PRC Views on Intra-Group Service Fees Make for Interesting Reading — Positions on the Application of the Benefits Test

By Gary D. Sprague, Esq.

Baker & McKenzie LLP, Palo Alto, CA

The State Administration of Taxation (SAT) of the People's
Republic of China (PRC) recently submitted a paper ("SAT Paper") in
furtherance of the continuing work on transfer pricing conducted by
the United Nation's Committee of Experts on International
Cooperation in Tax Matters ("Committee"). The paper is short --
less than seven full pages -- but its content is notable both for
the influence the SAT's views may have on the UN's further work on
intra-group service fee issues, and for the insights it gives into
positions the SAT may assert with respect to intra-group service
fees that multinational enterprises may seek to charge to PRC
affiliates.

In 2012, the Committee published the United Nations
Practical Manual on Transfer Pricing for Developing Countries

("Manual").  The Manual is intended to be a living document,
in that the Committee intends to regularly revise and update the
Manual, including by adding new chapters and additional material of
special importance to developing countries. Currently on the agenda
for further enhancements to the Manual are additional chapters on
intra-group services and management fees, as well as on
intangibles.

The SAT submitted its paper in response to a request for input
to commence the work on intra-group services and management fees.
The request for input attracted a handful of papers, which have
been posted on the UN's website. The SAT's response is the only
response from a national government.1

Transfer pricing practitioners are well aware of the challenges
inherent in devising an appropriate system for allocating
management expenses across a global enterprise. From the
perspective of a U.S. multinational, the U.S. Treasury and the
Internal Revenue Service have sought to limit the activities that
can be characterized as stewardship (or shareholder) activities and
therefore not charged out to subsidiaries. The U.S. regulations
promulgated in 2006 provided a definition of "shareholder
activities" which was considerably narrower than the scope of
activities which did not have to be charged out under prior case
law.2 The current U.S.
regulations require a U.S. multinational to charge out management
activities that result in a benefit to an affiliate. A "benefit" is
defined as follows:An activity is considered to provide a benefit
to the recipient if the activity directly results in a reasonably
identifiable increment of economic or commercial value that
enhances the recipient's commercial position, or that may
reasonably be anticipated to do so. An activity is generally
considered to confer a benefit if, taking into account the facts
and circumstances, an uncontrolled taxpayer in circumstances
comparable to those of the recipient would be willing to pay an
uncontrolled party to perform the same or similar activity on
either a fixed or contingent payment basis, or if the recipient
otherwise would have performed for itself the same activity or a
similar activity.3

In contrast, an activity is not considered to provide a benefit
if the present or reasonably anticipated benefit from that activity
is so indirect or remote that the recipient would not be willing to
pay an unrelated party for the service, or to perform the activity
for itself.4 The U.S. regulations
identify a category of "shareholder activities" which are not
considered to provide a benefit if the sole effect is either to
protect the renderer's capital investment in the recipient or to
facilitate compliance by the renderer with applicable reporting,
legal, or regulatory requirements.5

The intent of this rule is to require a U.S. parent to allocate
to its foreign affiliates expenses incurred for day-to-day
management activities,6 for activities
such as reviewing and approving the performance appraisals for
foreign management,7 or for conducting
a global strategy retreat that results in a strategy statement.8

The OECD's Transfer Pricing Guidelines for Multinational
Enterprises and TaxAdministrations
 ("OECD Guidelines")
provide a very similar expression of these principles. 
Chapter VII, "Special Considerations for Intra-Group Services,"
provides as follows:Under the arm's length principle, the question
whether an intra-group service has been rendered when an activity
is performed for one or more group members by another group member
should depend on whether the activity provides a respective group
member with economic or commercial value to enhance its commercial
position. This can be determined by considering whether an
independent enterprise in comparable circumstances would have been
willing to pay for the activity if performed for it by an
independent enterprise or would have performed the activity
in-house for itself. If the activity is not one for which the
independent enterprise would have been willing to pay or perform
for itself, the activity ordinarily should not be considered as an
intra-group service under the arm's length principle.9

The OECD Guidelines also include a description of "shareholder
activities" which would not justify a charge to affiliates. The
OECD Guidelines' definition is expressed with less detail than the
definition in the U.S. regulations. The OECD Guidelines define
"shareholder activities" as follows:In a narrow range of such
cases, an intra-group activity may be performed relating to group
members even though those group members do not need the activity
(and would not be willing to pay for it were they independent
enterprises). Such an activity would be one that a group member
(usually the parent company or a regional holding company) performs
solely because of its ownership interest in one or more other group
members, i.e. in its capacity as shareholder.10

When it comes to applying the benefit test in practice, in many
cases the tax administration auditing the cross-charge may have a
different perspective on the "benefit" being provided. The SAT
Paper suggests different views of when a benefit can be considered
to be conferred on a PRC affiliate.

The SAT Paper notes that, under PRC domestic law, charges for
"management fees" are not deductible.  The paper notes that
such "management fees" generally relate to "shareholder activities,
which are charged on the basis of an associated relationship
between investors and investees." The paper then asserts that
enterprises "often" seek to claim deductions for nondeductible
management fees by classifying them as deductible intra-group
service fees.

As a matter of policy, the SAT Paper starts its discussion of
the application of the OECD Guidelines to intra-group service fees
by expressing general agreement with the OECD Guidelines' framework
on intra-group services, including the "benefit test."11 The SAT Paper
then goes on, however, to propose that four additional
considerations should be taken into account in reviewing
intra-group services.

First, and most remarkably, the SAT Paper suggests that in some
cases no charge to an affiliate would be appropriate even if the
affiliate indeed did benefit from the service, but the parent
received a greater benefit. The SAT Paper states as follows:When
applying the benefit test, it should not only be considered from
the service recipient's perspective. Instead, the analysis should
be performed from the perspective of both the service provider and
the service recipient. One example is services provided by a parent
company that are associated with its own strategic management, but
not classified as "shareholder activities".  Although the
subsidiary may benefit from such services, the parent company will
benefit more. Therefore, the parent company should not charge
service fees to the subsidiary merely because the subsidiary may
benefit from such services.

This concept of disproportionate benefit as a basis to disallow
a charge entirely does not exist in the U.S. regulations or the
OECD Guidelines. The OECD Guidelines do acknowledge the need to
assess the value of the service to the recipient and how much a
comparable independent enterprise would be willing to pay.12 There is no
suggestion, however, that a disproportionate benefit means that no
charge at all should be made.  The SAT suggestion would
significantly increase controversies, as it would provide a basis
to reject the deduction of an intercompany charge in full, even
when admittedly there has been an economic benefit to the PRC
affiliate, on the basis of a subjective assessment of the relative
amount of that benefit to the PRC affiliate compared to the benefit
to the parent, and perhaps even to other enterprises in the group.
The use of "strategic management" as the SAT Paper's example of
such a case is intriguing, as it sets up an approach to strategic
planning expenses in opposition to that described in Example 14 of
the U.S. regulations.

The SAT's second suggestion provides another theory to disallow
a deduction even if the PRC affiliate admittedly has received a
benefit. In this case, the theory seems to be that an allocation is
not appropriate if the multinational parent provides services that
are costly or sophisticated and the PRC enterprise, if it were a
standalone entity, would not "need" the services.  The SAT
Paper states as follows:When performing the benefit test, analyses
should also be made with regard to whether the services are
necessarily needed by the subsidiary. For example, various advisory
and legal services provided by a parent company may indeed confer
some benefit to a manufacturing subsidiary in China. However, these
high-end services may not be needed from the perspective of the
subsidiary given its functions and a cost-benefit analysis.

Considering the functional profile of the affiliate makes sense
as a factor in the charge-out analysis, as that point indeed can
affect whether the service benefits the operations of the entity.
The reference to "high-end" services and a "cost-benefit analysis,"
however, creates the sense that the SAT is suggesting that, at
least in some cases, expensive U.S. lease costs for the home campus
and high U.S. compensation for sophisticated personnel (for
example) should not be charged to a PRC affiliate.

The third point made in the SAT Paper is that consideration
should be given to whether the particular intra-group service has
already been compensated through another transaction between the
parties. For example, the provision of technical support may
already have been compensated though a royalty payable for the use
of the technology. This point is valid, as it may well be the case
that the comparable transactions that underlie the transfer pricing
policy for the other related transaction include similar services
being performed by the licensor, contract manufacturing principal,
or other relevant entity. In those cases, it would be correct that
no additional service fee should be charged.

It is also true that if the relevant comparability analysis was
based on factual parameters that did not include the additional
service element as a function to be compensated through the
transfer price for the other goods or services, it would be
appropriate in that case to make a separate charge for those
separate activities that also benefit the affiliate. The SAT Paper
does not recognize that possibility, and thus could become a fairly
blunt instrument if field auditors point to this statement as a
reason to disallow intra-group service fee charges when other
intercompany transactions exist between the parties. Taxpayers will
need to be particularly attentive to documenting the basis for any
separate service fee charge as based on the comparability analysis
that determined the prices for the other transactions.

Finally, the SAT Paper asserts that the definition of
"shareholder activity" in the OECD Guidelines is too narrow. In
particular, the SAT Paper asserts that "management" activities are
not precluded from being charged-out under the OECD Guidelines,
meaning that enterprises are able to charge affiliates service fees
"relating to managing and controlling the subsidiaries." The SAT
Paper states that such charge-outs should not be allowed, on the
basis that:most … subsidiaries in developing countries have their
own management teams, and they only need management decision
approvals from the parent companies due to authorisation
requirements.  In this situation, we believe that these types
of management services are likely to be duplicative activities or
shareholder activities and, therefore, should not be charged.

This statement also would seem to present a clear potential for
conflict with the U.S. interpretation of when management fees
should be charged, as expressed in Example 13 of the U.S.
regulations.

The proper charge-out of intra-group services has generated
controversies in many countries over the years. In the majority of
cases, the disputes have been over questions of proof or the
appropriate mechanic to use as an allocation key.13 The
introduction of stock-based compensation expense into the
charge-out base by the U.S. regulations can create controversies on
the foreign end of those charge-outs.

The number of controversies will increase considerably, however,
if an international consensus cannot be maintained on the proper
interpretation of the benefit test as the essential framework for
determining what services are properly charged to an
affiliate.  Many practitioners were perplexed that "management
fees and head office expenses" were identified as a category of
"high-risk transactions" in Action 10 of the BEPS Action Plan.
Action 10 proposes to adopt transfer pricing rules or special
measures to "provide protection against common types of base
eroding payments, such as management fees and head office
expenses." The appearance of those items in Action 10 suggests a
question by at least some tax administrations as to whether the
deductibility of those charges should be further limited.

The denial of a deduction for an intra-group service fee charged
to an operating entity almost inevitably results in double
taxation. Accordingly, it is to be hoped that both the OECD and the
UN will continue the essential work of ensuring that an
international consensus exists on the application of the benefits
test.

This commentary also will appear in the July 2014 issue of
the
 Tax Management International Journal. For more
information, in the Tax Management Portfolios, see Maruca and
Warner, 886 T.M.
, Transfer Pricing: The Code, the Regulations,
and Selected Case Law, Culbertson, Durst, and Bailey, 894
T.M.
, Transfer Pricing: OECD Transfer Pricing Rules and
Guidelines, Boidman, Bloom, Coronado, Cheung, Tien, Su, and
Emmeluth, 6945 T.M.
, Chapter 40, "Transfer Pricing Rules and
Practice in China, and in Tax Practice Series, see ¶3600,
Section 482 - Allocations of Income and Deductions Between Related
Taxpayers.

 

  1http://www.un.org/esa/ffd/tax/TransferPricing/CommentsPRC.pdf.

  2 Compare Reg. §1.482-9(l)(3)(iv) and
TAM 8806002, with Young & Rubicam, Inc. v.
United States
, 410 F.2d 1233 (Ct. Cl. 1969), and Columbian
Rope Co. v. Commissioner
, 42 T.C. 800 (1964).

  3 Reg. §1.482-9(l)(3)(i).

  4 Reg. §1.482-9(l)(3)(ii).

  5 Reg. §1.482-9(l)(3)(iv).

  6 Reg. §1.482-9(l)(3)(iv).

  7 Reg. §1.482-9(l)(5), Ex. 13.

  8 Reg. §1.482-9(l)(5), Ex. 14.

  9 OECD Guidelines, Ch. VII, ¶7.6.

  10 OECD Guidelines, Ch. VII, ¶7.9.

  11 While the SAT Paper does not provide citations,
the language in the SAT Paper regarding the "benefit test"
reproduces the U.S. regulations rather than the OECD Guidelines'
Ch. VII text.

  12 OECD Guidelines, Ch. VII, ¶7.29.

  13 The SAT Paper proposes that a multinational
enterprise be required to disclose in the Master File, as being
developed by the OECD under Action 13 of the BEPS Action Plan, its
global policy for charging intra-group service fees, plus the
method and amount of service fees charged to each subsidiary.