Introduction
Changes Driven By Self-Assessment:-
The Arm's Length Rule
Control
Corporate Finance
Transfer Pricing And CFC's
Documentation
Penalties
Potential For Disputes
Conclusions
The 1998 Finance Act contains two important reforms in the UK international tax field. Changes to the transfer pricing and CFC regimes have been under discussion over a period of years. They were first publicly floated in the November 1995 Budget. The new transfer pricing legislation is based on a consultative document issued in October 1997 (Modernising of the Transfer Pricing "A Consultative Document", Inland Revenue, October 1997). The principal motivating factor was the need to adapt the arm's length rule to corporation tax self-assessment, which is due to come into effect for UK company accounting periods ending on or after 1 July 1999. The Government has, however, taken the opportunity to introduce a number of substantive changes which impact on international business.
Furthermore, the way in which the transfer pricing legislation has been drafted does not fit well with the intentions stated in the consultative document and the results may consequently not accord with what the Inland Revenue would like them to be. Significant uncertainty as to the scope and application of the rule is likely to arise.
Changes Driven By Self-Assessment
The existing transfer pricing rules do not apply automatically. Under the existing assessment mechanisms, transfer pricing adjustments may only be made where the Board of Inland Revenue so directs (Taxes Act 1988 Securitisation. 770(2)(d)).
The result of this unusual arrangement is that there may be circumstances where for example the arm's length principle is not respected in relation to inter-company transactions. The issue needs to be raised by the tax inspector when examining financial statements filed by the company along with its returns. Although companies have not been able to simply ignore these rules, it has meant that their application is less than uniform and has, as a practical matter, not always been given high priority.
Under the new self-assessment regime, every taxpayer must file a return which includes an assessment of the amount of tax which is payable by the taxpayer for the tax year or accounting period in question. Thus, taxpayers are now required by law to compute their own tax liability. In doing so, taxpayers must form their own opinion as to what is properly taxable and what is not. Verification of the conclusions reached by taxpayers is determined principally by enquiries into tax returns, thus shifting the onus of assessment to the taxpayer.
Under the new rules, companies will be required to compute profits for income and corporation tax purposes as if arm's length prices had been charged. No specific reference to the arm's length rule is intended to be required on the return. However, when signing the declaration on the return form, taxpayers will have to consider whether the arm's length standard has been complied with. It will thus be implicit in all transactions.
No prior direction by the Inland Revenue is required (Finance Act 1998 Securitisation. 109) in the context of self-assessment. The burden of justifying inter-company arrangements will shift from the Inland Revenue to the taxpayer. This is a reversal of the existing process.
The Arm's Length Rule
The formulation of the arm's length rule has been completely re-written. Although the stated intention is to enact the OECD formulation of the arm's length principle contained in Article 9 of the OECD Model Convention, the drafting is extremely convoluted and lengthy compared with the succinct statement in Article 9. The key concept in the new regime is in relation to so-called "provisions". If the "provision" in a UK taxpayer's actual accounts differs from the "arm's length provision" and the effect is to reduce profits or to increase losses in the United Kingdom, then the arm's length provision must be substituted for tax purposes (Income and Corporation Taxes Act 1988 Sch. 28AA "Sch. 28AA" Paragraph. 1).
This is a significant departure from the old rules. The old rules permitted adjustment of prices only. It would appear that the reference to "provisions" is intended to equate to the term "conditions" in Article 9 and extends to all terms and conditions of arrangements between related parties. In the consultative document, it was said that the expression referred to the sum of all the terms and conditions attaching to the actual transaction or series of transactions. In the Treasury Explanatory Notes to the Finance Bill, it was said to be broadly analogous to "conditions" in Article 9 and similarly wide in scope. It embraces all the terms and conditions attaching to a transaction or series of transactions.
The scope of the previous rule was very unclear and led to debates as to whether certain transactions were included (in Ametalco v IRC [1996] STC (SCD) 399, for example, the taxpayer argued unsuccessfully that it did not apply to interest free loans).
The new rules also attempt to spread the net as wide as possible. Transactions are therefore defined to include "arrangements, understandings and mutual practices (whether or not they are or are intended to be legally enforceable)".
Transactions now also include a series of transactions (Sch. 28AA Paragraph. 3). This is also a substantive change. Under the previous rule, only actual transactions were affected. The meaning of a series of transactions is expanded to include a number of transactions in pursuance of, or in relation to, the same arrangement. They need not be one after the other. There need not be a transaction between both of "any two persons". Similarly, the parties to any arrangement need not include one or both of those two persons. A series of transactions also includes where transactions exist to which neither of those two persons is a party.
Furthermore, the new rules explicitly include one substantive aspect of the arm's length rule. Thus, a transaction is deemed to differ from the arm's length standard if independent enterprises would not have made any provision (Sch. 28AA Paragraph. 1(3)).The new legislation does not include specific rules prescribing how arm's length prices are to be determined. The legislation does however attempt to give statutory effect to the OECD Transfer Pricing Guidelines. On one level, this is a significant improvement from a legal perspective. Under the existing rules, taxpayers have merely relied on an Inland Revenue press release dating back to 1981 to the effect that they are guided by the OECD principles. The attempt to incorporate Article 9 of the OECD Model and the Transfer Pricing Guidelines into domestic law is thus of some assistance in that it provides statutory recognition of and authority for them. However, the Guidelines themselves are not prescriptive and do not form a binding code as to how arm's length prices are to be determined.
The way in which OECD principles are to be adopted is by way of a rule of interpretation. The transfer pricing rules are to be interpreted in a way that best secures consistency between the domestic rules and the OECD Transfer Pricing Guidelines (Sch. 28AA Paragraph. 2). This curious method of incorporation by reference is bound to give rise to difficulties of interpretation. For example, the new UK rules are expressed to apply between "affected persons". The OECD Model provisions, however, apply to "enterprises" of contracting states.
The expressed intention of the new legislation is to incorporate Article 9 and the Guidelines generally into UK domestic law. On this basis, therefore, the Guidelines would apply where either no treaty is applicable, or where the treaty itself does not reflect the OECD Model (subject to the provisions of the treaty). The legislation does not say this however. The plain wording of the section (Sch. 28AA Paragraph. 2(1)(b)) seems to apply this rule only where there is a treaty incorporating Article 9 in whole or part. The new rules require a UK tax advantage before adjustments are required. This involves either a reduction of UK profit or the increase of a loss. Thus, the existing "one way street" approach is retained in the UK legislation.
Control
The basic rules relating to control have remained. One party must be under the control of the other, or both must be under common control. Control in the corporate sense generally means the power to secure by means of the holding of shares or the possession of voting power or other powers that the affairs of a company are conducted in accordance with the wishes of the person tested (Sch. 28AA Paragraph. 4(1)).
New rules have been introduced which will impact significantly on joint ventures. Under the existing rules, the transfer pricing regime cannot apply to transactions between a joint venture company and any of its shareholders, except a shareholder which has control. Where a shareholder has control of a joint venture company, transactions between the joint venture company and minority shareholders are not subject to adjustment.
Under the new rules (Sch. 28AA Paragraph. 4(2)(b)), transactions between a joint venture company and any controlling shareholder will continue to be affected. In addition, transactions between the joint venture company and any 40 per cent shareholder will be caught if another shareholder also owns 40 per cent. The effect of this on many joint ventures will be significant. For example, in a typical 50/50 joint venture, transactions between the joint venture company and its shareholders were previously unaffected. Under the new rules, transactions between the joint venture company and either shareholder will be caught.
Similarly, in the case of a 60/40 joint venture, under the old rules, transactions between the joint venture company and the 60 per cent shareholder were caught. The 40 per cent minority shareholder is not. The new transfer pricing rules will apply to transactions between the joint venture company and both shareholders in this case.
Limited transitional arrangements apply to joint ventures entered into before 17 March 1998 for a three-year period (Finance Act 1998 Securitisation. 108(6)).
In addition, extended attribution rights are designed to bring other participants into the control framework. It is now necessary to attribute rights and powers of "potential participants that they are or will become entitled to acquire as well as those exercised on behalf of the potential participant under his direction or for his benefit. The rights and powers must also be attributed of connected persons and those rights attributed to connected persons. Rights exercisable jointly with others must also be included. The result is that a wide range of transactions will be included. Controlled relationships can now be traced through trusts and similar arrangements with the result that beneficiaries will typically be treated as controlling companies where trustees in fact exercise control. The impact of this is potentially broad as it may affect all beneficiaries of discretionary trusts, no matter how remote the likelihood of their actually receiving any benefits.
Specific rules are also introduced in relation to unit trusts. They are deemed to be bodies corporate and the rights of unit holders are deemed to be shares. The rights and powers of unit trust managers and trustees are treated as those of the unit trust scheme and any provisions involving agents of a unit trust are deemed to involve the unit trust itself (Sch. 28AA Paragraph. 4(4)(a)(iii)).
Corporate Finance
Under existing law, domestic thin capitalisation rules only apply in relation to loans made by a 75 per cent foreign shareholder of a UK company (Taxes Act 1988 Securitisation. 209(2)(da)).
One of the effects of the new rules is to extend the application of this to minority shareholders who exercise control as defined for transfer pricing purposes. There is no explicit expansion of the thin capitalisation principle, but the application of the arm's length rule to financing arrangements will likely have the same effect.
The wide definition of transactions to include series of transactions as well as those involving multiple parties is believed by the Inland Revenue to provide them with the ammunition to attack a variety of arrangements including parent company guarantees of loans made by banks to UK subsidiaries, as well as back-to-back financing and other conduit arrangements. The wording of the legislation does not seem to support this view except in limited circumstances.
Controlled Foreign Companies are required to compute profits in order to determine the CFC charge as if they were UK residents. In other words, UK tax principles must be applied in determining how much profit is treated as that of certain UK shareholders. The arm's length rule is now automatically included in this, and therefore UK companies will have to conduct the same transfer pricing exercises in relation to their CFC's as they conduct in respect of UK resident companies.
There are no specific statutory rules on documentation relating to transfer pricing. The documentation obligations in the context of transfer pricing are subsumed in the general record-keeping obligations imposed by self-assessment. Taxpayers must keep such records as may be needed to enable them to deliver correct and complete returns and preserve them for six years from the end of the period for which a return may be required. The period may be extended in certain circumstances (Finance Act 1998 Sch. 18 Paragraph. 21(1)). Except in the case of certain specified records this duty may be satisfied by the preservation of the information contained in the original records (Finance Act 1998 Sch. 18 Paragraph. 22(1)). The penalties for a failure to keep records are relatively minor. No special penalties apply to transfer pricing documentation. However, as a practical matter, the failure to keep contemporaneous documentation on transfer pricing may have a significant impact in the context of tax geared penalties generally.
In its consultative document, the Inland Revenue adopted the principles set out in the OECD Guidelines. This requires documentation to be created and retained in accordance with the same prudent business management principles which would govern the process of evaluating a business decision of a similar level of complexity and importance". The consultative paper sets out proposed guidance on the Inland Revenue's views as to the preparation and retention of documents. This includes the following:
- identification of relevant commercial and financial relationships;
- identification of the nature and terms of any relevant transactions;
- methods and terms used to arrive at calculations;
- explanations of how and why the methods used fulfil the arm's length requirements; and
- the terms of all relevant agreements.
There has been considerable discussion on the subject of documentation. The draft guidelines were essentially confirmed and expanded upon slightly in October 1998 (Inland Revenue Tax Bulletin, Issue 37, October 1998, at 579). The guidelines are still likely to raise as many questions as they answer.
Under the previous law, specific information powers existed in relation to transfer pricing under Taxes Act 1988 Sections 772(1) to (7). These are to be repealed. The Inland Revenue indicated in the consultative document that the general information powers in relation to enquiries are considered appropriate in conjunction with the very wide information gathering powers under the Taxes Management Act 1970 Sections 20 to 20C and Regulation 10 SI 1994 No. 181. The use of information powers will be monitored centrally in order to ensure consistency. Disputes in relation to documentation will be referred to the International Division. If the Government feels that the general information powers are inadequate, then specific information powers may be reintroduced.
No specific transfer pricing related penalties are introduced. Taxpayers are responsible for reporting profits which must be computed on the basis of arm's length prices. Computation of liability prepared on any other basis will amount to an incorrect return for self-assessment purposes. If this results from fraud or negligence, penalties under Section 98 Taxes Management Act 1977 may be applicable. The penalties can amount to 100 per cent of the tax payable.
The application of the existing penalty regime in the transfer pricing context gives rise to a number of difficulties. The question of negligence in this context is particularly likely to be problematic. The consultative paper indicates that "taxpayers should not be liable for a penalty in circumstances where they have demonstrably made a reasonable attempt to reflect arm's length prices in the figures disclosed in their return". It is in this context that the question of documentation may be particularly material. Thus, although the documentation penalties are relatively minor, the failure to keep required documentation is likely to be viewed as a material factor in determining the application of penalties generally.
Other unresolved issues in relation to penalties include the application of transfer pricing principles where there is often no single correct conclusion to be drawn and where in the context of prices, a range of possibilities is acceptable. The existing criteria for mitigating penalties are not particularly relevant in most transfer pricing cases.
Some guidance has been provided on these issues recently by the Inland Revenue in the December 1998 Tax Bulletin (Inland Revenue Tax Bulletin, Issue 38, December 1998, at 603). They do indicate that penalties will be inappropriate where honest attempts have been made to comply with the arm's length rules, even if the resulting prices are outside the acceptable range. The Inland Revenue recognise that the imposition of penalties in this area is likely to be a sensitive issue and potential penalty cases will be closely monitored by the International Division to ensure consistency.
The drafting of these measures leaves much to be desired and the resulting uncertainty is likely to give rise to disputes. The previous transfer pricing regime lasted for some fifty years and gave rise to almost no litigation. The broad scope of application of the new rules and the discrepancies between what the language used in the legislation says and various official statements on the subject is however likely to generate litigation. Precisely how these rules will be construed remains to be seen. In recent times, the courts have been inclined to move away from literal interpretation. Nearly twenty years ago, Lord Wilberforce said in W.T. Ramsay Limited v IRC ([1981] STC 174 HL at p179): "there may, indeed, should be considered the context and the scheme of the relevant Act as a whole, and its purpose may, indeed, should be regarded". This was more recently echoed by Lord Steyn in IRC v McGuckian when he said that: "During the last thirty years, there has been a shift away from literalist to purposive methods of construction. Where there is no obvious meaning to a statutory provision the modern emphasis is on a contextual approach designed to identify the purpose of a statute and to give effect to it" ([1997] STC 908 HL at p 915).
Whether these rules of interpretation or indeed others are overruled by the statutory rule of interpretation which requires these provisions to be consistent with the OECD Guidelines remains to be seen. Under current practice, reference may be made to Parliamentary materials where legislation is "ambiguous, obscure or leads to an absurdity". The assurances given in Parliament as to the scope and meaning of these provisions will be essential in understanding how the rules will work. However, the rules as to what Parliamentary material is permitted may also be tested. The standard set by the House of Lords in Pepper v Hart ([1992] STC 898 HL) is that there must be:
- one or more statements by a Minister or other promoter of the Bill;
- together with such other Parliamentary material as is necessary to understand such statements and their effects;
- the statements relied on must be clear.
One of the unanswered questions at this stage is whether Inland Revenue Consultative Documents will fall within the above or whether it is only statements actually made in Parliament that may be considered.
Does the new regime produce any comfort for taxpayers? Protections offered are few. The Government have indicated that they plan to introduce an advance pricing agreement programme and further consultative documents on this will be issued. Although a Direction is no longer required to make a transfer pricing adjustment, the approval of the Board of Inland Revenue will still be required to make a transfer pricing adjustment if the taxpayer and the Inland Revenue are unable to agree. This will provide a degree of central monitoring to ensure consistency. In addition, there may be possibilities of netting-off mutual transactions between related parties.
This material must be read in conjunction with the Responsibility Statement
This article is based on a paper given by the author at a meeting of the Chartered Institute of Taxation European Branch in Amsterdam and published in Bulletin for International Fiscal Documentation, February 1999, Volume 53 No2 p46.
