High-value service charges and transfer pricing controversy

A company’s market competitiveness is built on multiple pillars, including innovation, supply chain efficiency, commercial success, and a host of strategic activities requiring specialised knowledge and capabilities and that are central to its core business (high-value services, or HVS). While the intangible property (IP) owned and deployed by the company in a more traditional sense (e.g., patents and trademarks) are often a critical value driver, the HVS performed or directed by a company’s personnel can generate efficiencies, create synergies, and ultimately drive the operational success of the company.

Examples of HVS include the following:

• A manufacturing company’s efforts to centralise procurement capabilities, resulting in improved raw material quality, a globally harmonised supply chain network, and cost savings due to synergies and unified vendor negotiations. Such efforts contribute to a more efficient value chain and increased profitability for the company.

• A life science company’s deployment of AI and data analytics capabilities to drive intelligence from laboratory and clinical trials data to inform R&D decisions, at the same time managing patient confidentiality and other regulatory requirements. The results are more effective experimental design, faster approval and commercialisation, and a higher return on investment on R&D.

• A professional services company’s efforts to elevate sustainability to a core strategic initiative, strengthening purpose for its employees, and increasing talent retention and productivity, which also have bottom-line margin impacts.

Given the strong potential importance of HVS within companies in driving value, they present an imperative for tax and transfer pricing (TP) practitioners to align such value with their international tax and TP structure. At the same time, tax authorities may not have the same perspective on value creation, instead focusing more on protected forms of IP, which has implications from a TP controversy perspective.

The US Internal Revenue Service’s definition of intangible property includes any “other item the value or potential value of which is not attributable to… the services of any individual” (Section 367(d)(4)(G) of the Internal Revenue Code), drawing a distinction between IP and services.

The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022 (the OECD Guidelines) define an intangible to be “not a physical asset or a financial asset, which is capable of being owned or controlled for use in commercial activities” and to require compensation in an arm’s-length transaction. The OECD Guidelines further clarify that neither the existence of legal, contractual, or other forms of protection, nor separate transferability, is a necessary condition for an item to be characterised as an intangible (the OECD Guidelines, paragraphs 6.6 and 6.8).

While HVS would not fall under these IP definitions as they are services performed by individuals, they can be connected to IP as they often tend to create non-legally protected IP such as know-how and trade secrets for organisations (e.g., an AI initiative, which may generate IP in the form of an algorithm and a method). Some HVS, on the other hand, might be completely separate from IP (e.g., a strategic procurement function that creates synergies).

Stepping outside the tax and TP environment, it should come as no surprise to the armchair economist that the services of individuals might be quite valuable within the context of a firm. Almost a century ago, Ronald Coase postulated that the raison d’être of firms is the reduction of transaction costs; notably, the costs related to the organisation of production (The Nature of the Firm, Economica, 1937). In this context, the services of individuals to optimally organise such production within firms’ supply chains can therefore be viewed as just as valuable as more traditional IP that is legally protected, such as trademarks or patents.

More recently, the work of Erik Brynjolfsson, Lorin Hitt, and Shinkyu Yang on organisational capital (Intangible Assets: Computers and Organizational Capital, Brookings Papers on Economic Activity, 2002) – which is considered to be a company’s culture, structure, organisational learning, best practices, and systems – highlights how arguably non-traditional intangible assets (and the people creating those assets) can be a large driver of a company’s overall value proposition. Therefore, it should come as no surprise that the efforts of individuals and services performed within the firm to preserve and further improve such organisational capital could be quite valuable indeed.

Perhaps the ability to ring-fence certain routine or benchmarkable services or IP (and legally protect them in the case of certain classes of IP, such as trademarks or patents) has created a status quo situation within the TP world whereby these routine services and IP are able to be valued and thereby more commonly transacted across intercompany affiliates, whereas, arguably, HVS and/or soft intangibles continue to draw more scrutiny from financial statement auditors and/or tax authorities.

Tax planning around HVS involves the strategic alignment of profit allocation with value creation within an organisation. With a common predisposition of tax authorities to view HVS as less valuable than IP, it is critical to build robust TP support for any intercompany transactions involving HVS, including the selection and application of TP methods.

Although often relied on by tax authorities, a comparable profits method (CPM) or transactional net margin method (TNMM) (the CPM method and the TNMM method are described under Section 1.482-5 of the Treasury Regulations and the OECD Guidelines, respectively) is often inherently not suitable to analyse a HVS transaction given the strategic and specialised (hence, non-routine) nature of the activities performed. The various applicable TP methods in pricing HVS transactions are expanded on below.

The comparable uncontrolled services price (CUSP) method or the comparable uncontrolled price (CUP) method may be deployed if sufficiently comparable services transactions among independent market participants can be identified (the CUSP method and the CUP method are described under Section 1.482-9 of the Treasury Regulations and the OECD TP Guidelines, respectively). When applying the CUSP method, the comparability analysis is crucial and must be supported by robust documentation.

The nature of HVS and their intermingling with IP across multiple legal entities in an organisation could lead to an application of the profit split method, which requires all the parties to the transaction to make non-routine contributions. In applying the profit split method, one area typically challenged is the quantification of relative contributions by the parties. The dynamic nature of businesses and the continual evolution of HVS can necessitate frequent reassessments.

There is an increasing focus, especially in tax authority examinations, on validating the benefit created by HVS on an ex post basis. For some organisations, a value-tracking capability may not be available and, as such, alternative methods may be considered to track benefit.

Even if multiple TP methods have been applied to triangulate the pricing of the HVS, the taxpayer will also need to be prepared to address the options realistically available to the parties involved in the transaction.

As discussed earlier, there might be a predisposition for financial statement auditors and/or tax authorities to view HVS transactions with a degree of scepticism. The authors’ experience with challenges in this context involves a number of the following potential arguments, sometimes combining them.

One of the most common areas of challenges involves whether the services are connected to the creation of, and/or existence of, IP, which tends to be a fact-specific matter for each and every taxpayer. If there is no disagreement between the tax authority and the taxpayer that HVS do create IP and are thereby inextricably tied to intangibles, it is commonly argued by the tax authority that the HVS are mispriced, or if appropriately priced, there must have been an outbound IP transfer to the HVS provider that was not compensated for to support such a (high) fee for the HVS.

Where the taxpayer establishes that there is no connection between HVS and intangible assets, the tax authority tends to look for ways to draw such a connection and thereby challenge the (high) HVS pricing. In either case, the pricing of the HVS is thereby going to need to be substantiated independent of any IP, so the exit tax and/or mispricing arguments become more difficult to sustain. In addition to exit tax and pricing considerations, one common challenge raised by the tax authority is to characterise the HVS as an IP transaction subject to withholding tax.

Tax authority challenges involving the selection and application of the best, or most appropriate, TP method for valuation purposes are not unique to HVS transactions. In the HVS context, there is a pre-disposition to viewing all services, HVS or otherwise, in a CPM or TNMM context, whereby the costs of providing such services are tallied and an arm’s-length profit markup is applied. Similar to the creation of IP, the costs of rendering HVS may not be correlated with the value that such services provide to the overall organisation. Therefore, the ability to directly or indirectly connect such services to their value can substantiate the pricing of HVS and becomes imperative to sustain such a charge in an audit setting.

While not determinative on intercompany pricing, it is very common for tax authorities to challenge HVS pricing by what such pricing implies. This takes the colloquial form of ‘sense checks’ or ‘smell tests’ and can range from calculating an implied cost plus profit markup under the CPM or TNMM (in the case that the CPM or TNMM was not selected as the best or most appropriate method) to translating the HVS fee to a percentage of the total system-wide profit and arguing that the HVS was mispriced due to having an implied cost plus or share of profit result that is ‘too high’.

There is no mention of such checks or tests in the TP regulations and/or valuation literature that the authors are familiar with, so a common taxpayer refrain is that such checks or tests are not a requirement in performing a TP analysis, nor determinative of the results under such an analysis. Furthermore, there is no reasonable standard on what ‘too high’ means in this context and, as such, any sense check or smell test becomes a ‘beauty is in the eye of the beholder’ form of argument. This all being said, it is important to anticipate such challenges ahead of a financial statement and/or tax authority audit so that one is prepared to adequately rebut any assertions based on sense checks or smell tests.

Like any prospective intercompany pricing transaction, there are a number of areas taxpayers can focus their attention on before implementing a HVS transaction that will assist them in the event of a future challenge. Substance, including key people functions and operational/financial capacity to control risks, is foundational to a robust structure.

Additional efforts will not be discussed at length here, but they can involve memorialising through intercompany agreements that mirror the on-the-ground behaviour, and formalising roles and responsibilities in operating manuals to support the structure that is underpinned by the HVS charge.

HVS transactions are expected to continue to be subjected to scrutiny by tax authorities, despite often creating substantial value for organisations. In this environment, a substance-based design, robust TP analyses, and thorough documentation are critical to withstand such scrutiny from tax authorities globally.

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