What do you believe are the best methods to identify routine verses non-routine services in regards to low or high value services?
From our perspective we’ve always looked at it as a battle of core services verses support services and, over the past few years, we have defined various categories to fit into those definitions. The real question is how are the people that we are going to try and sell the process on going to look at a low value service?
Just by coincidence I am going to give you an anecdote about something that happened recently and this will really tell you how people outside of tax define a low value added service. We ran a functions and risks review with one of our treasury people. In doing that, we were looking at one of the treasury groups in a particular jurisdiction and we were going through questions such as ‘How many people do you have in that particular office?’ The response was “Two, we have two people”.
We think two people is ok but then we start looking through our notes and we say to that person; “We’ve been told you have six people, are there four other people?” “Yes there are four other people”. “So they work for you?” His response was “they are operational and provide support but the two main people work on strategy and tactics, that type of thing. The other four, I don’t really think about them when we count staff.” To me that’s how certain people look at low value added services, a back office function.
The other thing I would like to touch on is the concept of what a core service is. You're going to find that it's not as clear cut as we think, which many may already know, but let's use the treasury example I just mentioned. I think for a number of companies, they may look at some core services as low value or back office. Obviously, there are certain functions that aren't as clear cut.
I think perhaps a better way to look at a core function is by dividing them into three segments. There is a strategic segment, a tactical segment, and, lastly, an operational segment which most of us think of as the low value service. As you start to look at the number of functions that are in this so-called grey area, it might be prudent to look at those three segments and analyse a particular function.
What factors will you consider when making the election?
For us it's a bit of a challenge and there are a number of factors, but here is the main thing; for years we've had a legacy process in place where we've identified seven or eight categories of low value services. This process has withstood audits in different jurisdictions. We have utilised the U.S. methodology which uses the Service Cost Method (SCM) and doesn’t call for a mark-up.
The focus in most audits has been on the process itself. That is the main subject addressed in BEPS. How is one identifying the cost centres? How is one identifying what a direct cost is? How is one identifying what an indirect cost is? And finally, how is one processing the billing? This is the nuts and bolts. In our audits, we have always passed muster on those aspects.
When I look at this and ask myself "do I want to rock the boat by doing an election?” I'm not sure I want to do that because the process seems to work for me right now.
The second issue is mark-ups. If you're engaged in a legacy process where perhaps one has used a zero mark-up, (which will perhaps be going out the door with the adoption of the simplified proposal), or even if one doesn’t formally adopt it, one will still look to the proposals for guidance.
You may accept mark-ups for certain processes where you have already considered services other than low value. I'll give you an example; for back office services historically, going back to the time since dinosaurs marched the earth, we've used 30 % mark-up. Then we engaged in something that's specifically addressed in the OECD’s BEPS (Organization of Economic Cooperation and Development Base Erosion and Profit Shifting) Action 10 proposal, the concept of the procurement type of business. We did an analysis, looked at comparables all over the place, and we elected out of 5%. The problem that you have now, with the new proposal, is whether they're saying 5% is to be considered a safe/locked in low value service mark-up.
Does that mean that tax authorities all over the place are now going to look at that 5% as what one should be charging on all low-value services? And do I now have an exposure for my amply documented procurement process? Again, something to consider where one has a process in place and has already established mark-ups based on good and solid research.
The third part, which is probably the main reason why I would perhaps not adopt it, is that you've got an inconsistency among many different countries. This is with the U.S. in particular where one may use 0% under the SCM. Yet, there are some non-OECD countries like India or China which may look at different types of mark-ups. So unless you have uniform adoption by both OECD and non-OECD countries, you're basically going to get yourself back into a situation where you're still auditing these issues among different countries. You have to ask yourself what you are gaining.
The last thing is if you're not going to adopt this approach, what are you going to rely upon? There are a couple of ways you can look at it and I haven't really formulated a decision because you don't have to make any type of formal election until down the road or at least until 2018.
There’s another approach I might want to take a little bit of a look at. Given that I have this disparity between countries; one approach might be if one finds that most of the costs are being incurred by two or three other countries, perhaps one should adopt an approach where focus is turned to those particular countries.
Now I know it comes off sounding like letting the dice roll on some of the lower volume countries, but one of the things needed to be weighed is the materiality of the numbers that you're dealing with. Again, in the particular process we conduct as a transfer pricing group, we act essentially as the messenger. A lot of the work being done to accumulate this data is performed by groups outside of your particular department who do not report to you and may question why do they have to do all this work (that is a discussion for another day).
Let’s say you’re counting on your legal entity finance managers to identify your cost centres. You're also counting on them to identify what's direct and what's indirect. You're asking they identify where those charges are going to. Lastly, you're also asking them to do the invoicing between the countries. It’s in your interest to try and simplify this process. Again, you weigh it against your audit risk at all times. Do you really want to make this process overly complex?
How important is the process for evaluating low value added services?
Although it's not designed to be a method for income shifting, which is what BEPS is all about, it does draw a great deal of attention from your senior financial figures. In our case, it would be our chief financial officer and in particular the legal entity finance controllers/managers in a number of countries.
From the CFO's perspective and also the controllers, one of the issues that often comes up in a down turn is, "Hey, is your particular entity incurring too much overhead," or "Why is your company doing so bad?" The first suspicion generally goes out to, "Let's take a closer look at overhead”, i.e., low value services and “Are you sure you're identifying all of those and are you charging all of those out?"
It can be a fairly large number in particular jurisdictions and in entities that are on the margin with profitability. The ability to charge those expenses out is a huge issue at a senior financial level. If you look at it also from the perspective of legal entity finance managers, you do have that issue. In addition, you're also very, very concerned with what your overall legal entity looks like. For example, if I'm in Belgium or if I'm in the UK, I'm running a business that is maybe in a down turn so one would be counting nickels.
In that process one of the things one will do, and it's a process we’ve instituted in our company on a fairly regular basis, is a thorough scrubbing of cost centres. The concept of low value services is a misnomer because it gives the impression it is minor - that we're not talking major bucks at times, but in reality it's quite the opposite. It may be the one issue that senior financial people can probably understand best coming out of transfer pricing.
Let's face it, some of the other things that we do are somewhat esoteric in nature and they may have difficulty comprehending, "Are you charging it all out via your expenses? Is it going to the right person?" Those issues do resonate and within our practice represents probably 30% to 40% of the calls we get from our legal entity finance managers - that is, it involves some form of service costs question in the nature of operational, procedural or which bucket of low value services the expenditures fall into. It's a big deal.
