Mark McLaughlin CTA (Fellow) ATT TEP outlines some potential pitfalls in management charges between related businesses.
Introduction
The use of management charges between related businesses is a relatively popular and well-known tax planning technique. Management charges are often considered if, for example, companies are ‘associated’ for small companies’ relief purposes to minimise tax liabilities by ensuring that more profits are subject to a lower rate of corporation tax overall.
There is some degree of acceptance of commercial levels of management charge in HMRC guidance, in the context of groups of companies (see BIM38230). In addition, HMRC acknowledges the use of service companies by partnerships, where the service company provides office accommodation and clerical services.
However, in this case HMRC’s view is that the management charges to the partnership should not be more than their cost plus a “modest uplift”, stating that “As a broad rule of thumb a modest uplift would be in the region of 5%” (BIM72070).
HMRC’s approach is probably based on the decision in Stephenson (HMIT) v Payne, Stone, Fraser and Co [1968] 44 TC 507. In that case, a firm of Chartered Accountants used a service company to provide the firm with staff, facilities etc. The firm agreed to pay the service company £47,000 in one accounting year, although the services rendered in that year cost only £32,000. The Revenue refused to allow the whole of the £47,000 in the relevant year, contending that no more than £32,000 fell to be deducted from profits for the year.
The High Court held that only £32,000 of the expenditure, plus a ‘nominal profit’ for the Service Company, could properly be deducted in that year.
Avoiding The Pitfalls of Management Charges
Problems can arise if management charges appear excessive or non-commercial, or if the charges are intermittent or vary widely. To qualify as an allowable deduction for the paying company, management charges must satisfy the normal tests of being revenue expenditure incurred wholly and exclusively for the purposes of the company’s trade.
HMRC is understood to be challenging management charges in some cases by applying ‘transfer pricing’ principles. There is anecdotal evidence that this has sometimes resulted in deductions being restricted or denied for the paying entity, whilst remaining taxable in the charging company. HMRC has also been known to argue that management charges are ‘disguised’ remuneration of controlling directors, with a view to imposing PAYE Income Tax and NIC liabilities thereon. In addition, management charges can give rise to VAT problems, as well as company law issues (both of which are beyond the scope of this article).
What Can Be Done?
It should help in any negotiations with HMRC if it can be demonstrated that the management charge has been calculated on a reasonable and commercial basis. The basis of charge should be properly documented in an agreement between the entities governing the provision of the management charges.
The charges should also preferably be consistent from one accounting period to another, and be invoiced at regular intervals. Above all, it is important to remember that there must be a valid basis for the charge, not simply dealing with business profits in a tax-efficient way.
The above article is reproduced from Practice Update (March/April 2010), a tax Newsletter produced by Mark McLaughlin Associates Limited. To download current and past copies, visit: Practice Update.
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This article notes that HMRC is sometimes using the transfer pricing principles to challenge what they see as excessive management charges, but it is worth noting that transfer pricing principles might sometimes provide strong support for taxpayers who wish to justify a charge higher than costs plus a small markup. Indeed, there are some potentially useful comments in the International Manual, for instance at INTM463050, which says:<br /> <br /> "It is however completely inappropriate to use a cost plus method consisting of a mark up on total costs, where the functions carried out are not the type of functions that would be contracted out at arm's length, being functions vital to the overall trade of the group. Payroll functions or legal work might be contracted out to an independent but more critical functions would not. What constitutes a critical function will depend on the nature of the trade. A cost plus agreement means the person proving the functions loses any benefit linked to the contribution those functions make to the profitability of the trade, since the provider gets the same flat rate irrespective of success. If those functions are critical to the overall success of the trade, then why would the person carrying out those functions accept a small return on his costs?"<br /> <br /> This wording has been inserted due to HMRC's concerns that UK companies which supply services to other overseas members of their multinational group might, in some cases, be abusing a cost plus approach so as to undercharge for services which, if they were being supplied to unrelated parties, would potentially have commanded a level of profitability greater than just a markup on the costs. However, this argument cuts both ways; if, based on HMRCs own comments, the arm's-length commercial charge for a service should be higher than cost plus a small markup, surely there is a pretty good argument that this charge should be fully deductible for the recipient of the service?