Part 1 of this series provided a high-level look at the process, tax, and regulatory complexities of intercompany service transactions. Part 2 took a deeper dive into the process-related challenges. In Part 3, we review the tax-related issues that can complicate these transactions.
The Intangible Nature of Services
When a multinational company provides a tangible product to its various entities, there’s usually little question about the validity of the transaction. You can see and touch the product and account for the quantity picked at a warehouse, shipped, and received. If an entity in France receives a shipment of 500 laptops from a company’s main warehouse in the UK, the transaction is easily audited, and any associated tax easily calculated, paid, and reported.
But when a global company provides services to multiple entities, the details of the transaction may be less clear—because services, by their nature, can be abstract. As part of everyday business operations, organizations routinely provide a variety of services to entities in other parts of the world. One of the greatest tax risks is an inability to defend the tax deductibility of an intercompany service transaction.
To allow a tax deduction for an intercompany service transaction, a country’s tax authorities will require details on the nature of the service provided: evidence that the entity billed for the service received a benefit, and proof that both the transfer price and the dollar amount allocated to a given entity were calculated and applied correctly.
When it comes to providing sufficient details on the service provided, many intercompany invoices don’t provide much specificity at all. The more abstract the service type, the more challenging it is to define and be specific about.
For instance, if a centrally based Human Resources (HR) director consults with a colleague in another entity on how to recruit new hires for senior-level roles, the intercompany invoice might simply list the service as “HR services.” Or if a member of the in-house legal counsel team consults with a particular entity on a litigation matter, the intercompany invoice might read “legal services.”
While the accounting staff receiving the invoice might deem that description sufficient to approve payment, the tax authorities will require much more detail to allow a tax deduction. If the organization’s systems and processes don’t make it easy to document the necessary level of detail, it will be difficult to provide the specificity required to defend tax deductibility—increasing the risk of losing lucrative deductions.
Demonstrating Value and Price
Global companies can also run into trouble demonstrating that the entity billed for the service derived benefit from it. In the HR example above, if the entity receiving the service also employs its own HR team, tax authorities might challenge whether that entity required or derived value from the consultation services provided. If the consultation between the central HR function and the other entity happened primarily by phone, there may be little documentation on how that advice was used and to what benefit. The more subjectivity involved, the more likely the tax authorities will scrutinize the transaction and challenge the tax deduction.
Even if there is sufficient detail about the service provided and documentation that the entity benefitted from it, the amount billed could be called into question. Tax authorities typically look at two considerations: Was an appropriate transfer price mark-up charged, and was the portion of the total invoice allocated proportionally to all entities involved?
To satisfy the first consideration, it’s necessary to document that the transfer price mark-up was calculated appropriately and consistently. That involves calculating the internal cost to provide the service then applying a markup based on what a third party would charge for the same service, arriving at an “arm’s length” price. For the second consideration, the organization must demonstrate that each entity involved has been charged proportionally, using an allocation key that’s proportional to the level of services received, e.g., the number of employees in the case of HR services.
Aside from the tax deductibility issues, intercompany service transactions can create challenges when it comes to applying VAT and other indirect taxes. It is difficult to apply the correct indirect tax to a service that is not clearly defined. Conversely, describing intercompany services in detail makes it easier to apply, pay, and report on indirect taxes accurately.
When Tax and Process Issues Collide
The nature of the intercompany process itself has the potential to trigger tax problems.
For example, many multinationals use a shared service center approach, which often reduces costs but also reduces the organization’s visibility into the entire intercompany transaction function. A lack of visibility and oversight can inadvertently result in the assessment of BEAT (base erosion and anti-abuse tax). Specifically, if a global company consolidates intercompany costs in the US by charging foreign services costs into the US first, then re-allocates them to entities in other countries, the organization could be hit with a 10 percent BEAT in the US. When that tax is assessed on millions or billions in intercompany transactions, the additional, unnecessary costs can add up significantly.
A lack of visibility and oversight likewise can create tax issues for organizations that consolidate property rent expenses. Multinationals often consolidate such costs through a single property management vendor then charge the expenses intercompany, across various countries. However, doing so incurs a nonrecoverable indirect tax. If the staff members responsible for the intercompany transaction function are aware of the implications, they can adapt their processes to avoid the unnecessary indirect tax expense.
Additionally, a lack of sufficient documentation on intercompany charges often stems from a lack of awareness that charges for shared services should be allocated across multiple entities for accounting and tax purposes. The company can’t fully deduct a particular shared services role in the country where the role resides if some of the staff’s work is done on behalf of entities in other countries.
Similarly, the decentralized nature of the intercompany function presents process issues that can create tax problems. In the case of transfer price mark-ups, it’s possible the same charge could inadvertently have a mark-up applied more than once if the charge passes through more than one entity. Or an entity might use a billing route that creates a higher tax liability, simply because it’s not aware that a different billing route would have avoided that liability.
When intercompany service transactions are handled manually, the inherent tax complexities tend to escalate. In contrast, an automated process guided by robust technology can ensure that intercompany services are detailed with more specificity, the transfer price is arrived at properly, the costs are allocated across entities appropriately, and the right indirect tax is applied and paid. In addition, automation can give detailed and immediate insight into the cost details of the services provided and their allocation, which greatly enhances the ability to defend the tax deductibility of the charges.
Many multinational organizations look to FourQ for technologies that reduce the tax complexities and risks associated with intercompany service transactions. Contact FourQ to learn about our OneBiller solution for automating, centralizing, and optimizing the intercompany accounting function.
Part 4 of this series will review the regulatory-related challenges of intercompany transactions.