This case brought forward the transfer pricing complexities surrounding the captive service providers. The aggressiveness and the detailed investigation performed by the tax authorities during this case informally imposed high standards in respect of the expected profitability of the local captive service providers.

 Setting the scene

The Company A acts as a software service provider for its related party from abroad;

Tax authorities questioned the low profitability achieved by the company during the last three financial years and requested that the company present their transfer pricing file;

The company shows that the hourly rates used when setting the transfer price were at market value. Further, it justified the low profitability by reference to the excess capacity (of approximately 50-60%) incurred by the local company that translated into a number of internal hours that could not be/ should not be charged to its related party;

Tax authorities rejected the arguments brought forward by the Company and argued that it acts as a captive software service provider and it should not bear the excess capacity risk as it does not have any autonomy (i.e. the organizational chart of the local company does not include a marketing and sales department, the evidence of projects directly pitched for by the local company is quite limited). Further, tax authorities attempted to perform a transfer pricing adjustment for excess capacity using as a threshold an 80% utilization rate which they considered the industry average. This translated into a transfer pricing adjustment.

 TiPS for reaction

 ”A”  finally succeed to defend its position, by demonstrating:

 -      Has attempted many times to indentify local projects that would allow the use of the excess capacity of the professional personnel employed

-      the existence of two third party clients to which the local company directly invoices

-      The lack of an exclusivity clause in the agreement between the two related parties

-      the long term strategy of the company, the policy regarding staff retention

-      the low profitability achieved by the related party beneficiary of the software services (this could be seen as an indicator that we are not dealing with export of profits

-      the cost of the local company’s employees currently exceeds the industry average level of the total operating expenses

-      the level of taxes paid by the local company (mainly salary tax) are significantly higher compared with any other local IT company


Technically speaking, ”A” was embarking on a TNMM approach (the transactional net margin method) that required complex adjustments for risk differences between the tested party and the independent companies. In the case at hand, the arm’s length level of profitability accepted by the tax authorities for local captive software service providers was set at 3.2% full cost mark-up;

Be aware: The outcome of this analysis also raised the flag on the potential weaknesses in the group’s transfer pricing system and uncovered ways for improvement which called for a centralized approach.