Although many large European and US companies choose to locate SSCs in lower-cost environments such as the Asian sub-continent or the Philippines, this is by no means a universal trend. There are downsides to such remote operations, especially when regular contact with ‘home’-based staff or employees – or the general public – is required and the headline cost advantages may prove to be transitory. Many multinational companies recognize the prospect of securing significant operational efficiencies and cost savings even if they establish an SSC in a comparatively high-cost location such as the UK or continental Europe.
Not just a practical matter
The potential benefits of establishing an SSC are often so obvious that the exercise is treated primarily as a management and operational challenge. A location must be identified, and the range of functions to be centralized determined. Consultation and negotiation will be necessary where jobs are to be lost at the home locations, or perhaps opened to transfer. Training schedules are required. Communications programs need to be drawn up to ensure that internal and external stakeholders are aware of and ready for the change.
While these are essential practical matters whose effective management can be key to the success of an SSC venture, there is a danger that they can distract the parent company from other fundamental decisions such as transfer pricing policy and other taxes such as VAT. Getting these wrong can lead to excess costs, poor cash flow and lost tax advantages. In the extreme, disputes with tax authorities, fines and penalties may be triggered. All of these detriments can make a significant dent in the economic benefits of an SSC.
Conversely, careful advance planning and analysis can not only avoid the worst of these adverse impacts, but in fact maximize the economic benefits.
Where related parties, such as an SSC and the operating companies it serves within the same multinational company, provide or take services, the appropriate price or cost at which those services should be accounted for inevitably becomes a non-trivial issue. In an ideal world of no tax, no externalities and completely free markets, the transfer pricing decision would have few if any implications outside the company. In the real world, however, with different tax regimes, different regulations and different tax rates in different jurisdictions, transfer pricing decisions can have a significant impact on both the total level of tax liability and where those liabilities fall due. Even in the absence of an aggressive and overt tax minimization strategy, transfer pricing decisions in relation to an SSC can have significantly variable economic impacts.
The transfer pricing issue has been a focus of concern for tax authorities in developed countries for many decades. Multinational companies in the main retain the freedom to set prices provided they are in line with the arms length in principal.
In general, tax authorities regard the open market as the best source of independent, appropriate pricing information. Where transactions take place between related parties, this principle implies that the transfer pricing decision is appropriate if it broadly reflects the price and terms and conditions at which the service would be provided in the open market between two unconnected principals. This arm’s length principle is also economically sound, and is likely to produce what is perceived to be a ‘fair’ division of profit and taxation and to deal with international double taxation treaties in a similarly ‘fair’ manner.
The arm’s length principle is endorsed by the OECD, which comments: “Transfer prices are significant for both taxpayers and tax administrations because they determine in large part the income and expenses, and therefore taxable profits, of associated enterprises in different tax jurisdictions.” Most OECD members adopt domestic transfer pricing policy and practice based on the OECD guidance5. In the specific case of SSCs, the guidance is set out in Chapter VII, Special Considerations for Intra-Group Services.
However, establishing an appropriate arm’s length price is itself a decidedly non-trivial issue. HMRC in the UK comment:
“The complexities of applying the arm’s length principle in practice should not be underestimated. Because of the closeness of the relationship between the parties there can be genuine difficulties in determining what arm’s length terms would have been – especially where it is not possible to find wholly comparable transactions between unconnected parties. There are many factors to take into account. Consequently, the exercise can be as much an art as a science.”
The ‘right’ price
A number of alternative approaches may be used in the attempt to determine a comparable price – or in practice, a price range for comparable arm’s length transactions. These methods fall into two categories: “traditional transaction methods” and “transactional profit methods.”
Generally, traditional transaction methods – such as determining a comparable uncontrolled price, or cost plus/gross margin approaches – are the most direct means of establishing whether conditions in the commercial and financial relations between associated enterprises are at arm’s length. However, the complexities of real life business situations may put practical difficulties in the way of these methods. Where there are no data available or the available data are not of sufficient quality to rely on the traditional transactional methods, it may become necessary to consider transactional profit methods, such as those based on comparable profitability or transactional net margin.
In all cases, determining the ‘right’ transfer price approach and, in particular, mounting and documenting a case which will convince tax authorities, can be a major challenge. The implications need to be fully considered in the planning stage of an SSC transition.
An associated issue, and one which in our experience is even more likely to considered only as an afterthought, is that of VAT. The VAT implications of transfer pricing between an SSC and the operating companies it serves can be at least as significant as the corporation tax consequences. Getting it wrong can lead to ‘stranded’ VAT costs which are unrecoverable for the enterprise and incorrect VAT charges being applied to external customers.
One of the key technical issues arises from the principle underlying European VAT regulation that the provision of services is liable to VAT only if it falls within the category of supply for a consideration. Neither the provision of a service by an SSC, nor a financial flow in the opposite direction, necessarily implies that the transaction falls under the VAT regime. Conversely, a supply of services may exist even when there is apparently no financial consideration.
In practice we find that most tax authorities seek to tax services supplied by SSCs to in house recipients. This is further complicated by the lack of symmetry between VAT systems, especially outside the EU, and the absence of double tax treaties. In this hostile environment, double tax is a constantly lurking peril. Especially in the financial services arena this can lead to significant above the line costs for business which may wipe out the fundamental economics of the SSC business case.
Alongside the core transfer pricing decisions which need to be considered in relation to an SSC, then, the issue of VAT on those prices is also critical.
Early planning, coherent approach
SSCs can bring clear operational and financial benefits to multinational companies. But their establishment is not simply a matter of practicality and implementation. An SSC raises complex issues of transfer pricing and tax liability which need to be considered in depth, and in a coherent, integrated manner, if the financial benefits to the group are to be maximized and financial penalties avoided.
KPMG’s joint Transfer Pricing and Indirect Tax teams can address the issues at an early stage to maximize value, minimize cost and control risk.
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