Understanding when and how to charge for central/intra-group services
Nouran Ibrahim and Hana Khalil of Saleh, Barsoum & Abdel Aziz – Grant Thornton Egypt discuss the rationale and basics of implementing mechanisms for the correct administration of central/intra-group service charges
In the complex world of multinational corporations, central services play a crucial role in ensuring the smooth operation and efficiency of various business units. Central services are those services that are provided by one group member to another. These services can have a wide scope; for example, IT, HR, finance, and technical and legal support. While central services offer significant benefits in terms of cost optimisation, expertise sharing, and standardisation, the question of whether to charge these services out to the recipient often arises. The decision is not straightforward and requires careful consideration.
Why charge for central/intra-group services?
From both an accounting and a tax legislative perspective, most countries will have a framework to encourage the correct alignment of revenues and costs. The matching principle, for instance, is a fundamental accounting concept that dictates matching expenses to revenues in the same accounting period to ensure accurate financial reporting.
In Egypt, the correct allocation of costs is essentially governed by articles 22 and 30 of Income Tax Law No. 95 of 2005. These articles address the premise of taxable profit determination after taking all relevant costs into consideration, and the commitment to the arm’s-length principle – highlighting the Egyptian Tax Authority’s right to adjust transactions that are not conducted at arm’s length. Furthermore, Article 38 of the Executive Regulations of the same law includes central cost allocations among the transactions that the Egyptian Tax Authority would closely examine in the context of the arm’s-length principle. It should therefore be construed that a lack of these charges would similarly be closely examined.
With this in mind, this article discusses the most common parameters of charging out central/intra-group services.
Charge-out mechanism: a step-by-step approach
The first step in determining whether to charge out a central service is to determine if a service has been rendered. This means that the service must provide commercial or economic value and benefit the recipient. This is referred to as the benefit test. The recipient needs to be willing to pay an independent party to perform the same activity, or be willing to bear the cost of performing the activity in-house.
Not all activities should be considered chargeable. Non-chargeable services may include shareholder activities performed solely for the benefit of the shareholder(s), such as consolidation of financial accounts, duplicative activities that provide no extra benefit to the recipient, and incidental benefits arising solely from group affiliation in the absence of deliberate actions leading to that benefit.
Once it has been determined that a service has been rendered, the next step is to determine the cost of the service, after excluding non-chargeable services. This involves identifying all direct and indirect costs associated with the service, such as salaries, benefits, supplies, and equipment.
Once the cost of the service has been determined, it needs to be broken down into directly allocable and indirectly allocable. Directly allocable costs are those that can be directly attributed to a specific legal entity, department, or business unit. Indirectly allocable costs are those that cannot be directly attributed to a specific legal entity, department, or business unit, and in these cases, costs can be attributed according to allocation keys.
An allocation key is a method of distributing indirectly allocable costs to the parties benefiting from the service. There are several allocation keys that can be used, such as number of employees, time spent, square footage, or revenue.
Once the costs have been identified for allocation, depending on the transfer pricing method, an appropriate mark-up may need to be determined. The appropriate mark-up will vary depending on the service being provided. Third-party, or pass-through, costs representing expenses incurred on behalf of group members as an intermediary, with no addition of value, would not be expected to be charged to the relevant beneficiaries at a mark-up.
The OECD Guidelines set forth a simplified approach for low value-added services, where a safe harbour of 5% may be added to the costs without performing any additional benchmarking analyses. To utilise the simplified approach, the services need to fulfil the criteria included in the OECD Guidelines, where, essentially, the services should:
Be supportive in nature;
Not be part of the core function of the group; and
Not involve any substantial or significant risk for the service provider.
What about VAT considerations?
When charging out central services, it is important to consider the VAT consequences. This will involve determining whether the service is subject to VAT and, if so, the appropriate/applicable VAT rate.
In a scenario where the central services are provided by an Egyptian company, and the services include a third-party service portion and a portion performed by the Egyptian central service provider:
Third-party costs passing through from one related party to another are generally considered a reimbursement of costs and are not expected to be charged at a mark-up; and
Services performed by one related party for another with an addition of value/benefit are expected to be conducted at a mark-up according to Egyptian VAT law.
Invoices from an Egyptian central service company should be issued for each beneficiary separately and charged at the relevant VAT rate.
The decision of whether to charge out central services is a complex one that should be made on a case-by-case basis. Broadly, services should be charged if they provide economic or commercial benefit to the recipient. There are several factors to consider, such as:
The benefits to the departments or business units that utilise the service;
Whether a profit should be made from conducting the service; and
The VAT consequences.