The New UK Transfer Pricing Regime

December’s pre-budget report announced important changes to the UK’s transfer pricing and thin capitalisation rules. These changes are more comprehensive than many commentators expected and introduce fundamental changes that will have an impact on most groups of companies. Indeed, many groups will find themselves having to worry about transfer pricing for the first time. Now all companies, which are part of a group, will need to take action now to assess how the new rules will affect them and to decide what action they are going to take. In this article we summarise the key proposed legislative changes, discuss the draft guidance on documentation and enquiries, released at the same time, and set out a framework for dealing with the changes.

What are the key changes?

The proposed rules are comprehensive and complicated and as such this article can do no more than outline the main issues. The rules impact upon both mainstream transfer pricing and thin capitalisation.

With regards to transfer pricing, the headlines are:

• The rules are expected to be contained in FA 2004 and will apply from 1st April 2004. FA 2004 will extend the existing transfer pricing rules to purely domestic transactions between UK companies. This means that, for the first time, transactions between UK companies must, for tax purposes at least, be conducted on arm’s length terms. Where arm’s length pricing is not in place, adjustments must be made when filing the CTSA return.
• One bit of good news is that small and medium sized businesses (1) (fewer than 50 employees and either turnover or assets of less than Euro10m) will be at least partially exempted from the transfer pricing rules. But transactions with some countries (2) will still be caught whatever the size of the business. And, for medium sized businesses, the Revenue has given itself the option to apply the rules if it believes that transfer pricing issues are significant. We do not yet have details of this, but this appears similar to the old ‘direction’ found in the pre-CTSA transfer pricing rules.
• For other than small or medium sized companies, there will continue to be a requirement to apply the transfer pricing rules when filing a CTSA return – but, for the first time, this requirement will apply to both UK/UK and cross-border transactions.
• For all companies, there will be a relaxation of penalties in relation to documentation for a two year transitional period for accounting periods beginning on or after 1st January 2004. During this period, in theory at least, no penalties will arise for failure to keep transfer pricing documentation. This does not mean that penalties will no longer be in point at all – tax geared penalties will still apply in the event of negligence in filing a return but only where this is apparent other than through the absence of documentation.
• Corresponding adjustments may be claimed to prevent double taxation when applying the rules for UK/UK transactions.

As regards thin capitalisation:

• The existing thin capitalisation rules in S209 ICTA 1988 are to be repealed and thin capitalisation will instead be dealt with under Sch 28AA only. This will, now, apply to UK/UK financing as well as to cross border financing.
• This means that companies must consider the borrowing capacity of UK borrowers, even in relation to purely UK/UK loans and interest must be disallowed on any part of a loan that would not have been made available (or would not have happened at all) at arm’s length.
• The exemptions for small and medium businesses described above will also apply to thin capitalisation.
• In considering borrowing capacity, the same criteria apply as before – ie what would a third party lender be willing to lend? ‘Would have’ arguments continue to apply.
• The grouping rules contained in S209 will not be carried over to Sch28AA. This means that the debt capacity of any borrower must be considered on a purely stand-alone basis – that is, based on the assets and income of that company (including its investment in subsidiaries). Any borrowing capacity arising from membership of a wider group must be ignored, including explicit or implicit guarantees.
• Corresponding adjustments will be available. In the event of disallowed interest on guaranteed debt, the guarantor may be able to claim the corresponding adjustment.
• If loans between UK companies are not arm’s length terms, the interest rate must be adjusted accordingly.
• Withholding tax can potentially apply on ‘excess’ interest, but it will be possible, on a claim, to pay this interest gross.

What transactions fall within the Scope of the New Rules?

Transfer pricing rules impose arm’s length pricing for every transaction between connected parties. Whenever anything of value is provided by one company to another it is necessary to consider whether inter-company pricing should be in place and ensure that that pricing is at arm’s length. This includes services, intangibles and funding as well as transactions in goods. It is impossible to list all of the transactions that are potentially caught but they include:

• Inter-company services (including head office support services)
• Funding. Any loan must be on arm’s length terms (including whether it would or could have been made in the first place)
• Guarantees
• Employee stock options
• Transactions (including loans) with dormant companies
• Intangibles such as brands, patents, know-how etc

Documentation Requirements

Revised Guidance

The Revenue used the pre-budget report statement as an opportunity to release draft revised guidance on documentation requirements and to add to the previous statements and policy on the conduct of transfer pricing enquiries as earlier set out in Tax Bulletin 60. The new draft documentation guidance sets out the types of documentation that the Revenue expect companies to keep and makes a distinction between ‘records’ and ‘evidence’. There is also a repeated reference to the level and extent of documentation being dependant on an assessment of risk. This mirrors closely the Revenue’s approach to audits where the precursor is a risk analysis – what tax is at stake and is manipulation of pricing likely? Thus for documentation, the level and depth of analysis should be dictated by the amount of tax at stake if the transfer pricing is wrong. In relation to the types of documentation, ‘records’ include primary records which companies might be expected to keep in the normal course of their business.

This includes routine accounting and tax adjustment records. Specific mention is made of records of transactions with associated businesses (to which the transfer pricing rules apply). All of this is routine record keeping and, as such, is neither surprising nor new.

‘Evidence’ refers to the ability to demonstrate that the transfer pricing meets the arm’s length standard. This refers to the specific work that companies must carry out to determine and/or demonstrate arm’s length pricing. The guidance cross-refers to the OECD Guidelines and includes a list of the types of records that might be used to provide that evidence. In keeping with previous guidance, the Revenue does not take a prescriptive approach – either in terms of the actual records to be kept or the form those records might take.

One new feature of the guidance is the suggestion that, while evidence should be provided to the Revenue within a reasonable time period after requested, it is not necessary to have that evidence prepared and ready to provide to the Revenue until that time. This leaves businesses with a dilemma. On the one hand, where the transfer pricing rules apply, there is still a requirement to file returns in accordance with the arm’s length principle. Companies must do something at that time to satisfy themselves that this is requirement is fulfilled. Indeed, the draft guidance states that a business would expose itself to the risk of a penalty if cannot make evidence available to the Revenue or if the evidence it does make available does not demonstrate a ‘reasonable attempt’ to get things right. On the other hand, the Revenue is indicating that it is not necessary to formally document this evidence until asked for. This suggests something of a two stage approach with evidence existing as at the time of the return, perhaps in skeleton form, but not necessarily fleshed out into a form to be supplied to the Inland Revenue until requested to do so.

The new draft guidance on documentation requirements is accompanied by further guidance on the conduct of transfer pricing enquiries. This is a particularly curious document that appears to conflict with the very extensive guidance to Inspectors contained in the recently published International Tax Manual. It is also not clear how this fits with guidance on risk assessment published in Tax Bulletin 60. It seems that the paper was designed to deliver a simple message connected with the approach to documentation and is summarised in the extract below:

” The length to which a business needs to go to establish whether a result is an appropriate ‘arm’s length’ result depends on a number of factors, including the amount of tax at stake. Where the amount of tax at stake is large, the business can expect the Inland Revenue may take an interest in whether the results have been established in an appropriate way and the business may well want to take steps to ensure that it has adequate evidence to support its position. But where the amount of tax at stake is not large, the business is entitled to expect the Inland Revenue will not make detailed enquiries and not request excessive amounts of evidence”.

We assume that the message we are meant to take from this is that the Revenue does not want to impose burdensome documentation requirements where the amounts at stake are not large – which is frequently the case with UK/UK transactions. While, on the face of it, this is a sensible approach that could be welcomed, it again leaves businesses with a dilemma. On the one hand, the Revenue is indicating that, with low risk transactions, there may be little chance of an enquiry.

On the other hand, we know that, in order to remain EU compliant, the Revenue must treat UK/UK transactions in the same way as it does cross-border transactions and it must be seen to do so. There is no guarantee that the Revenue will not attack the pricing on even the lowest risk transaction. Indeed, in cross border transactions we increasingly see the transfer pricing rules applied in relatively small cases where little is at stake. A ‘nod and a wink’ from the Revenue that it will not fully administer its new rules does not provide the sort of certainty business is looking for.

Temporary Relaxation of Penalties

The draft proposals include a two-year relaxation of penalties on companies for failure to maintain adequate transfer pricing documentation. There are two parts to this. The first is the general CTSA penalty (£3000) for failure to maintain adequate documentation. This will be disapplied in relation to transfer pricing documentation. The second is the penalty for submitting an incorrect return as a result of negligence or fraud. This penalty remains in place, but will not be enforceable where the only reason that negligence is contended is failure to maintain adequate documentation.

This is a somewhat confused initiative and it is far from clear what this will mean in practice. It should not be forgotten that companies continue to be obliged to file their returns in accordance with the transfer pricing rules. And penalties will still apply if the return is incorrect due to negligence. Furthermore, the concept of ‘negligence’ will continue to hinge on whether a reasonable attempt has been made to get the transfer pricing right. How can this reasonableness ever be demonstrated other than by some documentation of the efforts and analyses used to determine or test the transfer price?

So What Will Change?

The Government has felt the need to introduce pointless new rules to protect its existing cross border regime from a EU challenge. Many transactions will pose little or no tax risk. That is, any adjustment, when considered in conjunction with a corresponding adjustment, will not increase or decrease UK tax liability. For these transactions, it makes little sense to police these new rules. But the Government knows that it will have to be seen to do so.

There will be no winners when it does. It is aware of the compliance burden associated with the new rules and has taken some steps to reduce this. The revised guidance is very focused on the connection between documentation and risk and companies should bear this in mind when developing their strategies for dealing with the new regulations.

As far as the ‘low risk’ UK/UK transactions are concerned, there is probably a low likelihood of enquiry and, even then, any enquiry is likely to result in little tax effect. However, the government’s approach here has been communicated by ‘hint and suggestion’ rather than by clear guidance and, even for these low risk transactions, no company can be sure that it is immune from the occasional Revenue attack. Companies need to be ready for such an attack, but, for these transactions, basic documentation should suffice. This might for instance be little more than a record of the transaction (or group of transactions or transfer pricing policy) and a statement of why the pricing is considered to be arm’s length.

But, there will be other UK/UK transactions that pose a much greater risk. These include, for example, those that can be used as a ‘comparable’ for identical cross border transactions, or those that are part of tax planning solutions (perhaps using interest free loans).

We can expect the Revenue to focus on these and use their new powers to attack arrangements they do not like. These transactions need to be identified and addressed at an early stage.

For cross border transactions, there is likely to be little change to the current approach. Clearly, cross border transactions pose a much greater risk to UK tax revenue and the Revenue can be expected to pursue these in the same way as before. Indeed the publication of the new International Tax Manual, which includes very detailed advice to inspectors on transfer pricing issues, marks a

renewed determination to investigate transfer pricing. This Manual, which represents significant investment by the Revenue, contains detailed instructions to inspectors on the conduct of transfer pricing and thin capitalization enquires and is intended to increase the amount of transfer pricing work carried out ‘on the ground’.

In all cases, it is necessary to ensure up-front, when filing a return, that the pricing is supportable, even if formal documentation of the analysis and conclusions is deferred until a Revenue request.

What Do Companies Need To Do Now?

Companies need to understand how the new rules will affect them and then take targeted and focused action. This means they should:

• Assess whether they benefit from the exemptions for small or medium sized businesses and identify all transactions that potentially fall within the new rules, including transactions with non-exempt counties.
• Identify transactions that may be ‘disregarde’ under Sch 28AA, where, for example, substance and form diverge.
• Identify the impact on any implemented solutions that involve UK/UK transactions.
• Identify high risk transactions- where adjustments would have a significant tax effect and where penalties may be in point.
• Identify tax planning opportunities in UK/UK transfer pricing.
• Develop a strategy for dealing with the rules. This might include reducing the number of legal entities involved.
• Develop a compliance strategy. This might include introducing new pricing, changing existing pricing or adjusting for pricing in the tax computation if corresponding adjustments may be secured on a claim. It may also include seeking some advance comfort from the Revenue.
• Document according to risk. It seems at the moment that the Revenue is not expecting blanket extensive documentation of all UK/UK transactions. Rather, there should be a tailored approach that considers the risks inherent in each transaction and to fully document the ‘high risk’ transactions whilst applying a lighter touch to transactions with a low risk profile. This follows a sensible risk assessment approach and also reflects the Revenue’s approach – to concentrate their efforts where there is tax at stake. A similar approach may be taken for cross-border transactions.
• Develop a strategy for funding. This must manage thin capitalisation issues in the light of the availability of corresponding adjustments.
• Develop an action plan for implementing and monitoring the strategies.

With the new rules expected to come into force from 1 April 2004 companies face a challenging time in dealing with year-end pressures and in ensuring they avoid the worst of the traps that the new legislation brings.

1 Small businesses are those with fewer than 50 employees and either turnover or assets of less than Euro10m. Medium sized businesses are those

with fewer than 250 employees and either turnover of less than Euro 50m or assets of less than Euro 43m.

2 Those with which the UK does not have a double taxation treaty containing a non-discrimination article.

David Evans is Director in International Tax Services and Head of Ernst and Young’s EU direct tax group

Colin Clavey is Senior Manager in Ernst and Young’s Transfer Pricing Group