Related-Party Charges and Profit Routing
Orient Plastics (Pvt) Ltd is a Sri Lankan manufacturer owned by a Singapore holding company. Its profits are taxed at 30%. It pays the parent a management fee of 4% of turnover and a royalty of 3% of export sales. The parent employs twelve people and provides group treasury, brand and procurement services. Orient's turnover is LKR 6.8 billion, of which exports are LKR 4.1 billion. It has accumulated tax losses of LKR 1.2 billion from 2019-2021; advisers confirm these can be carried forward for six years but that continuity-of-ownership rules apply. Orient is considering acquiring a profitable local competitor with no losses. The group now proposes to (i) raise the management fee to 7% next year, (ii) route Middle East sales through a new Dubai subsidiary that buys at cost plus 2% and resells at cost plus 12%, and (iii) borrow LKR 2 billion from the parent at 18% when a bank would charge 13%. The board asks whether these proposals are acceptable tax planning.
1. Evaluate the deductibility of the management fee and royalty, applying the arm's length principle and the benefit test. What documentation is required?
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Deductibility test. An expense is deductible only if it is incurred in producing income and is not capital or private. For payments to a related non-resident, the arm's length principle also applies: the amount must be what an independent party would pay for comparable services. The benefit test asks whether Orient actually receives services of value.
Current fees. Management fee 4% of LKR 6.8bn = LKR 272m; royalty 3% of LKR 4.1bn = LKR 123m. The parent has only twelve employees. It can plausibly provide treasury and procurement coordination, but the scale of the fee must be supported by time records, service-level agreements and a cost-plus or benchmarking study. The royalty requires evidence that the parent owns the brand and that Orient's sales benefit from it. If the brand was developed by Orient, the royalty is vulnerable.
Proposed increase to 7% adds LKR 204m of deduction, a tax saving of about LKR 61m. An increased fee for the same services is difficult to defend unless the scope has genuinely expanded.
Documentation: intercompany agreement, invoices, evidence of services received, benchmarking or cost-plus study, transfer pricing disclosure, and a file showing the arm's length price. The group should also consider withholding tax on the royalty and treaty relief under the Singapore agreement.
2. Explain the tax treatment of the accumulated losses and how the acquisition should be structured.
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Losses. The LKR 1.2bn of losses can be carried forward for six years, subject to continuity-of-ownership rules. Losses from 2019 expire in 2025, 2020 in 2026 and 2021 in 2027, so a substantial part is close to expiry and should be used first. Losses can only be set against future taxable income, and the business that generated them must continue in substance; a change of activity or a break in operations can put them at risk.
Continuity of ownership. If more than the permitted percentage of share ownership changes, the losses may be forfeited. The advisers should model the ownership position before and after any transaction.
Structuring the acquisition. If Orient buys the competitor's shares, the competitor's tax history, including any hidden liabilities, comes with it; the competitor has no losses to preserve. If the competitor buys Orient's shares, Orient's losses are at risk. If Orient buys the competitor's business and assets, the losses stay with Orient but the competitor's tax attributes are not acquired. The structure should be driven by commercial logic first: whether Orient needs the competitor's capacity, customers or brand.
Recommendation: do not acquire a company merely to use losses. Model the cash tax benefit, check continuity, and obtain a tax indemnity for any share purchase.
3. Assess the Dubai restructuring and the parent loan against anti-avoidance principles and the directors' duties.
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Dubai routing. Buying at cost plus 2% and reselling at cost plus 12% shifts 10 percentage points of margin out of Sri Lanka. If the Dubai company has no people, premises or risk, the arrangement lacks economic substance and the general anti-avoidance rule may allow the tax authority to disregard it or reallocate the profit. Transfer pricing would also require the Dubai entity to be compensated on an arm's length basis for the functions it actually performs. If it is a mere conduit, an arm's length reward may be small, and the Sri Lankan entity should retain most of the margin. The group should document substance, decision-making and risk in Dubai before implementing.
Parent loan at 18%. A bank would charge 13%, so the excess 5% (LKR 100m a year) is not an arm's length expense. The excess is likely to be disallowed and may be treated as a distribution. Withholding tax on the interest and treaty relief must be considered, and the interest deduction may be limited by thin-capitalisation or interest-limitation rules.
Directors' duties. The Orient board must act in Orient's best interests, not merely as a conduit for group tax planning. A transaction whose main purpose is to reduce Sri Lankan tax, without commercial substance, exposes the directors to penalties and reputational risk. The board should obtain independent tax and transfer pricing advice, minute the commercial rationale, and reject proposals that cannot be supported.