Taxing authority and tax law
Tax authority: Her Majesty’s Revenue and Customs (“HMRC”) publishes its internal guidance on its website and this provides tax payer and their advisers with an insight into how HMRC applies the legislation. HMRC also publishes technical notes and Statements of Practice concerning a number specific transfer pricing related topics.
Tax law: The UK’s domestic transfer pricing legislation is now consolidated and set out in Part 4 of the Taxation (International and Other Provisions) Act 2010 (“TIOPA 2010”).
Relevant regulations and rulings
The UK does not have a rulings process for transfer pricing outside of an Advance Pricing Agreement (“APA”). The legislation governing the unilateral APA process is set out in Part 5 of TIOPA 2010. A statement of practice governing the application of the statutory provisions for APAS was first published in 1999 and a revised statement is expected before the end of 2010. For APAs to be admitted to the program there needs to be sufficient doubt or difficulty in approaching compliance with the arm’s length standard. Limited resources limit the UK to around 18-20 new admissions to the program each year although there is a stated intention to increase this number year on year. The UK also operates a thin cap agreement system which uses the APA legislation. These are known as Advance Thin Cap Agreements (“ATCAs”). Agreements in this regard are typically couched around covenants similar to that of third party lenders.
The UK operates a risk based approach to enquiries and in relation to compliance obligations. Most MNCs will have had a risk assessment in the UK and may approach HMRC for a discussion around the risks associated with their transfer pricing. This could result in a Low Risk rating which, although short of an APA and its contractual terms, would provide some comfort as to the meeting of their compliance obligations and the robustness of their intra-group pricing. Such discussions are encouraged by HMRC.
OECD guidelines treatment
Section 164 TIOPA 2010 confirms that the UK’s transfer pricing provisions are to be construed in alignment with Article 9 the OECD Model Tax Convention and its associated transfer pricing guidelines. For these purposes the transfer pricing guidelines mean all the documents published by the OECD at any time before 1 May 1998 “as part of their Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” and any other documents designated as such by Treasury order.
As at the date of drafting this entry, no Treasury orders have been made which means that the status of any updates made by the OECD since 1 May 1998, in particular the amendments published by the OECD in July 2010, under UK tax legislation is unclear. It is understood that HMRC are considering whether legislative changes are required.
Notwithstanding the above, HMRC actively participates in OECD Committees and generally tries to apply the most recent OECD pronouncements to the interpretation of double taxation agreements that are based on the OECD Model Convention.
Priorities/pricing methods
The OECD Guidelines are followed in regards to pricing methods. HMRC generally prefers transaction methods over profit methods (such as with the TNMM). However, there is a recent move by the HMRC towards testing results against systems profits. This may also be mirroring OECD developments in this area.
Following a recent tax case, HMRC are believed to more routinely challenge the robustness of external CUP data (in particular in relation to IP licenses) unless there has been a testing of the relevant parties bargaining positions in coming to the license agreement.
Transfer pricing penalties
For accounting periods ending on or after 1 April 2008, the provisions for neglect penalties are set out in Schedule 24 Finance Act 2007. These provisions are couched in terms of careless or deliberate inaccuracies rather than neglect. They are tax geared at up to 100% of the potential lost revenue figure. This is, however, now calculated without adjustment for the availability of loss reliefs and where the adjustment affects losses only; the lost revenue figure to which the penalty percentage is applied is calculated at 10% of the loss adjustment.
HMRC has recently published revised guidance setting out examples of negligence/carelessness which carry lower tax geared penalties (maximum penalty of 30%), and deliberate inaccuracies where the penalties will be higher (maximum penalty of 70%).
Examples of negligence and carelessness include:
- No attempt to price the transaction
- Shared service centre overseas, cost base, allocation key applied — turnover, modest mark up, but no consideration of benefits test for UK entity
- Policy, otherwise arm’s length, not properly applied in practice
Examples of deliberate inaccuracies include:
- A clear internal Comparable Uncontrolled Price has been omitted with no reasonable technical analysis to support why it has been disregarded
- A cost plus return to a company that has in reality controlled the development of valuable intangibles (as not demonstrable as a sub-contractor to group members)
- Material factual inaccuracies in the functional analysis on which the pricing analysis has been based
Penalty relief
The best protection against neglect penalties is a transfer pricing policy which fully documents and evidences due consideration of the application of the arm’s length principle in the preparation of the relevant tax return.
Documentation requirements
HMRC’s internal guidance sets out what types of documents that it might expect to be kept. This guidance is stated as building upon that published by OECD. The UK Guidance divides documentation into primary accounting records, tax adjustment records and, most importantly, evidence. Documentation relating to evidence of compliance with the arm’s length principle is to follow the OECD guidelines, and HMRC has set out some suggestions on what this should or may include, such as:
- An identification of the associated enterprises with whom the transaction is made
- A description of the nature of the business
- The contractual or other understandings between the parties
- A description of the method used to establish or test the arm’s length result, with an explanation of why the method is chosen
- An explanation of commercial and management strategies, forecasts for the business or technological environment, competitive conditions and regulatory framework
HMRC applies a risk-based approach under which they would expect the level and depth of analysis to be dictated by the perceived risk of tax loss through manipulation of pricing. This typically allows a light touch approach to most UK to UK transactions.
Documentation deadlines
Under the current guidance, the first two categories of documentation should be in existence when the accounts are prepared and the return submitted. In relation to documentary evidence of arm’s length pricing, it is not needed in a form capable of production to HMRC until a request by HMRC has been made. The previous guidance published by the HMRC confirmed that all documentation should be in existence at the time the return is submitted. In practice, evidence confirming adherence to the arm’s length principle should exist at the time of submission of the return if difficulties in its production are to be avoided.
Statute of limitations on transfer pricing assessments
Discovery assessments can be raised six years after the company’s accounting period ends, but this is extended to 21 years where the misstatement is due to fraudulent or negligent conduct by the taxpayer. With effect from 1 April 2010 these limits have changed to four years and 20 years respectively. Discovery assessments however require there to have been negligence on the part of the taxpayer (defined as carelessness in the preparation of returns from 2010).
The legislation applicable before 1999 operated in a different manner, and as a result, an investigation started now would not normally lead to transfer pricing adjustments for periods before 1999.
Return disclosures/related-party disclosures
There are no return disclosure requirements except those required in statutory accounts and in annual reports filed in compliance with any current APAs. The absence of disclosure requirements will typically leave prior years open to discovery assessments.
Audit risk/transfer pricing scrutiny
HMRC has developed a “Stage Gate” process for transfer pricing enquiries which is set out in the internal guidance published on its website. This process requires a transfer pricing specialist from with HMRC to be assigned where a case team identifies a transfer pricing issue that may necessitate an enquiry. The specialist helps the case team to prepare a risk assessment and a business case for submission to one of two panels set up for the purpose before any enquiry is commenced. The panels also review progress at regular intervals during the enquiry and sign off all settlement proposals.
HMRC considers that this process should lead to more targeted and focused enquiries on areas warranting specialist transfer pricing resources. The risk of audit is therefore high where there are red flags present in the accounts — changed business structure, losses, wildly fluctuating margins, high value-adding functions, etc.
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