UK: Current Issues In Transfer Pricing

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.

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 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.

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.

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.

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 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.

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.

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.

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.

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

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.

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.