can be applied, and hence the MNE does not need to study further the actual markup applied by independent parties performing comparable services. In order to be considered a low value-adding service, it is a requirement that the service is of a supportive nature and not part of the MNE’s core business.
If the service does not fall within the scope of a low-value-adding service, the MNE need to examine the markup on costs used by independent comparable service providers. Such financial data are usually obtained through commercial databases, e.g. ORBIS, COMPUSTAT, etc. The markup obtained from here is subsequently added to the service provider’s cost base to arrive at the arm’s length transfer price.
 Headquarters and service centers are part of the same legal entity.
 In most cost and management accounting textbooks, the term ‘allocation base’ is used but the meaning is the same.
 The video link uploaded to Blackboard presents these five methods in more detail.
 This is often in practice referred to as an ‘internal CUP’ or an ‘internal comparable’ because the MNE is one of the independent parties that take part in the transaction. Alternatively, CUPs can take the form of ‘external CUPs/external comparables’ when none of the parties in the comparable market transaction is part of the MNE. To be sure, both cases are examples of CUPs.
 The Cost-Plus is typically applied to tangible manufacturing activities where Cost of Goods Sold is a key part of the cost base. In contrast, service providers do not incur CoGS in their operation; instead their cost base consists of fixed salary costs, office rental space, etc. – in the accounting literature typically referred to as ‘operating expenses’, ‘fixed costs’, or ‘capacity costs’. As mentioned, we use the term ‘operating expenses’.
 Section D in OECD Guidelines Chapter VII.