Transfer Pricing analysis of professional services provided by related-party individuals and corporations
October, 17th 2016
When applying the arm's length principle to services rendered by an individual to a related party corporation, those same services supplied by the corporation to a third party can be used as an internal comparable.
The Spanish Central Economic-Administrative Court ("TEAC") has released an important decision in relation to the arm's length valuation of services performed by a partner to a corporation where that corporation also renders the same services to a third party. In a decision that overrides a previous one issued by the Catalonian Regional Economic-Administrative Court ("TEAR"), the TEAC suggests that, provided the corporation does not add significant value to the services rendered, the transaction between the corporation and the third party may be used as an internal comparable transaction for the application of the Comparable Uncontrolled Price method ("CUP") to the individual partner's compensation.
The decision in question implies that profits will be allocated as a whole to the individual, leaving income within the corporation only to the extent that it covers the incurred expenses. This could potentially trigger significant consequences for individuals rendering personal services through a non-transparent legal entity, as all the profits would be subject to Personal Income Tax rather than Corporate Income Tax. If profits are high enough, income will be taxed at higher rates (up to 48 percent instead of the corporate income tax rate of 25 percent).
Broadly speaking, the TEAC argues that, where the corporation lacks production means other than the work performed by the individual, the services rendered by the corporation to third parties are comparable enough to those rendered by the individual. As a comparable uncontrolled transaction, the CUP method is preferable to the Profit Split method, which the Spanish tax inspectors often apply during tax audits. This is especially the case when the services rendered by the corporation to third parties are considered to be intuito personae, that is, no professional other than the individual in question may perform them.
Moreover, the TEAC assumes that in these kinds of structures no functional analysis is needed for the tax auditors in order to challenge the arm's length's nature of the transfer prices. The reason for this assumption is that the corporation does not have production means that result in higher added value to the individual's provision of services, so that there are no functions, risks nor assets to analyse. Consequently, the tax inspectors solely need to argue the reasons that lead them to consider that the legal entity lacks of its own structure for performing its activity. Besides, even if the taxpayer could prove that there are other more reliable comparable transactions, the TEAC clearly states that "this is not a valid reason to reject the comparable selected by the tax auditors".
The provision of services by an individual through a corporation is not a recent issue in the Spanish tax landscape. Traditionally, the Spanish Tax Authorities considered this situation as an abusive tax scheme, thus applying domestic general anti-avoidance rules to allocate all the income to the individual partner. As a result of several court judgements confirming the taxpayers' claims on the matter (see, inter alia, the decision of the High Court of Murcia issued on January 26th, 2015), the Spanish Administration has turned towards the Transfer Pricing rules in order to challenge these kinds of structures.
Whereas this decision is binding only on the Spanish Tax Administration (taxpayers can still challenge its content before national courts), it may have immediate consequences for professionals that have been providing services to third parties through their own corporation during recent years.