Service returns: Ace your overheads

HMRC’s management expenses ‘first serve’

Last year, HMRC ran a one-to-many ‘educational’ campaign focused on management expenses claimed by UK holding companies. The campaign targeted cases where a UK company had claimed deductions under CTA 2009 s1219, but where HMRC perceived a risk that some of the relevant costs may have benefited subsidiaries. HMRC’s campaign brought focus to a difficult question: where a UK holding company incurs costs, what is the correct characterisation of those costs? Are they properly expenses of managing the company’s investment business? Or should they instead relate to a trading activity, such as the provision of services to group companies, and therefore require transfer pricing analysis?

These questions are often difficult in practice because holding company activity rarely falls into neat boxes.

The difficult line call

Senior management may be protecting shareholder value, managing an investment, supporting subsidiaries, driving group-wide initiatives, or doing all of those things at once. The tax analysis then becomes a factual question: who benefits, in what capacity, and would an independent party have paid for that activity? That is where the OECD consultation is interesting.

What the OECD draft brings to the court

The existing Chapter VII guidance on shareholder activities has historically been relatively short. The proposed revised guidance goes deeper into the topic, with much more structure, including specific discussion of costs associated with shareholder activities and activities performed by a shareholder that nevertheless satisfy the benefit test.

The draft makes three points that are directly relevant to the UK management expenses debate:

• First, the fact that an activity is performed by the parent, even by senior management, does not automatically make it a shareholder activity. Equally, it does not automatically mean that a service has been provided to subsidiaries. The answer depends on the functional and factual analysis of the activity actually performed;
• Second, the draft recognises that a parent may carry out activities connected with the management, coordination and protection of its investment. But where those activities are performed other than solely because of the parent’s ownership interest, and where subsidiaries receive a sufficiently direct benefit, those activities may be intragroup services; and
• Finally, shareholder activities may be performed by another associated enterprise, with associated costs being recharged in accordance with the arm’s length principle. Whether such costs should be borne by the shareholder or its subsidiaries will depend on the facts and circumstances of each case.

The consultation example on group-wide training illustrates the point. A parent introduces new business procedures and develops training for the group. The parent benefits economically from the initiative, but the subsidiaries also benefit because they receive training they would otherwise have had to perform themselves or purchase externally. On those facts, the draft treats the activity, fully or partially, as a service to the subsidiaries. That is very close to the practical question HMRC set UK taxpayers through the management expenses campaign.

The important point is that holding company costs need to be analysed with some precision. Some costs will be genuinely shareholder costs. Some will be properly expenses of managing the holding company’s investment business. Some activities may only incidentally benefit subsidiaries. But some costs sitting in a holding company may, on closer review, relate to services for which subsidiaries would have been willing to pay.

Be a multi-surface player

For tax directors, the practical risk is that management expenses and transfer pricing are reviewed in separate silos. The management expenses analysis asks whether the cost is deductible in the holding company. The transfer pricing analysis asks whether a transaction should be recognised and priced between connected parties. HMRC’s campaign highlights the importance of those two questions being looked at together.

The OECD draft does not change UK law, and it is not final guidance. But it gives more language, examples and structure around the boundary between shareholder activity and chargeable services. That makes it a useful prompt for UK groups to revisit how they support management expenses claims where the underlying activity is performed at parent or holding company level.

Key questions before the next rally

The best starting point is a practical review of the main cost pools and senior management activities in the UK holding company and to ask a series of questions:

•  Which activities are performed solely for the advantage of the holding company as investor or shareholder?; 
• Where the cost has been claimed as a management expense, is that characterisation supportable? If the activity is more likely to be analysed as a trading activity, is the related expenditure deductible under that head instead?;
• Which activities are expected to create a direct benefit for subsidiaries? Would they have performed the activity themselves or paid a third party for it?;
• Where a benefit exists, what is the arm’s length price for the service? Could the activities be considered as high-value services that transfer know-how or involve control of key operation risks?;
• Is documentation robust enough to support both sides of the transaction?; and 
• Where no service fee is recognised, is there a clear explanation for why not?

Therefore, a robust analysis should explain the purpose and character of the expenditure, whether any intra-group service has been provided and how any resulting service fee should be priced.

Practical take away

The OECD consultation may be framed as an update to Chapter VII. For UK holding companies, it is also a reminder that management expenses need to be reconciled with the group’s transfer pricing position and getting your positioning right early can be the difference between a service game to love and an argument with the umpire.

For further information please contact:

• Anna Lucey
• Ed Hnatkiwskyj