UK Transfer Pricing Rules: Impact of Applying Rules to Domestic Transactions
In December 2003 the Inland Revenue, the UK tax authority, released draft legislation on transfer pricing and thin capitalization, together with guidance on the subjects, in a document entitled, “Corporation Tax Reform: the Next Steps”. The main purpose of the draft legislation is to apply the transfer pricing and thin capitalization rules to UK domestic transactions. There are two principal reasons for doing this:
Whether the current UK rules or documentation requirements breach the European treaty is an open question and the Inland Revenue may be reacting more to the apparent direction of European case law than any particular settled case. However, companies with UK-European Union transactions should bear this in mind when evaluating any potential legal defense to a transfer pricing challenge by Inland Revenue.
The main effects of the draft legislation follow from these two reasons. First, the Inland Revenue has no great desire to tie up resources investigating domestic (i.e. UK-UK) transactions for no particular purpose, but it is determined to ensure that it has rules that cannot be challenged under the European treaty. The prospect of the legislation passing and becoming law, albeit in an amended form, is certain.
Second, to mitigate the effects on UK businesses and Inland Revenue, documentation requirements will be relaxed somewhat. Clearer guidance has been given on what documentation is essential and how an inquiry should be handled. However, recent instructions to UK tax inspectors mean that taxpayers are much more likely to be asked not only for documentation, but also for a group transfer pricing policy.
Third, as there is no consolidated tax return in the UK, the rules will bite, particularly where there is tax at stake – either where tax planning has taken place or where some more routine aspect of the tax system (such as losses in one company in the group) means that there is tax to be collected. One particular area where the new rules will bite is where no charge is currently being made for, say, services or for the use of assets (including intellectual property), and it may not be easy to identify such situations except at a local level. However, the most significant area is likely to be the need to consider financing and thin capitalization on a company-by-company basis. All borrowing companies (whether borrowing internally or externally) will need to be reviewed to assess whether there will be any impact – preferably before April 1, 2004.
There will be a two-year transition period during which existing penalty rules will be relaxed. This provision, and the easing of the documentation rules, will probably apply to cross-border transfer pricing matters, as well as to domestic (UK-UK) transactions. In addition, it will be easier to get a corresponding adjustment on the other side of a domestic transaction. This may well take the sting out of the proposals for a number of taxpayers, but it is prudent to check what the effects of the proposals will actually be. There will be limited exemptions for small and medium-sized enterprises (“SMEs”), but the definition of an SME is assessed at a group level. Groups with more than 250 employees, turnover of more that €50m, or a balance sheet worth more than €43m will not qualify. The denomination of these thresholds in euros means that a group may fall in and out of the rules from one year to the next and this may depend on exchange rate movements. Taxpayers with domestic transactions will need to review them because the requirement of filing a return based on the arm’s-length principle will not be relaxed.
Local accountants, controllers, and tax managers will need to ensure that domestic transactions are on an arm’s-length basis and a prudent group will need to ensure that it has a formal transfer pricing policy. This will result in an increased workload at the local level, regardless of the fact that formal documentation requirements will be eased. There may need to be a greater awareness of transfer pricing within UK companies if potential exposures are to be identified. In many cases, this work can be leveraged off work done for cross-border transactions. While the relaxation with respect to documentation and (for two years) penalties means that it may be appropriate to divert resources currently allocated to documenting cross-border transactions to the consideration of domestic ones.
The various relaxations noted above will mean that many groups should be able to avoid documentation exercises disproportionate to the risk or tax at stake. Nevertheless, some work will be required, if only internally, and the precise implications for any one group will depend entirely on its individual facts and circumstances.