Identify the principal transfer pricing legislation.
The UK’s main transfer pricing rules are set out in Part 4 of the Taxation (International and Other Provisions) Act 2010 (TIOPA). These are accompanied by provisions relating to advance pricing agreements (APAs) in Part 5 TIOPA.
Other relevant provisions are the diverted profits tax rules introduced by Part 3 of the Finance Act 2015 and the interest barrier rules, found in Part 10 TIOPA, which replace the worldwide debt cap regime, previously found in Part 7 of TIOPA. The new interest barrier rules are designed to implement base erosion and profit shifting (BEPS) Action 4 in the UK.
Other legislation to be aware of includes the double-tax relief provisions in Part 2 TIOPA, the provisions relating to permanent establishments in the Corporation Tax Act 2010 and the controlled foreign companies rules in Part 9A TIOPA.
Which central government agency has primary responsibility for enforcing the transfer pricing rules?
Transfer pricing rules are enforced by Her Majesty’s Revenue & Customs (HMRC).
What is the role of the OECD Transfer Pricing Guidelines?
The UK has fully incorporated the OECD Transfer Pricing Guidelines (Guidelines) into its domestic transfer pricing rules.
Section 75 of the Finance Act 2016 amended section 164 TIOPA so that it refers to the latest version of the Guidelines, automatically incorporating amendments to the rules made throughout the OECD’s BEPS programme. This amendment was effective from 1 April 2016 for corporation tax purposes and 1 April 2017 for income tax purposes.
A new version of the Guidelines was published in 2017 and section 164 of TIOPA specifically states that the UK legislation is to be construed in light of them. Domestic legislation therefore essentially incorporates the Guidelines, and updates are generally enacted through secondary legislation.
To what types of transactions do the transfer pricing rules apply?
The rules apply if the following conditions are met:
- an actual‘provision’ has been entered into by two persons through a transaction or series of transactions;
- the ‘participation condition’ is satisfied;
- the provision differs from the arm’s-length provision that would have been made between independent enterprises; and
- a potential UK tax advantage arises as a result of that difference.
There is no definition of ‘provision’ in the legislation and it is therefore interpreted in accordance with the Guidelines. HMRC practice is to interpret it widely, including ‘arrangements, understandings and mutual practices whether or not they are, or are intended to be, legally enforceable’. The case of DSG Retail and others v HMRC confirms that there may be a provision between two connected parties, even when the transactions were not directly entered into between those two parties.
The ‘participation condition’ is satisfied if either the same persons directly or indirectly participate in the management, control or capital of the parties, or one of the parties directly or indirectly participates in the management, control or capital of the other. This condition will be met if one person has voting control of the other, but also in a number of other circumstances, for example:
- a person would have voting control if all of the rights of people connected with them together with all future rights of that person and those rights that can be exercised for that person’s benefit or at their direction are aggregated; or
- a person has at least a 40 per cent share of a joint venture; or
- for financing arrangements, a person has acted together with others to provide financing to another person, and would have voting control of that person if their rights were aggregated together with the rights of those with whom they acted together in arranging the financing.
Determining the arm’s-length provision (or lack of provision, as the case may be) is the key to all transfer pricing analysis.
Do the relevant transfer pricing rules adhere to the arm’s-length principle?
HMRC adheres to the arm’s-length principle as enshrined in article 9 of the OECD Model Treaty in applying the transfer pricing legislation. However, other legislation – eg, the diverted profits tax and the interest barrier mentioned in question 1 – may restrict deductibility or impose a tax charge on a basis that is inconsistent with the arm’s-length principle.
Base erosion and profit shifting
How has the OECD’s project on base erosion and profit shifting (BEPS) affected the applicable transfer pricing rules?
From 1 April 2016 (for corporation tax purposes) and 1 April 2017 (for income tax purposes) UK law incorporated revisions to the Guidelines made as a result of the BEPS project.
The OECD published its final reports in respect of BEPS Actions 8 to 10 in July 2017 and their effect is to translate the BEPS amendments into the Guidelines. Since the Guidelines are incorporated into UK domestic law, these amendments are considered to be effective in the UK. For accounting periods ending on or after 1 April 2011, the 2010 version of the Guidelines (together with the BEPS Actions 8 to 10) is to be used in the reinterpreting of the UK Transfer Pricing Statutory Code. For accounting periods beginning after 1 April 2018, the 2017 version of the Guidelines is now explicitly incorporated into UK law.
For previous accounting periods beginning prior to 1 April 2011, documents published before 1 May 1998 are to be used.
In addition, the new interest barrier rules, referred to in question 1, implement the OECD’s recommendations on BEPS Action 4.
What transfer pricing methods are acceptable? What are the pros and cons of each method?
HMRC accepts all OECD transfer pricing methods. Although no absolute hierarchy exists within the Guidelines, HMRC considers that in all cases the comparable uncontrolled price (CUP) method is generally preferred and expects sufficient efforts to be made to identify a suitable CUP. If both traditional transaction methods and transactional profit methods can be applied with equal reliability, the Guidelines express a preference for traditional transaction methods, which are considered to be more direct. However, it may be difficult to find a transaction between independent enterprises that is similar enough to a controlled transaction such that no differences have a material effect on the price.
If a reliable CUP cannot be found, then, in line with the Guidelines, HMRC places emphasis on choosing the most appropriate method for the particular type of transaction, rather than establishing a rigid hierarchy of methods. For tangible property transactions, such as retail and manufacturing, the resale minus method is considered by the OECD to be the most useful. However, the most common difficulty with this method is the availability of reliable financial information on the comparable entities. For semi-finished goods (for instance, the transfer of goods from a supplier to a related party) and services transactions the cost-plus method (CPM) is most useful. The CPM is easy to implement. However, it may be difficult to find comparables that perform comparable functions, bear comparable risks, own the same assets and operate in comparable market conditions. The transactional profit split method (PSM) and transaction net margin method (TNMM) are considered to be useful for complex trading relationships involving highly integrated operations where it would otherwise be difficult to split the relationship into separate transactions to which the analysis can be applied. Following BEPS, we are noticing an increasing acceptance of and reliance on the transactional profit methods. A PSM could be difficult to apply and is very dependent on inputs that may change year on year, giving a need to update pricing more regularly than the traditional transactional methods.
Are cost-sharing arrangements permitted? Describe the acceptable cost-sharing pricing methods.
HMRC follows the Guidelines in relation to cost-sharing arrangements or ‘cost contribution arrangements’ (CCAs). Following BEPS, the CCA rules have been updated and take into account the value of each participant’s contribution.
CCAs arise where:
- participants have the expectation of mutual benefit from an activity and agree to share the contributions to that activity in proportion to the benefits they each expect to obtain; and
- each participant has an ownership interest in the property acquired and can exercise that interest without payment of further consideration.
HMRC recognises that although CCAs are uncommon in most sectors, when they do arise they can be genuine and based on good commercial reasons. Nevertheless, HMRC will consider CCAs carefully to ensure that the methods employed do not differ from those that would have been agreed between independent parties and that any required adjustments are made. However, HMRC notes that the Guidelines caution against making minor adjustments and considers that it will only be appropriate to disregard the terms of a CCA in exceptional circumstances.
What are the rules for selecting a transfer pricing method?
As set out above, there is no strict hierarchy of methods; rather, HMRC follows the Guidelines’ ‘natural hierarchy’. Generally, the CUP method is preferred, and in practice HMRC expects sufficient efforts to be made to identify a suitable CUP. If both traditional transaction methods and transactional profit methods can be applied with equal reliability, the preference is for traditional transaction methods.
If a reliable CUP cannot be found, then, in line with the Guidelines, HMRC places emphasis on choosing the most appropriate method for the particular type of transaction.
For more complex transactions, HMRC is open to exploring other methods if it is considered that they provide a stronger case for application of the arm’s-length principle.
Can a taxpayer make transfer pricing adjustments?
Transfer pricing adjustments in the UK should be self-assessed on the income tax or corporation tax return of the person who obtains the potential tax advantage. For companies, at present such tax returns generally need to be filed a year after the end of the accounting period in which the relevant transaction took place. Income tax returns currently need to be filed at the end of January in the year following the financial year to which they relate. However, HMRC is modernising its systems and introducing a new digital ‘tax account’ programme, and from April 2019 businesses are mandated to use this ‘Making Tax Digital for Business’ platform for their VAT obligations, and by 2020 the need for most tax returns is expected to fall away.
We would note that transfer pricing adjustments can only be made where there is a potential UK tax advantage, so adjustments that reduce profits or increase losses are not permitted. However, where a potentially disadvantaged person is also subject to UK corporation tax, it can usually make a compensating adjustment to its taxable profits. It can do so by making a claim to HMRC within two years of the potentially advantaged person filing their tax return showing the adjustment.
Generally, transfer pricing adjustments may not be made through a company’s accounts. As noted at question 34, the government consulted on whether to introduce a secondary adjustments rule into the UK transfer pricing legislation in May 2016. Although the consultation closed in August 2016, the formal results have not yet been published. We do not expect this measure to be introduced in the near to medium future.
Are special ‘safe harbour’ methods available for certain types of related-party transactions? What are these methods and what types of transactions do they apply to?
Most small and medium-sized enterprises (SMEs) are exempt from the requirement to apply transfer pricing in the UK. The definition of an SME corresponds with the EU’s definition: broadly, a small enterprise has fewer than 50 employees and either turnover or gross assets of less than €10 million, and a medium-sized enterprise has fewer than 250 employees and either a turnover of less than €50 million or gross assets of less than €43 million.
SMEs can, however, be subject to transfer pricing in certain circumstances. The exemption does not apply if the SME transacts with an entity in a ‘non-qualifying territory’ (ie, if that territory’s double-tax agreement with the UK does not contain a non-discrimination article). HMRC may also notify a medium-sized enterprise that it must apply transfer pricing for a particular period. An SME may also elect for the exemption not to apply, which it may wish to do in order to claim a corresponding adjustment in a jurisdiction that has a higher tax rate. Finally, where an SME is party to a transaction that is relevant to a patent box claim (see question 39) HMRC may issue a notice requiring that person to compute his or her profits in accordance with transfer pricing.
Disclosures and documentation
Does the tax authority require taxpayers to submit transfer pricing documentation? Regardless of whether transfer pricing documentation is required, does preparing documentation confer any other benefits?
HMRC has not issued any specific requirements relating to transfer pricing documentation. Transfer pricing adjustments should be made on the relevant income or corporation tax returns. However, taxpayers are expected to ‘prepare and retain such documentation as is reasonable given the nature, size and complexity (or otherwise) of their business or of the relevant transaction . . . but which adequately demonstrates that their transfer pricing meets the arm’s-length standard’. This includes, for instance, primary accounting records, tax adjustment records, records of transactions with associated businesses, and evidence to demonstrate that an arm’s-length result was achieved.
If an error is made in a tax return, the taxpayer may be subject to penalties. The level of the penalty is linked to the reasons for the error, on the basis that taxpayers are expected to take reasonable care in maintaining records that allow them to provide a complete and accurate tax return. For lack of reasonable care, the penalty is generally between zero per cent and 30 per cent of the extra tax due. For deliberate errors the maximum penalty is 70 per cent of potential lost revenue for HMRC, and a maximum penalty of 100 per cent of potential lost revenue can be imposed for deliberate and concealed errors. Penalties can in some circumstances be reduced if the taxpayer tells HMRC about the error. Following consultation by HMRC, the draft Finance Bill published on 6 July 2018 sets out a new points-based system for calculating penalties for failing to make tax returns, filing incorrect returns or filing to pay tax due. Each tax has a certain points threshold that, once reached, requires the payment of a fixed penalty.
Businesses must also comply with country-by-country (CbC) reporting, which was implemented in the UK by way of regulation on 18 March 2016. The regulations apply if the consolidated group turnover meets the threshold of €750 million.
As there are no formal mandatory documentation requirements, the main benefit of preparing and keeping proper transfer pricing documentation is that it would assist in resolving any future transfer pricing enquiries by HMRC. In particular, it shifts the burden of proof to HMRC and in general helps the taxpayer to achieve and maintain a lower tax risk rating with HMRC. In relation to the ‘master’ and ‘local’ file, HMRC does not require these to be filed with the CbC return; however, subject to ongoing Brexit negotiations, EU Directive 2011/16/EU may apply. Multinational enterprises (MNEs) with a UK entity as the ultimate parent entity may be required to share their master file with overseas tax authorities as it may be needed in conjunction with the CbC report in order to assess transfer pricing risk – and therefore will need to have compiled the master file in order to share it.
Additionally, HMRC has the power to impose penalties on taxpayers if that taxpayer’s inaccurate tax return, which was caused by careless or deliberate conduct, results in a loss of tax in the UK. Maintaining good transfer pricing documentation would help to demonstrate that the taxpayer had taken reasonable care in making any transfer pricing adjustments to its tax return, were this to be enquired into in future.
No additional documentation needs to be submitted to support an adjustment on the tax return, unless HMRC requests it. HMRC has information powers and may make formal requests for information if such information is not forthcoming in response to an informal request.
As mentioned above, CbC reporting is a legal requirement in the UK and applies to accounting periods commencing on or after 1 January 2016. The CbC regulations apply if the consolidated group turnover meets the threshold of €750 million.
HMRC’s guidance on transfer pricing documentation refers to the Guidelines at Chapter V, which contains recommendations for the preparation of transfer pricing documentation. HMRC will also accept any documents prepared in accordance with the EU’s Code of Conduct on transfer pricing documentation. Businesses that wish to follow this code must write to HMRC to inform it of this.
Despite the lack of formal requirements, HMRC generally prefers transfer pricing information to be in the form of a full transfer pricing report written by a professional adviser. HMRC will accept documentation prepared on a global or a regional basis as long as the analysis can properly be applied to the UK transactions.
Has the tax authority proposed or adopted country-by-country reporting? What are the differences between the local country-by-country reporting rules and the consensus framework of Chapter 5 of the OECD Transfer Pricing Guidelines?
CbC reporting has been implemented in the UK for accounting periods commencing on or after 1 January 2016. On 26 February 2016, HMRC announced a new measure requiring UK-headed MNEs, or UK sub-groups of MNEs, to make an annual CbC report to HMRC showing revenue, profit and capital figures for each tax jurisdiction in which they do business. There is a threshold of €750 million consolidated group turnover before the regulations apply.
Penalties apply when companies are not compliant with the CbC reporting rules including the notifications requirements. The penalties range from £300 to £3,000.
Timing of documentation
When must a taxpayer prepare and submit transfer pricing documentation?
As set out in question 12, any relevant transfer pricing analysis is made on the relevant income or corporation tax returns – separate, specific transfer pricing documentation is not required by HMRC, although the requirements of other jurisdictions should be taken into account with regard to documentation. However, as taxpayers are expected to ‘prepare and retain such documentation as is reasonable given the nature, size and complexity (or otherwise) of their business or of the relevant transaction . . . but which adequately demonstrates that their transfer pricing meets the arm’s-length standard’ in order to provide adequate detail on the relevant income or corporation tax returns, in practice clients tend to find it more convenient to compile a transfer pricing report to meet this standard.
Failure to document
What are the consequences for failing to submit documentation?
As set out in question 12, there are penalties imposed on the taxpayer for errors (whether deliberate or otherwise) made in tax returns.
Adjustments and settlement
Limitation period for authority review
How long does the tax authority have to review an income tax return?
HMRC may enquire into a transfer pricing filing through its normal enquiry procedure for tax returns. This means that HMRC has one year from the date on which the return is filed to open any enquiry. Once the enquiry is formally opened, there is no time limit imposed on HMRC for concluding the enquiry, although HMRC’s own guidance manual states that ‘unreasonable delay’ is to be avoided. The taxpayer may apply to the First-tier Tribunal (Tax Chamber) (Tribunal) to close an enquiry if necessary.
If an enquiry results in a transfer pricing adjustment but the disadvantaged person has already submitted their return for the relevant period, they will be permitted to amend their return in line with the adjustment. As noted at question 34, HMRC has issued a consultation document on the proposed introduction of a secondary adjustments rule in the UK.
Rules and standards
What rules, standards or procedures govern the tax authorities’ review of companies’ compliance with transfer pricing rules? Does the tax authority or the taxpayer have the burden of proof?
The UK’s tax authorities are increasing their efforts to examine transfer pricing documentation and refer to the Guidelines alongside HMRC’s international manual at INTM482040-482160.
The burden of proving that transfer prices are at arm’s length falls on the taxpayer. The taxpayer must submit a return under self-assessment, and it is required that they calculate their taxable profits using transfer pricing adjustment and maintain sufficient records and documentation recording the methodology adopted. If HMRC consider that there has been tax revenue lost as a result of negligence or carelessness (for accounting periods ending on or after 1 April 2009), the burden of proving the taxpayer’s negligence or carelessness falls on HMRC.
If the tax authority asserts a transfer pricing adjustment, what options does the taxpayer have to dispute the adjustment?
If a settlement is not reached through the enquiry process, or if HMRC issues a closure notice containing a determination with which the taxpayer disagrees, the taxpayer may ask HMRC to review the point. Alternatively, HMRC or the taxpayer may appeal to the Tribunal for a determination as to the correct adjustment. The UK’s most substantive transfer pricing case in recent times was DSG Retail and others v HMRC, which was decided by the Tribunal in 2009.
In cases where the UK has a comprehensive double-tax treaty with the other jurisdiction, and the taxpayer considers that the transfer pricing adjustment is incorrect, it may be able to apply for relief under the mutual agreement procedure (MAP). This would involve the taxpayer approaching the competent authority of the other jurisdiction and asking it to intervene. HMRC ought to cooperate with the other competent authority in attempting to reach a resolution.
Judicial review may also be an option where a taxpayer considers that one or more of the grounds for review are met. For instance, the taxpayer had a ‘legitimate expectation’ that HMRC would act in a certain way, and HMRC failed to do so. Other grounds include procedural impropriety, or irrationality. Judicial review applications may be made to the Tribunal.
Relief from double taxation
Does the country have a comprehensive income tax treaty network? Do these treaties have effective mutual agreement procedures?
The UK has a comprehensive double-tax treaty network – one of the largest in the world – and the vast majority of the UK’s double-tax treaties have effective MAP clauses. More recent UK double-tax treaties also tend to include mandatory binding arbitration clauses, and it is hoped that these provisions will prove more effective at resolving disputes.
How can a taxpayer request relief from double taxation under the mutual agreement procedure of a tax treaty? Are there published procedures?
HMRC has published a Statement of Practice (which has been updated on several occasions, the most recent iteration being 1/2018) that sets out the procedure a taxpayer should follow to apply for relief under the MAP of a double-tax treaty. It is noted that in the UK there is no set form of presentation of a case. However, other countries may have different requirements and the taxpayer should ensure that the procedures of both jurisdictions are followed in making its application.
When relief is available
When may a taxpayer request assistance from the competent authority?
Where the MAP is invoked under a UK tax treaty, it must generally be presented before the expiration of six years following the end of the chargeable period to which the case relates (unless stated otherwise in the relevant tax treaty).
HMRC may also use its discretion to unilaterally relieve some or all of the double tax if it concludes that the taxation applied by its treaty partner is in accordance with the relevant double tax treaty.
Limits on relief
Are there limitations on the type of relief that the competent authority will seek, both generally and in specific cases?
There are no such limitations.
How effective is the competent authority in obtaining relief from double taxation?
While HMRC does emphasise that there are no guarantees that the MAP will result in a binding agreement, it is generally considered to be effective at obtaining relief using this procedure. In the year 2016-2017, HMRC resolved 36 cases and admitted a further 80. On average, such cases took 24.4 months to resolve.
Advance pricing agreements
Does the country have an advance pricing agreement (APA) programme? If so, is the programme widely used? Are unilateral, bilateral and multilateral APAs available?
The UK has had an APA programme since 1999. Unilateral, bilateral and multilateral APAs are all available. Unilateral APAs are possible, but HMRC’s preference is for bilateral APAs. From 2017/2018, 16 applications were made (a decrease from 32 applications in 2016/2017), six applications were turned down and 27 APAs were agreed.
Describe the process for obtaining an APA, including a brief description of the submission requirements and any applicable user fees.
The business seeking an APA initiates the process, using the procedure set out by HMRC in its Statement of Practice 2/2010. HMRC requests that businesses considering seeking an APA contact HMRC first with an ‘expression of interest’ to discuss their plans before submitting a formal application. The intention is that HMRC can agree a timetable with the business. In many cases this will involve meeting with HMRC to discuss the issues. Such preliminary discussions may take place anonymously. Once HMRC has indicated that it is willing to consider the APA, the business may make a formal application. HMRC will then evaluate the application and seek further information from the business if required. Businesses should be prepared to grant HMRC open access to relevant documents and enter into an open dialogue with HMRC about the key issues. No fees are payable to HMRC, but charges may be levied by other administrations (although HMRC should be able to advise on this at the ‘expression of interest’ stage in proceedings).
How long does it typically take to obtain a unilateral and a bilateral APA?
HMRC aims to complete the APA process within 18 to 21 months of submission of the formal application, and it acknowledges that unilateral APAs may be completed much more quickly. The timeline in relation to bilateral and multilateral APAs will depend also upon the procedures of the relevant administrations in the other country (or countries). Data released for the 2017/2018 tax year indicate that the average time taken to reach agreement was 37.1 months, with 50 per cent of APAs being agreed within 35.1 months, which is significantly longer than HMRC intends the process to be.
How many years can an APA cover prospectively? Are rollbacks available?
The business should propose a term for the APA in the application. Typically, this will be three to five years (with a longer period only being considered in exceptional circumstances), depending on the length of time for which it is reasonable to suppose that the transfer pricing methods will remain appropriate.
Rollbacks are available: the taxpayer may request this, or HMRC may propose that the rollback of the APA would be an appropriate way of resolving enquiries into previous tax returns. The use of an APA in this way is subject to the agreement of other administrations in the case of bilateral or multilateral cases.
What types of related-party transactions or issues can be covered by APAs?
As set out in HMRC’s Statement of Practice 2/2010, the potential scope of an APA is flexible and it may cover any number of a business’s transfer pricing issues. Thin capitalisation issues are generally dealt with separately through a separate, similar, procedure. Generally HMRC will only consider agreeing an APA where the issues involved are complex, where there is a high risk of double taxation or where the business proposes to use a highly tailored method for its transfer pricing.
Is the APA programme independent from the tax authority’s examination function? Is it independent from the competent authority staff that handle other double tax cases?
HMRC has a dedicated APA team that handles the APA process. Other HMRC employees who deal with the taxpayer’s affairs and who already have knowledge of its business may also become involved in the process, particularly where a rollback is proposed to settle an enquiry.
Advantages and disadvantages
What are the key advantages and disadvantages to obtaining an APA with the tax authority?
The key advantage for a business in obtaining an APA is that it provides certainty to the business that (if the terms of the APA are complied with) HMRC will accept the treatment of the business’s transfer pricing issues for the term of the agreement. Bilateral and multilateral APAs are more useful in this regard as they provide similar assurances in respect of the other jurisdiction’s tax administration, minimising the risk of double taxation.
A key disadvantage to the procedure is the time and cost involved in negotiating APAs. HMRC’s latest figures (for 2017/2018) suggest that it agrees 50 per cent of APAs within 35.1 months, this has increased steadily over the past few years (2016/2017 was 34.7 months; 2015/16 was 32 months; 2014/15 was 15.6 months) and there is no way to guarantee an acceptable time frame. The protection an APA provides is also limited to certain ‘critical assumptions’ about the reliability of the method, and compliance by the business with the terms of the APA. If HMRC considers that the critical assumptions no longer apply or that the taxpayer has not complied with the terms of the APA it may nullify or cancel an APA.
Is the tax authority generally required to respect the form of related-party transactions as actually structured? In what circumstances can the tax authority disregard or recharacterise related-party transactions?
HMRC’s guidance follows the Guidelines on this point. There are two broad circumstances where it may be appropriate not to recognise the structure of a related party transaction and to recharacterise it:
- where the economic substance of a transaction, viewed in its totality, is inconsistent with its form; and
- where the arrangements made with regard to the transaction are different from those that would have been made by independent entities behaving in a commercial and rational way in comparable circumstances, thereby preventing determination of an arm’s-length price.
The Guidelines set out that any differences between the actual conduct of the parties and the economically relevant terms of the contract must be considered to ensure that the arrangement is not a ‘sham’. It is the functions actually performed, the assets actually used and the risks actually assumed that should ‘accurately delineate’ the transaction.
What are some of the important factors that the tax authority takes into account in selecting and evaluating comparables? In particular, does the tax authority require the use of country-specific comparable companies, or are comparables from several jurisdictions acceptable?
HMRC sees internal comparables as preferable (ie, those from within the business itself with an unconnected third party). HMRC’s practice suggests that for UK companies it generally makes sense to consider UK comparables only at first. It acknowledges that the aim is to compare ‘like with like’, so the focus is on whether territorial boundaries actually create market differences. There are no set rules on the types of comparables that are acceptable and the focus is on how similar the transactions truly are, and whether reliable adjustments can be made to counter any differences.
What is the tax authority’s position and practice with respect to secret comparables? If secret comparables are ever used, what procedures are in place to allow a taxpayer to defend its own transfer pricing position against the tax authority’s position based on secret comparables?
HMRC will be aware of other similar companies’ transfer pricing, but it does not use secret comparables in an enquiry for setting an arm’s-length price.
Are secondary transfer pricing adjustments required? What form do they take and what are their tax consequences? Are procedures available to obtain relief from the adverse tax consequences of certain secondary adjustments?
HMRC launched a consultation on whether to introduce secondary adjustments into the UK’s domestic transfer pricing legislation on 26 May 2016. This consultation closed on 18 August 2016. HMRC has not formally published the results of this consultation. However, it is widely understood that they are not currently seeking to push forward with the implementation of secondary adjustments into UK domestic legislation.
Non-deductible intercompany payments
Are any categories of intercompany payments non-deductible?
The introduction of the interest barrier rules (implementing BEPS Action 4) known as the ‘corporate interest restriction’ is found is part 10 TIOPA, which was amended in the Finance (No. 2) Act 2017. HMRC published draft legislation and guidance regarding the implementation of the interest barrier rules on 13 July 2017, which has since been updated. The latest guidance published by HMRC in relation to the interest barrier rules, in February 2018, is 577 pages long, an indicator of how complicated the application of these rules can be.
The rules apply retrospectively from 1 April 2017. Periods straddling this date are treated as two notional periods with the old ‘worldwide debt cap’ rules (previously found in Part 7 TIOPA 2010) applying to periods up to 31 March 2017 and the new interest barrier rules applying after this date.
The rules operate to restrict the extent to which a corporate group can claim deductions for interest expense and other financing costs to an amount that reflects the group’s activities taxed in the UK, taking third party borrowing into account. While the rules apply to all companies within the charge to corporation tax, groups with less than £2 million of annual net interest expense and financing costs will not suffer any restriction, as the rules only bite above that amount. Note that the £2 million de minimis threshold applies to the group as a whole rather than to each company within the group.
These rules are complex and their application to a group will need to be analysed on a case-by-case basis. However, the broad principles are: a UK group is permitted to deduct a total of £2 million worth of interest expense or other finance costs per year without restriction; above this £2 million de minimis, groups must either apply the ‘fixed ratio’ or the ‘group ratio’ in order to determine the relevant level of deductions. The fixed ratio is the default position; and imposes two main limits on the group’s tax-interest deductions (a fixed 30 per cent of the taxable earnings before tax-interest, depreciation and amortisation, and a debt cap). However groups may opt to apply the ‘group ratio’ (essentially the ratio of group-interest to group-EBITDA) if it gives a more favourable result (ie, higher level of deductions); and amounts that are disallowed in one accounting period may be carried forward and in certain circumstances be deducted in a subsequent period.
What legislative and regulatory initiatives (besides transfer pricing rules) has the government taken to combat tax avoidance with respect to related-party transactions? What are the penalties or other consequences for non-compliance with these anti-avoidance provisions?
The UK government is a supporter of the OECD’s base erosion and profit shifting (BEPS) project, and has accordingly introduced rules which limit deductions for interest expense and rules designed to eliminate tax advantages arising from hybrid mismatches.
In addition, the UK has developed a Diverted Profit Tax (or DPT), which is a separate tax from income or corporation tax. DPT applies to profits arising from 1 April 2015 and is focused on contrived arrangements designed to erode the UK tax base. Its primary aim is to ensure that the profits taxed in the UK reflect the economic activity. This is broadly consistent with the aims of the OECD Base Erosion and Profit Shifting project, although the UK legislation does not follow any particular OECD recommendation. Specifically, DPT aims to deter and counteract the diversion of profits from the UK by large groups that either:
- seek to avoid creating a UK permanent establishment that would bring a foreign company into the charge to UK Corporation Tax; or
- use arrangements or entities which lack economic substance to exploit tax mismatches either through expenditure or the diversion of income within the group.
More recently, the UK government introduced new anti-avoidance rules in the Finance Act 2019 to tackle profit fragmentation arrangements that aim to move profits from a UK person to an offshore person. These rules apply for any transaction from 1 April 2019 for corporates and 6 April 2019 for individuals. This anti-avoidance legislation requires affected parties to self-assess whether or not an additional tax charge (similar to a diverted profits tax charge) should be paid as a result of profits being moved out of the UK. The tax will apply when there is a tax ‘mismatch’ (ie, the overseas recipient pays tax at less than 80 per cent of the rate that would have applied to the UK persons).
A further recent development is the introduction of a tax on offshore receipts in respect of intangible property, which aims to deter the ownership of IP through low-tax jurisdictions.
Finally, the UK general anti-abuse rule (or GAAR) is designed to counteract the tax advantage that abusive arrangements would otherwise achieve. The primary policy objective of the GAAR is to deter taxpayers from entering into abusive arrangements, and to deter promoters from promoting such arrangements.
Under the general penalty regime for incorrect returns, a transfer pricing adjustment (or an adjustment under the other rules set out above) may lead to a penalty based on a percentage of actual tax loss.
- up to 30 per cent for a failure to take reasonable care;
- up to 70 per cent for a deliberate understatement or over-claim; and
- up to 100 per cent for a deliberate understatement aggravated by concealment.
HMRC may apply a lower percentage penalty where there is disclosure, the extent of mitigation depending on whether disclosure is prompted or unprompted. A 10 per cent penalty is applied to overstated losses.
How are location savings and other location-specific attributes treated under the applicable transfer pricing rules? How are they treated by the tax authority in practice?
HMRC applies the Guidelines in this regard.
Branches and permanent establishments
How are profits attributed to a branch or permanent establishment (PE)? Does the tax authority treat the branch or PE as a functionally separate enterprise and apply arm’s-length principles? If not, what other approach is applied?
The profits attributed to the PE are those that it might be expected to make if it were a separate enterprise, dealing independently with the enterprise. Profits are therefore calculated on an arm’s-length basis.
Are any exit charges imposed on restructurings? How are they determined?
No specific exit charges are imposed on restructurings, although a transfer pricing adjustment may be applied within the normal course of transfer pricing, if certain aspects of the restructuring are considered not to be arm’s-length. A UK taxpayer that restructures its business by moving assets out of the UK or migrating its tax residence to another jurisdiction will be subject to an exit charge unless a deferral or other relief applies.
Temporary exemptions and reductions
Are temporary special tax exemptions or rate reductions provided through government bodies such as local industrial development boards?
Northern Ireland sets its own corporation tax rate and is committed to matching the Republic of Ireland’s 12.5 per cent corporation tax rate for trading businesses by 2018.
There are a number of tax reliefs to encourage investment (eg, the enterprise zones scheme, which offers business rate reliefs and enhanced capital allowances). There are also enhanced reliefs for smaller businesses, such as the enterprise and seed enterprise investment schemes, the venture capital trust scheme and enhanced research and development tax credits.
The UK also has a ‘patent box’ regime that allows companies to apply a lower (10 per cent) rate of corporation tax to profits from its patented inventions. This regime has been amended in line with BEPS Action 5, with one key change being the introduction of a nexus requirement for the company’s underlying R&D activity.
Individual investors may benefit from a reduced 10 per cent rate of capital gains tax (with a lifetime limit of £10 million) if they satisfy the conditions required to obtain entrepreneur’s relief (for employees and office holders) or the new investor’s relief (for others).
Update and trends
Tax authority focus and BEPS
What are the current issues of note and trends relating to transfer pricing in your country? Are there particular areas on which the taxing authority is focused? Have there been any notable legislative, administrative, enforcement or judicial developments? In particular, how is the OECD’s project on base erosion and profit shifting affecting both policymakers and tax administrators?
Tax authority focus and BEPS41 What are the current issues of note and trends relating to transfer pricing in your country? How is the OECD’s project on base erosion and profit shifting affecting both policymakers and tax administrators?
The main trend to be noted is the intensification of enquiries from HMRC.
At the beginning of 2019, HMRC announced the profit diversion compliance facility. This new facility targets MNEs having outdated TP arrangements that could fall under the scope of the DPT.
In 2019, part of the UK Controlled Foreign Companies tax scheme has been declared as illegal state aid by the EU Commission. Hence, in addition to transfer pricing enquiries, and while the UK has appealed against the EU Commission’s decision, HMRC still needs to recover the unpaid tax benefits. This requires the tax authorities to understand where the significant people functions are located – a difficult exercise with a tremendous balancing act.
On the regulatory side the major project is the digital services tax regime. While the OECD is still working on developing a consensus solution to taxing the digitalisation of the economy, on 11 July 2019, the UK government published draft legislation for the next Finance Bill. The government wants to ensure that ‘large digital companies pay their fair share’.