The year 2008/2009 has seen important developments in UK transfer pricing, including a new commitment by HM Revenue & Customs (HMRC) to bring to bear specialist transfer pricing economics input and to litigate where necessary, new thin capitalisation guidance and interest expense restrictions, a landmark tax tribunal decision and preparations for further cases which may very possibly lead to some litigation in 2010.These changes can be viewed as part of a trend to raise the technical level of transfer pricing argument and transfer pricing compliance documentation.
HMRC’s focus on transfer pricing enquiries is echoed by a renewed focus in public debate over the “morality” of transfer pricing.This debate has been heard most forcefully in the Guardian newspaper’s recent “Tax Gap” series of articles, in which transfer pricing has been described as “the biggest tax avoidance scheme of all” and “the single greatest threat to corporate tax revenues”, with the practice of transferring valuable IP rights from the UK to low-tax offshore jurisdictions attracting particular attention.
Developments at HMRC
New transfer pricing group
In January 2009, a Business International Directorate was established within HMRC to address international tax issues, including certain transfer pricing issues.The Directorate has assumed governance of the Transfer Pricing Group established in April 2008. A separate specialist financial transfer pricing team exists to address thin capitalisation, financial services transfer pricing, the attribution of profits, the “anti-arbitrage” rules and the Investment Manager Exemption under Schedule 26 Finance Act 2003 and section 818 Income Tax Act 2007.The Directorate will be headed by Judith Knott and the financial transfer pricing team will be led by Andrew Martyn.
More guidance on ATCAs
On January 12, 2009, HMRC issued a brief which contained more guidance on Advance Thin Capitalisation Agreements (ATCAs).ATCAs are similar to Advance Pricing Agreements and were created by the UK in November 2007 under Statement of Practice 04/07.The brief said that most ATCAs should be submitted before filing the relevant tax return but after the relevant transaction has taken place (in practice, HMRC often make reference to senior bank covenants relating to the transaction when forming a view on arm’s length ratios for related party debt). Moreover,ATCAs will not be available for general thin capitalisation forward agreements, interest imputation on outward loans or quasi-equity discussions or agreements on appropriate levels for guarantee fees, although these issues may be considered if they are raised during discussions about possible ATCAs. In addition, the level of return appropriate to a group finance or treasury company may also take place within the ATCA dialogue.
Focus on fewer enquiries
HMRC is focusing on larger transfer pricing enquiries, increasing the likelihood of new litigation in the relative short term. It is able to do so because of its success in reviewing a backlog of existing cases. HMRC worked on approximately 700 transfer pricing cases in 2008/2009 and settled 50% of them. It opened only 109 new cases in the same period, producing an overall 35% reduction in the number of open cases, which is an indication of the degree of focus which it will now have. HMRC has been using a new transfer pricing risk assessment procedure since July 2008, including pre-return discussions.The Revenue is opening transfer pricing enquiries only where there is a likelihood of capturing a reasonable amount of tax, and is focusing on high-risk transfer pricing cases. It has not said whether it considers particular industries or types of transaction to be high risk but if one considers the global pattern of transfer pricing litigation, industries in which valuable intangible assets and royalties play a significant role such as pharmaceuticals or food and beverages are involved relatively often.
HMRC is keen for business to take on board the following messages from their new approach to transfer pricing:
- If you think you are low risk then why doesn’t HMRC? – have a more open relationship.
- Review the role of your comparability reports – carry out a sanity check of the conclusions, and deconstruct the report and consider alternative solutions.
- In practice, if behavioural risks are minimised this will override any inherent transfer pricing risks that HMRC judges a company to have, so don’t just put your transfer pricing study on the shelf.
Senior accounting officer role
While not strictly a transfer pricing issue, Finance Act 2009 introduced a requirement for Senior Accounting Officers of large companies to take reasonable steps to ensure that the company and its subsidiaries establish and maintain appropriate tax accounting arrangements. If relevant, they must provide company auditors and HMRC with an explanation of the respects in which those arrangements are not appropriate, and failure to do so may result in personal penalties.This development is likely to turn the attention of management to tax risk management, including transfer pricing risk management arrangements.
Since 2008 the UK penalty regime (which is not specific to transfer pricing) has involved potential tax-geared penalties of up to 30% of the additional assessment for failure to take reasonable care, up to 70% for deliberate wrongdoing and up to 100% for deliberate wrongdoing with concealment.There is also a penalty of up to 10% of the value of the reduction of any losses following a transfer pricing adjustment to a company which is not tax paying in the relevant period.
A worldwide debt cap
The UK worldwide debt cap, which applies for accounting periods beginning on or after January 1, 2010, is designed to limit UK interest relief where, broadly:
- UK subsidiaries of overseas-headed multinationals bear interest costs that exceed the worldwide group’s costs of third-party debt; and
- overseas subsidiaries of UK-based groups lend upstream to the UK.
The debt cap operates alongside other UK tax provisions dealing with deductibility of finance costs.
In particular, the UK transfer pricing rules operate independently of the debt cap rules.Accordingly, companies may find their deductions for finance costs restricted under the new rules, even where they are operating within the parameters of established ATCAs.
An election can be made to exclude debt incurred or advanced by a group treasury company from the scope of the debt cap rules.There is also an exemption from the debt cap rules for “qualifying financial services groups”, which essentially means groups where debt is intrinsic to the nature of their business.
There is currently no comprehensive HMRC guidance on the debt cap, although HMRC have published draft guidance on the anti-avoidance aspects of the new rules. Further guidance and secondary legislation are expected over the course of summer 2009. Aside from the broad-brush objectives mentioned above, the rules do not in any detailed way very obviously implement a coherent underlying policy, meaning that their impact is, in certain circumstances, surprising and counterintuitive.
Related party loans
Following decisions of the European Court of Justice, Finance Act 2009 relaxed an anti-abuse provision that had prevented a debtor from claiming deductions for interest owed to a connected creditor on an accruals basis, where the interest was paid “late” and not fully brought into account for UK tax by the creditor. For accounting periods beginning on or after April 1, 2009, companies can claim interest deductions on much late paid connected party debt on an accrued basis. However, the old restriction will continue to apply to loans from tax haven companies.
The UK has not so far had a tradition of transfer pricing litigation. However, 2009 has seen a significant transfer pricing decision in the tax tribunal and further significant cases are preparing for trial.
The DSG case
On 23 April 2009, the Special Commissioners (now reconstituted as the First-tier Tribunal) released their decision in DSG Retail Limited v Revenue & Customs Commissioners (2009 TC00001). It is the first substantive UK case law on pricing methodologies and the first case concerned with the detailed transfer pricing code introduced as Schedule 28AA Income and Corporation Taxes Act 1988 by the Finance Act 1998.
DSG Retail Ltd (DSG), a UK company, was an electrical goods retailer which encouraged customers to purchase extended warranty agreements.The liability to customers was insured or reinsured (the model changed for indirect tax reasons) by an associated Isle of Man company, Dixons Insurance Services Limited (DISL).An unrelated company (Cornhill initially, and subsequently another independent company ASL) stood in between.This arrangement still formed “a series of transactions” in the eyes of the Commissioners who heard the case, therefore falling within the UK transfer pricing regime.
DSG justified the premiums paid to DISL by reference to several potential internal “Comparable Uncontrolled Prices” (CUPs), all of which were rejected by the Commissioners for being too old, relating to different products (which presented higher or lower insurance risks), involving the sale of goods in a different situation (i.e. not in stores), but particularly because they did not reflect, or could not be reliably adjusted to allow for, the relative bargaining power of DSG in its relationship with DISL.As in their view this bargaining power was concentrated with DSG to the extent that DISL’s profit was effectively fixed, the Commissioners concluded that no traditional transactional method could reflect this, and thus a transactional profit method had to be used.They chose not to decide how much bargaining power DISL had, noting that this might have changed over time, for example at the point that the commercial arrangement was amended, and invited HMRC and the taxpayer to agree a split of residual profit taking into account the relative bargaining power of DSG and DISL (residual because the Commissioners identified a minimum routine profit that should have accrued to DISL on the basis of a market return on its capital employed).The case has now been settled by agreement.
(b) The concept of relative bargaining power
The decision of the Special Commissioners brings firmly into UK transfer pricing the concept of relative bargaining power, which they did not attempt to quantify, but which they used to:
- apply the residual profit split method and recommend a split of the residual profit on the basis of relative bargaining power;
- conclude that a large physical network (of stores) creates substantial bargaining power (a “point of sale advantage”);
- conclude that being the only supplier of a service (in this case insurance/reinsurance of the kind required by DSG) does not necessarily create significant bargaining power, even if the high cost of entering the market would be a barrier to entry for potential competitors; and
- allow that for short periods of time, such as during contract renegotiations, relative bargaining power and hence the appropriate transfer pricing result can change.
One prescient author said in 2006 that “perhaps in five years time we will see the (US) Glaxo case as one of the catalysts for a move to recognising the profit split method as the most commonly appropriate method, rather than the last resort in cases where non-routine functions and risks are carried by more than one side”.This certainly seems to have been borne out in the DSG case, and given the difficulty in finding comparables which will stand up to rigorous scrutiny, and the increasing involvement of economists and economics concepts in transfer pricing disputes, it surely must be the way in which some forthcoming UK cases will end.
There is also pressure from economists who are increasingly involved in transfer pricing disputes to look beyond conventional benchmarking approaches. In the words of one:“Game theory may well explain transactions more effectively than finding non-existent market comparables”.The application of game theory also encourages the use of the profit split transfer pricing method.
Given that a tax authority will review a related party transaction after the event with the benefit of complete and perfect information, it is possible to depict the bargaining process behind complex transfer pricing issues as a dynamic game of complete information to which standard game theory solution concepts can be applied. However, in the real world, this will not be the case so long as judges deny tax authorities the right to use the benefit of hindsight (as HMRC conceded in the DSG case).There is still a role for conventional transfer pricing and its imperfect “benchmarking” approach as long as that continues to be the case.
(c) Implications for transfer pricing compliance
What are the implications for transfer pricing compliance? They may include the following:
- consider whether “benchmark” comparable uncontrolled transactions could be ruled out as inappropriate because the relative bargaining power of the parties involved is not the same as for related parties in the transaction being benchmarked, taking into account intangible assets, competitive position, status and rate of time preference;
- similarly, consider whether benchmark companies and their profit margins could be ruled not to be comparable because they do not have the same relative bargaining power as the tested party in the transfer pricing transaction;
- as a minimum, for internal comfort and risk minimisation, corroborate any benchmarking exercise with a total, or better still if possible a residual, profit split; and
- for added comfort, consider whether the profit split outcome of each related party transaction is in line with the relative bargaining power of the parties involved, taking into account the factors listed above.
(d) Implications for transfer pricing planning
When new factors are introduced into a transfer pricing analysis, new opportunities present themselves for taxpayers, including the following:
- in transfer pricing disputes, taxpayers can look to each aspect of relative bargaining power to explain the choice of transfer pricing method, the choice of benchmark transaction or company, the profit outcome for any individual company and the pattern of profits across related parties; and
- in managing their global effective tax rate, taxpayers can consider not only how they have organised their functions, risks and assets, but also where they allocate competitive position, status and the differing rates at which their subsidiaries discount future profits.
(e) Wider implications
Lee Corrick, Assistant Director at HMRC with responsibility for transfer pricing, told the OECD business restructurings project meeting in June 2009 that in HMRC’s view the relative bargaining power of related parties is a key element in determining the transfer pricing method and the price itself.The question of any compensation that might be owing to a company that has been restructured should be resolved by answering the question: “given its relative bargaining power, could it have negotiated a better deal?” He asked the OECD restructurings Working Group to focus on developing the concept of bargaining power. It is therefore possible that the arguments and concepts of the DSG case may inform new international conventions on the calculation of “exit charges” and post-restructuring inter-company pricing following international business reorganisations.
Further transfer pricing cases
A number of transfer pricing cases are being prepared for trial, with some litigation very possible in 2010. One of these cases involves HMRC for the first time outsourcing an entire case to an external law firm.This pilot project may lead to further outsourcing of transfer pricing litigation, increasing HMRC’s effective capacity to engage in this activity.
A more litigious transfer pricing environment?
The proliferation of domestic and international transfer pricing law and practice has increased the need for lawyers’ interpretive skills – for example, the legal points of contention in the DSG case, such as what constitutes a “provision”, the relevance of international case law, the interpretation of detailed statutory codes around the world, the key future battlefield over the “characterisation” of transactions and the interpretation of various OECD projects on permanent establishments, restructurings, etc.
This is not to say that we can expect to see litigation on the US scale for example – HMRC have stated that the costs involved are a major constraint on their ability to litigate more than one or two cases at a time.
It is highly probable that in future cases HMRC will repeat their successful tactic of seeking to rule out potential CUPs on the basis of dissimilar bargaining power and instead try to impose a residual profit split.
An erosion of the arm’s length principle?
Some UK commentators suggest that the dismissal of potential CUPs in the DSG case combined with the introduction of the worldwide debt cap signify an erosion of the arm’s length principle in UK international tax (although HMRC Business International regard preservation of that principle as part of their mission). Some say that, when taken together with the US judgment in Xilinx, Inc., and Consolidated Subsidiaries v. Commissioner of Internal Revenue (United States Court of Appeals for the Ninth Circuit, 4142-01 now filed for rehearing) that the cost of stock options should be included in cost sharing agreements even if independent companies would not do so, the bizarre Canadian decision in General Electric Capital Inc. v.The Queen (98-712(IT)G, T.C.C.) that subsidiaries must have the same credit rating as their parent companies, and the (stalled) project to introduce a Common Consolidated Corporate Tax Base in Europe, this could be viewed as a global reaction to the failure of the arm’s length principle to eliminate disputes and double taxation. We do not believe that it is possible to draw this inference from the DSG case, as the potential CUPs in that case were dismissed because of a lack of comparability, albeit comparability in terms of relative bargaining power.
However, it is becoming clear that in the UK it is no longer safe to rely merely on benchmarking results, but rather that the characterisation of the parties’ relationship should be the foundation for the choice of transfer pricing method.That characterisation should take into account the relative bargaining power of each party, which introduces a new array of concepts and techniques into UK transfer pricing.