Formulating Management Charges Policy
Historically, intra-group services have often been charged using a standard approach, i.e. by means of a (net) cost-based remuneration method, mostly with a relatively modest markup of only 5%. This was often done more for practical convenience such that an extensive and costly transfer pricing analysis need not be carried out, rather than for tax planning purposes.
However, over the years, tax authorities have become more critical and have challenged the basis for allocation of costs, the markup level, but also more fundamentally, the (cost-based) remuneration method for certain intra-group services. In transfer pricing parlance, management fee is often used as a generic term to describe any charge between related parties, in the context of intra-group services.
In practice, setting a group management charges policy will prove to be challenging, given the range of services and the profile of service recipients who will benefit from each service. A fair basis for charging must be found bearing in mind (i) the provider’s costs, (ii) the benefits received by the service recipient, and (iii) the possibility of procuring the services from a lower cost third-party service provider.
We discuss some of the practical considerations you should explore why it would be critical to review your management charges policy, especially in the post-BEPS (base erosion and profit shifting) environment.
Challenges for Pricing Intra-Group Services
The tax authority in the country of a service provider would understandably encourage the charging of maximum possible costs to the service recipient, thereby resulting the highest possible remuneration. On the other hand, it would be in the interest of the tax authority in the country of the service recipient to keep tax deduction claimed on service charges incurred at the minimum.
Clearly, there could be a large scope for disagreement between tax administrations in the respective jurisdictions and this could occur concurrently in a number of jurisdictions. It would not be difficult to imagine that today, such cross-border disputes account for a large proportion of transfer pricing litigation.
Transfer Pricing Practice Applicable to Management Services
Typically, a management charges policy should address the following fundamental questions:
- whether a charge should be made at all, including shareholder activities, duplication cost, incidental benefits, etc.
- making direct charges wherever possible, but otherwise making indirect charges after choosing allocation keys; and
- using the most appropriate method for conducting benchmarking.
Essentially, the management charges policy should be designed with the above background in mind, and the policy should be such that it does not result in either over-charging or under-charging of management fees, which can eventually, prove to be a tax burden on an overall group basis. Clearly, it is not sufficient to add a random mark-up to the service provider’s costs and allocate the charge according to an allocation key. On the other side of the fence, close compliance with the principles described above could prove to be extremely time-consuming. A balance will have to be explored.
Practical Possible Approaches
It is possible to operate a simplified management charges policy which will still follow the broad conventions and have regard to the main challenges, along the following lines:
- recording evidence of benefits received by each recipient from each service in case of local challenge, whether outputs such as people trained or (if possible) outcomes such as increase in productivity or reduced defects, or just economies of scale from centralising the services;
- creating a matrix using the management accounts line items and asking the key transfer pricing questions in each column – to be used as both the information-gathering resource and a key part of the transfer pricing documentation;
- developing this matrix into a spreadsheet charging model, generating the charge for each service to each subsidiary in each period;
- defining each service as being a combination of one or more of a few generic services, conducting the benchmarking analysis to support the mark-up;
- capturing the charging policies in a services agreement and appropriately worded model invoices. The services agreement would cover, among other things, how the charging method would be updated and reviewed, the invoicing system, settlement dates, payment methods, any budget versus actual costs adjustments, how new services and recipients would be incorporated and how services would be terminated;
- maintain detailed documentation to support the transactions and have adequate justification (commercial expediency test) to undertake transactions in a particular manner; and
- supporting the charges by a report of the transfer pricing analysis including what/ who should be charged, directly or indirectly, through a comparable uncontrolled price or on a cost mark-up basis, and the results of benchmarking into arm’s length charges or profit mark-ups.
Developing a supportable and commercially sensible management charges policy cannot be done overnight. Deliberations should be based on the arm’s length standard to reflect the economic reality of the transaction. This may entail analysis of all the activities being performed, interviewing personnel and coming up with the proper cost drivers so that the fully loaded cost of providing these types of services can be derived.
We have extensive experience in preparing appropriate documentation for the management fees. If you need further assistance on preparing a management fee charging policy or strategies to build up your defence against a tax audit or would like to seek advice on specific transfer pricing issues, please reach out to the tax professionals at CCS for a discussion.