Could your company benefit from intercompany service charges?
For international businesses, it often makes sense to centralize certain management, administrative and technical services into one location. Centralized services can substantially reduce costs and help companies standardize processes and procedures. However, centralization also removes a potentially significant tax advantage.
Intercompany service fees can be charged on a cross-border basis when assistance benefits the commercial position of the recipient company. Services can include everything from technical services to back-office support if they abide by certain restrictions and international transfer pricing rules.
Tax authorities around the globe have concerns about multinational companies charging for intercompany services. Intercompany service charges reduce the amount of taxable income in the recipient country and increase taxable profits for the entity rendering the services.
However, there is just as significant a risk from not charging for services in the first place. A tax authority auditing a parent company can make substantial transfer pricing adjustments for services rendered. Tax authorities expect service companies to be remunerated for services provided.
Many companies can improve global cash flow by taking a fresh look at cross-border charges.
How can service charges improve cash flow?
Service charges may impact the cash and taxable income position of each entity within a multinational company. Service companies earn taxable income and receive cash from related subsidiaries. This cash and income infusion can help pay off debt and optimize effective tax rates within a company. Here are three examples:
Example 1: Funding acquisitions or expansions
Many parent companies incur substantial debt to fund acquisitions, which result in substantial tax losses at home. For a parent company, implementing a charge for bona fide services can facilitate payment of debt and reduce tax net operating losses at home. The service recipient would consequently pay lower income taxes. The net result is the company pays lower taxes and improves cash flow on a global basis.
Example 2: Operating in different tax jurisdictions
Another common scenario is where a parent company operating in a lower-tax jurisdiction supplies services to related companies in high-tax countries. This regularly occurs when overseas parents support subsidiaries in the U.S. or other high-tax jurisdictions. For a company earning profits in both countries, the tax benefit would normally be the service fee payment times the differential in tax rates.
Example 3: Charging for services separately
For industries with high duty rates, companies may include ancillary services in the cost of products shipped on a cross-border basis. Taxpayers may be able to reduce the dutiable value of goods by charging for services separately. In other words, reducing the goods price and charging a separate management charge could result in a lower duty payment.
Each of these scenarios could result in substantial tax savings and improve global cash flow through service chargeouts.
How to manage the task risk of intercompany service charges
Companies can benefit from intercompany service charges, but they need to manage tax risks. The IRS or any other tax authority can question the validity of intercompany service fee payments made on a cross-border basis. Taxpayers must prove, among other tests, that:
- The recipient benefited from the service provided.
- The charge was reasonable.
- The services were not duplicative or “stewardship.”
One typical argument is that the recipient company would be required to pay someone else for the services.
There are tax risks from implementing a service chargeout system, especially when implementing it for the first time. Tax authorities can, and regularly do, disallow deductions for cross-border service charges. If a company is unable to substantiate the benefits of services provided or the amount charged, taxpayers face an uphill battle to appeal. While a multinational can provide supporting documents to defend its position during an audit, often these materials are often dismissed as insufficient — especially if they are gathered after the charges are paid.
Best practices for implementing intercompany service charges
Four best practices can help your company implement intercompany service charges and minimize risk:
- Identify and document services provided on a contemporaneous basis.
- Develop a chargeout mechanism based on fully loaded costs.
- Implement an intercompany contract.
- Provide clear explanations on intercompany invoices.
Where possible, use a direct-charge method. Management and administrative staff should track their time spent supporting each company’s operations. Then, taxpayers are able to demonstrate the benefits that are provided on a day-to-day basis.
Indirect allocations of service fees on a pro-rata basis, such as sales, are less convincing to tax auditors, especially with limited background support. Authorities in recipient companies can challenge the allocation methodology as unreliable. In fact, some countries disallow indirect charging methods altogether.
Intercompany services are an essential component of multinational companies’ day-to-day global operations — and they can deliver substantial bonuses in terms of cash and tax rate management. To take advantage of transfer pricing and avoid scrutiny, multinational taxpayers should be ready to explain how services are provided on a cross-border basis.
How Wipfli can help
Wipfli understands multinational tax and reporting and is prepared to help you face unfamiliar regulations, increase tax efficiency and mitigate risk. We partner with accounting firms around the world to keep your business compliant, everywhere it operates. Contact us today to learn more.
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