The analysis of roles and remuneration in intra-group transactions – An updated approach of Romanian tax authorities

The development of the roles played by each entity in intra-group transactions carried out at the level of multinational groups has led to an evolution in the way they are analysed by tax authorities and should also lead to an evolution in the way they are documented and supported by the entities involved.

With the increasing attention paid by public opinion to multinational groups, tax administrations have also improved the way in which intra-group transactions are analysed, especially in terms of the remuneration received by each entity.

In the classical approach regarding the analysis of transfer prices used in intra-group transactions, the approach of tax administrations included, in most cases, a delimitation of the role of each entity. Thus, in most cases, an entity was classified within a single role: manufacturer, service centre, distributor, holding company etc.

The analysis resulting from this classification was simple enough to allow sufficiently clear comparable elements to be identified in the market, with a limited possibility to identify opposing arguments on both sides (both at the level of the tax administration, and at the level of the taxpayer).

Based on the elements identified in the market, the tax administration could determine whether or not transfer price adjustments were necessary.

However, over time, the roles played by existing entities at the level of a multinational group have begun to either be merged within fewer entities or increase in complexity.

In the first instance, when several roles are merged within a single entity, the analysis develops only extensively, as it requires only the performance of more than one analysis in order to identify sufficiently clear comparable elements in the market. Thus, documentation that would have been made separately at the level of several entities is now concentrated at the level of a single entity.

In the other instance, when the complexity of an entity's role increases, the analysis develops not only extensively, but also intensively, as it is necessary to detail the elements that are part of that role, beyond the simple classification as manufacturer, service centre, distributor or holding company.

This increase in role complexity generally occurs when intangible assets are involved.

As an example, we can consider a relatively simple situation: a group intends to develop a new consumer product. To this end, the coordinating entity of the group obtains funding from the entity in charge of product distribution. With this funding, the coordinating entity concludes a contract for research and development services with one of the service centres within the group, with all the resources needed for the project directly belonging to the latter. The product resulting from the project is manufactured by the production entity which, in the manufacturing process, proposes certain improvements to the product, in order to reduce production costs and increase its reliability.

In this example, starting from the classical approach of framing each entity in a single role, the situation would be as follows:

• the coordinating entity, as the initiator of the project, would be the owner of any intellectual property rights related to the product and would benefit from any royalties paid for the use of these rights;
• the entity that deals with the distribution of the products, as financier/banker, would be entitled only to the interest related to the granted funds;
• the service centre would only benefit from remuneration for research and development services;
• the production entity would be remunerated only for the manufacture of the products themselves.

The above-mentioned framing, although providing remuneration for each of the entities involved in the process of creating, manufacturing and distributing a product, do not fully take into account the contributions of the parties involved.

The updated approach to analysing such a transaction, as recommended in the July 2017 edition of the Transfer Pricing Guidelines for Multinational Corporations and Tax Administrations, published by the Organization for Economic Co-operation and Development, involves a closer analysis of intangible elements, which cannot be quantified at first sight.

By re-examining the example presented above, the updated approach could lead to different roles and remunerations:

• the coordinating entity, as the initiator of the project, would be the partial owner of any intellectual property rights related to the product and would have to share any royalties paid for the use of these rights with the entity that distributes the products;
• the entity in charge of distributing the products, although not the initiator of the project, provided the necessary financing, which would give it the role of co-owner of intellectual property rights related to the product and would ensure a part of any royalties paid for the use of these rights;
• the service centre would only benefit from remuneration for research and development services;
• the production entity would be remunerated only for the manufacture of the products themselves and, in addition, could be remunerated for research and development services as a result of the proposed improvements to the product.

Moreover, in an even more aggressive approach, the production entity could be considered entitled to part of the royalties generated by the product, given that market success also depends on the quality of the finished product, not only on the concept behind it.

Thus, while in the classical approach to role analysis, there were relatively few elements of debate between the entity and the tax authorities, based on the updated approach, by taking into account the contributions of intangible elements, role analysis can become a contentious area.

The roles and remunerations identified for each entity directly affect the taxable result that could be allocated in each country, both in percentage (by profit margin) and nominal (by net profit value). Therefore, each tax authority can present its own analysis of the allocation of roles and remuneration, depending on the financial contribution provided to the state budget.

Based on the previous example, the entity that distributes the products and provides financing for the development of the product could be treated differently by the tax administration of that country depending on its result:

• if the entity is currently making a profit, which is normal for a distributor, the tax administration could argue that the entity is also entitled to a portion of the product-related royalties collected by the coordinating entity, further increasing the taxable profit;
• if the entity makes a very low profit or even a loss, the tax administration could argue that the entity should only be considered as a simple lender to collect monthly/annual instalments from the coordinating entity, thus eliminating the risk of non-recovery of the borrowed amount (which could happen if the product is not successful in the market) and ensuring a taxable profit in that country.

These uncertainties of interpretation cannot be completely eliminated in the case of complex transactions, especially due to the high number of factors involved, particularly with regard to contributions that are not tangible and cannot be easily quantified.

The only viable approach is a detailed analysis of complex transactions, carried out in advance, taking into account both the contractual clauses and the factual situation, the purpose of which is to prepare arguments and, where appropriate, documents to be submitted to tax administrations in order to support the remuneration established in the case of intra-group transactions.