The UK has had transfer pricing legislation since 1915 but the legislation and documentation requirements became considerably more wide reaching and onerous with the introduction of Corporation Tax Self Assessment in 1999. Since then, whilst the basic concept in tax law has not changed, HMRC have greatly increased the extent and sophistication of their resources in this area, allowing them to identify and challenge transfer pricing issues more efficiently. In addition, the UK’s corporation tax penalty regime has become more harsh over recent years and this is coupled with HMRC becoming more eager to impose penalties upon the conclusion of a corporate tax enquiry.
It is now therefore more important than ever for companies within the transfer pricing regime to fully consider its ramifications.
Transfer pricing – the basic rules
In the absence of transfer pricing rules, a group of companies could choose to artificially move profits to low tax jurisdictions, thus reducing overall corporate tax payable. Most countries now have rules of varying degrees of sophistication which look to ensure that profits are taxed in the counties where the profits are economically made.
To counter the above, a UK company is required to use arm’s length pricing when undertaking transactions with connected parties whether they are overseas or in the UK. The arm’s length price for a transaction is the price that would be charged / paid for the same transaction between two completely unconnected parties. Where arm’s pricing is not adopted, UK tax law requires a company to increase its taxable profits accordingly in its corporation tax return if accounting profits are understated or to reduce tax losses appropriately if the non-compliance with the arm’s length requirement has led to a potential overstatement of losses. Significantly, the UK legislation does not allow a downward adjustment to taxable profits (or an increase in tax losses) if non-compliance with the arm’s length requirement has led to the overstatement of accounting results. However, where transfer pricing adjustments are required to be made in a UK corporation tax return for intra UK transactions, it is possible for the UK counterparty to claim a “compensating adjustment” so that their taxable profits or allowable losses are reduced or increased accordingly. Where the counterparty is outside of the UK, such compensating adjustments may be available via local law or via any double tax treaty with the UK but this should not be assumed and it is possible for double taxation to arise; local advice should be taken in such circumstances.
The scope of the transfer pricing rules is extensive and includes the supply of goods or services, management fees, the exploitation of intangible assets (such as royalties or licensing fees) and loans and other financing transactions.
Determining an arm’s length price for a transaction with a connected party can be subjective where a company does not undertake similar transactions with unconnected parties. In such circumstances, it is often necessary to determine a means, using one of several internationally accepted methods, of arriving at an arm’s length price. In this regard, publicly available data, such as published company accounts, filed royalty agreements or commercially known financing rates may be used to support the company’s determination of arm’s length pricing.
Irrespective of the method used to determine the transfer pricing policy, the company is expected to be able to demonstrate that it has documentary evidence to support the transfer pricing policy adopted. This is often undertaken by way of a transfer pricing benchmarking report but alternative evidence can be maintained if this is more appropriate. HMRC can levy a penalty of up to £3,000 if they consider that a company has not retained sufficient evidence to support the appropriateness of its transfer pricing policies, as well as tax geared penalties for any subsequent adjustment to profits. The documentation requirements are increased where the UK company falls in the “Country by Country reporting” rules introduced following the OECD’s BEPS project.
The approval of a corporation tax return by an authorised person signifies that the company considers that the calculation of the taxable profit or losses returned complies with the UK’s transfer pricing requirements. If HMRC, as a result of a tax enquiry, can demonstrate that a company has incorrectly applied the transfer pricing rules or, worse, not applied the rules, then, aside from corporation tax and interest thereon that may arise, penalties can be charged of up to 100% of corporation tax understated. Penalties can also be charged if losses have been overstated due to non-compliance with the transfer pricing rules.
In the UK there are certain exemptions from the transfer pricing requirements for UK companies which are members of (as defined) small or medium sized groups where the transactions are intra UK or are conducted with group members resident in territories with which the UK has concluded an appropriately worded tax treaty. Broadly, a small or medium sized group is one that, worldwide, has no more than 250 employees and either has consolidated turnover of less than €50 million or consolidated gross assets of less than €43 million. No exemptions are available where the counterparty is resident in a tax haven or in certain countries with which the UK does not have a tax treaty, such as Brazil.
HMRC consider that transfer pricing enquiries, particularly given the subjectivity which often arises in this area, can be an efficient means of increasing tax collected. In considering whether to commence a transfer pricing enquiry they will consider evidence available to them which may indicate that a company is making, for example, lower profits than would be expected from the industry sector, matters identified in other tax enquiries, such as VAT enquiries, media commentary or information provided to them by other tax authorities (especially where the UK company falls into the Country by Country reporting rules). Aside from the potential financial exposure, transfer pricing enquiries often create significant demands over a period of some time on senior management and can create uncertainty in financial statements.
Some good news ?
For most companies transfer pricing is often seen as an onerous compliance requirement. However, groups may wish to review their position to minimise, where valid and supportable, the level of profits that are made in higher tax jurisdictions.
How we can help
We can assist you in determining supportable arm’s length pricing policies and ensuring that these are appropriately documented. Such support cannot prevent a transfer pricing enquiry or, given the inherent subjectivity, guarantee success in the event of an enquiry. However, a documented, supportable policy can, at worst, mitigate penalties that may be levied by HMRC. We can also assist in reviewing existing policies to ensure that they remain valid and that any tax advantages can be maximised. Please contact Robert Leggett for further information.