UK: New Rules for Transfer Pricing and Thin Capitalisation

Last Updated: 22 March 1999
If a multi-national concern has a business presence in a number of different jurisdictions, it is likely that the various branches and companies concerned will be taxed at different rates throughout the world, depending upon whatever the rates of tax are in each of the jurisdictions in which they are tax resident. Any multi-national concern will of course want to minimise the amount of tax it pays on its various operations. To the extent to which it is possible to control this, it is therefore in the interest of such a business to maximise the amount of its profits that arise in low tax jurisdictions. One way of doing this would be to control intra-group trading arrangements so as to maximise the deductions that arise in high tax jurisdictions, and maximise the profits that arise in low tax jurisdictions.

Tax authorities throughout the world seek to prevent this form of manipulation of distribution of worldwide income by applying what are known as "transfer pricing" rules. Broadly speaking, these seek to adjust the tax consequences of transactions which are carried out on non-arm's length terms, so as to ensure that the same tax consequences follow from a non-arm's length transaction as would otherwise have arisen from an arm's length transaction.

This is done by substituting a proper market price for the artificially manipulated price.

The problem, of course, is how to set what a proper market price should be. Ideally one should simply take whatever the price would be on an arm's length transaction between arm's length parties, but this is difficult to do when the very nature of the transaction itself is controlled by the interdependent relationship between the two parties carrying out the transaction. It may, in short, be impossible to find a simple comparable price which would be the price paid on such a transaction between third parties.

Similar problems arise where loans are made between connected parties cross-border. By structuring the loan on non-arm's length terms a multi-national group may achieve the tax efficient redistribution of income to a low tax jurisdiction. The tax rules which seek to attack this practice are known as "thin capitalisation" rules. These rules seek to refuse tax deductions, or to impute taxable income, where a loan is carried out on non-arm's length terms.

These complex areas of tax law have recently been subject to fundamental review and reform by the Inland Revenue. The 1998 Finance Act radically reformed the transfer pricing and thin capitalisation rules.

Put very briefly, the effect of these reforms can be summarised as follows:

1. Companies are now under a reporting obligation to prepare their tax computations on the basis of proper arm's length prices - before, they simply had to report the actual transactions that took place, and the onus was placed upon the Revenue to make a direction that the transaction concerned should be adjusted for tax purposes in accordance with arm's length pricing.

2. The complex and lengthy OECD guidelines on the subject of transfer pricing are integrated by reference into UK law as an aid for construction of the transfer pricing legislation.

3. Transactions are not analysed on a single stand alone basis, but instead must be viewed in the context of the surrounding relationships that could influence the setting of the price on that transaction.


On 17 December 1998 the Inland Revenue published a Press Release on the subject of draft legislation for Advance Pricing Agreements and a draft statement of practice. Advance Pricing Agreements ("APAs") are intended as a way of resolving complex transfer pricing issues on a prospective basis or where there is considerable difficulty or doubt as to the method by which the arm's length principle should be applied for the purposes of the transfer pricing legislation.

Under the proposed new rules an APA may be requested by:

  • any UK taxpayer, including a partnership, with transactions to which the provisions of Section 770A of and Schedule 28AA to the Income and Corporation Taxes Act 1988 apply;
  • any non-resident trading in the UK through a branch or agency; and
  • any UK resident trading through an overseas branch.

APAs would determine the following:-

  • the arm's length provision for the purposes of Section 770A/Sch 28AA ICTA;
  • the profits attributable to a branch or agency through which a trade is carried on in the UK; and
  • the amount of any income arising outside the UK and attributable to the overseas branch of a UK company.

The Inland Revenue envisage that the APA process will comprise four different stages:

  • expression of interest;
  • formal submission of application for clarification;
  • evaluation; and
  • agreement.

In particular, the Inland Revenue strongly encourage taxpayers to discuss proposed applications informally by way of an expression of interest before detailed work in finalising a formal submission is undertaken by them. The Statement of Practice explains that this is to ensure that the application is one that can be considered for an APA and that the submission will be focused on relevant issues. The Statement sets out the information that should be provided to the Inland Revenue when submitting an expression of interest. It would be possible to discuss an expression of interest on an anonymous basis with the Inland Revenue provided that the Revenue is supplied with all other relevant information.

Although information supplied to the Revenue in relation to an APA request would be kept confidential within the Revenue, it may be passed around the Revenue internally and could be used for example to reopen assessments relating to prior years. It should also be noted that the information that would be required to support a formal application for an APA is extremely wide and potentially extends to all aspects of a taxpayer's business rather than simply to the transfer pricing transactions in question. It follows that taxpayers should expect their affairs to be examined in some detail by the Revenue when an application for an APA is made. APAs are more likely therefore to be sought by big groups whose affairs are usually scrutinised in detail by the Revenue in any event and who wish therefore to avoid transfer pricing problems going forward.

Under the new rules it will be possible to seek an APA in relation to specific issues as opposed to all of a taxpayer's transfer pricing issues. This may present certain risks, as the taxpayer may thereby highlight the fact that pricing is determined differently, for example, in different parts of its business.


The Inland Revenue Tax Bulletin Issue 38 contains an article which focuses on the way that penalties will apply to the new transfer pricing regime.

The article focuses on the way that penalties will apply to the new transfer pricing regime. Penalties under Sections 95 and 95A Taxes Management Act 1970 or paragraph 20 Schedule 18 Finance Act 1998 can arise where UK tax is lost as a result of fraudulent or negligent conduct by the taxpayer.

This article backs up the previous edition of Tax Bulletin which focused in particular on the documentation that taxpayers should generate and keep in order to support their transfer pricing policies. The present article stresses however that detailed documentation will not in itself free a taxpayer from the possibility of a penalty if the documentation does not show that he had good grounds for believing that arrangements and prices are in accordance with the arm's length principle.

The article does however point out that within the penalty regime the onus will be on the Revenue to show that there has been fraudulent or negligent conduct by the taxpayer. However, in practice the Revenue are likely to make an allegation of fraud or negligence and issue assessments on that basis leaving the taxpayer in the position of having to disprove the Revenue allegations.

Penalties can be abated depending on the circumstances and in particular how great an attempt the taxpayer has made to apply the arm's length principle correctly. The article gives a number of examples indicating how the Revenue would propose to apply the penalty regime in practice.

In order to avoid penalties it would be important for a taxpayer to do more than review his own position - he must apply the appropriate methodology in accordance with the OECD Guidelines which are now incorporated into UK law as an aid to interpretation.
Global Trading

The Inland Revenue Tax Bulletin Issue 38 also contains an article which deals with issues raised by "global training" in a financial sector and in particular businesses making markets in financial products on a 24 hour basis within different time zones.

This can involve different enterprises or different branches of a single enterprise. The article focuses in particular on the attribution of profits to individual countries; this can be problematic where functions undertaken in the course of such businesses are highly integrated across international borders. The purpose of the article is to set out guidance on the Inland Revenue's approach to such matters.

The Revenue confirm that where possible the approach set out in the OECD publication entitled "The Taxation of Global Trading of Financial Instruments" should be followed. However, the Revenue recognise that in certain situations it may be necessary and appropriate to employ a profit split approach in measuring the arm's length reward with which different enterprises/branches should be credited for undertaking functions in an integrated business. The Revenue indicate that in these circumstances it will not necessarily be appropriate to look simply at where the enterprise in question books or allocates the transaction but to analyse where, for example, the relevant capital comes from and to what degree such capital is exposed to risk under the transaction. Other factors will however also be relevant, for example the expertise of the financial trader may be relevant in determining an appropriate profit split and different situations and markets may also be influential.

Identifying where profits should be viewed as arising may be easier where the various parties are different legal entities since this will lead to the production of separate accounts and an audit trail. It is likely to be a more difficult exercise where the "parties" were different parts of the same legal entity.

For further information please contact George Hardy, e-mail: Click Contact Link , 2 Park Lane, Leeds LS3 1ES, UK, Tel: +44 113 284 7000

This article was first published in the Spring 1999 Hammond Suddards Tax Newsletter Update

The information and opinions contained in this article are provided by Hammond Suddards. They should not be applied to any particular set of facts without appropriate legal or other professional advice.

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