What is transfer pricing?
Transfer pricing is one of the most important issues in international tax.
Transfer pricing is the general term for the pricing of cross‐border, intra‐firm transactions between related parties. These transactions can include transfers of intangible property, tangible goods, or services as well as loans or other financing transactions.
The UK’s current transfer pricing legislation is based on the “arm’s length principle”.
The rules apply to UK taxpayers including UK branches of overseas companies. The UK transfer pricing legislation can also apply to transactions where both parties are within the UK.
Transfer pricing methodologies
The UK has a self-assessment regime where the onus is on the taxpayer to ensure that transfer pricing regulations are adhered to. HMRC has not issued any specific requirements relating to transfer pricing documentation. There is a ‘tick box’ on the corporation tax return to confirm eligibility for 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).
There are a number of transfer pricing methodologies for determining the arm’s length basis of a transaction. For example, the OECD recognises Comparable Uncontrolled Price (CUP), resale price, cost plus, transactional net margin, and profit split methods as acceptable but other methods can also be used if justifiable and appropriate. Crucially however, the most appropriate transfer 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.
Transfer pricing adjustments should be made on the relevant income or corporation tax returns and taxpayers are expected to prepare and retain such documentation as is reasonable given the nature, size and complexity of their business or of the relevant transaction which demonstrates that their transfer pricing meets the arm’s- length standard.
Country by Country (CbC)
The UK has now implemented the Base Erosion and Profit Shifting (BEPS) action plan 13 (see our BEPS article – https://www.enterprisetax.co.uk/demystifying-beps/). Going forward, businesses will have to comply with Country by Country reporting (CbC), which was implemented in the UK by way of regulation on 18 March 2016. The regulations apply if the consolidated group turnover meets the threshold of €750 million.
If your group needs to report, every year you must notify HMRC where you intend to report.
HMRC seeks the following information in the notification:
- Reporting period covered by the notification
- Which entity (including the unique taxpayer reference or equivalent) in the multinational group will file the CbC report and where they will file
- The names and unique taxpayer references of all of the multinational group’s entities that are tax resident in the UK, are UK permanent establishments of overseas group entities or are UK partnerships.
Currently for filing purposes, there are 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
For corporation tax purposes, it is necessary to keep primary accounting records and all supporting documents needed to deliver a correct and complete tax return. The accounting records are those created during the period in question. Tax adjustment records, records of intercompany transactions and documentation demonstrating an arm’s length result do not need to be prepared at the same time as the accounting records.
At the time of filing, the taxpayer need not have assembled its evidence to support that the transactions are at arm’s length, but it does need to have reached a conclusion and needs to have a basis of reaching that conclusion. If requested by HMRC, taxpayers usually have a maximum of 30 days to produce transfer pricing documentation.
It is recommended that documentation should be updated every two to three years or upon change to the business structure or functional analysis. A functional analysis describes the economically significant functions undertaken by a business – the general operations of an entity which may include manufacturing, marketing, financing, marketing among others.
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. Any adjustment and further assessment of profits subject to tax will usually be made on completion of the enquiry.
There are exemptions from transfer pricing documentation rules for SMEs, dormant companies (which have been dormant since 31 March 2004 and continue to be), charities and life assurance companies. It should be noted that 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 which is not a tax haven.
Some of the issues that may trigger transfer pricing audits by HMRC include:
- Business restructuring
- High levels of debt funding
- Perpetual losses
- Tax planning structures involving low tax jurisdictions or tax havens
One advantage a taxpayer has over the revenue authority is an intimate understanding of its business. This can be a valuable advantage in a tax dispute, especially if the facts are documented contemporaneously. However, if an error is made in a tax return, the taxpayer may be subject to penalties. The level of the penalty is linked to the reasons for the error, on the basis that taxpayers are expected to take reasonable care in maintaining records that allow them to provide a complete and accurate return.
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 by the actual provision.
For lack of reasonable care, the penalty is generally between 0%-30% of the extra tax due. For deliberate errors this rises to 20%–70%, and 30%-100% for deliberate and concealed errors. Penalties can in some circumstances be reduced if the taxpayer tells HMRC about the error.
Penalties in relation to transfer pricing documentation relate directly to the general record-keeping requirements. Under these rules, two types of penalties may apply; penalty for failure to keep or produce documentation and a tax geared penalty for a careless or deliberate error. At the time of writing, the fixed penalty for failure to keep or produce documentation is £3,000.
Transfer pricing is a key issue in international tax and transfer pricing strategies and documentation are increasingly under scrutiny by HMRC. It is therefore important that businesses impacted take advice and ensure that their transfer pricing policies and procedures are kept under review and updated.
Please feel free to contact us if experiencing the above issues in your business and would like to be advised on how to comply with UK transfer pricing regulations.
This article was in published in our June 2018 enewsletter. To be added to our mailing list, click here and submit your contact details on our sign up form.