Captive Services Provider Campaign

May 2019 | Article

By Jason Fritts and Kiley Green

Continuing the initiative it created in 2017, the IRS’s Large Business and International division (LB&I) announced three new compliance campaigns on April 16, 2019, one of which is the captive services provider campaign. LB&I created the compliance campaigns program as part of its restructuring to make better use of IRS resources and has developed 53 campaigns in total. The goal of the captive services provider campaign is to ensure U.S. multinational corporations compensate related captive service providers at arm’s length prices.

A captive service provider is a wholly-owned subsidiary existing for the sole purpose of providing services to their parent company and/or other related parties. The intercompany transactions relevant to the captive services provider campaign are ones in which a foreign captive subsidiary is performing services exclusively for its parent or other related entities of the multinational group. All of a captive subsidiary’s revenue is intercompany.

When related parties are providing services to one another, the prices paid and prices charged for these services must be arm’s length (i.e., at market price). This means that the service provider should be receiving the same return from the service recipient as third parties/unrelated parties if the service recipient was employing a third party/unrelated party for the provision of these services. According to the IRS’s announcement, “The section 482 regulations and the OECD (Organization for Economic Cooperation and Development) Transfer Pricing guidelines provide rules for determining arm’s length pricing for transactions between controlled entities, including transactions in which a foreign captive subsidiary performs services exclusively for the parent or other members of the multinational group. The arm’s length price is determined by taking into consideration data available on companies performing functions, employing assets and assuming risks that are comparable to those of the captive subsidiary.”[1] Typically, multinationals benchmark the profitability of the captive subsidiary in order to develop a range of prices that are considered arm’s length.

Our Approach
Eide Bailly’s recommended approach in a captive subsidiary transfer pricing analysis is to benchmark the profitability of the entity with the less complex functions and fewer risks. This has the benefit of:

  1. Being efficient.
  2. Being technically correct according to transfer pricing rules.
  3. Focusing on what tax authorities are primarily concerned with regarding transfer pricing, i.e., the correct amount of income tax paid and preventing tax avoidance.

Most often, tax advisors and authorities utilize a profits-based method to benchmark the arm’s length profit of the less complex entity based upon that entity’s functions, risks, and assets. Advisors search for companies with publicly-available financial statements domiciled in the germane geographic region that perform functions similar to those of the less complex entity. Once advisors identify a set of comparable companies, they examine what those companies earned as a markup on their total costs, or net cost plus markup. From there, advisors calculate the interquartile range of those markups to determine the arm’s length range of profitability that the less complex entity should earn.

Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), U.S. parent companies were incentivized to lower their effective tax rates by establishing captive subsidiaries in low-tax jurisdictions while maximizing the captive subsidiary’s profitability. However, with the decrease in the U.S. tax rate due to TCJA and the announcement of the captive services provider campaign, it is crucial for companies to perform an analysis to determine the arm’s length profitability of their captive services subsidiaries. Further, companies can select the point within that arm’s length range of profitability that provides them with the most tax-efficient answer. Treasury regulations for section 482 state, “In some cases, application of a pricing method will produce a single result that is the most reliable measure of an arm’s length result. In other cases, application of a method may produce a number of results from which a range of reliable results may be derived. A taxpayer will not be subject to adjustment if its results fall within such range (arm’s length range).”[2]

Finally, the TCJA introduced the Base Erosion & Anti-Abuse Tax (BEAT) effective for tax years beginning after December 31, 2017. Generally, BEAT only applies to C-corporations that meet the following two requirements: (1) average annual gross receipts of $500,000,000 for the prior three-year period and (2) a base erosion percent of at least 3 percent.[3] A base erosion payment is any amount paid or accrued by a taxpayer to a foreign related party in which a deduction is allowed. BEAT applies to outbound service payments, as it imposes a minimum tax on outbound, related party payments, including payments from a parent company to a captive service provider.

Eide Bailly can assist with a captive subsidiary transfer pricing analysis to ensure U.S. multinational companies pay related captive service providers at arm’s length prices and are compliant with the arm’s length principle. Do you have questions about your transfer pricing approach? Contact your Eide Bailly professional or a member of our International Tax Team to learn more about transfer pricing planning and intercompany accounting.

 


[1]https://www.irs.gov/businesses/corporations/irs-announces-the-identification-and-selection-of-three-large-business-and-international-compliance-campaigns

[2] § 1.482-1(e)(1)

[3] 2.0 percent for banks and securities dealers.

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