Her Majesty’s Revenue and Customs (HMRC). Schedule 28AA, Income and Corporation Taxes Act of 1988, § 12B Taxes Management Act of 1970, § 108-111 and Schedule 16 Finance Act of 1988 (ful text of the basic rule now appears in Schedule 28 AA ICTA 1988). The Finance Act of 2004 introduced provisions extending the transfer pricing code to include thin capitalization issues and transactions within the United Kingdom (UK), including between entities in the UK under common control. From 1 April 2004, transfer pricing laws are no longer restricted to cross-border transactions. There are grandfathering provisions for the exemption of dormant companies as wel as exemptions for certain transactions of small and medium-sized enterprises.
Finance Act (No. 2) 2005 introduced provisions to Schedule 28AA extending the transfer pricing code, effective as of March 2005, to include two additional situations in which financing transactions are entered into for an entity: (1) where two or more persons finance an entity and act together to col ectively control the entity, and (2) where a person finances an entity and a position of control wil come into existence within six months of the financing. Grandfathering provisions exist under certain conditions to ensure that the amendments wil only apply to transactions effective from 1 April 2007. Where a company’s accounting period straddles a relevant date (4 March 2005 and 1 April 2007, date of contract variation), profits and losses are to be calculated as if there were two distinct accounting periods divided by the relevant date.
The UK Finance Bill for 2007 did not introduce any specific changes to the transfer pricing legislation.
There are no specific regulations (with the exception of provisions for APAs as below), but there are “Guidance Notes” provided in HMRC Tax Bul etins (covering audit handling, share options, VAT considerations, Mutual Agreement Procedure (MAP), penalties and documentation). Additional y, HMRC has published several technical notes and made sections of their internal manuals dealing with Transfer Pricing available.
The Varney Report of November 2006 (produced by Sir David Varney for the Chancel or) included various recommendations for changes to the way HMRC interacts with taxpayers. HMRC has responded to the recommendations made and for transfer pricing this has included a mandated risk assessment, and the need to present a business case to one of two panels set up for the purpose before any enquiry is commenced. The panels will also review progress during the enquiry.
The OECD Transfer Pricing Guidelines are effectively imported into UK tax legislation, as the law is to be interpreted in a way that best accords with the guidance. Therefore, there is general adherence to the OECD guidelines.
With alignment to the OECD guidelines required under the statutory provisions, the most appropriate method of pricing is effectively required under the UK legislation. HMRC prefers transaction methods over profit methods (such as with the TNMM). However, there is a recent move by the HMRC towards testing results against systems profits. This may also be mirroring OECD developments in this area.
Two possible penalty regimes are currently applicable; however, provisions in the Finance Act of 2004 confirm that penalties for the failure to prepare and maintain adequate transfer pricing documentation wil be waived under certain circumstances in the two years beginning 1 January 2004. This period has now ended.
Currently, UK tax law provides that tax-geared penalties of up to 100% of any underpaid tax apply to the filing of an incorrect return due to fraudulent or negligent conduct under Section 95/96 of the Taxes Management Act of 1970 and Paragraph 20 Schedule 18 Finance Act of 1988. Failure to have a policy documented as arm’s length may be seen as negligent. A flat penalty of GBP 3,000 applies for failure to keep proper records under Paragraph 23 Schedule 18 of the Finance Act of 2004. There is a general increase in the use of neglect penalties across the board for all adjustments to profits.This is now extending to routine transfer pricing adjustments.
For accounting periods after 1 April 2008, the provisions for neglect penalties have changed. The statutory reference is found in Schedule 24 Finance Act 2007. These provisions are couched in terms of careless or deliberate inaccuracies rather than neglect. They remain tax geared at up to 100% of the potential lost revenue figure. This is, however, now calculated without adjustment for the availability of loss reliefs and where the adjustment affects losses only, the lost revenue is calculated at 10% of that adjustment.
The best protection against neglect penalties is a transfer pricing policy which ful y documents and evidences due consideration of the application of the arm’s length principle in the preparation of the relevant tax return. Mitigation of the current tax-geared penalties, where applicable, wil however be made having regard to size, gravity, disclosure and cooperation. For the code effective from 1 April 2008, mitigation is largely restricted to disclosure.
HMRC has long struggled with guidance in the documentation requirements area. Tax Bul etin 37 original y set out HMRC expectations; however, this guidance is now superseded by the guidance published with the pre-budget report in December 2003.
The guidance published with the pre-budget report 2003, and now confirmed in the HMRC manuals, sets out what types of documents HMRC might expect. This divides documentation into primary accounting records, tax adjustment records and, most important, evidence. Documentation relating to evidence of compliance with the arm’s length principle is to fol ow the OECD guidelines, and HMRC set out some suggestions on what this should or may include such as:
HMRC applies a risk based approach under which they would expect the level and depth of analysis to be dictated by the perceived risk of tax loss through manipulation of pricing. This typically allows a light touch approach to most UK to UK transactions.
Under the current guidance, the first two categories of documentation should be in existence when the accounts are prepared and the return submitted. In relation to documentary evidence of arm’s length pricing, it is not needed in a form capable of production to HMRC until a request by HMRC has been made. The previous guidance published by HMRC confirmed that all documentation should be in existence at the time the return is submitted. In practice, evidence confirming adherence to the arm’s length principle should exist at the time of submission of the return if difficulties in its production are to be avoided.
Discovery assessments can be raised six years after the company’s accounting period ends, but this is extended to 21 years where the misstatement is due to fraudulent or negligent conduct by the taxpayer. Determinations can be raised five years from the date of filing, or six years from the end of the company’s accounting period. The legislation applicable before 1999 operated in a different manner, and as a result, an investigation started now would not normally lead to transfer pricing adjustments for periods before 1999.
There are no return disclosure requirements except those required in statutory accounts and in annual reports filed in compliance with any current APAs. The absence of disclosure requirements wil typical y leave prior years open to discovery assessments.
HMRC now conducts a risk assessment before inquiry (details contained in Tax Bul etin 60), which was further confirmed at the time of the 2003 pre-budget report and is now in the International Manual. HMRC has also highlighted areas of concern that are likely to lead to inquiries (e.g., changed business structures and characterizations) and are investing time and resources into the transfer pricing investigation process. Additional y, there is pressure on HMRC to maximize taxes, and transfer pricing is known to be an area of high priority. A draft risk assessment approach and template was published at the time of the 2007 budget. This covers areas such as Corporate Governance and adequacy of systems and processes.
Section 85-87 of the Finance Act of 1999 introduced legislation on APAs. A Statement of Practice published in September 1999 supplements this legislation. Bilateral and unilateral APAs are available, but bilateral APAs are preferred. For APAs to be admitted to the program, there needs to be sufficient doubt or difficulty in approaching compliance with the arm’s length standard.
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