Without transfer pricing legislation, it would be relatively straight forward to manipulate the profits of connected parties, so that they fell into companies/organisations/structures where there was either no tax, or very low tax rates. This would deprive a government of the necessary funding to enable it to fulfil public needs.
The object of transfer pricing is therefore to analyse all transactions that take place between the connected parties and determine an amount that each of those transactions would take place at, if the parties were unconnected; the ‘arm’s length basis’. These transactions will not only include goods and services, but also financing arrangements/loans etc. The issue with financing is not solely the interest rate charged, but also would the recipient of the loan have been able to secure that level of finance from an unconnected lender, without the support of its parent undertaking.
By carrying out the transfer pricing analysis, adjustments can be made to arrive at an appropriate allocation of profit/risk for each type of transaction between the connected parties. Where the actual transactions do not take place on this arm’s length basis, appropriate adjustments must be considered for corporation tax purposes.
For UK purposes, transfer pricing generally only applies to large entities. A large entity is one that meets one of the following:
- It has more than 250 employees or,
- Where there are less than 250 employees then a large entity must also have a turnover of more than €50 million and gross assets of more than €43 million.
The figures above must be looked at on a group basis. For transfer pricing, identifying the group will include not only the more usual 51% ownership criteria, but can also involve looking at what are known as linked enterprises and partnership enterprises.
Although transfer pricing has traditionally been considered to only apply where there are cross-border transactions, for a number of years now it will also apply between UK resident connected parties, providing they meet the size criteria.
Taxpayers must keep sufficient records to make a complete and correct return; there is guidance from both HMRC and The Organisation of Economic Co-operation and Development (OECD) as to what transfer pricing records should be maintained.
This brings us to local authorities and LATCOs.
Although a local authority has a corporate tax exemption, it needs to be considered when determining whether or not the size criteria has been met. It is likely that a local authority will be largely using the criteria above and, therefore, so will the LATCOs that it owns. It is important that the LATCO has robust transfer pricing documentation to evidence the prices used for transactions with the local authority, so that HMRC will have confidence that the profits are allocated to the correct entities.
