Considerations for head office service charges

For many multinational enterprise (‘MNE’) Groups operating in the UAE, the UAE entity(ies) often acts as:

The global or regional head office, and/or

A shared service center providing centralized functions to foreign and domestic related parties

These scenarios present such Groups with specific challenges and opportunities with respect to the implementation of a head office service charge mechanism.

Risks and opportunities associated with head office charges

In the absence of a headquarter service charge mechanism, the Federal Tax Authority (‘FTA’) may assert that the head office should have charged a fee for the services provided and earned a mark-up. This may lead to adjustments and penalties in the UAE, and potentially double taxation if the adjustment is not accompanied by a corresponding adjustment (in another jurisdiction).
On the other hand, service charges paid by subsidiaries that are not supported by a robust Transfer Pricing model may be questioned by the tax authorities, and could trigger a Transfer Pricing audit.

For entities subject to the standard corporate tax rate of 9%, the implementation of a head office service charge may result in an overall tax benefit for the MNE Group, given the comparatively low tax rate in the UAE compared to numerous other jurisdictions.
For Qualifying Free Zone persons (‘QFZP’s), the opportunity cost of not implementing a head office charging mechanism from a tax optimization perspective is likely to be even greater (see further comments below).

For MNE Groups where the service provider is located in a Free Zone and avails or intends to avail the Qualifying Free Zone Person benefit, implementing an arm’s length charging mechanism takes on additional importance.
The provision of headquarter services to related parties is a Qualifying Activity.
One of the requirements for QFZP eligibility is compliance with Transfer Pricing rules and documentation requirements (Article 18 of the UAE Corporate Tax Law). A lack of an arm’s length head office charging mechanism could result in non-compliance with this requirement.
In addition, the lack of a charge to subsidiaries could suggest or indicate a lack of substance in the Free Zone (another QFZP requirement).

In the absence of a head office service charge mechanism, subsidiaries may appear more profitable as they do not bear their fair share of central costs.
Potential consequences from an operational and governance perspective include misleading performance metrics, potentially leading to inefficient budgeting and capital allocation.
From the perspective of tax authorities in foreign jurisdictions, the lack of a head office service charge may indicate that the real value creation sits with local entities, which could undermine the overall Transfer Pricing model.

In the event of a Transfer Pricing enquiry or audit, a lack of remuneration for central functions may lead to a perception that the Group’s Transfer Pricing governance is weak, which can spill over into closer scrutiny of all related party transactions.sits with local entities, which could undermine the overall Transfer Pricing model.

In determining a head office charge, the following should be considered:

Benefit test - Under both the UAE Transfer Pricing Guide and OECD Transfer Pricing Guidelines, a chargeable intragroup service exists only if two conditions are met: (i) a genuine service is provided, and (ii) the recipient derives a tangible benefit, such that an independent enterprise would be willing to pay for the service or perform it internally. Relevant documentation should be maintained to support the befit test.
Distinguishing chargeable services from shareholder activities - preparing consolidated financial statements, group-level reporting are examples of activities that are performed on account of ownership interest, do not confer a benefit on subsidiaries, and should not be charged out.
Identifying and classifying head office costs – this involves mapping costs into i) directly attributable costs – clearly linked to a specific entity, and ii) pooled costs – which relate to multiple entitiesand require allocation. Reasonable and economically relevant allocation keys that reflect the relationship between costs and the benefits received by each entity should be used (e.g. revenue or headcount).
A Transfer Pricing methodology involving compensating the service provider based on the costs incurred, plus an arm’s length mark-up is a common way of determining the head office charges. However, depending on the respective functions performed, assets owned/employed and risks of the service provider and recipients, a different methodology may be more appropriate.
An arm’s length mark-up is determined through benchmarking, preferably using local or regional comparables. For qualifying low value-adding services, the UAE Transfer Pricing Guide permits a simplified approach with a standard 5% mark-up, provided adequate supporting documentation is maintained. Certain categories of costs (such as pass through costs), may be charged out at cost.

Implementation

Reflecting the arrangements in intercompany agreements.
Putting in place robust governance and monitoring structures that ensure the policies are implemented (including year-end adjustments, if required).
Maintaining comprehensive documentation, including evidence of benefits, cost allocation schedules, and benchmarking studies.