Large businesses have identified that a major concern for them is the impact of transfer pricing enquiries on their business. As a result, HM Revenue & Customs (HMRC) has recently formed a Transfer Pricing Group (TPG) which will be involved in every transfer pricing enquiry carried out by HMRC.
HMRC has stated that in the norm, transfer pricing enquiries will be settled in 18 months with only the most complex cases taking 36 months, or else a decision will be taken to litigate the case to bring it to a conclusion.
HMRC has recently published statistics about the average time taken to resolve transfer pricing enquiries. In the quarter to April 2008 the average time taken to resolve transfer pricing cases settled during January to March 2008 was 24 months and the average age of the transfer pricing cases open at the end of March 2008 was 31 months.
What does HMRC require?
UK companies to which the UK transfer pricing regulations apply are required to include in their Self Assessment Tax Returns additional taxable income where less than an “arm’s length price” has been charged. An “arm’s length price” is one that would result from the transfer of the same goods or services between two unrelated entities in similar circumstances.
It applies to a very wide range of transactions, including:
- the purchase and sale of goods;
- the provision of management and other services;
- rents and hire charges;
- transfers of intangible property, such as trademarks, patents, royalties and know how;
- sharing of expertise, business contacts, supply systems etc; and
- provision of finance and other financial arrangements, e.g. loan guarantees.
The purpose of the legislation is to counter any Corporation Tax advantage generated by non-arm's length pricing and it takes no account of whether the setting of the original prices between the parties has been tax motivated.
The UK transfer pricing legislation applies in certain situations (see below) where there is a transaction between two connected persons and one person controls or participates in the other, or both are controlled by a third party. The controlled party or parties must be a body corporate or a partnership, although the controlling party could be an individual.
The control provisions deem a 40% participant in a joint venture to control that joint venture. A joint venture, for these purposes, is a company or partnership which is controlled by two persons, each of whom has at least a 40% interest in the venture.
Adequate documentation is required to demonstrate arm’s length pricing (see below).
Who does it affect?
Generally, the UK transfer pricing legislation only applies to businesses of a certain size as follows:
- large businesses – defined as those with (i) total worldwide group employees over 250 or (ii) total worldwide group turnover in excess of 50m Euro and including total worldwide group balance sheet in excess of 43m Euro.
- medium sized businesses – not large or small, applies only if so directed by HMRC with notice, going forward.
Small businesses are fully exempt (defined as up to 50 worldwide group employees AND total worldwide group turnover or balance sheet of up to 10m Euro).
It also affects all UK companies, regardless of size, transacting with related parties in countries without a suitable double tax treaty (broadly tax haven countries).
In determining whether the aforementioned tests are met there is a need to consider all partnerships and linked entities and not just subsidiaries.
It should be noted that even if a UK company is without the provisions of the transfer pricing legislation per se, the general requirement that expenditure on which a corporation tax deduction is claimed must be “wholly and exclusively” laid out for the purposes of the business must still be met. HMRC has been known to challenge claims for connected party payments on this basis.
Which transactions are affected?
The UK transfer pricing legislation applies to UK to UK transactions as well as those overseas.
In terms of transfer pricing adjustments UK / Overseas adjustments can be one-sided whereas UK/UK adjustments will generally result in a corresponding adjustment for the other party, unless Tax Avoidance is an issue, e.g. by the artificial use of losses.
What documentation should be kept?
Under Corporation Tax Self Assessment (or Income Tax Self Assessment for Partnerships) there is the requirement to keep and preserve the records needed to make a complete and correct Return for any period.
There is additionally HMRC guidance on transfer pricing documentation which, whilst it has no statutory authority, inadequate” documentation can lead to penalties (see below).
Recommended documentation includes:
- a description of related party transactions;
- a functional analysis – i.e. functions performed, assets deployed and risks borne;
- the chosen method for testing arm’s length nature of transfer price;
- economic analysis/benchmarking; and
- inter-company agreements.
Recommended timing for documentation preparation
Transfer pricing documentation should be prepared, by the time the relevant tax return is filed at the latest. However, earlier preparation is preferred to ensure that the price applied is arm’s length.
Penalties for inadequate documentation
The following penalties can be levied by HMRC:
- a general Corporation Tax Self Assessment penalty of £3,000 per return; and
- a tax geared penalty (up to 100% of the tax lost by reason of the offence) for submitting an incorrect return as a result of negligence or fraud.
For accounting periods beginning after 31 March 2008 please see the note below on HMRC transfer pricing enquiries.
“Negligence” is not defined in the legislation but the taxpayer’s obligation is to do what a reasonable person would do to ensure that their return is made in accordance with the arm’s length principle. This would include:
- setting prices conforming to the arm’s length standard using commercial knowledge; and
- being able to show by means of good quality documentation that an honest and reasonable attempt to comply with the arm’s length standard has been made.
If, for example, a company provides services to other group members at cost plus 5%, with the 5% agreeing to the group policy documented in Board correspondence and in a group arrangement, but it is established with HMRC that an arm’s length range for the services is 10% - 15%, HMRC would view any tax lost as a result of the undercharge as having been lost through negligence if the company cannot show from its records that it even considered whether the 5% rate complied with the arm’s length principle.
HMRC transfer pricing enquiries
HMRC is raising many more transfer pricing enquiries and with the commission incentive scheme now being offered to Inspectors, we can expect even more going forward.
The main areas of transfer pricing enquiries that we are currently seeing are management charges, financing (in particular what inter-company arrangements and guarantees exist), thin capitalisation and royalties. In particular, HMRC is requiring sight of the relevant transfer pricing documentation.
If you have any queries, please contact Tax Partner Fiona Cross on 020 7467 4000. Alternatively get in touch with your usual Vantis contact to discuss any issues regarding the Transfer Pricing regulations.