On April 16, 2019, the Internal Revenue Service (“IRS”) Large Business and International (“LB&I”) division released an overview of three new compliance campaigns, including a captive services providers campaign.
A captive services provider is a wholly-owned subsidiary that exists for the sole purpose of providing services for members of the same multinational group (i.e., all service revenue is intercompany). The campaign will target foreign captive services providers for a U.S.-based service recipient and will examine situations in which “…excessive pricing for these services would inappropriately shift taxable income to these foreign entities and erode the U.S. tax base.”1
Examples of services often performed by foreign captive subsidiaries include:
- Contract engineering or research and development services;
- Finance, accounting and/or tax services;
- Administrative support services;
- Information technology (IT), IT help desk and related IT services;
- Call center or customer support services; and
- Sales support and marketing services.
With the captive services provider campaign, the IRS seeks to prevent U.S. tax base erosion by conducting “issue-based examinations” and sending “soft letters”. A “soft letter” is formally referred to as Form 5935, which warns taxpayers of potential non-compliance and provides 60 days to respond.
Taxpayers should ensure sufficient documentation and support is available to support the service fees paid to foreign captive subsidiaries. In many cases, taxpayers will apply the comparable profits method (“CPM”) or transactional net margin method (“TNMM”) to confirm consistency with the arm’s-length standard. The CPM/TNMM involves the selection of uncontrolled companies with similar functions performed, risks assumed, and assets used to the foreign service provider. Depending on the facts and circumstances, there may be situations where reliable comparables for the intercompany service being analyzed may be difficult to identity in sufficient numbers to deliver a robust measure of arm’s length compensation for the services in question. These situations could potentially create opportunities for aggressive approaches under the new campaign.
While the IRS will naturally be approaching these transactions with a concern that mark-ups may be too high, the campaign comes at a time when many foreign jurisdictions are pushing for higher returns for intercompany services performed in their jurisdictions. Much of this push has focused on issues of nexus for foreign-booked sales with local sales support activities, compensation for local market factors and marketing intangibles, and questions around who controls development activities and resulting allocations of risks and intangibles under the revised OECD Transfer Pricing Guidance. Foreign tax authorities have been using these arguments to justify higher local returns. Authorities will often start with skepticism of the comparable search used, including scrutiny of the search process, support for acceptance or rejection criteria and application of reliability adjustments to weaken the taxpayer’s position. In many cases, the adjustments are not large enough to warrant a claim for double tax relief through a tax treaty-based mutual agreement process or an advanced price ruling.
As such, it is recommended that U.S. taxpayers with material outbound service payments to foreign captive services providers review their transfer pricing policies and related support, especially where there have been increases in reaction to foreign audit activity, to ensure pricing aligns with the facts and circumstances of the intercompany transaction. Depending on the materiality of the transactions, U.S. transfer pricing documentation prepared contemporaneously with the submission of the U.S. tax return and that comprises the ten principal documents under Section 1.6662-6(d)(2)(iii)(B) would be recommended to provide protection from penalties on additional tax owed.2
Finally, it should be noted that under the 2017 Tax Cuts and Jobs Act, the imposition of Global Intangible Low Tax Income (GILTI) now imposes a minimum U.S. tax on the U.S. parent of foreign affiliates above a certain return on assets. In addition, TCJA also imposes a Base Erosion Anti-avoidance Tax (BEAT) on intercompany payments from a U.S. group above a certain threshold for large U.S. companies. These too will be considerations in performing such a review of foreign affiliate remuneration practices and related risks.
The captive services providers campaign is within the Treaty and Transfer Pricing Operations practice area within LB&I and is intended to assist the LB&I to identify key issues and make the best use of its resources.
2 https://www.irs.gov/pub/irs-apa/treas_reg_1.6662-6.pdf, page 1054
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