TRANSFER PRICING Ros Martin CTA January 2018 INTRODUCTION The - - PowerPoint PPT Presentation

TRANSFER PRICING

Ros Martin CTA January 2018

INTRODUCTION

The basics

■ Transfer pricing looks at situations where profit is being diverted from one entity to another ■ It is assumed that this is being done to save tax ■ Opportunity will normally exist where connection between companies ■ Main provisions found in TIOPA2010

Example

■ A Ltd (UK) sells goods to its 100% subsidiary B Inc (US) for £100. The goods were purchased by A Ltd for £80 and have a retail price to third parties of £150. ■ Profit for A Ltd if sold to a third party would be £70 (150 - 80), but through the inter-company arrangement profit is only £20 (100 - 80). ■ B Inc then makes the remaining profit of £50 (150-100) so that the overall profit to the group remains the same.

OECD

■ Transfer pricing is often about cross-border transactions ■ Although can apply UK to UK ■ Agenda is set by OECD ■ Extensive guidance issued by them ■ UK legislation is based on OECD model

What does the legislation do?

■ Imposes an arm’s length price on affected transactions ■ But subject to exemptions ■ And provision made for compensation adjustments ■ And balancing payments

THE RULES

Basic transfer pricing rules

■ where associated enterprises are party to a transaction other than on an arm's length basis, and ■ that transaction has the potential to give rise to a UK tax advantage for one of the parties, ■ the taxable profits and losses of that party are to be calculated as if the transaction had been made on an arm's length basis.

Conditions

■ Provision by means of a transaction or series of transactions ■ Participation condition met ■ Actual provision differs from arm’s length provision between independent enterprises ■ Actual provision confers a potential advantage ■ Unless exemption applies

What is arm’s length provision?

■ Provision which would have been made between independent enterprises ■ This is the most difficult aspect of the transfer pricing rules

When is there a potential advantage?

■ Profits reduced ■ Losses increased ■ Profit turned into loss

Participation provision

■ One of the affected persons was directly or indirectly participating in the management, control or capital of the

• ther; or

■ The same person (or persons) was directly or indirectly participating in the management, control or capital of each of the affected persons.

Direct participation in management, control or capital

■ If A is a corporate body ■ And A is controlled by P ■ Control means power of P to secure that the affairs of A are conducted in accordance with their wishes – By means of holding shares or possession of voting rights in A or another corporate body – As a result of any powers conferred by the articles of association or other document regulating A or other corporate body

Indirect participation

■ Where P has the potential to be a direct participant in the management, control or capital of A ■ Where P is a number of major participants in P ■ Where P acts with other persons (Q) to provide financing arrangements to A ■ Where P acts with other persons (Q) to provide financing arrangements to both affected persons and would have control of both affected persons if the rights and powers of Q were attributed to P

Example

A Ltd C Ltd B Ltd 100% 100%

Example

A Ltd C Ltd B Ltd 100% 70% 30%

Example

A Ltd C Ltd B Ltd 100% 45% D Ltd E Ltd 40% 15%

Exemptions

■ Small or medium-sized companies or dormant companies ■ with regard to exchange gains or losses on loan relationship

• r derivative contracts

■ where the transactions are otherwise than between enterprises (broadly meaning a person with an intention to make a profit or gain or to undertake activity in a businesslike

• r commercial way).

■ with regard to the calculation of capital allowances ■ with regard to the calculation of any chargeable gain or allowable loss

SMEs

■ SMEs do not normally fall within transfer pricing provisions but – Can elect for exemption not to apply – Where affected person is resident in NQ territory can apply – Where entity is medium sized, HMRC can issue transfer pricing notice

Compensating adjustments

■ Basic provisions did not require an adjustment to be made by disadvantaged person ■ Often provided for in DTT ■ For UK to UK, there is a specific provision allowing this ■ Can also have affected person making tax neutral balancing payment ■ Or for the disadvantaged person to pay advantaged person’s tax

Additional points

■ Adjustments can be made regardless of normal time limits ■ DTR may need to be restricted ■ Some cases where no CA can be made – Disadvantaged person is not a company – Relates to exchange gains or losses from loan relationships or derivatives

Balancing payments

■ This is a payment made between connected persons to restore cash position ■ May be imposed if third party investors ■ Must meet conditions ■ If do, tax neutral

ARM’S LENGTH PRICE

Starting point

■ No right or wrong way to calculate an arm’s length price ■ Guidelines available to assist in the process ■ Issued by OECD

Basic principles

■ Comparability ■ Contractual terms ■ Functional analysis ■ Characteristics of property or service ■ Economic circumstances ■ Business strategies ■ Other points

Comparability

■ There must be a comparison between a controlled transaction and ■ A comparable transaction between independent parties under comparable circumstances ■ Need to – Identify commercial and economical circumstances – Taking account of industry – And factors affecting performance of business operating within that industry

Contractual terms

■ Needs to be examination of contractual terms ■ To determine division of responsibilities, risks and outcomes ■ May include written contracts ■ As well as communications between parties ■ Examination of actual relationship to see if anything is inconsistent with written contract

Functional analysis

■ Looks at activities undertaken in completion of contract ■ Identifies who takes responsibility, provides assets, takes risks ■ Compare these in controlled and independent scenarios

Characteristics of property or services

■ Are we talking about tangibles or intangibles? ■ Are these property or services? ■ What is the form of the transaction (license, sale etc) ■ Duration of transaction ■ Anticipated benefits

Economic circumstances

■ Must compare markets being served and include review of things like – Location – Size – Competition – Availability of substitutes – Supply and demand – Consumer purchasing power – Government regulation – Particular costs

Business strategies

■ What are the strategies of the business? – Innovation – Diversification – Risk aversion – Duration of arrangements – Market penetration schemes

Other points to note

■ Administrations should be disregarding transactions in only exceptional circumstances ■ Losses do not mean there is a problem but recurring losses might ■ Existence of particular workforce must be taken into account ■ Group synergies must be assessed

Transfer pricing methods

■ Five recognised methods – Traditional transaction methods

■ Comparable uncontrolled price ■ Resale minus ■ Cost plus

– Transactional profit methods

■ Transactional net margin ■ Profit split

Comparable uncontrolled price

■ Simplest method ■ Compares the price of a controlled transaction ■ With a comparable uncontrolled transaction ■ Looks at difference ■ Need to make sure no material differences between compared transactions ■ Preferred method but it is all about judging comparability

Example of problem

■ A manufacturer sells insulated jackets to a number of companies in different countries, who distribute the goods to the end user. In Ruritania, the climate is unusually mild all year round and therefore the associated distributor has to incur enormous marketing expenditure to shift any units. In Zenda, the climate is freezing all year round; the coats fly off the shelves as soon as the independent distributor can stock them. No marketing is

• required. The first distributor therefore has a much lower margin

than the second. There are prima facie differences between the transactions when the manufacturer sells to each party. Would these change the price the manufacturer would charge? Well they might: the Ruritanian distributor might (if he were independent) negotiate a lower price, in effect a subsidy for his marketing costs. The manufacturer might be willing to subsidise this if the alternative was a lack of sales in Ruritania. Alternatively the distributor might have to live with lower profits. You would have to find evidence of what would happen at arm's

• length. Differences between the markets in which the two

distributors operate might well affect the price which each paid for purchases. This would be true even if both bought exactly the same coats in the same number at the same time.

Example

■ A manufacturing company (X) manufactures the “TruBlender 3.0” This is a high-quality juice and smoothie maker aimed at the healthfood market. It is up to 5 times more powerful than the models of most competitors. The only competing manufacturer that can provide a juicer performing similarly is the Food Company, with its renowned “Dragon Blender.” ■ Now say that X has received an order from distribution company Y for the supply of TruBlenders. X and Y have the same shareholder (Z)

The two CUP options

■ X looks at the price for which it sells the TruBlender to a third party distributor (Internal CUP). ■ X looks at the price for which Z sells the Dragon Blender to a third party distributor (External CUP).

Resale minus

■ Purchase of goods for distribution from a connected party ■ Or sales price for a manufacturing company where product is distributed by connect party ■ Take known independent sale price then reduce with appropriate gross margin ■ Based on the costs to be incurred in making sale ■ And appropriate profit margin for selling enterprise ■ Obviously need to be able to calculate those figures

Example

■ Plum and Peach brews a very exclusive non-alcoholic beverage called “Fountain”. It sells this beverage to high-end nightclubs via associated distributors. The market price for one can of Fountain is £10. The company does not sell the beverage to independent distributors. Also, there is no company in the economic region in which it operates that brews a comparable beverage. ■ However, there are comparable distributors that sell a competing alcoholic beverage brewed by The Gin Company, called Spicer which is based in the same region. The market price for one bottle of this is also £10. The distributors report a profit of £2 and duty of £2 per bottle ■ No internal or external CUP exist

Example (cont)

■ However, it might be argued that the distributors of Spicer are comparable to the distributors of Fountain. The result is that the gross margin and custom duties reported can be used as input for the Resale Price Method. This would give a transfer price of £6 and so this would be the arm’s length price on a sale minus basis. ■ Of course, you would need to look carefully at this because, for example, customs duty might only apply to alcoholic

• beverages. The profit margin might also be different as this

is a different product.

Cost plus

■ Appropriate when no end market as semi-finished goods or provision of inter-group services ■ Take costs in making supply ■ Plus % then added to give appropriate profit margin ■ Calculated by reference to comparable uncontrolled transactions ■ Can be difficult ■ Often quite a random calculation

Example

■ Company X provides administrative support services such as invoicing and bookkeeping. There are many companies around that provide comparable services, including independent enterprise B. An associated company Y asks X is provide these services and you need to find the arm’s length price ■ Two methods – Internal cost plus method – External cost plus method

Transactional net margin

■ Quite problematic ■ As looking at this at transaction level rather than overall profitability of company ■ Again need to be looking at net cost plus or net resale minus

Example: net cost plus margin

■ Company X provides administrative support services such as invoicing and bookkeeping. Associated enterprise Y asks X to provide invoicing services. Y thinks that they need about 1,000 hours of such services. ■ X knows that the total cost of 1,000 hour of services is £125,000. In determining a potential arm’s length price, should find the terms and conditions (here: the price) of a comparable transaction. ■ There are many companies around that provide comparable services, including independent Enterprise B. X and B have exactly the same business model. Company X can look at Enterprise B to determine a good arm’s length price.

■ How to determine this price? As mentioned, first we need to find the ratio of operating profit to total cost. Say the total costs are £400,000 and the profit is £100,000. The net cost plus margin is 100,000/400,000 ie 0.25. ■ The second step is to use the Net Cost Plus Margin to calculate the arm’s length transfer price. To calculate the transfer price one simply has to add the Net Cost Plus Margin to the existing total cost. ■ We saw that the total cost of the services is £125,000. If we add to that amount the Net Cost Plus Margin of 0.25 (£32,250) we end up with a transfer price of £156,250 (or £156.25 per hour).

Example: net resale minus

■ Company X provides distribution services. Associated enterprise Y asks X to provide distribution services. This means that X should find the terms and conditions (here: the price) of a comparable transaction. ■ There are many companies around that provide comparable services, including independent Enterprise B. X and B have exactly the same business model. Company X can look at Enterprise B to determine a good arm’s length price.

■ How to determine this price? As mentioned, first we need to find the ratio of profit to turnover. Say there are sales of £500,000 and profit of £75,000. The net resale minus margin is 75,000/500,000 which is 0.15. ■ The second step is to calculate the arm’s length transfer

• price. For this, you simply charge a price at which the Net

Resale Minus Margin is 0.15. So if you know the overall sales

• f the items being distributed is £100,000 then we can say

that the transfer price should be £85,000 to give a margin of 15%.

Profit split

■ Often described as the method of last resort ■ Basically look at the profit for the transaction as a whole ■ Then work out how it would be split between the different stages ■ Huge difficulty working out the split ■ Two options – Contribution profit split method – Residual profit split method

Two options

■ Contribution profit split method – splits based on functions performed, risks assumed, assets provided ■ Assumes can put a value on each of those ■ If cannot then use the other option ■ Residual profit split method – looks at routine profit and then splits it on a holistic basis

Judicial commentary

■ DSG Retail and other v HMRC ■ Quite an old case ■ But does give a good idea of practical problems

THIN CAPITALISATION

Introduction

■ Brought into transfer pricing regime with effect from 1 April 2004 ■ Where money is put into company as loans rather than equity ■ Because enables a deduction for interest ■ Would not get for dividends ■ Thinly capitalised where debt:equity ratio is such that third party lender would not allow

Securities

■ Problem where interest paid on security is excessive ■ When compared with an arm’s length loan ■ Due to connection between lender and borrower ■ As stated above, likely to be to achieve a higher deduction ■ Now lots of other legislation which can be used to restrict interest ■ No hierachy

What is the arm’s length interest?

■ Difficult (again!) calculation ■ Need to take account of following factors – Whether the loan would have been made at all in the absence of the connection – The amount which would have been loaned – The rate of interest and other terms which would have applied

Note

■ If not part of company’s business to make loans, this is disregarded in making judgements ■ No account is taken of any guarantees provided with which the lender has a participatory relationship ■ When refer to security it can also include unsecured loans

Guarantees

■ Provision of guarantees can also be caught under the thin capitalisation rules ■ Guarantee has a very wide definition ■ Can include implicit guarantees ■ Same kind of issues considered as for loans

ADMINISTRATION AND PROCEDURAL

Basics

■ Transfer pricing falls within self-assessment ■ Taxpayer must apply transfer pricing principles when completing CT return ■ No separate pages ■ No special record keeping requirements ■ But OECD imposes obligations on both taxpayers and tax jurisdictions

Record keeping

■ Taxpayers should not be expected to incur ‘disproportionately high costs’ to

• btain documents from foreign associated enterprises or comparable data

from independent enterprises; ■ Taxpayers should be expected to have prepared or obtained documents required for tax purposes only if they are indispensable for determining an arm's length price; ■ Taxpayers should not be expected to have retained documents relating to transactions occurring in earlier years where the period of retention consistent with general domestic law has elapsed; ■ Taxpayers should not be expected to provide documents relating to the period after the transaction in question unless the documents contain relevant information for the purposes of multiple year data or information about the facts that existed at the time the transfer pricing was established; and ■ Taxpayers should not be required to produce documents not in their possession or control or which are otherwise ‘reasonably available’.

Compliance

■ Normal SA enquiry in theory ■ But all now down under auspices of Transfer Pricing Group ■ Policy document which outlines how this is done ■ Risk assessment falls into three areas: – Quantum – Behavioural – Transactional

Compliance (cont)

■ Adjustment due to transfer pricing in closure notice must be sanctioned by Commissioners ■ Unless agreed in writing by taxpayer ■ Penalties can be imposed as for all discrepancies ■ But HMRC agree that transfer pricing is not an exact science

Penalties

■ ‘Where taxpayers can show that they have made an honest and reasonable attempt to comply with the legislation, there will be no penalty even if there is an adjustment. Indeed, the

• nus will be on HM Revenue & Customs in this area, as it is

more generally, to show that there has been fraudulent or negligent conduct, or that there has been a careless inaccuracy by the taxpayer before any penalty can be charged.’

Country-by-country reporting

■ This is the latest initiative under BEPS ■ UK holding company (normally ultimate parent but some exceptions) ■ Provide information which will enable authorities to make a more informed judgement about potential issues

Advanced Pricing Agreements

■ Binding agreement that is entered into by UK entity with HMRC ■ Where thought to be transfer pricing issues ■ Agree methodology for achieving arm’s length price ■ Needs to be quite significant amounts at stake before it is worthwhile