Portugal Software Services: Bonus Compensation and Pass-Through Costs

A September 19, 2024 ruling by the Portuguese Administrative Arbitration Center upheld the cost-plus approach used by the taxpayer even though the Portuguese tax authorities objected to the exclusion of employee bonus compensation from the cost base. The cost base included certain pass-through costs, which led to the reported markup for 2019 being less than 4.1%. Given how low this reported markup was, it might have been in the interest of the taxpayer to report the financials on a net revenue basis that excludes pass-through costs from gross revenues and from the value-added cost base. I discuss this accounting issue followed by a discussion of the role of bonus compensation, which includes employee stock options.

Markups over Total Costs and Markups over Value-added Expenses

While the issue of gross revenue versus net revenue accounting was not the primary issue in this Portuguese ruling, it was a central issue in a similar dispute between the IRS and the Canadian Revenue Agency (CRA). A Canadian affiliate of a U.S. parent performed certain information technology and software services on behalf of the parent corporation. The Canadian affiliates incurred 10 million Canadian dollars ($) in total expenses with half of those expenses being subcontractor costs and the other half being value-added expenses. CRA objected to the $10.25 million in intercompany compensation as it reasoned that a 2.5% markup was too low. The taxpayer, however, noted that the $250 thousand in profits represented a 5% markup over value-added expenses. The following table shows the income statement for the Canadian affiliate as well in for the Portuguese software services affiliate.

Table: Gross v. Net Revenue Accounting for Two Software Service Affiliates (in Thousands, Local Currency)

The gross revenue for the Portuguese software affiliate was 9.497 million Euros (€) with total costs excluding bonuses = €9.126 million. Operating profits therefore were €371 thousand, which represented a 4.065% markup over total costs. The Portuguese ruling noted several of the accounting details including:

• €17 thousand in cost of goods (materials consumed); and
• €787 thousand in subcontracting expenses.

When these pass-through costs are removed from gross revenues and reported expenses, net revenues = €8.693 million and value-added expenses €8.322 million. Profits relative to value-added expenses represented a 4.458% markup. The increase in the reported markup is modest as pass-through costs represented only 8.81% of total costs as compared to 50% in our Canadian affiliate example.

The taxpayer prepared a transfer pricing report that used the Transactional Net Margin Method (TNMM) using the return to total costs rather than the more appropriate return to value-added expenses. Table 16 of this report was entitled “Interquartile range of margins on arm's length operating expenses” even though its reporting was on the markup over total costs for the third-party companies chosen as comparables. The median markup was 5.6%, while the interquartile range was from 4.7% to 7.5%. Since the taxpayer’s reported markup was less than 4.1% and therefore below the lower quartile, it is curious why the Portuguese tax authorities accepted this TNMM analysis as alleged supported for the taxpayer’s position. The dossier also reported the maximum markup, which was 13%, and the minimum markup, which was-3.4%. It appears that the Portuguese tax authorities accepted the full range as the arm’s length rate.

Returning to our Canadian affiliate, its 2.5% return to total costs is below even the minimum markup noted in this transfer pricing report. The representatives of this North American multinational responded by noting how its 5% return to value-added expenses was within the interquartile range of markups reported in this transfer pricing report. Such an analysis would have a classic apples to oranges problem in that the third-party companies in the set of comparables noted in the Transfer Pricing Dossier likely have subcontracting costs as well as other forms to pass-through costs. A proper application of TNMM would remove these pass-through costs before computing the markup. The same caveat applies to the comparison of the 4.458% return to value-added expenses received by the Portuguese affiliate.

Bonus Compensation and the Employee Stock Option Issue

The Portuguese Administrative Arbitration Center ruling noted the key issue in this litigation:

The cost base attributable to services provided to related parties did not take into account bonuses paid to employees. A tax assessment was issued where these bonuses had been added to the cost base on which the profit was determined, resulting in additional taxable profit … The Applicant argues that the balance sheet bonus does not represent a value to be considered, from an economic-financial point of view, when determining a price to be charged: the balance sheet bonus represents the positive result of the price charged.

This claim that employee bonuses are not an economic value to be considered is akin to the claims made by U.S. multinationals with respect to employee stock options (ESOs). When an option is issued, its actual realization is usually deferred and depends on the movements in the stock price over time. Stock option compensation can be viewed on an ex post basis using the value at the time of exercise or on an ex ante basis using the expected value at the time of grant. A third party would likely not wish to be exposed to the volatility of measuring compensation using time of exercise valuation, but market pricing would include the expected cost of ESOs in the measure of total compensation. David G. Chamberlain recently argued that time of grant valuation is consistent with market pricing, whereas time of exercise valuation is not. A generation ago I made the same point in a discussion that predated the adoption of Financial Accounting Standard 123, which represents the U.S. financial accounting treatment of ESOs.

The OECD secretariat’s 2004 report “Employee Stock Option Plans: Impact on Transfer Pricing” provides a clear articulation of the issues regarding the valuation of ESOs and makes a convincing case that the value of ESOs is an economic cost. I recently discussed this issue in terms of litigations in Ireland, Israel, and the U.S. The Portuguese Administrative Arbitration Center ruling noted that the actual expense from the bonuses was approximately €334.5 thousand but did not note how much of the compensation had been expected. Only the expected cost of the employee compensation should have been included in the tax base under arm’s length pricing.

The Portuguese Administrative Arbitration Center ruling also noted a timing issue:

... only considered in the calculation of the net margin of the operation all personnel costs actually incurred in the 2019 tax period, which also include the bonuses earned by the Applicant's employees, following the results obtained in 2018 and which negatively affected the 2019 tax result, calculated off the books … the Defendant believes that at the end of the year, the amounts invoiced should be adjusted according to the real expenses (actually incurred), with the SIT including the bonuses paid to employees in 2019, which were not recognized in the accounts as expenses for the 2018 period and which, for tax purposes, were considered by the Claimant as a deductible negative asset variation in the 2019 period. The negative asset variations indicated in the IRC model 22 declaration, in the amount of €334,508.55, correspond to bonuses paid to staff for 2018, which were not foreseen as expenses in the respective financial year. This amount was deducted from the net profit for 2019.

In other words, this compensation related to services provided in 2018 rather than in 2019. Similar timing issues exist for ESOs. Time of grant valuation properly address such timing issues whereas time of exercise valuation can distort the timing of when economic costs occur. If the taxpayer’s concern were properly addressed, the expected value of these bonuses should accrue to 2018 but could not be ignored entirely.

References

Portugal vs “Software Services S.A.” (CAAD, Case No 71/2024-T).

David Chamberlain, “Charging Out Stock Option Expense Can Be Arm’s Length”, Tax Notes International, April 15, 2024.

Harold McClure, “Transfer Pricing and Employee Stock Options: Testing Economist T. Scott Newlon’s Hypothesis,” Tax Management Transfer Pricing Report, Oct. 18, 2000.

Harold McClure, “Stock-Based Compensation and Transfer Pricing For Irish and Israeli Affiliates”, Tax Notes International, July 1, 2024.