Directing expenses: news in the transfer pricing scenario
Directing expenses: a specific type of intercompany services
Among the services exchanged between the entities belonging to a multinational group, the so called Directing Expenses must be analyzed with an in-depth attention. These costs represents the remuneration granted by the subsidiaries to the holding company for the provision of centralized services consisting mainly of general direction costs (management fees) and costs related to the administrative functions (Human resources, Accounting, Training, R&D). For the purpose of the transfer pricing analysis of the remuneration paid by the service recipient, the OECD Guidelines underlines the importance of an appropriate functional analysis (so called FAR analysis). The centrality of the FAR analysis finds confirmation within the Italian practice of the Revenue Agency, referring to the statements contained within the Circular no. 32/1980.In particular, the Circular states that for the purpose of the costs recognition the taxpayer must demonstrate:
- The existence of an effective advantage for the subsidiary that receives the service by the holding company;
- The relevance of the cost incurred with respect to the service received.
From a burden of proof perspective, the taxpayer has to demonstrate both the aforementioned requirements. Otherwise, during a tax audit, the Tax Authority could challenge these costs, resulting in an increase of the tax base and, consequently, the application of interests and penalties. Penalties will be applicable only if the taxpayer has not opted for penalty protection by preparing the transfer pricing document set (Country File for simple subsidiary; Masterfile and Country File for sub-holding) and flagging the box in the annual tax return. It must be highlighted that he transfer pricing documentation, compliant with the standard form prescribed by the Act no. 78/2010 and the Circular of the Revenue Agency no. 58/E 2010, grants the exemption from penalties in case of tax assessment on transfer pricing items. Therefore, the compliant taxpayer will eventually be required to pay only the higher taxes on the tax base after the tax audit.
Evolution within the Italian Courts
Over the years, the Italian Courts have attempted to develop the most objective criteria in order to outline the methods and cases in which the costs deriving from directing expenses incurred by the Italian subsidiaries can be legitimately recognized . Since 1999, with sentence no. 14016, the Court of Cassation had stated the requirements of objectivity and demonstrability. As for objectivity, it is a matter of evaluating the effective usefulness of a service, comparing the situation subjected to analysis with the behavior that in similar circumstances an independent company, operating stand alone with respect to a multinational group, would adopt. If it is possible that a third party operator would have reasonably benefit from the provision of the service received from the holding company, and would have paid an independent service provider a remuneration comparable with that was paid to the parent company, it can be said that the usefulness of the service and is verified. The Provincial Tax Commission of Milan in sentence no. 158/2005vstates that the effectiveness and the relevance requirements must be demonstrated on the basis of the following elements:
- Existence of an intercompany contract which clearly indicates the services provided and the methods of performance;
- Regular billing to the beneficiary company and regular accounting of the costs incurred for obtaining the service;
- Possession of regular accounting documentation of the company acting as service provider, containing the amounts received as remuneration;
- Possession of certification report issued by a primary auditing firm certifying the costs incurred in the provision of services by the parent company;
- Production of documentation to support the effectiveness of the service rendered and the benefit for the service recipient company.
With regard to this last point, it should be noted that a criterion for identifying the effectiveness of the benefit is offered by the OECD Guidelines, that states that intra-group services cannot be considered activities that “duplicate” a service that another entity of the group already carries out independently or purchases from a third party.
In particular, paragraph 7.11 states that:
“In general, no intra-group service should be found for activities undertaken by one group member that merely duplicate a service that another group member is performing for itself, or that is being performed for such other group member by a third party. An exception may be where the duplication of services is only temporary, for example, where an MNE group is reorganising to centralise its management functions. Another exception would be where the duplication is undertaken to reduce the risk of a wrong business decision (e.g. by getting a second legal opinion on a subject). Any consideration of possible duplication of services needs to identify the nature of the services in detail, and the reason why the company appears to be duplicating costs contrary to efficient practices. The fact that a company performs, for example, marketing services in-house and also is charged for marketing services from a group company does not of itself determine duplication, since marketing is a broad term covering many levels of activity. Examination of information provided by the taxpayer may determine that the intra-group services are different, additional, or complementary to the activities performed in-house. The benefits test would then apply to those non-duplicative elements of the intra-group services. Some regulated sectors require control functions to be performed locally as well as on a consolidated basis by the parent; such requirements should notlead to disallowance on grounds of duplication.”
The decision of the Court of Cassation, 30 June 2020 no. 13085
With the decision of 30th June 2020 no. 13085, the Supreme Court ruled on the directing expenses, retracing the arguments already highlighted in previous judgments. In particular, the previous decision dated 10th October 2018, which introduced the concept of “congruence” as a parameter for assessing the effectiveness and deductibility of the costs incurred by the Italian subsidiary for centralized services provided by the foreign holding company . With the recent decision of June 2020, the Court confirms the existence of the burden of proof regarding the effective benefit of the service received by the Italian taxpayer. To this end, the provision of the intercompany agreement containing the terms and condition of the intra-group transaction will not be sufficient, meanwhile all the elements suitable for establishing the extent of the advantage achieved by the receiving company will have to be proven. In the case submitted to the attention of the Court, the Italian Tax Office contested the Italian taxpayer the generic nature of the invoices, which not specifically indicate the nature of the services. The Court points out that the most important elements for the evaluation of the benefit are the accounting documents which provide non-generic information. They can be useful in linking the choice to share the costs among the group’s subsidiaries with the actual (and not occasional) advantage achieved by each entity. On this point, the Court highlights that it is not sufficient to demonstrate that the Italian company does not have an administrative structure capable of carrying out the activities covered by the service provided by the parent company. The Court implicitly confirms the position expressed in the decision of 2018, in which for the first time was made a distinction between the anti-avoidance legislation and the transfer prices regulation, underlying that the transfer pricing rules are completely independent from the anti-economic requirement .
Final remarks
In preparing intra-group policies, multinational groups and, in particular, the Italian subsidiaries must ensure both the possession of appropriate intercompany agreements and the availability of supporting documents, containing complementary information, suitable to fulfill the burden of proof required by the Italian TP regulation. Specifically, the Italian taxpayer would be able to achieve greater security in terms of compliance if he prepares:
– Invoices relating to intragroup services received from the parent company including, as well as the amounts, a non-generic description of the service itself;
– The documentation on transfer prices, including within the Country File (or Local File) an in-depth descriptive functional analysis of the advantages achieved in the context of transactions involving centralized services.
Given that transfer pricing is not a “science”, as highlighted by the OECD Guidelines, the most recent Italian legislation and practice has shown a progressive approach in the relationship with the taxpayer in terms of cooperative compliance, encouraging and sometimes positively suggesting the conduct to be adopted in order to prevent tax litigation.
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