Corporation tax and transfer pricing

For many years, transfer pricing rules protected the UK tax base. These rules were introduced to catch cross border transactions, on non-arm's length terms, between connected parties. However, as a result of the Inland Revenue's aversion to recent EU court decisions, the UK transfer pricing regime was radically changed with effect from 1 April 2004, and further tightened in 2005. The changes bring transactions between connected UK companies into the UK transfer pricing regime, and at the same time create exemptions for small or medium sized enterprises (SMEs) under EU criteria. In addition, failure to maintain sufficient records justifying your UK to UK pricing will incur penalties, although they will not be enforced in the period up to 31 March 2006. However, if the profits arising after 1 April 2004 are incorrect, a tax penalty can be imposed in addition to the outstanding tax and interest thereon.

What effect do the changes have?

An arm's length transaction does not take place unless the terms for any transaction(s) between connected parties are those which would apply if the transaction(s) had been undertaken between independent parties.
If your UK company, which is not an SME, 'transacts'¹ with another UK connected party on non-arm's length terms, and you have consequently understated its income or overstated its deductions, you are now obligated to make a transfer pricing adjustment in your corporation tax return. The adjustment must be to increase profits, or decrease losses, to reflect the application of the arm's length principle in the transaction.
If the other party in the transaction is within the charge to UK tax, they can also generally claim a corresponding adjustment. This will not necessarily equate to a neutral result for both companies together, however. For example, the company making the transfer pricing adjustment may have an increased tax liability, whilst, for example, due to losses carried forward, the company claiming the compensating adjustment may not obtain any immediate tax benefit by doing so.

Are there any exemptions?

To qualify as an SME, your group, or stand-alone company, must have less than 250 employees and either a turnover of less than €50m, or assets of less than €43m. If you do qualify, then transactions with other UK parties (or with parties in a number of foreign countries, typically non-tax haven jurisdictions) will not need to be adjusted to arm's length prices. espite this classification, the Revenue has retained the power to apply the rules to medium sized enterprises if they perceive the need arises.
There are no exemptions specifically for companies in the same UK group of companies. or is there any exemption from the rules for dormant companies, except where the company was already dormant as at 31 March 2004. requently dormant companies have old balances, owing intra group, on interest free terms.

Which transactions will be affected?

The legislation is widely drawn and aims to catch any series or type of arrangements, understandings and mutual practices involving connected parties. Consequently, you should not only consider whether the price paid for something is too high, but also whether income has been undervalued, or perhaps not even recognised. For example, appropriate tax return adjustments would have to be made if a UK parent company guaranteed the borrowings of a UK subsidiary (where no arm's length charge is made to the subsidiary as a guarantee fee) who could not independently have borrowed on the same terms. There are numerous other examples of transactions that will be affected, including:

companies which are thinly capitalised as a result of owing interest incurring amounts to other group companies (when compared with interest cover and shareholders' funds);
companies which have amounts owing to them from other group companies on interest free terms;
companies which provide services to other group companies in circumstances where an arm's length charge is not made. This might include in certain cases, the provision of shares or options to employees of group companies.
Specific exclusions do exist where other legislation applies to transactions between connected persons. This is the case with capital gains and capital allowances, where 'market value' is often substituted. It may also apply where a UK branch transacts business with the head office of a non UK company.

What action is needed?

If none of the above exemptions apply, you should review all transactions with connected parties including: debt levels; guarantees; interest; rents; royalties and management charges; as well as transactions in physical goods and the provision of services. You will also need to compile and retain documentary records justifying the prices used. Please be warned that failure to comply can result in penalties. The Inland Revenue states that the documentation should include:

a record of the commercial or financial transactions affected;
the nature, terms (eg. prices) and quantum involved;
the method by which the above were arrived at, including a study of comparables;
evidence of how the method has resulted in arm's length terms; and
contemporaneous commercial agreements (e.g. distribution contracts and loan agreements), any budgets and forecasts or other information relied upon.

The Revenue has indicated that the degree of research and documentation expected will reflect the levels of taxation at stake.

And finally

This Taxflash outlines the key aspects of the current transfer pricing rules affecting companies. Please be aware that the transfer pricing rules are also applicable to partnerships, and to transactions that a company or partnership may undertake with an individual or a trust. For further guidance regarding the above or any other aspects of the transfer pricing rules, please contact your local UHY Hacker Young tax partner or manager.

Additional notes:

Connected parties: parties involved in a transaction, where one directly or indirectly controls the other, or where both are under common control. The expression may also apply where two or more persons act in concert to control ownership, or a person acts together with another person or persons who have control.
Control: includes present and future rights and powers, exercisable by a person, on their own behalf, for their own benefit and, if applicable, by their spouse, other relative or by a trustee of a settlement where the person is the settlor.
Joint ventures (JV): Although one party in a JV may not control the JV enterprise (whether a company or a partnership), if they and another involved party each 'control' at least 40% of the interests, rights and powers in the JV enterprise, the transfer pricing rules consider those parties connected with the JV enterprise.
¹ Transacts: 'in a very broad sense including any arrangements or understanding regarding the provision of any service or facility.'

April 2006

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