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  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.
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 Ltd. To download current and past, see the Newsletters section.