The continuous globalization of trade has led to an increase in intra-group services. Intra-group services are those provided by one or more entities within a group to other fellow units, or for the benefit of the group as a whole. Such services include administrative, finance, human resources, information technology (IT), management, marketing, procurement, research and development, and technical services, among others.
For commercial reasons and cost efficiency, Multinational Enterprises often choose to centralize certain functions or services through “shared services” or “global in-house centers.”
The application of shared services has been a popular and proven business strategy. Based on the website of the Global In-House Center Council Philippines, the trade association of in-house centers operating within the country represents more than 60 members, predominantly Fortune 500 companies.
One of the definitions of “shared services” is an operational philosophy that involves centralizing those administrative functions of a company or group of companies that were once performed in separate divisions or locations. Back-office functions/services, such as accounting and finance, purchasing, inventory, payroll, hiring, and IT, are normally the kind of services that can be shared among the various business units of a company or group of companies.
The idea of implementing shared services is to improve processes, enable technology investment, generate profits, and reduce costs by standardizing practices and procedures.
For transfer pricing purposes, shared services are generally considered intra-group services that should comply with the arm’s-length principle. It is necessary to determine whether the amount of the charge is in accordance with the principle: the charge for shared services should be that which would have been made and accepted between independent enterprises in comparable circumstances.
DETERMINING AN ARM’S-LENGTH CHARGE
According to Organization for Economic Co-operation and Development (OECD) guidelines, the direct charge method is generally the appropriate approach in determining arm’s-length charging. Through the direct charge method, the associated enterprise is charged for specific services. This approach, though, may not always be appropriate or may be practically difficult to apply. Hence, the use of the indirect method, which relies on estimation and allocation of cost, is acceptable.
A typical example where cost will be allocated is with shared service centers. In this circumstance, the cost allocated to recipients should be based on an appropriate measure of usage such that each service beneficiary bears its fair share of the total cost incurred by the service provider.
What is an acceptable and appropriate measure of usage? The Philippine Tax Code does not provide a hard and fast rule to guide taxpayers in allocating costs. No uniform method of accounting can be prescribed for all taxpayers, and the law contemplates that each taxpayer should adopt such forms and systems according to their best judgement. However, existing rules suggest that costs may be segregated first through specific identification, if possible. Costs that can be segregated through specific identification are the salaries and wages of employees working for a specific function or company, and depreciation, amortization, repairs, and maintenance of assets used for a specific function or company.
If specific identification is not possible, allocation based on relevant data may be used, if applicable.
The allocation of costs is essentially an accounting issue and, given that the law does not expressly provide rules that will govern each situation, the method of allocation adopted should, at best, be one that is reasonable, justifiable, and consistently used. Hence, a method of accounting that reflects the consistent application of generally accepted principles in a particular trade or business in accordance with accepted practices in that trade or business is regarded as accurately reflecting income.
Considering that there is no tax law prescribing the allocation method, any method of allocation may be used, provided that such basis adopted should, at best, be one that is reasonable, justifiable, and consistently used. To be reasonable, the Bureau of Internal Revenue (BIR) suggests that the allocation basis should have a correlation with the costs being allocated.
Typical allocation methods acceptable to the BIR are the proportion of area occupied for rental, utilities, and the number of employees for office supplies and communication.
For transfer pricing purposes, the allocation method chosen must lead to a result that is consistent with what a comparable independent service provider would have been prepared to accept.
Once the method of allocation is chosen, it is necessary to determine the arm’s-length charge and the profit element. The service provider is expected to earn a return (typically in the form of a markup) on the cost of providing the service. To determine what the appropriate return should be, refer to what independent parties charge for a similar transaction. The service provider must conduct a benchmarking study to identify the independent companies providing comparable services, as well as the return that they earn.
After determining through a benchmarking study the arm’s-length markup, the next thing to consider is whether the service provider will adopt a cost-plus markup method or a full cost-plus markup method. The decision will depend on the business strategy of the service provider or the group.
Ideally, the basis for costs should be determined based on the actual costs incurred in rendering the shared services. However, it may be difficult and time-consuming to determine the actual cost incurred. In this case, estimated costs (a close approximation of actual costs) are acceptable. Estimated costs are predetermined or standard costs of performing a service under normal conditions, and are developed from historical data analysis.
Shared service companies or global in-house centers have grown significantly in the Philippines. Our country is seen as an established location for these enterprises. According to a report from the Board of Investment, shared service companies are projected to generate $7.61 billion in revenue by 2022.
As this multi-billion-dollar industry brings positive growth to our economy, the BIR will definitely set its eyes on these enterprises to ensure compliance with transfer pricing rules to avoid tremendous losses of tax revenue for the government.
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 director 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 07 May 2019