CTSA - taxflash no.4

This is the fourth Taxflash in our series designed to inform clients about the changes to CTSA, in this case in relation to transfer pricing. If you would like copies of our earlier Taxflashes please let us know.

Introduction

In its simplest form transfer pricing relates to a transaction where a price is set between connected persons which results in either reduced profits, or increased losses, for the UK taxpayer, leaving the offshore taxpayer in a position to make a larger profit. Transfer prices affect not only the transfer of goods but also the supply of services or the provision of or transfer of assets, including money. Associated persons have the opportunity to set transfer prices, and hence profit levels, between themselves at any particular level, where there is common ownership or control. They may have many reasons for setting price levels to favour one of the related parties.

The Inland Revenue have long perceived the need to regulate such transfer prices to prevent the avoidance of tax by these means.

The background of change

There is no clearer indication of the meaning of self assessment than provided by the new rules relating to transfer pricing and the change in emphasis from Inland Revenue led enquiries to enforced taxpayer adherence. In other words, whereas in the past the Inland Revenue had to challenge the arrangements to make an adjustment, now it is the taxpayer's obligation to use arm's length prices and retain the records to prove the point. Failure to do so can result in penalties.

Transactions Affected

This legislation is widely drawn to cover transactions or a series of transactions of any kind.

Specific exclusions are provided where other legislation already places constraints on transactions between connected persons, as in the case of capital gains tax, capital allowances, financial instruments and foreign exchange regulations, where 'market value' is often substituted.

Associated enterprises and control

Enterprises are associated with one another where one of the parties to the transaction directly or indirectly participates in the management, control or capital of the other, or a third person controls both parties to the transaction. Control is widely defined to include rights and powers exercisable by a participant directly or by other persons on the participant's behalf, at their direction or for their benefit.

Joint ventures (JV)

Although a participator in a JV may not control a JV enterprise (whether a corporate body or partnership), if he and another participator each control at least 40% of the interests, rights and powers of the JV enterprise, the transfer pricing legislation will apply. The extended definitions given under associated enterprises and control apply equally in this instance.

Exemptions

Some transactions that take place within the UK may be generally exempted from the legislation provided one of three conditions are met, namely : -

UK taxing of profits - Both or all the parties are within the charge to UK income tax or corporation tax on the transaction(s), and must not be entitled to exemption from that charge, and where income tax is involved, that party must be resident in the UK for the years where the transaction is charged.
Double tax treaty relief - Neither party must be entitled, on the profits arising from the transaction(s), to double tax relief in respect of foreign taxes under the relevant treaty convention.
Domestic relief for foreign taxes - Neither party must be entitled to claim the foreign tax as an expense from the profits.

Arm's length principle

If these conditions are not met the legislation imposes an obligation on the taxpayer, who has gained an advantage, to increase profits on the transaction(s) by substituting a price derived under the arm's length principle.

This principle is that the appropriate transfer price, for any given transaction(s) between associated persons, is the open market price that would have applied had the transaction been between unrelated persons acting at arm's length.

Records

In addition there is a legal requirement to maintain records to satisfy the Inland Revenue that the arm's length price has been considered for all affected transaction(s). Failure to maintain adequate records can lead to fines of up to £3,000. Thus it is imperative that all cases where the arm's length principle will apply are identified and appropriate records put in place before the end of the first accounting period under CTSA, as well as setting up routines for later periods.

Advanced pricing agreements (APA)

It is possible for a taxpayer to enter into an APA with the Inland Revenue to agree, in advance, the price to be used in transaction(s) over a period of time. This may be desirable in particular cases where problems are foreseen and obtaining an APA may prevent later problems.

Action required

Review all transactions with connected parties, including interest, rents, royalties, management charges, as well as the sale of goods or services and retain records justifying the price set. Please contact the tax partner or manager with whom you normally liaise for further guidance.

Every effort has been made to ensure that the facts in this document are correct at the time of going to press. No responsibility for loss occasioned to any person acting or refraining from acting as a result of any material in this publication can be accepted. Authorised to carry on investment business by the Institute of Chartered Accountants in England & Wales.

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