Operational substance and the deductibility of expenses in transfer pricing

Introduction

In the evolving landscape of international taxation, transfer pricing (TP) has become one of the most scrutinised areas for multinational enterprises (MNEs). A central tenet of TP compliance is ensuring that intercompany arrangements reflect arm’s length conditions. However, in addition to pricing, the deductibility of intercompany charges—such as for services, royalties, and interest—also hinges on operational substance.

This article explores the intersection of operational substance and deductibility in the context of intercompany services, intellectual property (IP) transactions, and intercompany financing, drawing on guidance from the OECD Transfer Pricing Guidelines and recent tax authority practices.

Defining Operational Substance

Operational substance refers to the actual economic activities, presence of personnel, and decision-making capacity associated with an entity. Tax authorities assess substance to determine whether a transaction reflects commercial reality or is merely a vehicle for shifting profits.

Indicators of substance include:

• Physical presence (e.g., office space, equipment)
• Qualified employees conducting core functions
• Active decision-making and risk control
• Financial capacity to bear risks

Lack of operational substance can lead to denial of deductions, recharacterisation of transactions, or profit reallocation.

Intercompany Services: Substance and Deductibility

The OECD Guidelines stipulate that a deduction for intercompany services is justified if:

• The service was actually rendered, and
• The recipient derived a benefit from it (i.e., it would have been willing to pay an independent third party for the service).

Key Substance Requirements:

• Service provider must have the capacity (personnel and expertise) to perform the service.
• Service recipient must use the service for its business operations and be able to demonstrate the benefit received.
• Proper documentation should detail the nature of the service, cost base, allocation key, and benefit analysis.

Common Pitfalls:

• Duplicative or shareholder services
• “Headquarter” charges without documentation of benefit
• Charges to entities with no operational activity (e.g., holding companies)

Case Example:

In Medtronic v. Commissioner (T.C. Memo 2016-112), US IRS scrutiny included whether the U.S. parent received a benefit from intercompany services and whether the charges aligned with the economic reality of the functions performed by the Irish subsidiary.

Intellectual Property (IP): License Fees and Substance

Intercompany licensing of IP is a major transfer pricing challenge, especially when IP is held in low-tax jurisdictions. The deductibility of royalty payments requires that:

• The IP-owning entity has substance: i.e., it performs development, enhancement, maintenance, protection, and exploitation (DEMPE) functions.
• The licensee receives identifiable benefit from using the IP.

Substance Test under the DEMPE Framework (OECD 2017):

• Entities claiming returns from IP must control and financially bear the relevant risks.
• Mere legal ownership is insufficient without actual control over IP-related decisions.
• Tax authorities may reallocate returns if functions are performed elsewhere.

Implications for Deductibility:

• Royalty payments to an IP holder without DEMPE substance may be disallowed.
• Payments must be supported by robust documentation, including valuation reports and functional analysis.

Example:

In several cases across the EU (e.g., Apple in Ireland), tax authorities challenged the allocation of massive IP-related profits to entities with little or no local substance, affecting both deductibility and attribution of income.

Intercompany Financing: Interest Deductibility and Substance

Interest payments on intercompany loans are also under increased scrutiny. The BEPS Action 4 report limits interest deductibility through earnings stripping rules, but even outside those rules, substance in the lender and borrower is key.

Substance Requirements for the Lender:

• Must have decision-making authority and risk assessment capability.
• Should manage the credit risk and have financial capacity to bear it.
• Avoid “conduit” or cash box entities with no financial intermediation functions.

Substance Requirements for the Borrower:

• Funds must be used for business purposes.
• Repayment capacity must be realistically assessed.
• Terms must reflect arm’s length conditions (tenor, interest rate, covenants).

Thin Capitalization and Hybrid Mismatches:

• Excessive interest deductions may be denied under thin cap rules.
• Hybrid instruments can be challenged if they create mismatches in tax treatment across jurisdictions.

Tax Authority Trends and Documentation Standards

Increasingly, tax authorities require contemporaneous documentation that includes:

• Local entity functional analysis
• Description of intra-group transactions and benefits
• Contracts and service level agreements
• Detailed cost allocations and benchmarking

Audits often assess whether:

• The service provider exists in reality, and not just on paper
• The IP owner employs people involved in R&D
• The financing entity makes active lending decisions

Failing to demonstrate operational substance can lead to transfer pricing adjustments, denied deductions, or penalties.

Conclusion

Operational substance is not merely a formalistic requirement—it is the foundation upon which the deductibility of intercompany expenses rests. In the post-BEPS era, tax authorities demand that form follow function, and entities must ensure their intercompany arrangements reflect economic reality.

For services, IP, or financing transactions, MNEs must align structure, personnel, and financial flows to withstand scrutiny. Investing in proper TP documentation, robust governance, and internal controls is not just prudent—it's essential.

• Valeninos G. Pavlides, Director, Tax Services – Transfer Pricing Services, Baker Tilly Cyprus