Subsidiaries of Multi National Enterprises (‘MNEs’) generally avail the services of their group companies for routine business operation and management. When such intra group services are paid for, questions often arise as to whether the services received are essential for business operations of the subsidiary, or are the services carried out by the MNE group with a view to secure their investment in the subsidiary, the latter being generally referred to as ‘share holder activity’. Income tax regulations of many jurisdictions provide for tax deduction only for the first class of services received.
The 1979 Organization for Economic Co-operation and Development (‘OECD’) report suggested a ‘justification of benefit test’ to identify shareholder activities. However, in 1995, the OECD revisited the position and observed that intra-group service will be regarded as rendered when ‘the activity provides a respective group member with economic or commercial value to enhance its commercial position’ [see end note 1].The 1995 Guidelines modified the definition of ‘shareholder activity’[see end note 2] as the activities ‘that a group member performs solely because of its ownership interest in one or more other group members, i.e. in its capacity as shareholder’. There was, thus, a noticeable deviation in the 1995 model from the 1979 model.
The US approach
In 1977, the United States Regulations [see end note 3] clarified that the expenses incurred on overseeing the activities of a subsidiary shall be regarded as ‘stewardship activities’ and shall be attributable to dividend received. US Courts have interpreted these regulations to mean the activities that related to securing investments in foreign subsidiaries. In Columbian Rope Co’s case [see end note 4], the Tax Court held that rendition of services to a ‘fully staffed’ subsidiary would be regarded as shareholder’s services and not a service for the purpose of the subsidiary.
On the other hand, provision of services essential for the ‘day to day’ operations of the subsidiary have been held to not to be in the nature of shareholder’s activities in Eli Lilly and Co [see end note 5]. In relation to services that benefit both the parent and the subsidiary, the Technical Advice Memorandum [see end note 6] issued by Internal Revenue Service of the USA provides that an examination has to be done as to which of the entities have derived ‘direct and proximate benefit’ from the service[see end note 7].The services would be regarded to have benefited the entity which has obtained direct benefit than the entity that has derived an indirect benefit[see end note 8].
Thus, over the years, the Courts in USA adopted a broad standard for identification of share holder activities. However, in 2009, a narrower concept of ‘shareholder activity’ was introduced in the regulations [see end note 9], which its meaning to those activities which have ‘the sole effect of protecting the capital investment of the service provider or to facilitate compliance with reporting or legal or regulatory requirements for the MNC group [see end note 10]’. Thus, both OECD and the US moved to the ‘sole beneficiary’ test for determination of shareholder activity.
European Union’s approach
In Europe, Tax deduction of expenses is governed only by the general law on deductibility and the Transfer Pricing regulations cover the determination of quantum of expense to be allowed [see end note 11].
However, Revenue Authorities of a few States have issued internal guidelines on deductibility of share holder costs. German Revenue Authorities seem to suggest that no charge may be made for the administration, management, control, advisory or similar functions insofar as they arise from shareholding relationships or from other connections establishing a relationship of the parties.The Austrian Administrative Court [see end note 12] held that ‘group charges and allocation fee’ paid to the holding company, without any verifiable evidence would be considered as distribution of hidden profits and not as allowable business expense. The Spanish High Administrative Court [see end note 13] held that costs incurred to adopt the requirement of parent were in relation to shareholder activities.The Dutch Ministry of Finance has clarified that if the group company is not able to independently, without a guarantee from an AE, raise a loan, the guarantee will be provided in a shareholder’s capacity.
India does not have specific guidelines for identification or treatment of consideration paid for shareholder activity. A specific observation has however been made by India in the UN Practical Manual on Transfer Pricing for Developing Countries that share holder services will not be regarded as services at all [see end note 14]. India has, however, agreed that identification of shareholder services would need a great deal of analysis.
The issue of categorizing certain services as shareholder services has been raised by the taxpayer [see end note 15] as well as by the Revenue Authorities [see end note 16] before juridical forums in India. However, the judgments did not give a conclusive ruling.Contrary views exist on the question of whether issuance of corporate guarantee to a subsidiary is a transaction entitled to a separate consideration [see end note 17].
To sum up, the activities performed by the parent company, which a subsidiary would not have hired an unrelated company to perform, would be regarded as shareholder services [see end note 18].The responsibility of establishing that the services paid for is not shareholder service is on the Taxpayer. In the absence of proper documentation, the Revenue Authorities have been considering Arm’s Length Price of any payment to be ‘nil’, though the Courts have held against such determination [see end note 19].
To defend a claim for deductibility of intra-group services, the taxpayer as well as the service provider should maintain adequate documentation.The documentation could illustratively be:
a) Detailed description of the service ideally captured in an agreement
b) Resolution from the subsidiary for the need of such services
c) Proposal and quote form the services provider for the services
d) Details of persons who would render/ have rendered such services, their qualification, their rolls and responsibility in the share holder entity
e) Document capturing the fact of rendition of the service, e.g. minutes of teleconference / videoconference, copies of presentations received, e-mails, details of visits etc.
f) Control exercised by the taxpayer on the service provider which rendition of such services
g) Satisfaction report from the subsidiary after completion of the rendition of services.
This issue, though is in nascent stage in India, has been prevalent in other jurisdiction since 1960s. It would only be appropriate for the Central Board of Direct Taxes to consider the precedence and issue a Circular to guide the taxpayers, Revenue Authorities and Appellate Authorities. Sans such circular, taxpayers should formulate transparent policies for rendition of services and maintain documentation on the basis of the practices of other jurisdictions.
[The author is a Principal Associate, Direct Tax Practice, Lakshmikumaran & Sridharan, Mumbai]
- Para 7.6 of 1995 Guidelines
- Para 7.9 of 1995 Guidelines
- § 861 regulations
- Columbian Rope Company v Commissioner  42 TC 800
- Eli Lilly and Co v Commissioner  84 TC 996
- TAM 8806002
- Similar observation can be found in the Circular issued by Italian Tax Authorities
- Similar observations are made by the New Zeeland Revenue Authorities also
- Para 3.1.1 of Final Report on Shareholder Costs of the EU Joint Transfer Pricing Forum
- VwGH 14.12.2000, 95/15/0129
- Resolución del Tribunal Económico-Administrativo Central of 25 July 2007
- Para 10.4.9.4
- Ground no 13 in Bharti Airtel Ltd v ACIT  161 TTJ 428 (Del), Para 21 in Four Soft (P.) Ltd v. DCIT  44 taxmann.com 479 (Hyderabad - Trib.)
- Para 11 in Invensys Systems Inc., In re  317 ITR 438 (AAR), Para 3.2 in DCIT v Lear Automotive India (P.) Ltd  41 taxmann.com 307 (Delhi - Trib)
- Everest Kanto Cylinder Ltd. v DCIT (ITA No 542/Mum/2012) holding that Corporate Guarantee to a subsidiary would entail a consideration and Bharati Airtel Ltd v ACIT [ITA No 5816/Del/2012] holding otherwise.
- Merck and Co v United States  24 Cl Ct 73
- CIT v. EKL Appliances Ltd.  345 ITR 241 (Del)