Without a doubt, globalization of businesses has been thriving. Multinational and domestic firms alike are often engaged in multiple transactions with and on behalf of each other in a bid to achieve cost efficiency due to readily available resources and administrative convenience or practical exigencies. These types of transactions are usually made without any intention to make profits.
Some of these common practices include allocation of common costs such as those related to IT and procurement, cross-charge of personnel, and other types of cost-sharing arrangements. This recoupment of costs and expenses is commonly known as “reimbursement” or “pass-through costs.”
The usual question about these transactions revolves around whether these cost-sharing arrangements and reimbursements must have an arm’s length mark-up. To come up with an answer, it is essential to discuss some of the global transfer pricing guidelines in treating cost-sharing or cost-pooling arrangements and inter-company reimbursements.
COST-SHARING OR COST-POOLING ARRANGEMENTS
Members of a corporate group occasionally enter into a cost-sharing or cost-pooling arrangement among themselves to share group costs or costs of routine support services. This arrangement arises from a common need for such support services. It also results in mutual benefit, a concept that is fundamental to cost-pooling.
A party to a cost-pooling arrangement must reasonably expect to benefit or must be one that actually benefits from the services with respect to cost-sharing and contributes at arm’s length to the costs of services. The contribution must be in proportion to the nature and extent of expected benefits that a party receives. No payment other than the costs allocated to each participant should be made.
NO MARK-UP FOR PAYMENTS CHARGED UNDER A COST-SHARING OR COST-POOLING ARRANGEMENT
In one BIR administrative order, a cost-sharing arrangement is defined as an agreement under which the parties agree to share the costs in proportion to their respective share of anticipated benefits. The allocation must be made on a “no-mark-up, reimbursement” basis.
On the other hand, some global transfer pricing guidelines state that as an administrative practice, payments may be charged without mark-up to a related party for its proportionate share of the cost of services in a cost-pooling arrangement on the condition that each participant’s share of the costs must be borne in the form of cash or other monetary contributions, that the services are not provided to any unrelated party, that the provision of services to the related parties is not the service provider’s principal activity which will depend on the specific facts and circumstances of each case, and that there is sufficient documentation showing that the parties intended to enter into a cost-pooling arrangement before the provision of the services (for example, a cost-pooling arrangement should be supported by a written agreement which, among other things, must be duly signed by all related parties involved in the arrangement).
The guidelines also require taxpayers to maintain transfer pricing documentation to support the arm’s length basis of the allocation of costs under a cost-pooling arrangement. Such documentation should include:
(a) Description of the types of services provided;
(b) Reasons for selecting a specific method of allocating costs;
(c) Contributions by each related party;
(d) Benefits that are anticipated; and
(e) Details of the calculations used.
Regarding the selection of an appropriate apportionment basis or allocation key, certain guidelines provide that this would depend on the nature and usage of the service. Generally, the most appropriate allocation key is one that most accurately reflects the share of benefits received or is expected to be received by the service recipients. This is largely a question of judgment.
Moreover, it is mandatory for taxpayers to demonstrate that due consideration and analysis have been undertaken in arriving at the choice of allocation key. The allocation key adopted by the taxpayer would be acceptable as long as it is reasonable, founded on sound accounting principles, and consistently applied year to year throughout the group unless there are very good reasons for not doing so. Lastly, the allocation key chosen must lead to a result that is consistent with what a comparable independent party would have been prepared to accept.
REIMBURSEMENT OR PASS-THROUGH COST
Sometimes, a group service provider may arrange and pay for, on behalf of its related parties, services acquired from other service providers (whether independent or related). A reimbursement transaction typically entails a back-to-back arrangement between the taxpayer and its related party for the procurement of goods and services from a third party on a cost-to-cost basis. The related party first procures the goods or services from the third party on behalf of the taxpayer and is subsequently reimbursed at cost by the taxpayer. Most often, the level of value addition or extent of service by the related party is insignificant.
Some global transfer pricing rules mention that the group service provider may pass on the costs of the acquired services to its related parties without a mark-up, provided that:
(a) The acquired services are for the benefit of the related parties;
(b) The acquired services have been charged at arm’s length;
(c) The group service provider is merely the paying agent and does not enhance the value of the acquired services or does not require any significant functions to be performed. However, where a recharge does not pertain to reimbursement of third-party costs (incurred by a taxpayer on behalf of the related party for administrative convenience), but where the taxpayer has, in fact, performed value addition or was responsible and accountable for the service provided by the third party or where intra-group service has been performed, then a mark-up can be insisted on; and
(d) The costs of the acquired services are the legal or contractual liabilities of the related parties. This condition can be met even if the group service provider is legally or contractually liable to pay for the acquired services. This is if it has a written agreement with its related parties for the latter to assume the liabilities related to the acquired services.
The above treatment is premised on the view that independent parties in comparable situations would agree not to earn a mark-up on the costs incurred.
The group service provider should nonetheless charge an appropriate arm’s length mark-up for its function in arranging and paying for the acquired services on behalf of its related parties especially when the group service provider adds significant function or provides value-added services. The mark-up should be based on the aggregate costs of its resources in performing the said function and reflect the nature of its own services and extent of value-add generated for the related parties in the group benefiting from such services.
For example, Related Party A may use its own resources to arrange, select, and liaise for the provision of corporate secretariat services by an independent firm for its Related Party B. The fees charged by the independent firm may qualify as strict pass-through costs. Hence, Related Party A may recoup the fees from Related Party B at cost and without mark-up. However, Related Party A’s own costs of arranging, selecting, and liaising should be charged to Related Party B using an appropriate arm’s length mark-up.
Please be reminded that the application of the above transfer pricing guidelines on cost-sharing or cost-pooling arrangements and reimbursements would largely depend on the specific facts and circumstances of each case and thus, requires a careful examination of each case.
While there is room for the taxpayer to justify its charges at cost and without an arm’s length mark-up depending on facts and circumstances of each case, the key responsibility of the taxpayer is to be able to maintain sufficient transfer pricing documentation and supporting documents. Otherwise, the justifications are nothing but a “lip” justification that may not withstand the scrutiny of tax authorities.
Let’s Talk Tax is a weekly newspaper column of P&A Grant Thornton that aims to keep the public informed of various developments in taxation. This article is not intended to be a substitute for competent professional advice.
Nikkolai F. Canceran is a partner from the Tax Advisory & Compliance division of P&A Grant Thornton, the Philippine member firm of Grant Thornton International Ltd.
As published in BusinessWorld, dated 06 April 2021