Cost Allocation: A Guide to Maximizing Efficiency and Minimizing Tax Liability

Shared service costs refer to the expenses incurred by a company for services that are used by multiple departments or business units. In UAE, we have seen various Group companies sharing common services with respect to various departmental functions. These services can include IT, HR, finance, and legal, among others.?

Usually, the burden of all such costs is being borne by one main business unit out of the Group, so there is a dire need to allocate these costs is important for several reasons:

????????????Results in accurate financial reporting for each department or business unit.

????????????Promotes fairness and transparency within the organization ensuring each department or entity is only paying for the services they use.

????????????Assist management in better decision making for budgeting, outsourcing, consolidation, or other cost-saving measures.

????????????Contributes toward improved accountability by identify areas where departments or business units may be overusing resources. This can lead to improved accountability and cost savings.

?The method used for allocating shared service costs should be chosen based on the specific needs of the organization.

Case Study:

Recently, we implemented a shared service cost allocation mechanism for a group of entities consisting of more than eight entities with the aim to spin off couple of entities. Our goal was to carve out two entities from the group, but the financial reporting was not accurately reflecting the true picture of profitability. This was because all shared costs were being recognized in the main entity. To correct this issue and accurately value the entities being carved out, we needed to ensure that the profitability was accurate.

To achieve this, we conducted an exercise to formalize a shared service cost allocation mechanism. We used a combination of methods for different functions based on their practicality, including allocating costs based on revenue, the number of transactions, and the resources used by each business unit. This helped us to identify the actual profitability of each entity, which in turn supported the successful carving out of both entities from the group.

Corporate Tax Perspective

Allocating the cost of shared services within a group of entities can be beneficial for corporate tax purposes as it can help to reduce the overall tax liability of the group. By allocating the costs of shared services to other entities within the group, the entity providing the shared services may be able to claim a tax deduction for the costs incurred. This can help to reduce the entity's taxable income and ultimately lower its corporate tax liability.

It's important to note that, allocating the cost of shared services must be consistent with the arm's length principle, it means that the cost allocation should be based on the value of services provided and not on the ownership structure.

Conclusion

In summary, shared service cost allocation is important for financial reporting purposes because it allows organizations to accurately assign the cost of providing support services to the business units that use them, which is important for budgeting, forecasting and determining profitability.?the decision to allocate cost should be based on the organization's overall financial and strategic goals.