Many corporate groups operate through multiple entities, at times involving more than one tax jurisdiction or in some instances between free zones and the mainland. It is not cost-effective to have teams for various support functions in each entity of the group.
A group operating in multiple countries will have a single team providing IT support to the group. Functions such as legal, accounting, finance, HR, payables, and R&D are usually centralized. The entity providing support services is referred to as a ‘service center’, and the entity availing the services as ‘service recipient’.
‘Cross charge’ is a mechanism whereby the costs incurred by the service center are recovered from the service recipient, generally based on an allocation key. In the case of IT support services, the costs incurred by the service center (hardware, software, and employee costs) may be allocated to other entities based on the number of tickets created. Similarly, costs incurred on the legal function may be allocated based on the time devoted by the legal team, or the costs incurred on the accounting function may be recovered based on the number of accounting entries passed.
Having appropriate allocation keys is critical. Commonly, headcount, area occupied, and revenue are used as allocation keys. Cross charges are subjected to an audit by tax authorities of both locations - i.e., the country/free zone of the service center and the country of the service recipient, especially under Transfer Pricing regulations.
In the country of the service center, the tax authorities will scrutinize whether appropriate profits have been earned and offered to tax by the service center. The arms’ length test is applied in such a case, whereby the tax authorities seek to compare the profits earned by the service center with those earned by other third-party service providers engaged in providing similar services.
‘Arm’s length’ approach
Essentially, it is verified as to whether the service centers have recovered the full costs, plus an appropriate markup from the associated enterprises, after taking into consideration factors such as nature of services, functions performed, assets utilized, risks assumed, the extent of involvement by the associated enterprises. Where the profits are not at an arms’ length, a Transfer Pricing adjustment is made, whereby profits equivalent to arms’ length profit are subjected to tax.
In the country in which the service recipient is based, the payments made to the service center are subjected to the benefits test and the arms’ length test by tax authorities. Under the benefits test, the authorities verify whether the service recipient has actually availed and benefited from the services provided by the service center. A deduction from profits of the payments made to the service center is allowed by the tax authorities only to the extent the benefits have been availed.
Master service agreements
The service recipient generally proves benefits availed either as cost savings or increase in revenues. If the payments are found to be in excess, a Transfer Pricing adjustment is made, whereby the excess payments made are disallowed as a deduction from profits and subjected to tax.
Tax authorities perceive payments of shared service center costs/group costs as ‘repatriation of profits’ or excessive arms’ length price, hence the need to defend with facts and documentation when asked to do so.
The UAE would grant credits if a tax were deducted in an overseas jurisdiction. The OECD has encouraged countries to levy a withholding tax only on the profit element in the cross charges.
Considering the overall tax litigation risk involved in case of cross-charges, overseas or between free zones/mainland entities, it is necessary for organizations to have a robust pricing policy in place. A ‘Master Service Agreement’ or separate agreements should be entered into between the service center and service recipients.
A regular study should be undertaken to test compliance of the pricing policy with the arms’ length principle. This shall help organizations to defend and mitigate litigation risk. In certain cases, where complex issues like IP development or marketing intangibles are involved, organizations may also consider obtaining clarification from the Federal Tax authority once the rules are known.