The use of in-house shared service centers has become increasingly common among large multinational companies.
These centers allow for the centralized processing of back-office functions within a single location, creating opportunities for rationalization, concentration of expertise, and cost savings.
Administrative and support operations typically transferred to shared service centers include a range of finance and personnel functions, like payroll, accounts receivable, accounts payable, tax compliance, and other accounting-related services.
Despite their advantages, shared service centers need to be structured carefully to secure the intended benefits, especially where transfer pricing and related VAT/GST issues are concerned.
Joining me today to explore some of the potential benefits and challenges involved with shared service centers are Darren Mellor-Clark, a Director with KPMG in the United Kingdom and Enrique Martin, a Senior Manager also with KPMG in United Kingdom.
Interviewer
Darren, for a large multinational looking to set up a shared service center, a first decision is where to locate it. Is it fair to say that most companies will choose lower-cost locations in developing countries?
Darren
Yes, I think that's a very fair comment. It's true that, I think, many large European and US companies choose to locate their shared service centers in lower cost environments such as the Asian Sub-Continent or the Philippines, increasingly. However, I think we should note that there are downsides to that remote operation model. I think that one of the problems we frequently see is when regular contact with home-based staff or employees or indeed the general public is required. Or, perhaps, when the cost advantages don't turn out be permanent.
Enrique
Indeed, and I would add that one thing we are seeing, perhaps more frequently in those types of services that involves customer contact, is a tendency to bring some of those back in to more developed economies perhaps because there is a feeling that the client wants to fill a closer service or there have been customer complaints around some of the services. So I think the general tendency, yes, it is to go to developing economies, low cost space, but as the sector evolves there is more of a mix as to where multinationals choose to locate their services.
And in addition to location, what other practical matters need to be worked through?
I think that it's important, really, first off, to identify the range of functions that need to be centralised and what advantage the business is looking for in their target operating model in centralising and off shoring those jobs. Another important consideration, of course, particularly in the current environment, is that if jobs are to be lost in the home locations, or perhaps opened up to transfer, then the necessary consultations and negotiations will be required along with, of course, training programs for new staff members.
And I guess one other critical aspect is to take into account the regulatory environment that they are going to find a new location including tax and whether some of the views of the tax authorities may jeopardise the savings that can be gained from moving to a low-cost location.
Yes, I think that's a very fair point, Enrique, because I think getting it wrong at the start can frequently lead to excess costs. We see a cash flow that, perhaps, is not optimised and the tax advantages themselves lost or, in the worst case, disputes with authorities that can lead to fines and penalties.
So, let’s talk about transfer pricing in the context of shared service centers. What issues arise in this area that are especially relevant for companies with shared service centers?
Well, when a multinational company decides to set up a new operation such as a shared service center, this new operation is, merely by definition, going to interact with all or some of the different entities of the multinational enterprise around the world and that's when transfer pricing kicks in. Transfer pricing looks at how the transactions between different parts of a multinational enterprise are conducted both in terms of the terms and conditions and the prices charged for those. And the reason this has relevance for tax authorities is because, obviously, by setting the prices charged between members of a multinational group we can affect the profit that's left in each of the different jurisdictions and therefore the tax receipt that each of the local tax authorities can get their hands on. So it is one of the key things that tax authorities are going to look at. It, as we said earlier, it is one issue that can create a lot of problems and could potentially undo the benefit of moving to that low-cost jurisdiction through penalties, through adjustments to the pricing and it is an area that is being looked into with increasing scrutiny by tax authorities around the world. What this means is that not only are we going to have two deal with the tax authorities where the shared service center is based and be able to demonstrate to the tax authority in that country that we are pricing the services correctly from the point of view that we will also have to show that the recipients of the services are paying a fair price, a market price, for those services. So it becomes a cross-border issue; we have to deal with two different tax authorities, there are also compliance issues at both ends and it can potentially consume a lot of resources both in the tax department of the international enterprise but also can have cash consequences to the company.
So how do multinational companies set transfer prices that the tax authorities will accept?
That's one of the key areas and one of the difficult questions to answer. There is a set of principles that guide transfer pricing amongst most developed economies and increasingly some of the developing economies which join into this view of the world that are set by the OECD guidelines. The OECD guidelines set a series of transfer pricing methodologies that are recognised to being capable of producing an arm’s length price between parts of a multinational group. These methodologies generally rely on comparable data, on data that’s observed in the market in transactions between independent companies that are involved in providing similar services to those that the shared service center provides. So when we go about setting our transfer prices the thing we have to bear in mind, and the ultimate goal, is to be able to demonstrate that the price is an arm’s length price, that it's a price that two independent parties would have agreed for the services being considered. So one possible way of reaching this arm’s length price is to go to publicly available sources of information and look for these prices. The most simple way would be to identify a transaction covering exactly the same services between two independent parties and look at how much they've charged each other. However, the real world doesn't generally work like that. We have limitations as to what information can be observed publicly and therefore we normally rely on another of the OECD methods, namely cost plus or the transactional net margin method which, in essence, looks at the margin that have been achieved by the companies that are providing these services. And these would be, in a nutshell, the main accepted OECD methods for transfer pricing of shared service centers. However, the OECD also recognises that it may not be possible to observe enough information to be able to achieve these methodologies and therefore the multinational enterprises remain free to adopt other methodologies as they see fit provided that it can be shown that they produce an arm’s length result. In the case of shared services centers, the pricing element tends to be done on a transactional basis and what we normally do is to look at the profitability of independent companies involved in similar services. One option that some more experienced players in this arena have is through contacts or through information on the, for example, Indian market, that's a good example, where companies have been operating for a number of years now. There are some companies that provide these types of services to non-related parties and it may be possible to get a closer look at what prices they charge. But in general we would be looking at applying a cost plus type of methodology.
Enrique, can you expand on the alternative approaches that may be used to determine a comparable price range for comparable arm’s length transactions?
Sure. Some of the most common approaches will involve using information on publicly available databases and just go through those databases and identify the companies that meet the criteria of a transfer price in a study i.e. they are independent and providing services to nonrelated parties, and explore the data on those databases to come up with a view as to what price should be charged. This price can be set with reference to cost and in that cost base we can include the cost per hour of the employees, overheads and so on. And, as I touched briefly upon, another possible way of going about finding this right price is to buy contracts in the industry or studies that may have been performed in the industry, identify, perhaps, contracts between independent parties and get a bit more detail on how the pricing has been done. For example, if there was an IT support center providing services to a range of different companies, it is perhaps possible to find the agreement between that IT center and the independent company that it provides services to and get a closer view as to how the price has actually been agreed rather than target a profit margin on top of the cost incurred in providing the services.
I understand that transfer pricing between a shared service center and the related operating companies also carries VAT/GST implications. Can you describe some of the VAT issues that need to be considered in the shared service center context?
Yes, sure, of course. I'm glad you picked up on the VAT and GST applications because although we are using VAT as a shorthand it is important to remember that VAT or GST or perhaps sales taxes are present in most jurisdictions and I think the first thing to keep in mind is really that the VAT implications of transfer pricing between the shared service center and the operating companies can lead to costs that are as significant as the corporate tax and indeed, potentially, when not taken care of wipe out much of the operational saving involved in transferring the service center offshore or to a third party provider. I think one of the things that we frequently see is, if the arrangements are not structured correctly then the operating companies can end up with stranded VAT costs in the shared service center locations that can’t be recovered either by the shared service center or by the operating company. There's also, clearly, a significant risk that without proper care and attention and operating systems it's perfectly possible for VAT to be charged to external customers incorrectly thus exposing the business to penalties, interest, etcetera.
How do tax authorities tend to approach the application of VAT to services provided by shared service centers to related parties in practice? Can tax treaties help to resolve issues in this area?
Yes, it's a very good point. I think that we need to start from the fact that remembering, at least in European area, and this is quite a common application across most jurisdictions but let's stick to Europe to start with, we've got to remember that the provision of services is only liable for VAT if it falls within the legal category of a supply for consideration. So what we need to bear in mind is that the mere payment flows between a shared service center and the operating companies do not necessarily mean that there has been a supply for consideration and therefore that VAT is not necessarily due on those supplies. However, what we do find is that, in practice, most tax authorities will not really pay much attention to the no supply argument and they seek to assume that there is automatically a supply of services between a shared service center and the operating companies rather than perhaps a mere allocation of costs. And they will then look to tax those services. So, I think that one of the important points, is to consider this issue upfront and to really give some thought to the type of service that is being brought within the operating company and ensure that you have its tax treatment correctly analysed. By correctly analysed, what I really mean there is ensuring that you understand the treatment as the service leaves the shared service center jurisdiction which can lead to a tax charge and also as the service enters the operating company jurisdiction which can lead to a second tax charge. So, in many ways, and I have seen this quite a lot in practice, particularly with some of the services coming out of Russia or the former Soviet Union countries, it is quite possible to end up with 18% Russian VAT on the charge coming out of the shared service center and then a 20% tax hit as it enters the UK. Obviously, for the mathematicians among you, leading to a 38% combined tax rate which can really start to eat in to those savings of moving the service offshore. And I think you mentioned tax treaties and that's a key difference there between the corporate tax aspects of this and the VAT or GST in that, generally speaking, most nations, when they are green tax treaties, will only cover corporate tracks elements. I'm not aware of a single treaty that covers VAT or GST so it's perfectly possible for this lack of symmetry to end up with a double tax charge which, of course, leads to a considerable issue. Really, what we've got to remember as well is that in the financial area, so I'm talking banks, insurance companies etcetera, fund management companies; many of these will face significant restrictions on their ability to recover the VAT that they incur in the form of a tax credit so therefore I would say that it is absolutely essential to ensure that you’re are on top of the VAT or GST treatment right from the outset.
Thank you Darren and Enrique for your insights on the transfer pricing and VAT/GST issues that a company should consider when establishing a shared service center. Before we sign off, do you have any final thoughts?
Yes, I think it's undeniable that shared service centers can bring, when properly deployed, clear operational and financial benefits to multinational companies. However, I think, as Enrique and I have briefly discussed, the use of these centers does raise complex issues of transfer pricing, VAT and corporate tax that need to be considered in order to maximise the financial benefits of the group and minimise exposure to financial penalties from the various tax authorities
Yes, just add onto what Darren has just said, I guess the other final remark would be that whenever a new shared service center is being designed, thought of or the project has been started, it would be crucial to get tax, by tax I mean transfer pricing, or other areas of corporate tax and VAT and indirect tax, involved from the onset with a view to make sure that the operations are designed in a way that they meet the compliance requirements of each jurisdiction and, more importantly, that the model that’s ultimately implemented does not create any of the VAT or transfer pricing problems we have discussed.
Interviewer’s Closing Remarks
Thank-you Darren Mellor-Clark and Enrique Martin
Listeners can find more details on this topic in the September 2011 edition of KPMG’s frontiers in tax publication
Our most recent podcast in this series includes KPMG Tax partners from the United States, the UK and Japan providing their perspectives on tax reforms in their countries aimed at increasing tax revenues from the offshore profits earned offshore by domestic multinationals.
Earlier podcasts have addressed international regulatory reforms affecting the insurance industry and the new US FATCA rules requiring foreign institutions to disclose information about US bank accounts.
Thank-you and we look forward to you joining us again next time.
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