Business

Friday June 5, 2009

Management fees – a licence to bill?

KPMG CHAT - A column by By BOB KEE


High intra-group charges on subsidiaries pose concern

WORLDWIDE, major economies are facing a decline in their growth and hence the profitability of many companies will be affected. Within multinational groups (MNGs), holding companies are facing rising pressure to increase (or at the very least maintain) their bottomline.

Most companies have already implemented cost-cutting measures, just as many are seeking to recover their costs through intra-group charges. This could be by creating a new fee to be charged or increasing an existing fee.

Typically, the basis for the holding company charging its subsidiaries is that, it is payment for certain intra-group services rendered. For many MNGs, the charge is sometimes generalised as management fees.

Let’s take the case of a US MNG (USCo) which charges its Malaysian subsidiary (MCo) a management fee of US$1mil for the provision of finance, treasury and legal services. From a Malaysian income tax perspective, there are two main issues which MCo needs to consider with regards to the management fee charged by USCo.

First, is the management fee charged by USCo justifiable? The basic principle is that MCo would only be willing to pay the management fees if the service it receives from USCo confers real economic or commercial benefits.

Another way of looking at it is: would MCo be willing to pay a third party to perform the same services or would it have performed them inhouse if USCo did not render the services?

The payment of management fees would qualify for tax deduction if MCo can prove that the services received provided positive economic or commercial value which would enhance its commercial position.

One of the pitfalls faced by many MNGs is the general presumption that an agreement between USCo and MCo will address this issue. Whilst having an agreement is generally a good practice, the mere existence of an agreement would definitely not satisfy the Inland Revenue Board’s (IRB) requirements.

What the IRB requires is documentation that describes clearly the specific details of services rendered, proof that services were in fact rendered and that the services provided benefits to MCo.

Taking our example, if MCo is paying USCo a management fee of US$1mil and one of the services provided relates to legal services. Then MCo needs to provide documentation relating to the legal advice received and from the advice received, it should be clear why the legal service is beneficial to MCo.

Perhaps the legal team at USCo helped review a sale and purchase agreement to ensure that MCos’ rights are properly protected. It is recognised that quality of documentation is not always ideal and may not always be available.

As such, companies are advised to balance the need to maintain documentation against the potential tax impact involved. There is no hard and fast rule, only good judgment.

Assuming the management fees are justifiable, the next issue to address is whether the amount of US$1mil is fair, i.e. is it at arm’s length?

The introduction of the arm’s length provision into the income tax legislation effective Jan 1, 2009 now specifically requires all intra-group charges to be at arm’s length. This must be supported with proper documentation and analysis on a timely basis.

If MCo cannot prove the charges received are at arm’s length, the IRB could deny a tax deduction on the amount deemed to be excessive, i.e. the non arm’s length portion. This could lead to double taxation for the MNG.

As a measure to withstand the potential challenges from the IRB and avoid the risk of double taxation, MCo should maintain robust transfer pricing (TP) documentation to support the management fee. The TP documentation should be prepared contemporaneously, i.e. at the time of developing or entering into the related party transaction.

It should also be updated when there have been material changes. Preparing TP documentation on a timely basis will enable MCo to show it has acted reasonably and in good faith to comply with the arm’s length requirement. This could even provide the MCo an avenue to mitigate penalties in the worst case scenario of a TP adjustment by the IRB.

Preparing documentation is always a prudent practice but should not lead to a situation where the taxpayer is overly burdened. It should be acknowledged that there are cost-benefit considerations when deciding on the amount of documentation to be maintained.

One suggestion which could help alleviate the burden of keeping documentation is to introduce “safe harbour provisions”. For example, the IRB could set a “safe harbour” threshold of RM500,000 or a certain percentage of turnover when dealing with management fee charges or other similar charges.

Where the amount involved is below this threshold, companies only need to maintain an agreement as opposed to other additional source documentation. Safe harbour threshold can also be applied in other areas, for example, by defining what level of mark-up is acceptable for certain related party transactions. This will also help reduce the cost of documentation compliance for taxpayers.

Without a doubt, intra-group charges are very common in most MNGs and because of this, it is a popular target for the IRB during tax audits. Therefore, maintaining proper documentation is the key to defending a tax deduction and the only way to demonstrate that reasonable efforts have been taken to comply with the arm’s length provision.

Another tax issue which needs to be addressed is withholding tax on payment of management fees to non-residents, which is outside the scope of this article.

● The writer is executive director (transfer pricing) with KPMG Tax Services Sdn Bhd. Views expressed in this article are solely that of the author and do not necessarily represent the views of KPMG or its associates.


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