A taxpayer can only deduct management fees as an expense if management services were supplied to it in the production of its taxable income.
By LEON HARRIStaxes good 88(photo credit: )
Suppose you operate in business through a number of companies and some make profits, some make losses. Can you arrange for Company A to pay an amount equal or similar to its profits as a management fee to Company B which made losses, as a way of offsetting profits against losses?
Recent Court Decision
There have been many court cases on this subject. One typical case recently was Sheer Lavie Construction and Development Ltd v. Ashkelon Assessing Officer (Civil Tax Appeal 551/05 of August 31, 2008, Beersheva District Court). In that case, Reuven Lavie was engaged in "ground services for foreign workers" in 2000-2002 via three firms he owned. Each one operated out of the same office and Lavie steered work between them at his discretion.
One company claimed large management fee expenses regarding payments to the other two companies totaling around NIS 1.5 million, pursuant to two intercompany agreements between them. The ITA rejected these management fee expenses.
The court ruled the intercompany agreements were fictitious agreements because they were not concluded on the dates stated in them. The agreement covering the biggest payments was in fact "an attempt to support a retroactive and manipulative analysis of the data and to divert sums from one company to another for non-commercial reasons which were unconnected to corporate management … the company did not provide any data, evidence or documents to justify the amounts or link them to management … and most of the explanations provided were contradictory."
In other words, sloppy back-dated tax planning.
A company is, of course, a separate legal entity. The Israel Tax Authority (ITA) reviews management fees carefully - if the companies were real people, Mr. A. would not give up his profit lightly to Mr. B. Therefore, any management fee must be reasonable.
There are a number of hurdles to navigate, as discussed below.
'Reportable tax planning act'
To make sure the ITA knows what is going on, management fees are now included in a blacklist of "reportable tax planning acts" under Israel's tax shelter reporting rules.
This applies to a payment of NIS 2 million or more by a party to a "related party" for management or advice or similar, if the payment reduces tax payable.
If you commit such a "reportable tax planning act," you must report it on Form 1213 and attach it to your annual tax return. The assessing officer may then issue a partial best judgment assessment of your income and tax due, disregarding the act.
If the act was deemed to be artificial or fictitious, a deficiency fine of 30% of the tax shortfall may be levied, among other things. However, no such exposure arises if you obtain an advance tax ruling from the Tax Authority.
A related party is generally defined as: (1) spouse, brother, sister, parent, grandparent, descendant, spouse's descendant and spouse of each of them, or (2) An entity in which the taxpayer holds 25% or more; a party that holds 25% or more of the taxpayer; and a sister entity held 25% or more by a party that holds 25% or more of the taxpayer.
Expense deductibility rules
A taxpayer can only deduct management fees as an expense if management services were supplied to it in the production of its taxable income (Section 17 of the Income Tax Ordinance [ITO]. So it must be clear that management services were indeed supplied and helped generate taxable income.
The amount of a management fee must also be reasonable. This depends on the circumstances, of course. It might, for example, be a reasonable hourly rate multiplied by the number of hours worked by each management person in the production of income of the company concerned.
Also, the ITA will check the allocation basis was applied during the tax year concerned, not retroactively after the year-end, when the profit and loss results were known. Otherwise, the ITA may reject such transactions as being "artificial or fictitious" (ITO Section 86).
Transfer pricing rules
Any amount billed between related parties must be on market based "arms length" terms - price, credit period, and so on, if any party is resident outside Israel or taxed outside Israel on that transaction (ITO Section 85A).
Related parties covered by this requirement include those that control 50% of the other party or those that are 50% or more commonly controlled.
This must be substantiated by a "transfer pricing" study available for inspection within 60 days after any demand by the ITA to see it. This will apply to both the payer and the related recipient of any management fee.
Loss utilization principles
In general, business losses may be offset against income derived by the same company from any source in the same year.
Unrelieved business losses may be carried forward for an unlimited number of years by that company to offset business income, capital gains derived from business activities, or business-related gains subject to Land Appreciation Tax.
Withholding tax
Management fees and other payments made to a non-Israeli resident are generally subject to a withholding tax, usually at a 25% rate. This is collected by the Israeli bank making the payment.
Any lower rate requires upfront written approval from the ITA. The ITA rigorously scrutinizes requests to reduce withholding tax on management fees.
Domestic payments between Israeli firms are subject to different withholding tax rules - typically at 30% for "assets and services" - unless the recipient holds a certificate from its tax office allowing a lower rate based on its circumstances.
As always, consult experienced tax advisers in each country at an early stage in specific cases.
leonharr@gmail.comThe writer is an international tax specialist.
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