Local Deductibility of Management Services Charges (article)
Multinationals regularly centralize or share service functions among related party entities in order to generate cost efficiencies, maintain consistency, and leverage centralized expertise. In order to justify the costs associated with these shared functions, commonly referred to as management fees or intercompany/intra-group service fees, multinationals must meet the arm’s length standard regarding the calculation of service charges to related party entities. The local deductibility of management or service fee expenses is a key to avoiding double taxation on those expenses, because losing the deduction in either the service provider’s or service recipient’s local jurisdiction makes the income taxable in both.
Establishing the value of the genuine benefit provided to the service recipient is the primary support for the deductibility of management service fee charges (i.e., whether the service recipient truly would pay for these services in an arm’s length situation). The arm’s length nature of the charge is one of the primary points of contention when asserting local deductibility of a management fee or intercompany services charge under audit. The following points indicate that genuine benefit has been provided:
- Operational benefits are received from the service;
- The related party will not or is not already independently performing the service on its own;
- The recipient would otherwise incur the cost to perform the services from another provider or through hiring additional personnel; and
- An unrelated party would charge for the service in an uncontrolled transaction.
After genuine benefit of the service is established, the arm’s length charge for the service must be calculated in an appropriate manner that accurately reflects the cost and value of the services provided. While time sheets supporting intercompany invoices would provide a direct mechanism to track the benefit provided, nature of services, and cost of services, a direct approach is not feasible for most multinationals. Therefore, multinationals must regularly calculate the cost of services rendered and quantify the benefit of services rendered on behalf of related party entities.
A management fee calculation involves a combination of interviewing the personnel or departments providing services for multiple entities, analyzing the activities being performed, and selecting the appropriate allocation keys. An allocation key may be a percentage of time spent - such as hours or days spent providing services – or it may be appropriate for certain departments to use relative headcount or other ratios that may accurately attribute the cost of providing services to the appropriate beneficiary. Service activities that would be considered stewardship or duplicative would not be charged in the cost of providing beneficiary services as they do not provide a genuine benefit to the service recipient.
After the appropriate cost of providing a service is derived through applying the appropriate allocation key to the fully burdened cost of providing services, a profit element must be considered. Because an independent services business would not provide services at cost to a customer, management or intercompany services charges should incorporate a profit element or markup on the fully burdened cost of providing these services. The fully burdened cost of providing services would include all payroll costs, benefits, and a relevant consideration for overhead expenses. A sample of comparable service providers would yield an arm’s length range of markups. For U.S. taxpayers, a safe harbor election is available to charge certain categories of intercompany services at the cost of provision, without a profit element. As with many safe harbors, however, the U.S. side of the transaction may be covered by the safe harbor while the other side may not be covered.
For U.S. multinationals, foreign deductibility of intercompany services charges is a significant issue. Where local deductibility is denied, double taxation occurs for the multinational. Thus, support for the arm’s length nature of the charges is paramount to supporting local deductibility.
Multinationals will be the best prepared to defend deductibility of these charges through their ability to clearly demonstrate benefit and methods for deriving the charges. Regular intercompany invoices with specifics relating to the nature of services provided help document the arm’s length nature of charges.
Foreign taxing authorities are increasingly wary of intercompany service charges that they perceive to be pro-rata allocations of cost that do not provide genuine benefit to the local entity. Local tax inquiries can uncover a discrepancy between local personnel’s perception of the benefit received and the benefit asserted by the headquarter service provider. Therefore, transparency and consensus with foreign subsidiaries is important to build a supportable process. The examples below highlight a few local jurisdiction requirements multinationals are facing in order to avoid double taxation on intercompany management expenses:
- Mexico now requires local entities to prepare digital invoices to deduct expenses incurred outside of Mexico such as management fees.
- Columbia now limits deductibility to a percentage of local taxable income, regardless of the benefit provided and the cost of the services provided.
- Brazil does not allow the deduction of related party management fees.
- Canada is aggressive to require specific details supporting the beneficial nature of services charged to Canadian taxpayers.
- China now requires review of the arm’s length nature of all outbound payments for services by Chinese taxpayers.
If you have questions on how to evaluate the management services provided within your company, please contact your local CBIZ MHM tax professional.
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