Many taxpayers (Russian operational companies) had firsthand experience with the Russian tax authorities, which disputed the costs for the services of a foreign parent or other group company. Here are just a few examples of claims:
“The primary documents are of the same type with the same list of services. Not a single document of the company contains information about the cost of particular types of services acquired or about the amount/scope of services and does not allow deciding on the reality of services.”
“The consulting materials contain general information and are designed for the group of companies, but not for the Russian customer.”
“The services were actually provided for the needs of the shareholder to comply with the standards it set in the group, so they should be allocated to the shareholder according to the BEPS plan.”
“The cost of services is indicated as a total amount, not broken down by each specific service. Moreover, the cost of services is determined not based on the volume actually required but by allocating the expenses incurred by the parent company to provide services to all group companies.”
“The customer has enough qualified employees on its staff.”
Similar claims can also be observed in disputes on the intragroup services between Russian companies.
In general, it can be seen from the above quotes that the tax authorities challenge:
- that the services were actually rendered and the documentary support is sufficient;
- that the amount of services acquired is correspondent to the service fee (the reasonableness of the so-called “allocation keys” usually used as a basis to calculate the fee/allocate the provider’s costs to all group companies);
- the economic justification of the costs for the services, i.e. whether there was a real need to acquire the services for the customer’s commercial activity .
These claims are standard and inspectors often simply carbon copy them. However, so far, no uniform approach to evaluating taxpayers’ arguments can be observed. In our experience, the tax authorities almost always give the Federal Tax Service of Russia complete control over deciding whether the taxation of intragroup services is correct. Each dispute becomes its own kind of roulette (decisions on the taxpayers’ appeals can be totally different in similar circumstances).
Due to the increasing number of claims of the tax authorities to intragroup services and total absence of a “systematic approach” of the local tax authorities to this matter, the Russian Federal Tax Service has been receiving more and more requests to provide instructions and clear criteria for valuing intragroup services for tax purposes. And the day has arrived.
On August 6, 2020, the Federal Tax Service of Russia (“FTS”) posted on its site Letter No. ShYu-4-13/12599@ “On Certain Issues of the Taxation of Intragroup Services” (the “Letter”). The Letter provides for the approaches the tax authorities should follow when verifying the justification of expenses for the services acquired from foreign related companies.
It should be noted that the approaches considered in the Letter seem to us quite balanced and liberal. Although the Letter did not reflect all of the practical aspects, hopefully it will help taxpayers if and when they need to defend their expenses for intragroup services for tax purposes.
- FTS recommendations on approach to justification of expenses
- Reality of services (whether the services existed and were actually provided)*
*Services can by nature be regular (day-to-day) support on administrative matters; financial services; legal advising; HR administration, etc.
Services may be provided: on the basis of requests for a specific service; by accessing services in exchange for a preset fee; by providing resources the Russian company does not have, and in other forms.
It should be considered that if functions and/or support for some of the processes are assigned to a provider there is no need to have formalized requests for each separate service; the taxpayer may submit documents and information showing that the service was expected to be received (for example, rules for coordination describing the actions (or functions) to be performed by the provider’s representatives).
- No duplicate expenses
- The taxpayer does not pay multiple providers for identical services.
- Duplication is assessed by analyzing the functionality, experience and skills the Russian taxpayer receives and is not limited to establishing that department titles of the services provider coincide with the department titles of the taxpayer/department titles of another provider or that there are staff members in positions with similar names.
- Economic value
- do the services provided have economic or commercial value for the taxpayer?
- would third parties have agreed to acquire such services or sell such services by developing their own technologies or hiring additional personnel?
- would the company have paid for the same services in favor of an independent entity in comparable circumstances?
- does the service fee represent compensation for the foreign shareholder for its shareholder’s activity?**
** Shareholder activity is caused by the desire of the owners to monitor their investments in subsidiaries. The shareholder activity is carried out even though the operating companies would not have paid to an independent enterprise for the same actions or would not have performed these actions themselves.
The following, in particular, cannot be considered as provision of services: getting information about the company’s activity; participating in the general shareholders meeting; activity associated with ensuring other group companies comply with the laws of other countries (including audit and preparing consolidated statements); activity for the acquisition of participations (including costs relating to the parent company and investor relations); activity for other group companies to comply with the requirements of a foreign stock exchange, etc.
Such a widespread form of cooperation between the parent company and Russian operating company as providing global policies, strategies and standards should be analyzed carefully to see whether such global policies/strategies/standards are an attribute of belonging to the group per se or are a targeted development that affects the Russian company’s business and profitability.
- Use of services in business of the Russian company
- the service deliverables must be used in the taxpayer’s business;
- a negative financial result from using the services received cannot per se be the sole reason to reject the expenses (the taxpayer’s intention to receive an economic benefit must be assessed);
not using the service deliverable due to objective business circumstances should not per se be a factor evidencing that the expenses are unjustified (the cases when other companies in the same industry commonly acquire such services from independent enterprises, and other public information can be used to assess the justification).
2. FTS recommendations on assessing the pricing mechanism
FTS approach is that the price factor, the pricing mechanism and principle is an inherent feature of the service itself (even though arm’s length prices in controlled transactions cannot be monitored in field and desk tax audits). This said:
- the pricing methods must be transparent and be applied uniformly throughout the group (the taxpayer is entitled to also submit transfer pricing documentation and its particular parts);
- the composition of the expenses of the foreign provider should not be estimated;
- the pricing method defined as the sum of the costs incurred by the provider plus the usual markup for a certain area of activity (“cost+”) is an ordinary business practice; the mere fact that this pricing method is used should not be considered the allocation of income and costs within the group of companies or be a separate and sole ground to deem the expenses unjustified;
it should also be considered whether these costs (which the customer pays for services) are treated as income of the service provider for corporate income tax purposes in the country where it is a tax resident.
3. FTS recommendations on the documentary support
- the list of documents to be submitted to justify the costs for the services is not exhaustive;
- the following supporting documents may be taken into account, inter alia: business correspondence and email correspondence, details of telephone calls, meeting minutes, memoranda and statements, timesheets, reports on services provided which include a breakdown of services describing the counterparty’s actions, presentations, printouts from the taxpayer’s internal electronic systems, printouts of a digital calendar, computer screenshots, a list of the counterparty’s employees who participated in rendering the services, and a list of the taxpayer’s employees who participated in accepting the services, written explanations and representations from the parties, a functional analysis of the services rendered, etc.
other evidence should also be analyzed, such as the service deliverables, witness statements, trip tickets, attendance logs and reconciliation reports.
4. FTS recommendations on the approach to audit
- a formal approach is not allowed (specific facts, circumstances and documents must be given an overall assessment);
- if it is not sufficiently obvious from the documents that the services were actually rendered, or if the nature of the services rendered is not obvious (for example, if the “acts of services rendered are templates and abstract”), the tax authority must request additional explanations and documents;
- the volume of documents requested must be reasonable.
5. To be continued…
Although the Letter is based on an attempt to develop a balanced approach to the tax regime for intragroup services, it should be acknowledged that the document has not properly covered a number of issues in this topic.
For example, although FTS generally approved cost+ pricing method, it did not provide any assessment of the long existing (and yet to be resolved) problem of “allocating the expenses of the foreign provider” on the basis of group companies’ financial and other indicators (we recall the “BAT” and “MUMT” cases here).
Moreover, there is certain apprehension, which is caused by the fact that on a number of issues the tax authorities should themselves establish certain circumstances to confirm and/or reject the costs for intragroup services , e.g. third parties’ readiness to acquire similar services, the presence of experience and skills of the service provider that are beyond the company’s needs, and signs of a “targeted development” in the service deliverables.
It is difficult to determine whether the tax authorities are ready (and able) to carry out such analysis considering that all of these concepts are judgment based and, for objective reasons, no criteria can be introduced in this area. As a result, FTS recommendations could remain merely declarative while the local tax authorities will continue to use standard arguments that the services acquired have no economic value. However, now they will be citing the above-mentioned Letter.
The document also does not consider the problem of intragroup services being requalified into hidden distribution of dividends or assets of the company. Many companies that are members of multinational groups have already faced this problem. And there are still no clear criteria that would allow taxpayers to assess the level of risk of such requalification and that would require the tax authority to do a comprehensive and balanced analysis of each specific situation. Usually the tax authorities conclude that hidden dividend distribution occurs when services are fictitious; however, they do not cite the grounds for such requalification.
The problem is also aggravated by the fact that requalification of intragroup services as hidden profit distribution is usually coupled with the beneficial owner concept being applied to the remuneration for the requalified services. As a result, the remuneration not only cannot be deducted by the company for profit tax purposes, but as well the foreign recipient of the income is also unable to enjoy the reduced tax rates on dividends provided by the relevant tax treaties.
We believe these issues deserve detailed treatment with the results being set forth in a separate letter from the FTS. In our opinion, the tax authorities need to state their position on the following:
- which factors (and in what combination) should be considered indicators of hidden profit distribution under the guise of paying remuneration for services provided within the group?
- who should be deemed the beneficial owner of hidden dividends: the company providing the services, the direct shareholder of the Russian entity paying the remuneration, or the group’s ultimate parent company?
- how can the foreign company that is deemed the beneficial owner of the hidden dividends prove it is entitled to the reduced withholding tax rates provided by the tax treaty with the state where the company is a tax resident?
- how can the look-through approach be used, if necessary, in terms of complying with additional requirements (share, investment amount, etc.) if the applicable tax treaty sets such requirements?
It is obvious that this matter was not resolved and we expect the practice on issues of providing intragroup services to evolve further.
Dentons’ Tax practice has extensive experience assisting taxpayers who acquire intragroup services both at the preaudit stage (preparing defense files, assessing the risks of challenging the expense deduction) and at the field tax audit stage (accompanying during tax control measures and appealing their results). We would be happy to provide you with comprehensive legal support.