Is it business as usual for management services and royalty fee charges to be disallowed?
Is it business as usual for management services and royalty fee charges to be disallowed?
Intra-group charges for management services and royalty fees are among the most contested areas of transfer pricing in Africa. Multinationals operating across the continent regularly find themselves on the receiving end of disallowances from Revenue Authorities — and the frustration is mounting. This article unpacks why these charges continue to attract scrutiny, what the OECD Guidelines require, and why the answer to "do we even have to charge for this?" is still a firm yes.
Management services and royalty charges have been a topic of discussion in the context of developing nations for many years. They are known to be subject to scrutiny from various Revenue Authorities, and the common trend has been the disallowance of these charges for income tax purposes. We had a meeting with an unhappy and frustrated Chief Financial Officer (CFO) who had had enough of the disallowance of the charges, that he was ready to provide the management services and right of use of intangibles at no cost. “Do we really have to charge for this?”, is the ultimate question we had to answer.
Why these charges attract scrutiny
The most common scenarios for these types of charges are when they are provided from the parent entity or head office in developed nations (the continent of Europe and North America are what we usually see). When these charge are received by a subsidiary in the developing countries of the African continent, there is normally a preconceived notion that there may be some form of profit shifting involved. Invoices are received on a quarterly or annual basis by in-country subsidiaries with a generic narration that says, “Fee for management services” or “Royalty charge”. That one liner normally comes with a hefty cost at the bottom of the invoice. However, these charges may also come from one developing country to another, as is the case in our current example. This is evidence that scrutiny to such charges is applied by Revenue Authorities, irrespective of who or where the service provider or licensor of IP is.
What the OECD Guidelines say
From a transfer pricing perspective, Chapter VII of the Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations provides guidance as to the principles underlying the charging of intra-group services. The OECD Guidelines concentrate on two key issues when looking at intra-group services, namely, determining whether a service has been rendered and determining an arm’s length charge in relation to that service. In determining whether a service has been rendered, you would need to identify the service provided, perform a benefits test to determine whether the service provides an economic or commercial value to the service recipient as well as ensuring that the costs involved do not consist of excluded activities such as shareholder activities, duplicative activities and activities of incidental benefits. In determining an arm’s length charge you would need to calculate the relevant cost base, identify the most appropriate charging mechanism (by either applying a direct charge or indirect charge with the selection of appropriate allocation keys), as well as incorporating an arm’s length profit element or mark-up as appropriate. Chapter VI of the OECD Guidelines provides guidance specifically tailored to determining arm’s length conditions for transactions that involve the use or transfer of intangibles. A part of calculating the charges in relation to intangibles involves delineating the development, enhancement, maintenance, protection and exploitation (DEMPE) functions and determining an arm’s length price consistent with the functional analysis.
The most common reasons for disallowance
Insufficient documentation
Reasons for the disallowances of these expenses include the following amongst others: lack of sufficient documentation that support the transactions as well as the policies applied. As tax
advisors, we normally recommend taxpayers to prepare contemporaneous transfer pricing documentation (including the supporting benchmarking studies, intercompany agreements and supporting calculations), even if there is no requirement for the documentation to be submitted. This will assist in ensuring that transactions are documented and well without having to scramble should a request for the submission of documents arise.
Failure to meet the benefits test
Failure to meet the benefits test is another reason which results in disallowance of expenses where the recipients of the management services are unable to demonstrate that a benefit was indeed received as result of the services. In some cases, it is found that there is an element of duplication where services are received from parent entities, even though there are in-country specialists within the employ of the service recipients with similar skill sets. This ultimately results in the failure of the benefits tests as the service can be performed in-house by the service recipient.
Cost base and allocation keys
Cost base and allocation keys are another contentious issue where service providers don’t only allocate costs relative to which entities made use of the services but also use the inappropriate allocation keys to recover indirect charges. The application of allocation keys should always be employed to match the cost with the benefit provided by the service. Service providers should also ensure that only the value adding costs are included in the cost base.
Mark-ups and benchmarking
The mark-ups applied may also result in scrutiny as some service providers add inflated mark-ups on costs without the necessary supporting benchmarking studies as support. The contemporaneous documentation argument stands, as the regular preparation ensures that supporting documentation such as the benchmarking studies are kept up to date.
DEMPE functions and royalty charges
In relation to royalty charges for the right to use intangibles, disallowances normally result in relation to DEMPE functions, the issue may be either that these functions are not extensively documented, or there is a mismatch in relation to functions based on what is documented and what happens on the ground. The substance over form argument normally makes its way in discussions relating to intangibles where the common position is that the in-country licensees perform more functions and do more in-country in relation to the DEMPE activities. This then results in the payments of the royalty fees being questioned by Revenue Authorities which may result in a disallowance.
So, do you still have to charge?
All the above that is mentioned may be a bit overwhelming to a CFO or tax manager as transfer pricing may only be one of many aching pains that they need to deal with. However, the idea of not charging in-country subsidiaries for such expenses may lead to more harm than good. Not charging for transactions with offshore related parties would go against the science of transfer pricing which hypothesise the dealings of connected persons as those that would have existed between third parties. There is no third party that would provide a service free of charge.
So, the answer to the question raised by the CFO is a resounding “Yes”, yes they do have to charge for the management services that they provide as well as the royalty fee for the right of use of an intangible. However, they have to ensure that they are covered in all aspects of the issues raised above which seem to be the focus points behind the scrutiny of Revenue Authorities within various African countries