Service transactions – a new focus for tax authorities?

It is a truth commonly acknowledged that related-party settlements have been scrutinized by tax authorities for several years. In 2022, more than 500 transfer pricing controls were taking place: 370 were completed and 242 were pending. In 2022 alone, the amount of additionally estimated income exceeded PLN 1 billion (almost PLN 220m more than in 2021).

Not only the number of controls made and income reassessed has changed. According to the Ministry-released information, in 2022 the most frequently revealed TP irregularities concerned the sale of goods (121 controls) and the provision of services (104 controls). Previously, these were valuations of intangible assets and restructuring.

This means tax controllers are now focused not only on transactions that are in many ways difficult or unique. They also target seemingly simple transactions, such as service transactions.

Group services…

It might seem there is nothing difficult about fulfilling documentation and reporting obligations for service transactions. Documentation is rather standard and benchmarking analysis for the mark-up often give the feeling that group service transactions are safe. Not really.

…is where details make a difference

Unfortunately, you can no longer assume that since the mark-up used to calculate the remuneration is arm’s length, the transaction is on the safe side. Not anymore.

As it turns out, in the case of services, tax controllers focus primarily on verifying the cost base. They check if costs were reasonable when included in the billing of services, but also whether the costs used in the calculation were budgeted or actually incurred. Keys used to allocate costs to service recipients are equally important. Any change in the cost base or allocation keys may involve a change in the amount of the tax base and trigger a major additional estimation. An example: if the cost base is PLN 1 million, after taking into account a profit mark-up of 5%, the value of settlements will be PLN 1.05 million. If some of the costs in the cost base are challenged and, for example, PLN 300k are excluded, the value of settlements drops to PLN 735k. For the service recipient, this means a decrease in the cost of purchased services by PLN 315k and consequently an increase in the tax base.

…and benchmarks have weak points

Unfortunately, there are more sensitive areas in the control of service transactions. According to the Ministry of Finance, controls by tax authorities are primarily challenging benchmarking analyses. It is well known that controllers review the adopted comparability criteria in detail and modify them. Often times comparability criteria adopted in the analysis filed by the taxpayer are accepted after a very detailed review of the final research sample and after making adjustments: rejecting the originally accepted entities or adding new ones which tax authorities believe are more comparable. Tax controllers also analyze the financial statements of the entities in the sample and highlight certain items that demonstrate their incomparability to the audited controlled transaction. It also happens that the comparability ratio itself raises questions from tax authorities.

No documentation, but still arm’s length!

Some taxpayers justify the lack of benchmarking for a service transaction claiming there was no documentation obligation in place. What a mistake! Documentation obligation is one thing and the review of arm’s length conditions of a transaction is another. Regardless of the taxpayer’s documentation obligations, the obligation to keep transaction settlements arm’s length remains an open question. In our experience, tax authorities examine and challenge the settlement of individual service transactions regardless of documentation obligations – for example, when auditing income tax settlements for the year. Sometimes domestic entities were exempt from documentation obligations, and having an up-to-date and good analysis was a great asset while disputing with authorities challenging the settlements in services.

Importantly, transactions that are exempt from the documentation obligation must still be reported using the TPR form (to a limited extent). This means they can be selected for scrutiny on the basis of the form just like transactions subject to documentation obligations. That’s exactly what happens, so it is a good idea to have up-to-date analyses proving the transaction is arm’s length.

One step ahead of tax authorities

‘Better safe than sorry’ might be a catchphrase, but it actually is a good tactic in avoiding or managing a dispute with tax authorities. It’s worth safeguarding against situations that could significantly disrupt a taxpayer’s business – especially if they involve seemingly simple service transactions. Having gone through the activities of auditing bodies, we know it is recommended to once again check group settlements in service transactions: whether the cost base, allocation keys or the way remuneration is calculated in general is not questionable. Given the dynamically changing economic situation, in principle, every year taxpayers should also answer the question of whether the benchmarking analysis they have is still valid and indeed confirms the settlements are arm’s length. Basically, you need to make sure the tested entities are indeed comparable.

Documentation obligations aside, let’s change perspective on benchmarking analyses. Stop seeing them as a formal obligation, but rather as a security measure in case an arm’s length transaction is challenged. Benchmarks can also serve as the basis for renegotiating or setting the terms of a new service transaction.