Intercompany services transfer pricing framework: PwC

Kristina Novak

Principal, Transfer Pricing, PwC US

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Marco Fiaccadori

Principal, Transfer Pricing, PwC US

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John Cianfrone

Director, Transfer Pricing, PwC US

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Intercompany services transactions continue to present important and evolving challenges for taxpayers. These transactions often involve a multitude of transfer pricing considerations, and their treatment for transfer pricing purposes has the potential to impact non-transfer pricing tax items. Around the world, tax authorities are increasingly reviewing and scrutinizing services transactions. As a result, intercompany services arrangements remain an important component of most taxpayers’ transfer pricing profile.

Stock-based compensation: treatment in controlled services transactions

The treatment of stock-based compensation (SBC) in controlled services transactions can be a challenging issue for taxpayers and one that can diverge significantly across jurisdictions, potentially creating double taxation or mismatches that require careful coordination. As global enforcement intensifies, taxpayers should review for consistency across jurisdictions, align transfer pricing and local tax positions, and monitor developing administrative practices and case law, particularly in regions where services charges are often challenged.

Characterization matters

Characterization remains a critical issue in intercompany services transactions. A common difficulty is that many intercompany services arrangements involve at least a component of embedded intangibles. In these situations, it can be difficult to determine whether the arrangement is a services transaction with an intangibles component, an intangibles transaction with a services component, or two separate transactions. It is important to accurately delineate which intangibles are used in connection with the rendering of the services, which are benefiting from the rendering of the services, and which are providing a direct and independent benefit to the recipient as a result of the performance of the underlying activities.

The resulting characterization may have collateral tax consequences beyond transfer pricing. For instance, if an intercompany payment is characterized as a royalty, withholding tax, treaty eligibility, and other considerations must be evaluated. These items may have downstream consequences on other tax considerations, such as foreign tax credits or subpart F for US tax purposes.

It also is important in these scenarios to focus on the underlying economics, considering the alternatives reasonably available to the parties in connection with the controlled services transaction, and available data over the formal characterization of a transaction when identifying potential comparables. Which transfer pricing method and what comparables offer the best measure of an arm’s length result can be a difficult analysis that requires a holistic review of data reliability and comparability.

US tax considerations under Section 250 and BEAT

The treatment of intercompany services may have direct implications on both foreign-derived deduction eligible income (FDDEI) qualification and base erosion and anti-abuse tax (BEAT) exposure.

Under Section 250, services provided by a US taxpayer may qualify for FDDEI under specific rules that vary depending on the type of service rendered and the characterization of the transactions.

For BEAT, a key question is whether services qualify for the Service Cost Method (SCM) exception. Payments that fall within the SCM exception are excluded from the base erosion payments. Taxpayers must define activities falling within the SCM exception precisely and measure those costs carefully in a manner consistent with their broader transfer pricing approach.

The IRS recently reinforced this position in a Generic Legal Advice Memorandum (GLAM). While the guidance confirmed existing statutory rules, it also emphasized the importance of recurring documentation and method selection. SCM qualification and selection is not an exercise performed once and simply rolled-forward—companies should revisit annually.

When cost-based pricing falls short

Cost-based pricing is common for intercompany services when services transactions can be tested by reference to benchmarkable returns earned by independent companies (i.e., routine returns). When services involve unique intangibles or the bearing of unique risks, however, cost-based approaches may become less reliable. In these situations, taxpayers should consider other potential approaches to pricing the services and consider what data may be available to best measure an arm’s length result.

Managing headquarter services challenges

Headquarter services present unique challenges. Common issues include distinguishing chargeable services from stewardship activities, allocating costs across jurisdictions, and demonstrating that centralized functions such as HR, legal, or finance provide tangible benefits to affiliates. In some cases, headquarter services may be part of a broader bundle of contributions and difficult to isolate.

In the United States, headquarters services may overlap with Section 861 considerations, which govern the allocation and apportionment of expenses, including stewardship costs, for foreign tax credit and other purposes. Stewardship costs are generally defined as the costs a taxpayer incurs to benefit themselves as the owner of a related entity, rather than benefiting the related entity directly. These are expenses resulting from "duplicative activities" or "shareholder activities" as those terms are defined in the services regulations under Section 482. Shareholder activities include the costs of maintaining an investment or fulfilling shareholder responsibilities, such as overseeing a subsidiary's compliance with regulations that the service provider itself (e.g., parent) is subject to, rather than the costs of the subsidiary's day-to-day operations. This analysis requires consistency with transfer pricing rules and the benefit test in which activities that provide a direct benefit (i.e., one that the affiliate would be willing to pay a third party to do or be willing to perform itself) to an affiliate should be charged.

These allocations can therefore draw scrutiny from both US and non-US tax authorities, which generally have an opposing interest in such allocations. Robust contemporaneous documentation that explains the approach can be a critical first line of defense.

Key considerations for service arrangements

Practical steps can help companies reduce risk and strengthen defensibility:

Confirm intercompany contracts are current. Intercompany agreements should be updated as applicable to reflect the envisaged relationship between the parties. In addition, the actual conduct of the parties should be monitored to ensure alignment with the terms of the intercompany contract.

Substantiate data. Taxpayers should be in a position to demonstrate the underlying data of the cost base in services transactions. This includes the cost centers included and excluded, an ability to explain the connection between any individual cost item and the service rendered, and detail around indirect allocations, among others.

Consider the use of contingent payment arrangements. Taxpayers are provided flexibility to structure contingent payment services arrangements to the extent appropriate steps are taken in a manner consistent with the facts and circumstances. If pursuing a contingent payment arrangement, taxpayers should consider putting in place a written contract in a timely manner, including the relevant specified contingencies and the basis for the payment, while assessing the best method to measure the arm’s length pricing of those contingencies.