Transfer pricing

Charging out headquarters costs

By Sean Foley (US), Yoko Hatta (Japan) and Arwed Crueger (Germany)

eadquarters service charges can often be the focus of a difficult tax audit. Tax authority examiners seem to enjoy ticking and tying headquarters service charges. When the taxpayer is receiving the charge, they can seem to relish requiring the corporate tax department to prove the benefit the local company received. Companies that are unable to meet this challenge may face, at best, a hard fight through the competent authority process or, at worst, double taxation. In theory, identifying a direct benefit and charging an arms length price may seem straightforward. But many headquarters expenses do not readily fit into this simple model, as they often are services carried out for the whole group. This may lead tax authorities to take the position that the local affiliate does not derive a direct benefit. A methodology called activity-based costing (ABC) can help by first showing the mechanism by which the benefit is conveyed and then using that benefit to allocate charges.

Background
Headquarters service charges have been subject to relatively consistent rules in most jurisdictions for a long time. This may be about to change, as first, US taxpayers, and then the rest of the world, face the new Internal Revenue Service (IRS) regulations (see Proposed Treasury Regulations, section 1.482-9). In particular, the new IRS regulations may force companies to revisit their headquarters charges and to charge out a significantly higher proportion of costs than in the past. The UK, Switzerland, Japan, and India recently have also adopted new rules.

Overview
This chapter: lays out the current rules for intra-group charges under the 1995 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines), while comparing the guidelines to the current and proposed US regulations; considers methods for charging out costs, particularly activity-based costing; discusses developments in Europe and the Asia/Pacific region; and focuses on the allocation of headquarters costs and will skip over lightly the amount, if any, that such costs should be marked-up. The relative importance of the amount of any markup as compared to the cost base subject to allocation can be illustrated by the following example. Consider a corporate headquarters with a cost base of $100 million located in the parent companys home jurisdiction. Let us assume that 60% of the consolidated groups revenues are from sources outside the home country jurisdiction. At one level, this might indicate that $60 million of cost should be charged out to foreign subsidiaries. Let us also assume that today the company charges out only $20 million, and these costs are charged out without a markup. If the local tax authority steps in and requires the corporate headquarters to increase the markup from 0% to 5%, the company is facing an income adjustment of $1 million.

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Biography Dr Arwed Crueger
KPMG Deutsche Treuhand-Gesellschaft Aktiengesellschaft Wirtschaftsprfungsgesellschaft Marie-Curie-Str. 30 Frankfurt, D 60439 Germany Tel: +49 69 9587 2906 Fax: +49 69 9587 19 2906 Email: acrueger@kpmg.com Website: www.kpmg.com Arwed Crueger is a senior manager within KPMG in Germany and is responsible for KPMGs quantitative transfer pricing activities in Germany. Dr Crueger has lead an exhaustive number of transfer pricing engagements focusing on topics like cost allocation, permanent establishments, base shifting, brand name evaluation, stripped-buy-sell and principal structures, quantitative analysis or documentation. He has worked with companies from the automotive and electronics sector, with banks, insurance and re-insurance companies, asset management companies, stock exchanges and securities houses. He is a member of a workgroup of the German Ministry of Finance for quantitative analysis. Before working with KPMG in Germany, he worked as a management consultant with a big four organization and for a major German bank. He holds a doctorate in economics and a masters degree in economics. Dr Crueger is a regular speaker at conferences. He regularly publishes articles and books on transfer pricing. His latest book deals with transfer pricing and cooperation.

On the other hand, even if the tax authority accepts the 0% markup, it might well require the corporate headquarters to charge out a higher percentage of its cost base. If the charged cost base jumps up to $50 million, the company is suddenly facing an income adjustment of $30 million an entirely different order of magnitude.

Headquarters costs: whats involved

Multinational companies often structure their business to take advantages of economies of scale by providing centralized services. The focus of these services may be in the parent companys headquarters in the home jurisdiction or in one or more regional headquarters or service centres, or often in some combination of regional and worldwide service centres. The services provided by the companys headquarters may include some or all of the following functions: marketing; accounting; finance or treasury; tax; legal;

human resources; information technology; engineering support; strategic planning; shareholder relations; acquisitions; intellectual property management; and senior executive management. At an analytic level, headquarters services can be categorized as follows: services that benefit particular subsidiaries directly; services that benefit several subsidiaries or the group as a whole; and services for the groups shareholders benefit. Services that specifically benefit foreign subsidiaries can be project-based services. These are often the easiest to address. The company headquarters human resources (HR) department may undertake a project to rewrite the job descriptions for a Belgian subsidiary. Clearly the staff time and associated costs are for the benefit of the Belgian subsidiary. Similarly the HR department might be responsible for crediting certain pension accounts for employees throughout the group. While the costs associated with this activity might not be identified as readily as the project-based costs in the job description rewrite example, there is little doubt that group subsidiaries, with employees participating in the pension plan, are directly benefited by the HR departments services. The principal issue to be addressed in this category is appropriately identifying the costs associated with the particular benefit provided. Services that benefit the group as a whole are often the most contentious type of costs. As a starting point, it is generally clear that the particular services provide a benefit to the groups business. They are ordinary and necessary business expenses. The difficulty is that these expenses do not provide a clear and direct benefit to any particular subsidiary. A particularly common example of this type of service is the strategic planning service that global headquarters often provide. This might be among the most valuable service in the group. If strategic planning is done well, the group may prosper, while if done poorly the group may fail. Strategic planners may determine that production for a particular product should be outsourced, thereby reducing costs. Outsourcing may allow loss-making manufacturing operations to focus on higher-margin products and to reduce their costs. Lower costs for outsourced products may improve distributor sales. These benefits may be real, but are often difficult to demonstrate on a subsidiary-by-subsidiary basis. The strategic plan can harm a particular subsidiary by forcing it to compete with a more efficient product source or even to close its doors. The principal issue in this category is to identify the benefit provided to a particular subsidiary. Services undertaken for the benefit of the groups shareholders are widely recognized as costs that do not have to be

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charged out. These costs are sometimes referred to as shareholder or stewardship services. They include the preparation of consolidated financial statements, activities related to stockholder meetings and the board of director meetings of the parent company, and activities related to share holdings (forming subsidiaries and the cost of issuing shares for example). The principal issue in this category is to distinguish nonchargeable shareholder expenses from chargeable expenses that benefit the group as a whole.

Biography Sean Foley

KPMG LLP 2001 M Street NW Washington, DC 20036-3310 US Tel: +1 202 533 5588 Fax: +1 202 533 8548 Email: sffoley@kpmg.com Website: www.kpmg.com Sean Foley is a KPMG LLP (US) principal with KPMGs economic and valuation services practice in Washington, DC. His areas of focus include advance pricing agreements (APAs), inbound and outbound planning and intangible migration services. Before joining KPMG LLP Foley was the , director of the IRS APA programme in Washington, DC, from 2000 through 2002. From 1997 to 2000, he was special counsel to the IRS Associate Chief Counsel (International). Foley clerked for Justice Ruth Bader Ginsburg when she sat on the DC Circuit and was legislative director to Congressman Sander Levin, a member of the House Ways and Means Committee. He teaches transfer pricing at the Georgetown University Law Center LLM programme. Mr. Foley has both an LLM (Taxation) with distinction and a JD summa cum laude from the Georgetown University Law Center, and a BS from the University of Michigan.

The rules of the road

This chapter discusses the OECD Guidelines for intra-group services that form the legal basis for most of the worlds transfer pricing regimes. Certain aspects of the OECD Guidelines will be compared with specific country rules, particularly the US rules and the new proposed regulations for controlled services (see Federal Regulations 53448, September 10 2003). In 1996, the OECD issued chapter VII of its Transfer Pricing Guidelines entitled Special Considerations for IntraGroup Services. Chapter VII provides important guidance for charging out headquarters costs. As an initial matter, the guidelines establish a willingnessto-pay standard for intra-group services. An activity is one for which a charge should be made if an independent enterprise would have been willing to pay for the service or to perform the service itself on an in-house basis (paragraph 7.6). This willingness to pay standard has also been adopted by most Asia-Pacific and European countries, but it differs from the current US rules, which look to whether the service was intended to benefit another member of the group (see Treasury Regulations, section 1.482-2(b)(i)). The US rules also require a charge where the service is undertaken for the joint benefit of the group (see ibid). This later standard is sometimes referred to as the general benefit theory. The recently proposed US regulations make an important change to the US rules by adopting the OECD Guidelines willingness-to-pay standard and by rejecting the general-benefit theory (see Proposed Treasury Regulations, section 1.482-9(l)(3)(i) and 1.4829(k)(1)). This change in the IRS position could result in fewer charges for a parents activities that generally benefit the controlled group (to the extent that the IRS applies the general benefit theory in practice), and reduces the possibility of double tax with respect to such activities. Examples in the Proposed Treasury Regulations requiring charges for centralized treasury functions and the formulation of company-wide personnel policies, however, suggest that the rejection of the general-benefit theory may in fact be quite narrow. Other changes in the proposed regulations, particularly the shareholder and duplicative-expense rules discussed below, may require increased charges. The OECD Guidelines distinguish a type of shareholder service that does not require a charge. A shareholder service

is an activity performed by a parent company solely because of its ownership interest in one or more group members. Shareholder services would include costs relating to: the juridical structure of the parent company, such as shareholder meetings, share issuance, and the supervisory board; parent company reporting requirements including consolidation of reports; and raising funds for parent company acquisitions. The proposed US services regulations include a new definition of shareholder expenses that is generally consistent with the OECD Guidelines. The preamble to the proposed US regulations states that the new shareholder definition is relatively narrow (see Federal Regulations 53448 and 53457). Several examples apply this new definition to treat expenditures as non-chargeable shareholder expenses, including cases when a parent corporation reviews a subsidiarys compliance with US anti-bribery laws, or a parent corporation engages outside advisers to maximize the parents ability to repatriate funds under new foreign currency exchange controls (see Proposed Regulations, section 1.482-9(l)(4), examples 9 and 10). These examples and others in which a charge is required (that is, when the subsidiary clearly benefits from parent activities such as through increased profitability) are relatively straightforward and do not particularly elucidate the test.

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Biography Yoko Hatta
KPMG Tax Corporation (Japan) Izumi Garden Tower 1-6-1, Roppongi Tokyo, Miknato-ku 106-6012 Japan Tel: +81 3 6229 8350 Fax: +81 3 5575 0761 Email: yoko.hatta@jp.kpmg.com Website: www.kpmg.com Yoko Hatta is a partner with KPMG in Japans transfer pricing practice in Tokyo. She has provided advice to Japanese financial service companies, manufacturers, trading companies and other specialized industries in connection with corporate and individual tax planning and controversies. Relative to the corporate tax area, she has handled US tax issues such as transfer pricing between related companies and branch taxation, USJapan tax treaty issues such as permanent establishment, and various state and local taxes, for more than 10 years. In regard to transfer pricing, she has participated in numerous bilateral APA discussions and negotiations with tax authorities both in the US and Japan to resolve transfer pricing disputes. Ms Hatta is a certified public accountant in the US.

One example makes clear that the formulation of company-wide personnel policies and parent company involvement in the hiring, firing and compensation of senior executives of subsidiaries are considered daily management activities and not shareholder activities under the Proposed Regulations, thus requiring a charge (see section 1.482-9(l)(4), example 13). The OECD Guidelines distinguish shareholder services from non-shareholder services by providing the following three examples of non-shareholder services that would require a charge: detailed planning services for particular operations; emergency management or technical advice (trouble shooting); and assistance with day-to-day management. (Paragraph 7.9) Like the proposed US regulations, these examples are relatively clear-cut and do not provide a great deal of guidance on where to draw the line between shareholder and non-shareholder costs. The OECD Guidelines also conclude that any benefit to a member attributable solely to being part of a larger concern is not chargeable. This is sometimes termed a passive association benefit. For example, a subsidiary that receives a better credit rating because it is affiliated with a multinational group would not need to pay for this benefit. This is in contrast to an actual guarantee from another group member, for which a charge would generally be

required. Similarly, where a subsidiary benefits from a global marketing or public relations campaign, a charge would typically be required (Paragraph 7.13). The proposed US services regulations adopt the OECD stance on passive association (see Proposed Treasury Regulation, section 1.482-9(l)(3)(v)). The OECD Guidelines provide that no intra-group charge should be made for activities that merely duplicate a service that is performed by another group member. There are two exceptions to this principal. First, if the duplication is only temporary, for example, the group is reorganizing to centralize its management functions. Second, where the duplication is undertaken to reduce the risk of a wrong business decision (by getting a second legal opinion on a subject for example) (Paragraph 7.11). This exception, unfortunately, casts uncertainty into what is otherwise a relatively clear rule. The recently-proposed US services regulations include this same limitation on duplicated services. In a new example, even though both the parent company and its subsidiary have lawyers (hired outside counsel in case of the subsidiary), the cost of the parent companys legal department must be charged to the subsidiary where the parent companys lawyers are providing a valuable second opinion (see Proposed Treasury Regulation, section 1.482-9(l)(4), example 6). The OECD Guidelines recognize that services that provide only an incidental benefit to a group member do not have to be charged out. The example given is analysis by headquarters on whether to reorganize the group, to acquire new members or to terminate a division. While this analysis might provide a benefit to the particular group members involved, such as those members who will make the acquisition or terminate their division, it may also produce economic benefits to other group members by increasing efficiencies, economies of scale or other synergies. These incidental benefits will not ordinarily require a charge (Paragraph 7.12). The proposed US regulations have a similar concept. Under the proposed rules, services that provide only an indirect or remote benefit do not have to be charged. A new example in the proposed regulations is very similar to the group reorganization example in the OECD Guidelines (see Proposed Treasury Regulations, section 1.482-9(l)(4), example 2. With regard to the amount of the charge, it is important to note that the Guidelines do not presume that cost or even cost-plus is the appropriate charge for intra-group services. Rather, intra-group services are to meet the same armslength standard as any other transaction (Paragraph 7.19). The US services regulations diverge from the OECD Guidelines by providing a large and useful safe harbour carve-out under which almost all headquarters-type charges can be charged out at cost (see Treasury Regulations, section 1.482-2(b)(7)). The proposed services regulations clearly move in the direction of having an arms length charge for most services, although they do provide for a simplified-cost-based method that may

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Table 1: Possible allocation keys
Activity Manufacturing support Human resources Legal department Resource management Transportation Finance Audit Intellectual property management Information technology Training Possible allocation key Number of units produced Relative headcount Number of corporate entities Relative space Number of trips Relative debt Number of audits Number of licence agreements Number of workstations Hours of training provided

The allocation key might be turnover, staff employed or some other basis appropriate to the nature and usage of the service (Paragraph 7.25). For example, staff level might be appropriate for payroll services while standby costs for priority computer backup could be allocated in proportion to relative expenditures on computer equipment.

Activity-based costing
How can taxpayers make sure that inter company charges comply with these rules and therefore preserve the deductibility of these expenses? In many cases, headquarters expenses may fall into an amorphous category where it is difficult to identify which entities realize a specific benefit, as these expenses are incurred for the benefit of multiple entities. In such cases, it is useful to have as specific an allocation analysis as possible. One method used by a number of companies to allocate headquarters costs for transfer pricing purposes is activitybased costing (ABC). Activity-based costing allocates the costs associated with cross-border services performed by headquarters to its foreign affiliates. ABC measures how resources are consumed within the corporate headquarters through the support of different affiliates. The method determines the costs of performing different activities and allocates those activity costs between beneficiaries of those services based upon their relative levels of support. The use of ABC allows a taxpayer to identify the specific factors that are the source of the benefits (human resources expenses allocated based on headcount for example). Activity-based costing measures the flow of expenses from resources to activities to cost objects. Resources are essentially a companys people, plant and equipment. In many cases, this will be the corporate headquarters general and administrative (G&A) expenses. Activities are the main functions performed by the company and which consume the companys resources. The resource driver is the measure for determining activity costs from resources. For example, the amount of time spent on different activities might be a resource driver for determining the cost of each activity. A cost object is an item to which costs flow. Cost objects are typically the domestic and foreign entities supported by the corporate headquarters. The activity driver is the measure for determining the costs of cost objects based on their support by different activities. The ABC framework is appropriate for allocating G&A expenses, which often include a large amount of fixed costs and support different activities. ABC generally offers a better understanding of those expenses by relating them to the activities that they support. For example, one ABC method often favoured by tax authorities but difficult to implement in practice is the use of timesheets to measure the amount of time spent by employees on different activities. Provided good time measurements

allow some headquarters costs to be charged without a markup (see Proposed Treasury Regulation, section 1.482-9(f)). For calculating the amount of any charge, the OECD Guidelines start with a preferred method called a direct charge under which the company providing the service can demonstrate a separate basis for the charge, recording the work done and the costs expended (Paragraph 7.20). Where the service provider is rendering the same services to both controlled and independent parties, then the service provider is presumed to be able to use the direct charge method (Paragraph 7.21). Fortunately, the OECD Guidelines recognize that the direct charge method may not be practical in many cases (Paragraph 7.22). The Guidelines recognize an alternative indirect charge method using cost allocation and apportionment methods. The allocation key must make sense under the circumstances, contain safeguards against manipulation and follow sound accounting principles, and be capable of producing charges or allocations of costs that are commensurate with actual or reasonably expected benefits to the recipient of the service (paragraph 7.23). The OECD Guidelines state that the indirect charge method is appropriate because the value of the service rendered to various subsidiaries cannot be quantified except on an approximate or estimated basis (sales promotion activities carried out at international fairs for example) or where the administrative burden of tracking the services on a separate basis is disproportionately burdensome in relation to the activities (Paragraph 7.24).

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Diagram 1: Activity-based costing framework
Resources

Resource drivers

Activity 1

Activity 2

Activity 3

Activity drivers

Cost object A

Cost object B

exist, personnel expenses can be apportioned to the different activities based on these estimates. Other types of expenses might best be allocated using other measures more relevant to the nature of the activity. Table 1 lists the possible allocation keys. Where there is no particularly applicable apportionment key, the default allocation key is often net sales. Diagram 1 presents the analysis of expenses from resources to activities to cost objects. Diagram 2 provides a numerical example of ABC. The principal effort required by the ABC approach is to associate resources with activities. A common failure with allocation models is to treat headquarters departments, such as treasury, accounting, or human resources, as a single activity. It is important to drill down into each department and to segregate the various activities that comprise the overall departments function. This effort typically involves conducting interviews with the management and employees of each corporate headquarters department. Alternatively this information can be gathered by questionnaires. These interview or questionnaires are used to: determine the nature of the services; establish the benefits provided to foreign affiliates; and review the activity drivers for apportioning expenses and determine if they are appropriate. In those instances in which it is possible to identify a specific charge for the activity performed to support a beneficiary, the costs for the activity are charged directly to that beneficiary. This procedure reflects the direct charge method described in the OECD Guidelines. For the activity costs that cannot be charged using the direct charge method, an activity driver is selected, based on

the nature of the activity, to allocate the costs associated with those activities. The activity driver should be an appropriate proxy for the time or effort spent on a service or the benefits received from this service. As part of this allocation, one particularly difficult, but critical step, is to identify those activities that benefit only the parent company (shareholder or stewardship expenses for example). Much of the available guidance on what constitutes a shareholder expense is discussed above. This guidance, at the end of the day, is relatively sparse. This area of identifying shareholder expense is often one of the more contentious areas of a tax audit of headquarters expenses. Many audits are ultimately settled on arbitrary lines, such as reducing all allocated expenses by some agreed amount, such as 15%. This is sometimes referred to as a stewardship haircut. Activity-based costing is an important tool for taxpayers seeking to determine the appropriate charge for headquarters services. A careful ABC study, by tying costs (resources) to specified activities (services) and finally to particular cost objects (subsidiaries), will provide a basis for a taxpayer to sustain a deduction for a charge, and to support the particular allocation methodology used in the corporate headquarters tax jurisdiction.

European perspective
In general, the European states apply the OECD Guidelines for intra-group services. This section provides short overviews of recent developments affecting headquarters services in the UK and Switzerland.

UK
The Inland Revenue has issued guidance on the application of several aspects of the new transfer pricing legislation set out

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Diagram 2: Activity-based costing example (US$)
Resources $100 Totals $100

Resource drivers

60%

20%

20%

Activity 1 $60

Activity 2 $20

Activity 3 $20

$100

Activity drivers

100%

50%

50%

100%

Cost object A $60 + $10 = $70

Cost object B $10 + $20 = $30

$100

in the Finance Bill 2004. One such area of guidance is for centrally-provided services. The draft guidance explains the circumstances in which it may be appropriate to use a cost-plus method in applying transfer pricing to the intra-group supply of business support services.

Determination of cost-plus as an appropriate method

The Inland Revenue guidance states that a cost-plus method is an appropriate way to establish an arms length result for the supply of services between two connected companies. The following criteria should be satisfied: The service being provided is ancillary to both the business of the service provider and the service receiver. The service supports the delivery of the business activity. If such a service was provided by a third party, there would be relatively low commercial risk and the profits generated would be relatively modest (that is, less than 10% of the cost base). If the service was withdrawn, the service recipient would undertake the activity itself or obtain the service elsewhere. The service provider does not provide similar services to third parties. The exception to this is where the services provided are in relation to financial services or intellectual property because cost-plus is unlikely to give an arms length result in these cases.

the cost of purchasing the service; and the service providers own costs. It is not generally necessary to add a markup to the bought-in services because the price paid will already include a profit element for the third party. If significant work is undertaken by the company buying in the service, it is required to reflect this by adding a markup on the internal costs.

In-house service delivery

Where the services are provided in-house, the full cost of providing the service can be taken as the cost base, with the appropriate mark up being one that reflects the modest profit element that an independent party could expect to earn for delivering such services. The cost base is defined as the full cost (including overhead costs) calculated on an absorption cost basis (not marginal cost).

Amount of a markup
We recommend using market values to determine the markup amount and to devote more time and effort to this issue and the corresponding documentation the higher the tax risk is.

Applications, enquiries and penalties

It is important that there is consistency in the markup across the whole group and from year to year, unless there is a significant change in circumstances. The draft guidance indicates specific factors that could influence decisions on initiating Inland Revenue inquiries, including the application of the draft guidance to circumstances outside its specified scope and inconsistent usage across the group. The new legislation has also introduced a relaxation of the documentation penalty regime until March 31 2006, whereby no penalties will be levied as long as there has been a reasonable attempt to demonstrate arms length pricing. The

Methods to estimate the arms-length result Contracted-out services

Where one member of a group of companies buys a service and then supplies it to other members of the group, the cost has two components:

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draft guidance states that application of this guidance to centrally-provided services would generally constitute a reasonable attempt to demonstrate an arms length result providing that, where a cost-plus method is applied, there is a reasonable basis for setting the markup used. This of course requires meaningful documentation to strengthen the case. Guidelines, which do not provide for a markup on disbursements and transitory costs. As a result, that reduction in the cost basis for markup calculations could reduce taxable profit for some companies. Companies with intra-group services need to check whether their transfer pricing practices are compatible with the OECD Guidelines. The safe harbour rule has vanished and documentation requirements may also apply. The choice of a markup might require additional analysis.

Switzerland
On March 19 2004 the Swiss Federal Tax Administration issued the New Circular 4/2004, which will influence the transfer pricing method applicable to service companies and intra-group services. The circular points out that the director of the Federal Tax Administration has informed the cantonal tax administrations in its letter of March 4 1997, that when taxing multinational enterprises they have to consider the OECD Guidelines. Under the former rules, a safe harbour was applicable to service activities in Switzerland whereby the taxable profit was deemed to be at least 5% of total expenses incurred, or onetwelfth (8.33%) of total local payroll costs. As a result of increasing pressure from the OECD, Switzerland has now abandoned the safe harbour rules to be in line with the OECD. The circular explains that there is no basis under Swiss law or regulations for the so-called automatic cost-plus-5% approach. In addition to applying the arms length principle, the circular states that service companies should follow OECD Guidelines and prepare documentation.

The Asia-Pacific perspective

Globalization has been changing the business models in the Asia-Pacific region rapidly. Multinationals may have plants in China, a back office in India, and sales offices all over the world. Transfer pricing issues in the Asia-Pacific region are no longer contained only in the area of transfers of tangible goods. In this section, some of the particular rules and administration of transfer pricing for headquarters services in Australia, China, India, and Japan where large amounts of international related-party transactions are observed.

Australia
Australia generally follows the OECD approach discussed above. The Australian Tax Office (ATO) will divide costs into chargeable and non-chargeable activities and will look to whether the service is expected to confer a benefit on the recipient. Australia will generally look to apply the comparable-uncontrolled-price method (CUP) or the costplus method. Australia will accept however, cost allocations in proportion to the individual group members expected benefit. Australia does have an additional category of so-called noncore services. If a service qualifies as non-core, the ATO may not make transfer pricing adjustments. Non-core services include activities that are supportive of the groups main business and are generally routine, but are not similar to activities by which the group derives its income. To qualify as non-core services, the amount of the charge must be small relative to the business operation.

The relevant transfer pricing method

The new circular refers to the OECD Guidelines and indicates that taxpayers should use one of the two most common methods for intra-group services, the comparable-uncontrolled-price method (CUP) or the cost-plus method. The new circular also states that it would normally be inappropriate to use the cost-plus method for management functions and financial services. A functional analysis is necessary in complicated situations to support the method chosen by the taxpayer.

China Reasonable markup

An arms length charge for the provision of intra-group services should include a profit markup. According to the new circular, to determine the cost-plus margin that the service provider should earn, reference can be made to comparable uncontrolled transactions. The new circular also recommends that an acceptable markup should be selected from a range of results. The new circular indicates that a markup of less than 5% would be possible only in exceptional cases, and only by providing supportive documentation. It is important to note that the previous safe harbour required a markup on the full amount of costs incurred by the service activity. That is not the case under the OECD Reasonable fees paid for concrete and justifiable services to affiliated companies can be deducted in China. In practice, however, it is very difficult to prove to the satisfaction of the tax authority that all the service fees are related to offshore services. General management fees paid to related companies that cannot be substantiated by concrete and justifiable services are not deductible. There is the precedent where the Chinese tax authorities denied the deduction of certain cost allocation charged by the overseas parent and related companies, on the basis that these activities are cost allocation rather than services provided to the foreign investment enterprise (FIE). It is advisable to make precise allocations driven from specific factors rather than charging general management fees.

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According to Circular Huifa (1999) 372, repatriation of all service fees out of China can only be made after obtaining the tax clearance certificates (tax payment and exemption confirmation) issued by the local tax authorities There was an amendment on the form to be attached to the Japanese tax return for taxable years beginning on or after April 1 2003. Japanese corporate taxpayers have to report transactions as well as the transfer pricing methodology for the transactions with foreign, related parties on schedule 17(3) of their tax return. Any transfer pricing methodology reported must be consistent with those methods identified as allowable under the Japanese transfer pricing rules. It is expected that the exercise of reviewing all intra-group service transactions will amount to a significant task. So far, there is no legal requirement to provide specific documentation in Japan.

India
Detailed transfer pricing provisions have been introduced under the Indian Income Tax Act 1961 (April 1 2001). Payments for intra-group services come within the purview of the Indian transfer pricing legislation and need to satisfy the arms-length principle. Where associated enterprises enter into a mutual agreement for allocation of costs of any benefit, service or facility, the taxpayers share of allocable costs should be determined having regard to the arms length price of the benefit, service or facility received by the taxpayer. Indian law does not state clearly whether a markup needs to be charged.

Unanswered questions
Headquarters charges have long been an area of keen interest to taxing authorities and as a double-tax threat they should be a primary concern to corporate tax departments. Despite years of effort through the OECD Guidelines and now the new proposed IRS services regulations, critical questions remain largely unanswered such as: What is a shareholder expense that does not require a charge-out? What is the most appropriate allocation key? Should headquarters charges be marked-up? Taxpayers looking to create a robust charge-out scheme, often turn to activity-based costing to the cost associated with specific activities to specific benefits. In the end, there are two important trends on a collision course. Countries such as the US and Japan have enacted or are about to enact new rules that narrow the category of expenses that do not have to charged out, pushing headquarters to increase their level of charges and possibly require a markup. At the same time many non-OECD countries such as China and India are deeply sceptical of the charges emanating from offshore headquarters and often challenge the deductibility of these charges. Given the increasing number of audit challenges on both sides of the headquarters charge equation, multinationals are well advised to document their headquarters costs to withstand close scrutiny from both the paying and the receiving end. The views and opinions are those of the author and do not necessarily represent the views and opinions of KPMG Deutsche Treuhand-Gesellshaft Aktiengesellschaft Wirtschaftsprufungsgesellschaft, KPMG LLP or KPMG Tax Corporation (Japan). All information provided is of a general nature and is not limited and is not intended to address the circumstances of any particular individual or entity. These articles were first published by International Tax Review magazine, a Euromoney Institutional Investor PLC publication, in the June 2004 Transfer Pricing supplement.

Japan
In June 2002 the Japanese National Tax Agency (NTA) amended its 2001 guidelines by providing guidance on intra-company services rendered within multinational enterprise groups. These amendments focus on intra-company services provided by multinational headquarters to foreign affiliates and provide a set of examples of intra-company services that should be remunerated on an arms length basis. Stewardship (shareholder) services are mentioned specifically as non-qualified services that should not be charged-out. Stewardship services are only indirectly defined. The examples of chargeable services include services that could be partially considered stewardship services. This indicates that the Japanese guidelines have a narrow scope for stewardship services. The amended guidelines generally conform to the OECD Guidelines. The 2001 Japanese guidelines defined the arms length price for intra-company services generally as the total cost, including allocated indirect costs, when no appropriate comparable transactions are specified. The basic stance of the guidelines is that the arms length charge must be determined primarily by the basic three methods for calculating an arms-length charge, that is, the comparable uncontrolled-price method, the resale-price method, and the cost-plus method. In the event that comparable transactions cannot be found, cost (includes indirect cost) is used as a base to justify the arms-length price. During 2002 the Regional Tax Bureau gathered information on how intra-group service fees are treated by asking taxpayers to fill out a questionnaire at the time of the examination. The focus of the Tax Bureau seems to be two fold: to grasp how the service charges are treated, and whether valuable intangibles have been transferred through intra-group services. The results of these questionnaires will not be used as a basis for additional tax assessments; however, the Tax Bureau is now fairly familiar with how service transactions are handled by Japanese entities.

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