UK: Share Schemes - Transfer Pricing and Share Plans

Last Updated: 1 October 2004
Article by David Pett and Judith Greaves

Originally published September 2004

The Finance Act 2004 extended the scope of the transfer pricing rules to transactions between UK group companies. Transfer pricing can now apply where there is no overseas involvement. This and subtle changes in the Inland Revenue's interpretation of their so called ‘capital exemption’ from transfer pricing could give rise to significant and unexpected corporation tax liabilities for those companies within the scope of transfer pricing.

What is transfer pricing?

Essentially, this is about the price at which one group company supplies goods or services to another group company. As both companies are connected the price might not necessarily be commercial or ‘arm's-length’. The profits of one company could therefore be overstated and the profits of the other understated. As tax authorities could lose tax revenue many countries, including the UK, have taken powers to require companies to set transfer prices at ‘arm's-length’ or adjust tax computations so tax is payable as if ‘arm's-length prices’ had been used.


Until the so called ‘Waterloo’decision in 2001 transfer pricing did not appear to have any application to employee share plans. The Waterloocase involved employees of an overseas subsidiary of a UK parent being granted options by an employee trust. The Special Commissioners held that the entire arrangement represented a ‘business facility’ by the parent to provide the subsidiary with the benefit of a share scheme for its employees and therefore the companies should be taxed on the basis of a payment by the subsidiary to the parent for the ‘arm's-length’ value of that facility. There was no appeal and the Inland Revenue has taken Waterlooas establishing the principle that transfer pricing applies to share plans. However, the decision left unanswered many practical issues concerning the application of the transfer pricing rules. This void has to some extent been filled by Inland Revenue policy statements and comments. The OECD has also recently (3 September 2004) published its own study on the subject ‘Employee Stock Option Plans: Impact on Transfer Pricing’.

Internal UK Transfer Pricing

The Finance Act 2004 has extended transfer pricing to transactions between UK companies. For most transactions any additional taxable income in one company is offset by a corresponding relief in another, often with no change in the overall tax payable by the group. However, for share plans the position is more complex. The interaction of transfer pricing and statutory corporation tax reliefs for options and share awards (such as under Schedule 23 Finance Act 2003) could effectively restrict or eliminate entirely the benefit of these reliefs, although the Inland Revenue has indicated to us that this is not its intention.


  • Decide whether this applies to you. Is your group small enough to be exempt from transfer pricing? Are your share plans sourced solely from new issue so you qualify for the ‘capital exemption’?
  • If transfer pricing applies, prepare to make and document the necessary transfer pricing charges but consider whether the use of the Inland Revenue's ‘hedging methodology’ would give a better result than an option pricing theory approach. Monitor developments in the Inland Revenue's attitude concerning the interaction of statutory reliefs and UK to UK transfer pricing.
  • If the impact of transfer pricing is sufficiently significant, consider if alternative share scheme structures (eg our ‘ExSOP’ arrangement) might mitigate the impact.
  • Where UK trusts are involved, consider if interest free loans to the trust should have an arm's-length finance charge.
  • We are meeting the Inland Revenue in October 2004 to discuss issues arising from the extension of transfer pricing to share plans and if there are any questions or points you would like to have raised please e-mail please contact us.

Exemption for SMEs

Small and medium sized enterprises are generally exempted from transfer pricing. The conditions for exemption, which are measured on a consolidated basis, are:-

  • small - fewer than 50 employees and either turnover or assets of no more than €10 million (currently about £7 million);
  • medium - fewer than 250 employees and either turnover of no more than €50 million or assets of no more than €43 million. The Inland Revenue can invoke the transfer pricing rules if the tax is substantial. If a company is not covered by these exemptions, transfer pricing applies to UK to UK transactions from 1 April 2004 regardless of the company's accounting year end or, in the case of share-based transactions, whether the options or awards were granted prior to 1 April 2004.

Inland Revenue Policy

The various Inland Revenue policy statements on transfer pricing include the following:-

  • for share options, the arm's-length value can be calculated either using an option pricing theory such as Black Scholes or the Inland Revenue's own theoretical ‘hedging method’. This is described in the International Manual and involves making a supposition that a reasonable level of hedging is undertaken by buying shares in the market and holding them in a trust, and estimating the costs of acquiring such shares and the financing and running costs of holding them;
  • charges based on the difference (the ‘spread’) between the market value of the options on exercise and the exercise price (the ‘spread method’) are not acceptable as an arm's-length basis;
  • if awards can only be satisfied by the issue of new shares, then the arrangement relates only to capital and the question of a transfer pricing charge does not arise;
  • if a subsidiary runs its own share scheme, buying its parent's shares in the market to provide options for its employees, transfer pricing does not apply between the parent and the subsidiary.

The Inland Revenue's view that the ‘spread method’ is not an acceptable arm's-length basis is controversial. It is an acceptable basis in the USA and the recent OECD September 2004 study was non-committal.

Comments in Tax Bulletin 63 encouraged the view that there was potentially a ‘safe harbour’, where transfer pricing would not apply, if awards were satisfied by newly-issued shares. However, comments in the International Manual suggest the Inland Revenue is seeking to narrow the scope of this so-called ‘capital exemption’. There is therefore uncertainty as to the extent to which a company can rely on this ‘capital exemption’ where market purchased shares are, or may be, used to satisfy some awards or options.

Structuring share plans so that subsidiaries are responsible for the grant of options and organising the supply of shares on exercise should prevent transfer pricing problems between the parent and the subsidiary providing the subsidiary is in reality ‘running its own thing’. However, if the parent is driving the arrangements it may be difficult to avoid the transfer pricing rules applying between the parent and the subsidiary. There would also be a number of commercial issues to be considered before adopting such a subsidiary driven approach.

How can we help?

  • We can help you calculate your arm's-length charges.
  • We can review how the transfer pricing rules interact with other legal, tax and accounting rules affecting your share plans and any share plan hedging arrangements you may have, and then make recommendations.
  • We can help you document any changes needed to implement recommendations.
  • We can assist you in trying to obtain Inland Revenue agreement as to the scope of the capital exemption in your particular circumstances.

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.

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