The Government has announced that from 1 April 2004 transfer pricing and thin capitalisation rules will be extended to apply to transactions between two UK entities. The changes will have a significant impact on UK businesses and it remains to be seen whether the Inland Revenue will use the new legislation to raise the tax take.
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Who will be affected
Action points
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What are the transfer pricing rules?
The transfer pricing rules apply to transactions between certain related parties which take place other than on arm's length terms. If one of the parties to the transaction pays less UK tax than it would have paid if the transaction was on an arm's length basis then for the purposes of calculating its UK tax liability it must substitute the arm's length price.
There is currently an exclusion from the rules for transactions between two entities both within the charge to UK tax. The extension of the rules to UK entities is in response to EU case law which has held it is not possible to treat transactions between two UK entities differently from transactions between a UK entity and an entity in another EU country.
Specific rules apply to loans between two connected parties. Interest paid by a UK entity to a connected party will be disallowed if the interest paid is excessive either because of the rate of interest or the amount of the loan. The rules also apply to interest paid to a third party where the loan is supported by a guarantee given by a connected party, for instance a parent company guarantee. These rules will replace the existing thin capitalisation rules which can treat interest as a distribution.
The new rules will apply even where the transactions are between two UK companies and there is no loss to the UK revenue authorities, although the other party can also use the arm's length price for calculating its tax so reducing its tax liabilities.
When are two entities related for these purposes?
Broadly the rules apply:
- between two parties when one of the parties is a company or partnership and the other party has at least 51% control of the first party
- where both parties are companies or partnerships and the same person has at least 51% control of both parties
- to joint venture companies or partnerships which are controlled by two persons each having at least a 40% interest in the joint venture company.
The rules are predominately an issue for companies but they can also apply to partnerships, other body corporates for instance local authorities and charities and to individuals when they exercise the relevant control over a company.
Exemption for small and medium sized businesses
Small and medium sized businesses (SMEs) are, in general, exempt from the rules. For these purposes a SME is one which employs fewer than 250 persons and has an annual turnover not exceeding EUR 50 million or an annual balance sheet not exceeding EUR 43 million. In calculating these limits members of a group and certain other linked businesses are aggregated.
The exemption for SMEs does not apply to transactions with certain countries, broadly tax havens. The Inland Revenue will also retain the right to apply the rules to medium, but not small enterprises, where there is a significant amount of tax at stake.
When do the new rules come in?
The new rules will apply to all transactions on or after 1 April 2004 even if they are pursuant to existing arrangements. The rules could therefore apply to existing intra-group arrangements.
Record keeping obligations
UK companies which cannot take advantage of the SME exemption are required to prepare their tax returns on the basis of the transfer pricing legislation. They are also required to keep records to support the basis on which the returns have been prepared, including the application of the transfer pricing rules. Companies can be subject to penalties for failure to keep the necessary records. There will be a relaxation of the penalties regime for the first two years.
The Inland Revenue has published draft guidance on what records it will expect a company to keep. The guidance states that companies should prepare details of intra-group transactions at the time they file their returns although not necessarily details of how an arm's length result was achieved. This is helpful in reducing the burden for UK companies. It should however be noted that this does not remove the obligation on a company to prepare their returns on the basis of an arm's length result.
What does it mean in practice?
The Inland Revenue recognises that the new rules will be burdensome for UK companies and has tried to mitigate the impact. The Inland Revenue has stated that it will not normally raise enquiries in relation to transfer pricing where there is no UK revenue loss because both parties are paying tax at the same or a similar effective rate. However companies cannot completely ignore the rules as there is an obligation on them to prepare their returns in compliance with them. The Inland Revenue states that where the tax at stake is low it does not expect businesses to perform excessively complex calculations in order to establish the correct price. An approach that ‘gives a broadly correct result is entirely acceptable’. This clearly reduces but does not entirely eliminate the burden on companies.
A judgement therefore needs to be made, periodically and in the light of the particular circumstances of the group or entities concerned, as to whether an Inland Revenue enquiry into a particular return is or is not likely to be made; and as to the level of effort to be devoted both to the setting of prices between related entities and to the creation and maintenance of records in support of the chosen pricing.
What should you be doing in preparation for the new rules?
Companies which do not benefit from the SME exemption should:
- identify intra-group transactions which may be caught. These include both formal and informal arrangements such as
- intra-group IP licences (even where there is no formal licence agreement)
- the provision of group services such as tax and payroll services
- property transactions including circumstances where property is shared on an informal basis
- secondments or sharing of employees
- share incentive arrangements internal and external banking arrangements
- identify those transactions where there is a real risk of loss to the Inland Revenue because of variations in the effective rate of tax (eg because of carried forward losses). These are the main risk areas and resources should be concentrated on these
- put in place agreements to govern intra-group arrangements which retain the maximum amount of flexibility.
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What can we do to help?
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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
Deloitte Transfer Pricing—Clarity. Consistency. Confidence. (Video)
