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Introduction to UK transfer pricing
Transfer pricing rules
- The UK’s transfer pricing (TP) legislation is in the Taxation (International and Other Provisions) Act 2010 (‘TIOPA 2010’) Part 4, and is based on the arm’s length principle as per Article 9 of the OECD Model Tax Convention on Income and Capital, ie it follows the OECD Guidelines. The rules are not heavily formulaic but instead are principles-based.
- The TP rules apply to UK taxpayers, including UK branches of overseas companies and there is a self-assessment regime, ie the onus is on the taxpayer to confirm its transfer pricing meets the standard or to adjust its tax return accordingly.
- The regime is a 'one-way street', ie upwards-only adjustments are permitted, and offsets between years and entities may not be accepted.
- For larger groups (over €750m) the UK has implemented Country by Country Reporting (CbCR).
- Changes to the transfer pricing documentation requirements will apply from accounting periods commencing on or after 1 April 2023.
- The documentation requirements will be implemented via regulations (i.e. a Statutory Instrument) which will specify that Master File, Local File and Summary Audit Trail documents must be kept and provided to HMRC on request within 30 days.
- The Master File and Local File will need to contain all the information set out in Annexes I and II to Chapter V of the OECD Transfer Pricing Guidelines.
- The documentation should be prepared in advance of a company filing its UK corporation tax return and this point is to be reinforced by changes to the legislation on penalties in Schedule 24 to Finance Act 2007.
- The UK’s transfer pricing rules follow the OECD Guidelines. The Guidelines, updated in January 2022 are mentioned in UK legislation, and unlike in many countries, they must be used for interpretation of the arm’s length principle.
- Her Majesty’s Revenue and Customs (HMRC) has an International Manual providing guidance for Inspectors on its view of transfer pricing matters, and much of this content is publicly available.
Transfer pricing methods
- The most appropriate pricing method should be selected on a transaction by transaction basis, providing the most reliable measure of an arm’s length result in each case. The current OECD methods, namely the comparable uncontrolled price, resale price, cost plus, transactional net margin, and profit split methods are all accepted but the method used must be in line with the functional and risk profile of the entity. Other methods can also be used if justifiable and appropriate.
- There is no set hierarchy as the UK legislation currently refers to the 2022 OECD Guidelines. In practice, however, a ‘natural hierarchy’ may be said to favour the comparable uncontrolled price method.
- The UK has a self-assessment regime, where the onus is on the taxpayer to ensure that transfer pricing regulations are adhered to. There is a ‘tick box’ on the tax return form for taxpayers to confirm their eligibility for the small and medium-sized enterprise (SMEs) exemption from the transfer pricing rule, and a second ‘tick box’ for taxpayers to claim corresponding adjustments (for UK–UK transactions). HMRC requires taxpayers to make computational adjustments in cases where transactions, as recorded in the statutory accounts, are not on an arm’s length basis and the taxpayer is potentially advantaged in respect of UK tax.
Transfer pricing documentation
Preparation of transfer pricing documentation
- The UK accepts the OECD transfer pricing documentation model based on the Master File and Local File templates. This approach is considered best practice in the UK.
- Lack of carefully prepared documentation will generally be seen as (at least) 'careless' behaviour and any adjustment will likely result in penalties.
- The UK introduced CbCR regulations for fiscal years starting on or after 1 January 2016 for groups with revenues over €750m.
- Any documentation should be prepared in English and be available by 12 months from the accounting period end, before the tax return is submitted.
- Currently the HMRC manuals refer to four types of documentation that should be kept:
- primary accounting records
- tax adjustment records
- record of transactions with associated businesses
- documentation to demonstrate an arm’s length result.
Master and UK local file
- From April 2023, large businesses will be required to maintain a Master File and Local File, and a supporting Summary Audit Trail. The definition of ‘large’ will align to the CbCR threshold: ie, multinational groups with annual consolidated revenue in the immediately preceding period of equal to or more than EUR 750 million are considered ‘large’. This legislation has not yet been finalised.
- HMRC is also introducing the Summary Audit Trail but there is limited detail as to what information will be required.
- HMRC has confirmed the 30-day timescale for the provision of the Master File, Local File and SAT following request. The purpose of the Master File and Local File is to support the transfer pricing policies underlying the filed corporate tax return, and therefore should be prepared in advance of the annual filing.
- Where a group self-assesses that all of its international related party transactions are immaterial (not yet defined), HMRC does not intend to require it to complete a Local File or make an annual declaration. Instead HMRC expects such groups to keep a record of any analysis undertaken to support that self-assessed position and provide that analysis upon request, within the same 30-day time scale as for documentation.
- Currently, unless a group is covered by the UK’s Small and Medium Enterprise exemption, then profits or losses should be calculated with reference to the arm’s length principle. Records and evidence are required to be kept in order to demonstrate to HMRC that the results of transactions with related businesses are determined with reference to the UK’s transfer pricing rules and the application of the arm’s length principle. Transfer pricing documentation should be proportionate to the nature, size and complexity of a group’s business and consist of information and records relating to a period covered by the tax return.
- In reality since the publication of the BEPS Action 13 report and the updated OECD Guidelines, more and more groups have been using the OECD Local File and Master File templates to prepare their transfer pricing documentation – whether they cross the EUR 750 million threshold or not. We have also found in our experience that this is expected by HMRC tax Inspectors.
- Transfer pricing documentation must be preserved until the latest of six years from the end of the accounting period, the date on which any enquiry into the return is completed, or the date on which HMRC is no longer able to open an enquiry.
- Changes to HMRC information powers specifically in relation to obtaining transfer pricing related records (which will be defined in the regulations to be laid) will also come into force from April 2023. Changes are to be made to ensure that the relevant transfer pricing documents can be requested outside of an enquiry and to remove the requirement for the documents to have to be in the ’possession or power’ of the UK entity in question when they are in the ’possession or power’ of another person within the multinational group.
Some risk factors for challenge
- High risk business models include commissionaire and toll manufacturing.
- Limited risk distributor and contract services/ contract R&D arrangements could also potentially be affected, especially where significant people functions are in the UK.
- Persistent losses in a 'low risk' entity.
- Licensing payments to low tax jurisdictions.
- Business restructurings, or changes in TP model, can also trigger a challenge but needless to say, businesses can evolve, and if the previous TP method no longer appears the most appropriate, it should always be reviewed, rather than being ignored for the sake of maintaining consistency.
- Penalties in relation to transfer pricing documentation are derived from the general record-keeping requirements. Two main types of penalties may apply; penalty for failure to keep or produce documentation and a tax geared penalty for a careless or deliberate error.
- The fixed penalty for failure to keep or produce documentation records is currently £3,000. From April 2023, for large businesses, failure to do the work necessary to maintain the relevant records or to produce those records on request will lead to the presumption that an inaccuracy is careless. The taxpayer can only displace this presumption by providing the documents and evidencing the underlying transfer pricing information had been prepared in advance of filing their Corporation Tax return, or otherwise showing they took reasonable care.
- The tax-geared penalty dependent on whether the inaccuracy is considered:
- careless (maximum penalty of 30% of potential lost revenue (PLR))
- deliberate but not concealed (70%)
- deliberate and concealed (100%).
- Where there is a reduction in the amount of losses carried forward, a penalty of 10% of the reduction may be due.
- A business may receive a mitigation of a penalty for behavioural factors and/or if it had made a reasonable attempt to demonstrate an arm’s length result.
- An enquiry into a tax return by HMRC may be made up to 12 months from the due filing date of the tax return, unless the return is filed late in which case the enquiry can be made 12 months after the return is filed. In practice, this usually means two years from the end of the accounting reference date, and if no enquiry notice is issued then the tax return may be considered closed.
- HMRC may in certain circumstances make an enquiry on a company for prior years (a 'discovery' assessment) under certain circumstances. Discovery assessments can be raised where the loss of tax is not due to careless or deliberate behaviour– up to four years; careless– up to six years; deliberate– up to 20 years.
- Non-compliance with CbCR and notification requirements can draw penalties ranging from £300 to £3,000. Daily penalties may also apply where information is consistently not provided
Economic analysis and how to demonstrate an arm’s length result
- HMRC will expect to see that a search for potential internal comparables has taken place before defaulting to an external database search for comparables. The only exception is when the Simplified Approach is used for Low Value Adding Services (LVAS).
- Where the Simplified Approach is adopted it should be applied, as far as is possible and practicable, consistently on a group-wide basis.
- The group should maintain documentation detailing:
- the nature of each category of low value-adding intra group services and why they are believed to fall within the definition;
- the benefits believed to be received by the recipients of those services;
- the allocation keys adopted for each category of low value-adding services and the reasons they are believed to be appropriate;
- relevant contracts between the parties; and
- calculations of the charges made by or to relevant group members in accordance with the process outlines in HMRC’s guidance.
- Local comparable companies are preferred, whilst EMEA or regional comparable companies can be accepted.
- Note that where databases are used, contrary to popular understanding, there is no specific requirement that the interquartile range be used (however, it will often be calculated as a means to eliminate outliers, given that incomplete information will always be an issue in external database searches).
- Note also that HMRC is not permitted to use 'secret comparables'. There are also no published TP 'safe harbours' or norms in the UK, and the key is always the facts and circumstances of the specific case.
Advance Pricing Agreements (APAs), dispute avoidance and resolution
- Advanced Pricing Agreements (APAs) are written agreements between a business and HMRC to govern the appropriate transfer pricing method for a forward-looking period.
- APAs are also used in financing and thin capitalisation cases, where they are known as ATCAs.
- HMRC no longer accepts unilateral APAs (excluding ATCAs).
- They will not allow 'DIY MAP' or downwards profit adjustments by taxpayers on their tax returns.
- The UK has an extremely extensive treaty network, and the Mutual Agreement Procedure (MAP) will often be available when double tax occurs.
- There is no charge for APA or MAP, unlike in many countries, but HMRC may refuse to accept a case, for example where it is deemed insufficiently complex.
- It is UK policy to allow for arbitration in the event that agreement cannot be achieved and it will seek to include such a provision in its tax treaties. Following the UK’s departure from the EU, the EU Arbitration Convention will no longer be available, but the UK has ratified the OECD Multilateral Instrument (MLI) and hence where the other country (treaty partner) has also agreed, arbitration should be available to eliminate double taxation. NB this must be checked on a country by country basis.
- For 2020-21, the number of enquiry cases have decreased (albeit by 1) for the first time in five years, and there has been a corresponding drop in APA applications from 29 to 24. There has also been a greater number of APA applications being withdrawn and rejected. 11 applications were withdrawn, compared with 4 the year before and 4 applications were rejected compared with none the year before. 24 APAs were agreed this year which is a decrease of 2.
- The implication is that there is appetite from taxpayers to apply for APAs but that either the conditions are too restrictive to enter into the programme, or other elements such as length of process or macro-economic conditions are causing them to have second thoughts.
- 23 ATCAs were agreed in 2020-21, compared with a peak of 164 in 2015-16 and the number of ATCAs in force has also dropped dramatically with 97 in 2020-21, and 568 in 2015-16. With the introduction of the Corporate Interest Restriction it is no surprise that the popularity of ATCAs is on the decline. Unilateral ATCAs are however still useful in certain situations when certainty or transparency of interest deductions is required.
- 62 MAP cases relating to transfer pricing and permanent establishments were resolved in the period 2020-21.
- There are exemptions from transfer pricing documentation rules for SMEs, dormant companies), charities, and life assurance companies. The SME exemption only applies if the transactions are between a UK taxpayer and a related party in a qualifying territory, which is broadly a territory that is not a tax haven.
- The exemption criteria are based on EU recommendation 2003/361/EC as follows:
- Small: less than 50 employees, and either turnover or gross assets not exceeding €10 million
- Medium: less than 250 employees and either turnover not exceeding €50 million or gross assets of less than €43 million.
- HMRC can direct that medium-sized enterprises should apply transfer pricing rules, though this is uncommon in practice.
The profit diversion compliance facility (PDCF)
- HMRC launched a diverted profit tax (DPT) disclosure facility in January 2019 with the aim of encouraging groups who-ich may have previously used arrangements of a type targeted by DPT to reconsider their transfer pricing policies or restructuring as appropriate.
- DPT is a targeted additional tax in place since April 2015 which brings the rate up to 25% (the main corporate tax rate is 19%) to counter 'contrived arrangements…that…erode the UK tax base'.
- HMRC believes that this compliance facility gives the opportunity for businesses to come forward and in many cases to avoid the penalties for 'prompted' disclosures
- One of the underlying drivers for the facility was that in many cases where UK profits appear suppressed, it may in fact be the transfer pricing that should be updated.
- This facility may potentially be relevant where cross border arrangements that have not been reviewed in recent years, where the functional profile has changed, where transfer pricing policies are based primarily on the contractual assumption of risk and legal ownership of assets and where there are inappropriate or out of date comparables.
- High-risk business models, as noted above, include commissionaire and toll manufacturing. Those with limited risk distributor and contract services/ contract R&D arrangements could also potentially be affected.
Digital services tax
- The new digital service tax (‘DST’) is a rate of 2% applied to specific types of revenue arising from digital services and applies from 1 April 2020.
- The tax applies to three main categories of business:
- Search engines
- Social media platforms; and
- Online marketplaces.
- The DST is not a tax on the online sales of goods, but it applies to revenues earned from intermediating those sales.
- It is relevant to businesses that generate revenues of at least £500 million. In addition, the first £25 million of UK revenues will not be taxable. These thresholds are designed to ensure that smaller businesses and start-ups are out of scope.
- The UK has stated that it prefers a multilateral solution to these issues and is participating in the OECD discussions on the Pillar One and Pillar Two proposals.
HMRC and taxpayer behaviour
- HMRC has recently placed a great focus on improving the standards of transfer pricing documentation and economic analyses via reviews of taxpayer and agent 'behaviour'. It will expect local reviews of functions, assets and risks, accurate characterisation, and high-quality TP documentation, otherwise penalties may be sought. HMRC is very keen to stress the benefits of 'ooperative compliance'.
- The economic fallout of COVID-19 is likely to have widespread impact and an increase in TP, DPT and Corporation Tax enquiries globally is expected. All MNCs should be reviewing their potential exposure to transfer pricing enquiries and DPT and updating documentation accordingly.
- It is also likely that HMRC will continue to focus challenges towards companies with commissionaire/LRDs and 'cost plus' service entities, especially where they are claiming losses because of the pandemic.
- Where supply chains have been disrupted or work brought to a halt due to lockdown measures, expected profits may not eventuate. Comparable companies will often have been affected in the exact same way as multinational groups, but evidence must be gathered and documented contemporaneously.