IRS Announces Captive Services Provider Campaign

July 2019

Summary

The Internal Revenue Service (IRS) Large Business and International division (LB&I) announced the launch of the Captive Services Provider (CSP) Campaign on April 16, 2019. The CSP Campaign was started to correct potential errors in transfer pricing between foreign CSPs and their U.S. service recipients; LB&I intends to ensure that such pricing is consistent with the arm’s length principle. In this alert, we provide background on LB&I campaigns and CSPs, discuss why LB&I may have targeted CSPs for a campaign, and next steps for both the IRS and taxpayers.
 

Background

CSPs are affiliated enterprises whose sole or primary function is to provide services to the parent company and/or other affiliates, usually under a formal services agreement. Their functions range from customer support and related services, back-office services (e.g., finance, accounting, administration, and information technology), software development and testing, document review and data entry, and other forms of office support. CSPs normally charge for services provided on a fully-loaded cost basis, plus a mark-up, and they typically bear limited operating or financial risks.

In general, LB&I campaigns were introduced to improve return selection, identify issues representing a risk of non-compliance, and use limited resources efficiently. The potential scope and extent of various compliance risk issues that become subject of an LB&I campaign are identified primarily through internal data analysis, as well as suggestions from IRS employees. For the CSP Campaign, LB&I is expected to conduct issue-based examinations and issue soft letters as the key treatment streams. A soft letter serves as a pre-audit warning to a taxpayer, whereby the IRS notifies a taxpayer of potential non-compliance and to which the taxpayer has specified period (e.g., 60 days) to respond or face potential follow-up on the issue. 

The CSP Campaign is notably the first transfer pricing campaign since the Inbound Distributor Campaign, which was announced with the first series of LB&I campaigns in 2017. LB&I has not provided any updates to the Inbound Distributor Campaign to date.
 

Potential Drivers of the CSP Campaign

The IRS is concerned that U.S. taxpayers are overpaying their foreign CSPs, which depletes the U.S. tax base. Although the largest recipient of U.S. offshoring investment is India, jurisdictions such as China, the Philippines, Poland, Thailand, Costa Rica, and others have also become important offshoring destinations. Lower labor costs for skilled workers, such as those in information technology and software development industries, drive firms to invest in a CSP operation. Although many offshoring locations such as India, Malaysia, and China at one time offered tax holidays for new investments, those tax holidays have since expired, so tax arbitrage is unlikely to be a key factor in ongoing investment decisions. Therefore, the low cost of skilled labor in offshoring countries helps offset the relatively high tax rates in those same jurisdictions.

Moreover, key offshoring jurisdictions such as India and China have become notorious sources of tax and transfer pricing audits and controversy; significant transfer pricing controversy with India has involved CSP affiliates of U.S. multinationals. As a result, LB&I’s detection of patterns of high profit margins for CSPs transacting with U.S. service recipients may indicate strategies employed by the CSPs’ parent companies to minimize FIN 48 reserves and reduce potential transfer pricing scrutiny in the CSPs’ jurisdictions.
 

Implications to Taxpayers

The CSP Campaign will require initial preparation and upfront training for selected IRS auditors. Due to the significant ramp-up period, the CSP Campaign is unlikely to impact taxpayer exams until mid-2020.

Historically, the IRS has not committed significant exam resources to captive service providers, but the campaign announcement strongly indicates a material change in posture. Therefore, companies with significant CSP operations should review and potentially refresh their transfer pricing analyses used to support the profits allocated to their CSPs. Compensation should be set at arms-length, with reference to similar transactions or, more likely, the margins earned by comparable third parties located in the same or similar jurisdictions. Furthermore, if issued a soft letter, taxpayers should respond in a timely manner to ensure compliance with IRS regulations.

Special thanks to Abby Schlehuber for her contributions to this article.
 

CONTACT
 
Mark Schuette
Partner
  Michiko Hamada
Managing Director

 
Bob Bowne
Senior Manager