UK: Current Issues In Transfer Pricing

Last Updated: 2 March 2001
Article by Jonathan Schwarz
Introduction

Introduction
The Scope Of The Rule:-
Transaction Or Series Of Transactions
Participation In The Management, Control Or Capital
UK Tax Advantage
The Arm's Length Standard
Documentation
Penalties
Advance Pricing Agreements
Emerging Issues:-
Transitional Problems
Electronic Commerce
Homes Of Non-Domiciliaries Owned By Offshore Companies
Corporate Finance
Transfer Pricing Litigation
Conclusion

Introduction

The last twelve months have seen the most activity in legislation and rule-making since the arm's length principle was introduced into UK tax law some fifty years ago. The enactment of the principle transfer pricing rules and supporting administrative provisions are now to be found in three different sets of legislation: TA 1988, s770A which gives effect to TA 1988, Sch 28AA, FA 1998 ss109 to 111, and the statutory framework for Advance Pricing Agreements (APAs) in Finance Bill 1999 Clauses 76-77.

Substantial explanation of the Inland Revenue position was also published in the Tax Bulletin Issue 37 October 1998 Page 579 and Issue 39 February 1999 Page 623 dealing particularly with record-keeping requirements, penalties and cross-border funding.

A draft statement of practice relating to the administration of APAs has also been released. The new transfer pricing regime is in effect for the purposes of corporation tax as respects accounting periods ending on or after the commencement of corporation tax self-assessment (1 July 1999) and for the purposes of income tax as respects any year of assessment ending on or after that day.

Transfer Pricing And Self-Assessment

One of the most profound changes introduced by Finance Act 1998 is that the arm's length principle is now mandatory for all taxpayers. Under the old rule, transfer pricing adjustments could only be made where the Board of Inland Revenue so directed. The effect of the removal of the direction requirement is two fold. Firstly, it means that taxpayers must self-assess the application of the arm's length principle. Secondly, all taxpayers within Sch 28AA are required to do so even if the issue is not raised by the Inland Revenue. The combination of these two consequences is a shift in the burden of justifying related party arrangements from the Inland Revenue to the taxpayer.

Current practice does not require specific disclosure of pricing between related parties, nor is there a specific declaration on self-assessment tax returns. It is regarded as implicit when a return is signed that the arm's length standard has been complied with in relation to every affected transaction.

The old transfer pricing regime contained specific information powers (TA 1988, s772). These have been abolished and the Inland Revenue will rely on their more general information gathering powers, both in relation to self-assessment (TMA 1970, s19A for income tax; FA 1998, Sch 18 para 27 for corporation tax; as well as TMA 1970, s20). The Inland Revenue have indicated that they will keep the adequacy of these information powers under review.

Although a direction by the Board of Inland Revenue is no longer required to make a transfer pricing adjustment, the approval of the Board of Inland Revenue will still be required to make such an adjustment if a taxpayer and the Inland Revenue are unable to agree. The intention of this mechanism is to provide a degree of central monitoring to ensure consistency.

The Scope Of The Rule

The stated intention of the new legislation is to give effect to Article 9(1) of the OECD Model Convention. That reads:

"Where:

  1. an enterprise of a contracting state participates directly or indirectly in the management, control or capital of an enterprise of the other contracting state; or
  2. the same persons participate directly or indirectly in the management, control or capital of an enterprise in a contracting state and an enterprise of another contracting state;

and in either case, conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly."

The provisions of Sch 28AA are considerably longer than the OECD Statement and have been criticised since they were first published for their lack of clarity and uncertainty of meaning. The basic transfer pricing rule for domestic law purposes is as follows:-

  1. There must be a provision (the actual provision) made or imposed between any two persons (the "affected persons").
  2. The provision must be made or imposed by means of a transaction or a series of transactions.
  3. At the time of the making or imposition of the actual provision, one of the affected persons must participate directly or indirectly in the "management control or capital" of the other, or the same person or persons must participate directly or indirectly in the "management, control or capital" of each of the affected persons.
  4. The actual provision must differ from that which would have been made as between independent enterprises (the "arm's length provision").
  5. The actual provision must confer a potential UK tax advantage on one of the affected persons or on each of them.

Where all of these requirements are met, the profits and losses of each advantaged person must be computed for tax purposes as if the arm's length provision had been made or imposed instead of the actual provision. Each of the four requirements is elaborately expanded in the legislation. Unfortunately, despite the length of the provisions, their meaning is far more clear and some taxpayers may have difficulty in deciding whether they are within the rules or not.

Transaction Or Series Of Transactions

For transfer pricing purposes, "transaction" includes arrangements, understandings and mutual practices (whether or not they are intended to be legally enforceable). "Arrangements" which have a very wide meaning in tax law in any event are further expanded to mean any scheme or arrangement of any kind, whether or not they are intended to be legally enforceable. Clearly, the legislation is aimed at including almost any form of dealing between affected persons.

An area that is likely to give rise to difficulties of application is in relation to a series of transactions. A series of transactions includes a number of transactions each entered into in pursuance of or in relation to the same arrangement. They need not be one after the other. The legislation also includes as part of a series of transactions, those involving multiple parties. Thus, where a provision is made or imposed between two persons by a series of transactions, that series will still qualify for this purpose even if:-

  1. there is no transaction in the series to which both of those persons are party;
  2. the parties to any arrangement in pursuance of which the transactions in the series are entered into do not include one or both of those persons; and
  3. there is one or more transactions in the series to which neither of those persons is a party.

The effect of these rules is likely to give rise to disputes as the extent of their application is not immediately obvious.

Participation In The Management, Control Or Capital

This expression is taken directly from Article 9(1) of the OECD Model. The terms "management"," control" and "capital" are not dealt with as separate concepts in the legislation and appear to be a collective expanded expression of notions of control. Participation may be direct or indirect. Unlike other areas of taxation where the terms direct and indirect have remained undefined, Sch 28 para 4 defines direct and indirect participation.

Direct participation exists only where a person controls a body corporate or a partnership. For this purpose, the general definition of control contained in TA 1988, s840 is applied.

The meaning given to indirect participation represents a significant extension of the transfer pricing regime compared to the old rules. These extensions will be of particular importance to privately held companies. Firstly, indirect participation includes joint venture participants where at least two of them have 40% shareholdings.

The second form of indirect participation requires attribution of rights and powers to participants in a wide variety of circumstances. Broadly, these include rights and powers which a potential participant is entitled to acquire at a future date or will become entitled to acquire. Rights and powers of connected persons and of persons connected with connected persons are also to be attributed. In addition, any rights which are required or may be required to be exercised on behalf of a potential participant or under their direction or for their benefit are to be included. Thus, beneficiaries of trusts may have trustees' rights attributed to them, jointly exercised powers are also subject to attributions. Control may be traced through a unit trust by treating it as if it were a company.

UK Tax Advantage

Adjustment is only necessary if there is a UK tax advantage. A UK tax advantage exists where the application of the actual provision instead of the arm's length provision means that a smaller amount is treated as profit (or income) for any chargeable period, or that a larger amount is treated as a loss in the same way, where both sides of the transaction are within the charge to UK tax. Again, the criteria are complex but involve essentially three conditions. Firstly, where the person is within the charge to income tax or corporation tax in respect of the income or profits arising from the relevant activity. Secondly, where a person is not entitled to any double tax credit relief in respect of the income or profits, and thirdly, where the person is not entitled to deduct foreign tax. For example, transactions between a foreign owned UK company and a UK branch or agency would not be within the rule if the branch or agency constituted a permanent establishment within an applicable treaty. If the branch or agency was not a permanent establishment and therefore protected from UK tax, such transactions would be within the rule.

The Arm's Length Standard

The new legislation specifically requires the transfer pricing rules to be applied in a manner which is consistent with the OECD Transfer Pricing Guidelines. As a result, the determination of arm's length provisions are to be determined in accordance with the principles set out in those guidelines. The legislation seems to suggest that this is only the case where there is a tax treaty in place, although Inland Revenue view is that it applies in all circumstances.

The legislation refers to "provisions" which are required to be adjusted. Although there is no specific definition, Treasury Explanatory Notes to the 1998 Finance Bill advise that the expression was broadly analogous to "conditions" in Article 9 of the OECD Model and similarly wide in scope. It thus embraces all terms and conditions attaching to a transaction or a series of transactions. What is important about this expression is that unlike the predecessor rule in TA 1988, s770, it goes beyond the pricing of the transaction and applies to all of the terms and conditions. The extent to which the Revenue may, as a result, be able to rewrite transactions to some extent although the outer limits of this power are likely to be the subject of disputes. Only one statutory rule provides any guidance on this. Sch 28AA para 1(3) specifies that a provision which no independent enterprises would have made is deemed to depart from the arm's length standard. OECD principles require the actual transaction to be recognised and re-categorisation is generally not permitted.

Documentation

TMA 1970, s12B (income tax) and FA 1998, Sch 18 para 21 (corporation tax) require taxpayers to keep and preserve records needed to make and deliver a correct and complete return for any chargeable period. The draft guidance note on documentation included in the Consultative Document on Transfer Pricing was widely criticised and amended guidance was published in the Tax Bulletin in October 1998. The approach is broadly the same as that previously announced, although the rules are stated in the form of principles, rather than specific requirements. The Revenue continue to be guided by OECD principles on this point.

Taxpayers should prepare and retain documentation as is reasonable, given the complexity or otherwise of the relevant transaction and which identifies:-

  1. relevant commercial or financial relations falling within the scope of the new legislation;
  2. the nature and terms of relevant transactions;
  3. the method or methods by which the nature or terms of the relevant transaction were arrived at including any study of comparables and any functional analysis undertaken;
  4. how that method has resulted in arm's length terms or where it has not, what computational adjustment is required and how it has been calculated;
  5. terms of relevant commercial arrangements with both third party and affiliated customers and any budgets, forecasts or other papers containing information relied on in arriving at arm's length terms or in calculating any adjustment made in order to satisfy the requirements of the new legislation.

Penalties

The application of penalties in the context of self-assessment and transfer pricing has given rise to widespread concern. Transfer pricing is not an exact science. As a result, the concept of fraud and negligence, as well as the criteria for mitigating penalties do not fit easily with transfer pricing given the nature of the rule. In the Tax Bulletin Issue 38, the Inland Revenue have however confirmed that they will continue to apply the factors set out in Leaflet IR160 and paragraph 5525 of the Investigation Handbook to transfer pricing penalties. Some clarification has been given in considering what abatement of penalties should be available in respect of "size and gravity". The Revenue will take into account:-

  1. the absolute size of the adjustment;
  2. the size of the adjustment relative to the turnover and profitability of the business;
  3. where this is possible, the size of the adjustment in relation to the volume and value of the related party transactions giving rise to the adjustment.

Much concern has been expressed as to what constitutes "negligence" in the context of transfer pricing. The Revenue have reaffirmed that where taxpayers can show that they have made an honest and reasonable attempt to comply with the legislation, there will be no penalty even if there is an adjustment. The onus will be on the Revenue to show that there has been fraudulent or negligent conduct. Each case must be judged on its own facts and merits, based on what a reasonable person would do. Examples of this given by the Revenue include:-

  1. using commercial knowledge and judgment to make arrangements and set prices which conform to the arm's length standard or to make computational adjustments where they do not;
  2. being able to show (for example by means of good quality documentation) that they made an honest and reasonable attempt to comply with the arm's length standard and the legislation;
  3. seeking professional help where they know they need it.

The guidelines emphasise the necessity for suitable documentation in the context of penalties in order to demonstrate an honest attempt to comply with the rules.

All potential penalty cases will be monitored both by International Division working in conjunction with Compliance Division in order to ensure a consistent approach.

Advance Pricing Agreements

The availability of advance pricing agreements was an important issue on which views were sought by the Government during the consultation process. Previously, advance pricing agreements have been available on an informal basis and were made pursuant to the mutual agreement procedure in tax treaties. Any domestic agreements were made under administrative law principles such as those in R v IRC, ex parte MFK Underwriting Agencies Ltd [1989] STC 873 (QBD) and R v IRC, ex parte Matrix Securities Ltd [1994] STC 292 (HL). Draft legislation was made available by press release on 17th December 1998 for inclusion in FA 1999, along with a draft statement of practice relating to their administration. These are designed to put APAs on a sound legal and structured basis.

The Government has declined to widen the scope of the APA process to include matters such as capital gains, capital allowances, exchange gains and losses, financial instruments, funding arrangements and general deductibility of expenditure on the basis that the APA legislation is intended essentially to codify existing practices.

In principle, the procedure for an APA is simple. Taxpayers may make an application for an APA. This is in essence the making of an offer in contractual terms. It includes setting up taxpayers' understanding as to how the transaction in question ought to be taxed, those aspects that require agreement and the manner in which it is proposed that they should be agreed. This is then followed by negotiation leading hopefully to a binding agreement.

The APA legislation contains a useful measure not found in other clearance procedures. The legislation specifically contemplates an informal consultation process to explore the possibility of an APA. Although the draft statement of practice indicates that the Inland Revenue encourages applications for APAs, it may decline to accept certain applications. It regards the process as designed to offer assistance in resolving complex issues. This criterion has been criticised. Uncertainty and materiality have been suggested as better concepts. Although the ultimate statement of practice will adopt a more positive attitude, clearly they will not agree to take on every case. They have indicated that size alone will not be a criterion for declining applications.

Emerging Issues

Although the legislation is less than a year old, a number of particular issues of concern are emerging.

Transitional Problems

Concern has been expressed about the fact that the new rules broaden the scope of application of the arm's length principle. Only one narrow transitional rule has been introduced relating to joint ventures. FA 1998, s108(6) provides that joint ventures where there are 40% shareholders who are caught by these provisions will not be within the new rules until after 17th March 2001, if the contractual arrangements were entered into before 17th March 1998 and there are no variations or terminations of contractual rights during the intervening period.

As a result of the previous direction mechanism, taxpayers who were potentially within the old transfer pricing rules may not necessarily have paid the same degree of attention to those issues as they might have under the new rules. Concerns have been expressed as to the use of discovery rules to transfer pricing during the transitional period. In particular, will information provided under the new rules be used in order to re-open closed years settled under the old legislation? The Inland Revenue have indicated that they cannot give assurances in this respect and discovery assessments may be made in accordance with their usual practice as set out in Statement of Practice SP8/91.

Electronic Commerce

The impact of electronic commerce on transfer pricing was considered at the OECD Conference in Ottawa on electronic commerce towards the end of 1998. It was noted that electronic commerce has the potential to make some of the more difficult transfer pricing problems more common. In addition, as a result of nearly instantaneous transmission of information and the removal of physical boundaries, it may become more difficult for tax administrations to identify, trace, quantify and verify cross-border transactions. Apart from these, electronic commerce was not regarded as presenting fundamentally new or categorically different problems for transfer pricing. The five most significant potential transfer pricing issues identified by the OECD were:-

  1. applying the transactional approach;
  2. establishing comparability and carrying out a functional analysis;
  3. applying traditional transaction methods;
  4. the tax treatment of integrated businesses;
  5. determining and complying with appropriate documentation and information reporting requirements.

Homes of non-domiciliaries owned by offshore companies

An early problem in interpreting the new rules has arisen in relation to non-domiciled individuals who occupy homes owned by offshore companies, which may or may not be owned by offshore trusts. In such circumstances, arguably the individuals participate in the management, control and capital as defined in Sch 28AA para 4. Does this mean that where the occupation is rent-free, the company is required to impute market value rental income for Sch A purposes, and is the occupant obliged to operate the non-resident landlord's scheme? The Inland Revenue have indicated to some professional advisers that they do not intend to pursue this point while not conceding that the rules do not apply in this way. This has opened broader questions as to what the scope of application of the rules are. In particular, do the rules apply to all persons or do they apply to business enterprises only, as contemplated by the OECD Model?

Corporate Finance

There is some overlap between the transfer pricing rules in Sch 28AA and the thin capitalisation rules in s209(ii)(d) and (da). The thin capitalisation rules broaden the opportunity for applying thin capitalisation from the 75% ownership requirement under s209(ii)(da) to any person who participates directly or indirectly in the management, control or capital of a UK company. The transfer pricing provisions also go further in that they apply to outward investment from the UK. In an article in the Tax Bulletin October 1998 page 580, the Inland Revenue have considered the interaction of these rules. The guidelines that they have previously set out in relation to thin capitalisation contained in Tax Bulletin Issues 17 and 35 (June 1995 and June 1998) are also to apply for transfer pricing purposes. The Inland Revenue have regarded that, even if excess of interest does not reclassify as a distribution, interests may be disallowed in a series of transactions such as the provision of a guarantee by a related party to a bank who then lends to a UK borrower. Similarly, outward investment in the form of an interest-free loan is within the transfer pricing regime. Under the previous regime, the Inland Revenue accepted that where under mutual agreement procedures in a double tax treaty, a foreign borrower would not receive an interest deduction in an overseas country, the Revenue did not seek to impute interest on the loan. Competent authority proceedings were always involved. The Inland Revenue now say that the presence of a treaty is irrelevant and the lender must only consider whether an outward interest-free loan requires a transfer pricing adjustment.

Transfer Pricing Litigation

There have been no cases recently on the transfer pricing legislation. However, Sch 28AA and its predecessor are only part of the armoury available to the Inland Revenue to attack non-market value transactions. The use of other instruments is illustrated by the Special Commissioners decision Rochester (UK) Limited and Another v Pickin SCD 160 [1998] STC (SCD). In that case, the UK company which was controlled by a Canadian parent agreed to purchase seeds from a Dutch supplier for the purpose of extracting oil. After some years the Dutch supplier agreed to supply the seeds to a newly incorporated Swiss company, which made arrangements for the extraction of the oil, which it then supplied to the UK and Canadian companies. The Inland Revenue considered that arrangements had been fraudulently made for the Swiss company to be inserted in the chain as a device to enable the UK company to pay excessive prices for the oil supplied by the Swiss company, thereby evading UK tax on the UK company's profits. They also argued that certain payments made by the UK company to the Swiss company relating to medical research were for no consideration. The UK company was assessed on the basis of the part of the price paid to the Swiss company which exceeded a reasonable price for the oil and for the payments relating to medical expense on the basis that they were not incurred wholly and exclusively for the purpose of the UK company's trade within TA 1988, s74(1)(a). They were therefore not deductible and remained profits of the UK company.

Much of the case considered assessments out-of-time and the Special Commissioners concluded that the Revenue had failed to discharge the burden of proving fraudulent or negligent conduct in relation to the out-of-time assessments. In relation to the in-time assessments, the Special Commissioners found that the payments had been made as part of a commercial arrangement and that they had been made wholly and exclusively for the purposes of the trade of the UK company.

Although the Inland Revenue failed in this instance, the case is illustrative of several aspects of modern transfer pricing practice. Firstly, the facts and documentation determined the outcome of the case. Secondly, other statutory weapons available to the Inland Revenue to tackle non-arm's length and related party transactions may be used. Thirdly, the Inland Revenue will test cross-border structures and arrangements thoroughly. The tax at stake in this case in relation to the transfer pricing aspects was approximately £900,000 spread over seven accounting periods. It illustrates therefore that the Inland Revenue will pursue these issues even in relation to relatively small businesses.

Conclusion

The same observation may be made about another transfer pricing case before the Special Commissioners, Newidgets Manufacturing Limited v Jones (SpC 197). In that case, a UK company was the wholly-owned subsidiary of a foreign parent. A manufacturing licensing agreement was concluded between the foreign parent and the UK company whereby the UK company paid a royalty in consideration of the grant of exclusive rights to manufacture widgets in the UK under technical information provided by the foreign parent and the non-exclusive right to use the technical information in the manufacture of spare parts. The royalty was calculated as a percentage of the ex-works selling price. The Inland Revenue were provided with a copy of the agreement and subsequent amendments. The company deducted royalties it had paid in calculating its profits. Assessments issued against it in relation to the accounting periods in question were settled by agreement pursuant to TMA 1970 Section 54, and by letter the inspector agreed the UK company's tax computations in respect of the accounting periods.

The Inland Revenue subsequently took the view that the grant of rights had not been at arm's length and issued directions pursuant to TMA 1988 Section 770(2D) to adjust prices and raised a further assessment for the accounting periods in question.

The taxpayer appealed on the ground that the inspector had sufficient information before him to come to a final and conclusive agreement with the taxpayer and that the Revenue were not entitled to raise the further assessments. The Revenue's response was that unless the taxpayer had stated expressly or impliedly that the agreement had not been made at arm's length, then the inspector did not have sufficient information to make a final and binding agreement under TMA 1970 Section 54.

The Commissioners found no evidence that the taxpayer had supplied misleading information and that there had been ample information available to the inspector to make a final determination. The inspector had intended to make a final determination and it was not open to the Revenue as a result to re-open the matter by issuing a

direction. The purpose of Section 54 was to protect the taxpayer by producing finality. This is what the taxpayer sought and it appeared objectively from the evidence that the inspector had been willing to grant finality. The Revenue's argument, that the bar on re-opening closed years could only apply where the inspector's attention had been drawn to the fact that arm's length prices had not been operated, was not accepted. They argued that since transfer pricing had not been referred to in Section 54 agreements, they were entitled to re-open the matter. One of the issues before the Special Commissioners was whether the company's accounts complied fully with the relevant standards. It was found that the obligation to disclose, whether or not transactions were carried out at arm's length (which the accounts and computations did not do) did not arise until 1995 after the years in question. It remains to be seen whether this decision will be appealed. If the Special Commissioners' view is upheld, this will give some comfort to taxpayers that the rules relating to discovery are no different in transfer pricing than in other areas, an issue which the Inland Revenue appeared to be advancing.

The recent activity in modernising the UK transfer pricing regime cannot be viewed in isolation. It is part of a worldwide trend which has been led by the United States which finalised its transfer pricing regulations in 1994 followed by the revised OECD Model Guidelines published in 1995. There are few countries that have not paid attention to either introducing the arm's length principle or beefing up their rules and transfer pricing administrations in recent years. While the major themes are common, the manner in which the rules are interpreted and applies is far more uniform. Transfer pricing will require attention in any international business activity in the decades to come.

This material must be read in conjunction with the Responsibility Statement

This article is published as Chapter 6 in TaxLine Annual Review 1999/00 by the Tax Faculty of the Institute of Chartered Accountants for England & Wales.

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No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

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