Money Matter

Service fees need valid commercial reasons

Article exclusively contributed by Asia Progress (Tax Division)

In our previous article, we explained why the Inland Revenue Department (IRD) had taken steps to review the exact nature of business undertaken by service companies apparently set up by Mr Chan and for which his wife was shown as the main shareholder. The couple had been asked to provide relevant documents and evidence to support the commercial activities of the companies and to make it clear why they had been established.

The IRD assessor pointed out to Mr Chan that, in the department's view, for a service company to have commercial substance, there is usually a service agreement, under which another firm pays a previously negotiated fee. In consideration of the fees paid, the agreement generally provides for the service company to supply certain stated requirements for the other firm. Mr Chan contended that, in this instance, the service companies were providing procurement and vendor sourcing services for his own business.

In response to this, the assessor further explained that the IRD does agree that, in some cases, there are valid commercial reasons for the use of a service company arrangement. However, their concern here was that, having regard to the services involved, the fees paid were well in excess of commercially realistic amounts. By implication, it appeared they were not incurred wholly in the production of the chargeable expenses. Furthermore, no service agreement had been signed, no accounting records were being kept and, worse still, the fees had been decided on an arbitrary basis and bore little relation to the costs of the services provided.

The assessor gave Mr Chan further details of why the IRD considered the service charges to be inflated without commercial reason. Firstly, they had found that, under this arrangement, the service companies did not function as separate entities operating at arm's length in their dealings with the firm. All their business activities had to be approved by Mr Chan himself, and the board and management did not have any independent decision-making role. Besides, there were no supporting documents about the respective rights and obligations which the separate companies had in dealing with Mr Chan's firm.

The assessor also drew attention to the qualifying conditions that are generally required in order to produce chargeable expenses. From the IRD's point of view, these should include things such as the provision of premises, staff, plant and equipment, and miscellaneous supplies. In charging for professional services, there should also be day-to-day duties requiring the use of certain expertise.

Nevertheless, according to the findings of the assessor, there was no sign of arm's length transactions, no clear basis for calculating the fees, and most of the charges were not even settled by the end of each year. Furthermore, Mrs Chan was basically a housewife with no professional knowledge about sourcing materials and she had not travelled to the mainland to visit vendors in the previous few years. Besides that, the service companies used the same office address as Mr Chan's own garment trading business, no proper books or records were being kept, and all the expenses incurred by the service companies were related to the personal expenses of Mr Chan and his wife. The handling of those expenses was another area of concern for the assessor.

The result was that the IRD told Mr Chan they did not consider the service companies had been set up for sufficient commercial reason. They seemed to be only for the purpose of tax evasion and, most importantly, the companies were closely controlled by Mr Chan and his wife and were not operated at arm's length. Therefore, the IRD did not consider the management fees paid to the service companies as deductible expenses for Mr Chan's company.

Q&A on management fees paid to service companies
Q1 What is the minimum requirement for management fees to be deductible?
A1 There are two minimum requirements. Firstly, the service company must enter into a service agreement and it must function as a separate business operating at arm's length in dealings with the firm which is party to the agreement. Secondly, there must be clear qualifying conditions as the basis for making charges and the amount that is claimed must be commercially reasonable. This is judged by what is considered an appropriate mark-up after covering the overheads and profits of the service company.

Q2 What further information will the IRD consider for the deduction of management fees to be allowed?
A2 A firm must establish that the amount claimed in respect of each qualifying service falls within section 16 of the Inland Revenue Ordinance and must provide a detailed statement to the IRD which includes:
a. why the service is required by the firm in order to conduct its business
b. the amount included in the total management fee in respect of particular services, and
c. an explanation of why the amount should be accepted as being commercially realistic and deductible.

Taken from Career Times 25 February 2005

(Last review date: 23 August 2013)

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