UK: Transfer Pricing Reform in The U.K.

From April 1, 2004, the U.K. transfer pricing rules applying to U.K. companies and permanent establishments (hereafter known as a "U.K. business") will be extended to apply to domestic transactions within the U.K. (i.e., between U.K. businesses), as well as to cross-border transactions.

From that date, the existing thin capitalisation rules will be abolished and will be incorporated within the new transfer pricing rules. The new rules apply in relation to the calculation of profits of U.K. businesses that arise on or after April 1, 2004.

The old legislation (section 770A and Schedule 28AA of the Income and Corporation Taxes Act 1988 ("ICTA")) required a U.K. business to calculate its taxable income by reference to an arm’s-length basis only for transactions with connected businesses outside the scope of U.K. tax where this would increase the amount of income subject to U.K. tax.

Subject to the comments below, the new legislation will extend the scope of Schedule 28AA to:

1. include transactions within the U.K.;
2. include thin capitalisation rules (thereby repealing section 209(2)(da) ICTA);
3. exempt small- and medium-sized enterprises where the related business is in a territory with which the U.K. has a double tax treaty containing a suitable non-discrimination article; and
4. enable the Inland Revenue, in exceptional circumstances, to require a medium-sized enterprise to apply the transfer pricing rules.

The U.K. government has reformed the transfer pricing rules in an attempt to head off potential claims from taxpayers that the existing transfer pricing rules (under which only crossborder transactions with related parties were required to be priced on arm’s-length terms) were discriminatory, as they were contrary to the freedom of establishment of companies under the EC Treaty. This followed a finding of the European Court against similar German corporation tax rules in Lankhorst-Hohorst Case C-324/00.

The U.K. government first announced this proposal as part of a wide-ranging corporation tax reform consultation document in August, 2003, in which they set out only the main principles of the new rules. In the consultation document, the Government acknowledged that the crossborder element of the old transfer pricing rules "has led to the uncertainty about the appropriateness of the U.K. rules in light of the evolving jurisprudence of the European Court of Justice." The Government also stated that it sees the extension of the transfer pricing rules as an opportunity to subsume the necessary protection against thin capitalisation within the transfer pricing regime.

The Government said it recognised that the extension of transfer pricing rules to transactions within the U.K. has the potential to impose significant new administrative work with respect to compliance. To mitigate this additional burden, the Government provided that the wider rules would not affect smaller businesses because the relatively low value of transactions, which smaller businesses have with related parties, means that the administrative work required to apply transfer pricing rules (whether cross-border or domestic) is generally disproportionate to the amount of tax at stake.

The Inland Revenue then produced a "technical note" on the proposed changes to the rules. This technical note was also drafted as a consultation document in keeping with the previous document but provided draft clauses and commentary on the new rules.

The document stated that the Government intended to introduce legislation in the Finance Bill 2004 to reform the rules to ensure that the U.K. regime remains robust against legal challenges under European law and that a fair division of profits between related enterprises is preserved.

It also provided the first details of which type of businesses constitute small- and mediumsized businesses ("SMEs"), thus defining the types of businesses that will further benefit from exemption under the new rules: small businesses must have fewer than 50 employees and either turnover or assets of less than £7 million (or 10 million Euros); and medium-sized businesses must have fewer than 250 employees and either turnover of less than £35 million (or 50 million Euros) or assets of less than £30 million (or 43 million Euros).

The commentary in the document again states that SMEs will benefit from an exemption from the rules which the Government stated "is thought will cover the vast majority of transactions with related businesses."

However, what the commentary does not state, and which must instead be determined via an Annex to a European Commission Recommendation on SMEs (referred to in the draft legislation) is that in determining whether a business is small- or medium-sized, the employee and turnover/assets data of that business will have attributed to it the same data from all "linked" and "partner" enterprises of that business.

By way of summary, the Annex defines "linked" enterprises as those companies within a parent-subsidiary (i.e., vertical or up/downstream) relationship (both directly and indirectly held), and "partner" enterprises are largely those companies with 25% or more shareholdings (either solely or jointly with other linked enterprises) in that enterprise.

The definitions under the Annex suggest that a U.K. business with vertical relationships (a parent, subsidiary or partner) would have attributed to its employee numbers and financial criteria the data of all of its associated companies when determining whether that business would qualify as a SME (and, thus, be exempt from the new rules). This definition applies to businesses with vertical relationships both worldwide and within the U.K. However, the situation that is not so clear is when determining whether the data of two (or more) U.K. companies owned by a non-U.K. parent would have to be aggregated and attributed to the business under consideration in determining whether either or both of the U.K. businesses could qualify as a SME (ignoring, for the moment, the attribution of the parent company’s employee and financial data to either of the subsidiaries). This relationship is not specifically covered by the "linked" or "partner" enterprises definitions, as the relationship under consideration would be horizontal, rather than vertical or up/down-stream.

As part of the consultation, Jones Day has spoken to the Inland Revenue about the attribution point generally. The Inland Revenue believes that the Annex does cover such a horizontal relationship, even though it acknowledges that the "linked" and "partner" definitions do not specifically address the point. The Inland Revenue’s technical expert on this legislation believes that the Annex does encompass this type of relationship in the article entitled "Establishing the Data of an Enterprise" in the Annex although he admitted that the drafting is vague. The Inland Revenue states that it takes the view that horizontal aggregation was intended to apply to a business in assessing its employee and financial criteria, even though the drafting of the legislation may not specifically address that point, and that is how it would be interpreted by the courts due to the purposive approach adopted when interpreting European legislation.

Accordingly, although the Inland Revenue has made much of its claim that the wider new rules will not apply to smaller businesses within the U.K., any business which is part of a worldwide or domestic group of companies (including associated companies) which in aggregate has more than 250 employees and whose annual turnover exceeds 50 million Euros, or whose annual balance sheet exceeds 43 million Euros, will not generally be able to qualify as a SME. In fact, the Inland Revenue goes one step further by suggesting that even where a U.K. business is a subsidiary of a non-SME (either U.K. or non-U.K.), or has more than 25% of its shares held by a non-SME (either U.K. or non-U.K.), the U.K. business is immediately prevented from qualifying as an SME by virtue of the fact that its parent or associated company is not an SME. This applies even if the aggregated employee and financial data of the non-U.K. group is less than the maximum limits.

The Inland Revenue acknowledged that its repeated references to small and medium-sized businesses generally being exempt may be "potentially misleading" in circumstances without qualification by reference to the aggregated data restrictions of grouped and associated companies. It said that this would be rectified in further publications.

In keeping with the Government’s request for comments on the technical note, Jones Day did make a formal response to the Inland Revenue on this point in particular.

Prior to the release of the Finance Bill each year, the U.K. government makes an announcement proposing tax changes effective from shortly after that date with respect to which legislation is published in the Finance Bill. The Finance Bill generally becomes law from mid-July of the same year when the Bill receives Royal Assent.

The Government issued a press release dealing specifically with the transfer pricing changes; the press release stated that the legislation will "exempt small- and medium-sized enterprises from the requirements of Schedule 28AA except in relation to transactions with a related business in a territory with which the U.K. does not have a double tax treaty containing a suitable nondiscrimination article."

Again, there was no mention of the restriction upon U.K. businesses to qualify as a small- or medium-sized company if it happens to be a member of a worldwide group.

We await the Finance Bill to view the proposed legislation for the new transfer pricing rules and to determine whether our comments to the consultation on the aggregation point have been reflected in the drafting.

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