Management or service charges between related businesses are fairly common. Such charges are sometimes applied as part of a tax planning exercise, e.g. between associated companies where a trading company falls within the marginal rate of corporation tax, but the service company falls well within the small profits rate. A management charge by the service company can sometimes help to level out the profits of both companies, ensuring a lower rate of corporation tax overall.
However, the well-known “wholly and exclusively" requirement must generally be satisfied in order to obtain a deduction in the business which pays the management charge. It is therefore important to ensure that the management charge is calculated on a commercial basis, and is reasonable. Ideally, the basis of charge should be properly documented in a management services agreement between the two businesses. The management charges should preferably be consistent from one accounting period to another, with invoicing at regular intervals.
If HMRC considers that a management charge is excessive, this could result in a disallowance of at least some of the expenditure in the paying business, but with the full amount of the charge being taxed in the service business.
HMRC's Business Income Manual indicates that reasonable management charges will be readily accepted in certain situations. For example, in the case of group of companies, there might be a group service company which incurs management expenses such as payroll costs. HMRC guidance (at BIM38230) indicates that HMRC will accept service company recharges to group members on a reasonable basis, such as by reference to the number of employees in each company. However, the guidance also mentions transfer pricing in the context of regulating management charges. Transfer pricing is generally applicable to companies, but HMRC warns that similar considerations will apply to partnerships that have dealings with service companies owned by the partners.
In the case of unincorporated business, HMRC points out (at BIM72070) that some partnerships use service companies for avoidance purposes, but states that there is no objection to the setting up of service companies as such. However, the guidance also states that where the service company provides office accommodation and clerical services, the charges to the partnership should be no more than cost plus a "modest uplift". So the question arises: what is a modest uplift? HMRC’s guidance apparently changed in early 2011. Previously, BIM72070 stated that as a broad rule of thumb a modest uplift would be in the region of 5%. However, the reference to 5% has been removed.
In addition to the possible ways in which HMRC could challenge management charges or services such as under the ‘wholly and exclusively’ rule or on transfer pricing principles, it is important to keep in mind that the management charge must satisfy generally accepted accounting practice.
In Craig v Revenue and Customs  UKFTT 90 (TC), the taxpayer was a sole trader who was also a director and shareholder of a limited company (Wild Bill Ltd). The company issued invoices to Mr Craig’s sole trader business, as follows:
30 April 2006 - Professional fees for the year ended 30 April 2006 - £59,000
1 May 2007 - Professional fees for the years ended 30 April 2006 and 30 April 2007 - £51,000
HMRC opened an enquiry into Mr Craig's tax return for 2006/07, which included his accounts as a sole trader for the year ended 30 April 2006. During the enquiry, HMRC asked precisely what the May 2007 invoice for £51,000 was for. HMRC argued that the invoice appeared to be an attempt to reduce profits of the sole trader in one year and transfer income to a later accounting period of the limited company. HMRC also presumed that the effect of doing this was to take the sole trade out of the higher rate tax bracket, leaving the company to pay corporation tax at a lower rate. Similarly, with regard to the April 2006 invoice, HMRC argued that this looked like another artificial attempt to reduce Mr Craig's true turnover and profit in order to take advantage of the lower rate of corporation tax.
HMRC amended the accounts to disallow almost all the total of the two invoices, which totalled £110,000. However, HMRC then time-apportioned that sum between 15 March 2006 which was the date when Wild Bill Ltd was incorporated, and over the years ended 30th April 2006, 2007 and 2008. This treatment was based on HMRC obtaining internal accountancy advice about the accruals concept (interestingly, the enquiry revealed that the charge of £110,000 related to services provided before Wild Bill Ltd had actually been formed).
The tribunal said that based on that evidence, it was perhaps unnecessary to consider any principles of commercial accounting. However, they went on to do so anyway. They noted that HMRC had effectively granted the taxpayer a concession by spreading the deductions over three trading years, and said that based on the evidence it might have been necessary to consider whether the expenses were incurred ‘wholly and exclusively’ for the purposes of the trade. The tribunal decided in favour of HMRC, and dismissed the taxpayer's appeal.
In an earlier case on service charges and accounting principles, Stephenson v Payne, Stone, Fraser & Co  44 TC 507, the taxpayers were a firm of chartered accountants. A service company was set up to provide the firm with staff, heat and light, water, etc. The firm agreed to pay the company a service charge of £47,000 for their accounting year to 30 November 1961. The cost to the company of providing those services was £32,000, resulting in a profit for the service company of £15,000. The service charge for the following year was fixed at £21,000, taking into consideration the profit made in the previous year, and also the service company’s policy which was that it would not make an undue profit at the expense of the firm. Both parties in the appeal agreed that no part of the £47,000 charge constituted a prepayment.
The background to the service charge was that a member of the firm had died in October 1960. The effect of the tax rules at that time was to treat the surviving partners as having set up a new profession. The tax rules for the opening years of a trade or profession which preceded self-assessment were such that the profits for the first three tax years were normally computed by reference to the actual profits of the first year’s period of account. It was therefore in the taxpayer’s interest to keep the profits of the first period as low as possible. The service company had been set up towards the end of 1960, and the partners in the firm were the directors and sole shareholders in the service company.
In the High Court, the judge said that it was necessary to consider ordinary principles of commercial accountancy. The judge said that the difficulty for the taxpayers was that the profit of £15,000 in the 1961 accounting year was not actually a profit at all, but an allocation of part of the actual cost of the services for the subsequent period of account. In other words, what had taken place was a mis-attribution of costs. The court therefore held that the deduction to be attributed to the 1961 accounting year was £32,000, plus a nominal amount of profit. This is perhaps where HMRC forms its view in BIM72070 that only a modest uplift to costs in service charges is allowable.
There are various other issues to consider with management or service charges apart from those mentioned, such as VAT (nb in the William Craig case, no VAT was added to the invoices of £59,000 and £51,000). Thus although management and service charges can be helpful, they do need to be considered fully, implemented properly and managed with care.
Mark McLaughlin CTA (Fellow) ATT TEP