A speedier resolution of transfer-pricing enquiries?

Transfer-pricing enquiries can be one of the biggest drains on the time and on the resources both of any business’s tax department and the business itself. The process of agreeing with HM Revenue and Customs (HMRC) an appropriate “arm’s length return” for a group’s internal transactions often involves extensive discussions (leading possibly to litigation) spanning many years, and will of necessity require many management hours to resolve.

HMRC has published new guidance on the practices and procedures which it will adopt for conducting transfer-pricing enquiries. HMRC has for several years published material in their Manuals on how it normally conducts a transfer-pricing enquiry. The new guidance is important, as it builds on the material in the Manuals and suggests a clear timetable and procedure for enquiries. The guidelines provide an opportunity for businesses to familiarise themselves with the new practices, and to be aware of what HMRC expects from them; such businesses may expect a more efficient and speedy resolution of enquiries into their transfer-pricing arrangements. At the same time, as businesses become more global, they can expect an increased focus from HMRC and other tax authorities on the pricing adopted for their group transactions.

What is a transfer-pricing enquiry, and why do they take so long to resolve?

Transactions between members of a group can in theory provide an opportunity to move profits to jurisdictions with relatively low tax rates, by charging or paying a below-market rate for services or goods. The “transfer-pricing” rules counter this, by requiring United Kingdom (UK) businesses to adjust their corporation tax returns on the basis each UK company enters into “arm’s length” transactions with its associates. Compliance with the transfer-pricing rules does not, of itself, guarantee that profits earned outside the UK will not be subject to UK corporation tax; for example, the controlled foreign companies (CFC) rules can result in the non-UK profits of companies controlled outside the UK being subject to tax here.

Her Majesty’s Revenue and Customs (HMRC) has power to “enquire” into a tax return, to ensure that it is correct. This power can be used to verify that a business has correctly reported its transactions with its associates, although such an enquiry may not be limited to transfer-pricing issues. An enquiry may also consider whether the profits of the UK company’s non-UK subsidiary are subject to UK corporation tax; eg, is the non-UK subsidiary tax resident - by virtue of being managed and controlled - in the UK, and/or do the CFC rules require the UK company to be taxed in respect of the undistributed profits of its low tax subsidiary?

Determining what is an arm’s length price for any particular transaction is not an exact science. It is a highly fact-specific exercise, which can require the examination of copious amounts of evidence and involve extensive debate on economic theories of profit attribution. It can be a particularly difficult exercise to perform on transactions between members of a group, as there may not be a readily available “comparable” for such a transaction - group members may enter into transactions with each other that they would never enter into with an unrelated party. Without a clear framework for discussion, transfer-pricing enquiries can become unfocused, slow, expensive and difficult to resolve.

What is HMRC doing about it?

Her Majesty’s Revenue and Customs (HMRC) has published guidance on the practices and procedures which it will adopt for conducting transfer-pricing enquiries. The stated aim of this guidance is to achieve:

  • greater certainty;
  • an efficient risk-based approach to dealing with tax matters;
  • speedy resolution of issues; and
  • clarity through effective consultation and dialogue.

The key features of the guidelines, and our comments on them, are:

  • Targets for settling transfer-pricing enquiries:
    • 18 months to settle all but the most complex transfer-pricing cases;
    • 36 months to settle the most complex cases;
    • this time limit to run from the date the enquiry commences; and
    • Her Majesty’s Revenue and Customs (HMRC) must have settled - or taken a decision to litigate - by the end of this 18, or 36, month period.

Norton Rose comment:

The guidelines are guidelines only, which is unfortunate because it prevents HMRC from being held to these targets - the guidelines state that an enquiry will not be closed down for the sole reason that a target date has been, or is expected to be, missed.

  • The guidance will also apply to certain cases concerning the attribution of profit to a permanent establishment, but it will not apply to certain ‘thin-capitalisation’ cases.

Norton Rose comment:
There is a separate regime for dealing with thin-capitalisation negotiations.

  • To achieve the targets, each transfer-pricing enquiry must pass through five “stage gates”. At each stage, a decision will be made by HMRC whether (and how) to proceed with the enquiry. The decision will be subject to review and approval by a panel process. In addition, HMRC will form a transfer-pricing team, to conduct the enquiry. This will be led by the business’s Customer Relations Manager, and include at least one transfer-pricing specialist from HMRC’s Transfer Pricing Group.

Norton Rose comment:

Businesses should make the most of opportunities to influence the outcome of the decisions at each of these stages, to ensure that enquiries are brought to a satisfactory conclusion as speedily as possible.

  • Stage Gate 1: HMRC risk assessment. Is an enquiry appropriate and, if so, how it will be structured, resourced and managed? To influence this decision, businesses are expected to ensure that HMRC has a full understanding of their business and the transactions which they undertake.

Norton Rose comment:

Influencing the decision at this stage may require a degree of disclosure to, and openness with, HMRC which many businesses may not be used to, and which some may not be willing (or able) to provide - eg, pre-return discussions with HMRC, and the provision of real time information, which may help convince HMRC that due thought has gone into the pricing and terms of any transaction. Although HMRC is encouraging open dialogue with businesses, this does carry some dangers of which businesses should be aware before proceeding. Businesses should always be conscious that any enquiry may become contentious. A balance has to be struck between disclosing too much informally (and regretting it subsequently) and disclosing enough to bring the matter to a swift conclusion. In particular, material may be legally privileged and it may not be tactically wise to disclose it at an early stage.

  • Stage Gate 2: HMRC formulation of a business case. Is there enough evidence that the case is of sufficient value and importance to HMRC to open an enquiry, given the resource commitment needed to conduct the enquiry?

The guidelines list six factors which should be included in the business case:

  • a description of the issues in point, including points of principle;
  • the amount of tax potentially at stake;
  • other issues that impact upon the risk (eg, precedent value, and assessment of the business risk and the transaction risk);
  • risks involved in settling the case;
  • resource required to conduct the enquiry, including from specialists; and
  • estimated timescale to complete the enquiry.

Norton Rose comment:

Although the formal business case will not be provided to the business, a business may be able to influence the content of the business case by emphasising those factors which point against opening an enquiry such as the absence of any points of principle, the small amount of tax at stake, not a test case, the business has a low tax risk, the case does not involve high risk transactions, the absence of risks from settling the case, and the significant resource required to conduct the enquiry.

  • Stage Gate 3: Approval of the enquiry timetable and action plan. The enquiry timetable is determined at this stage, setting out the key stages of the enquiry, including the details of the phases of the enquiry, dates for regular progress meetings or calls with the business, issue of information requests, time limits for the business to respond and for key meetings.

Norton Rose comment:

This will be a critical stage of the process, as it determines whether the case has an 18, or 36, month deadline (ie, is the case “particularly complex and high risk”), the steps which HMRC and the business are to take and the deadlines for taking them.
HMRC is required under the terms of its guidance to be clear and open about the transactions subject to the enquiry, making explicit:

  • which transaction(s) is(are) to be the subject of the enquiry;
  • what aspects of the transaction and its pricing is to be tested;
  • the criteria by which the transaction is to be tested; and
  • the information HMRC needs to understand in order to achieve this (though further information may be required as the enquiry progresses).

This information should assist businesses, as HMRC is committed to agreeing the timetable and action plan with the business at an early stage in the enquiry. Effort put in at this stage, to keep the scope of the enquiry within reasonable bounds, and to ensure that only realistic deadlines are set, may help to limit the cost of conducting the enquiry and result in a speedy conclusion. Co-operation with HMRC at this stage may also reduce the risk of HMRC using its formal powers to obtain information.

Businesses which wish an enquiry to be settled within the 18 month timetable will want to emphasise to the enquiry team features which suggest that the case is not complex or high risk: eg, does it involve business restructuring? does it relate to transactions relating to the use of intellectual property or other intangibles? does it raise questions of whether the characterisation of entities is properly reflected in the pricing methodology? is there any need for HMRC to use formal information powers and proceedings etc? is there a limited amount of tax at stake? does the business have a low risk assessment? are there any transactions with low tax jurisdictions? and does the case have any precedent value. Inevitably, many of the transactions that are the subject of a transfer-pricing enquiry will fall into these categories. Even if this is the case, there is a clear incentive for both the taxpayer and HMRC to agree a formal timetable for the enquiry and to seek to comply with it.

  • Stage Gate 4: Six monthly reviews. How should the enquiry continue?

Norton Rose comment:

Each of these six monthly reviews should provide an opportunity to persuade HMRC that the enquiry should be closed or, perhaps, that the case should be moved from a 36 month deadline to an 18 month deadline (or vice versa). At the very least, it is an opportunity to review the steps which both parties have to take, and the deadlines for taking them. As the enquiry progresses, it is hoped that the information required from the business can be refined further, and that these six monthly reviews will not be used by HMRC to add to the list of information and documents required to be produced by the business. If requests become burdensome and/or appear to lack direction, the business may consider applying for a closure notice.

  • Stage Gate 5: Resolution decision. Should the enquiry be closed without adjustment, a negotiated settlement sought, or the case proceed to litigation?

Norton Rose comment:

The guidelines do not guarantee a settlement within the 18 month or 36 month periods. If HMRC believes its case to be strong, the case may be litigated. Traditionally, transfer-pricing cases have not been litigated in any great number, for a variety of reasons. It is likely that this will change. Taking the matter to litigation will, of course, extend the dispute considerably, potentially adding years to the time it takes to reach a resolution.

What does HMRC expect from business?

In order to achieve the objective of a speedier resolution of transfer-pricing disputes, HM Revenue and Customs (HMRC) expects the following from businesses:

  • at an early stage of the enquiry, agreeing a documented enquiry plan and timetable;
  • to make every effort to act fully in accordance with that timetable;
  • to seek to agree a revised timetable where, due to unforeseen circumstances, it is not possible to keep to the original timetable;
  • to maintain relevant documentation that can be made available to HMRC on request during an enquiry;
  • to fully resource the enquiry;
  • to respond to information requests in accordance with an agreed timetable; and
  • to provide access to relevant business personnel.

The guidance acknowledges that co-operation will not be forthcoming from all businesses and indicates how HMRC will respond. For example, the guidance states that where a business does not accept the invitation to take part in pre-return and pre-enquiry discussions, HMRC may not have the full information needed in order to carry out a fully informed risk assessment and it may be necessary to open an enquiry in order to obtain the information required to carry out a full assessment of transactions with affiliates. In these cases, the guidance states that there is a risk that the assessment phase will be carried out in the enquiry, and businesses will be asked, at the commencement of the enquiry, to provide the documentation to support the return and self-assessment. The guidance also states that where a business does not wish to agree an enquiry timetable and framework, HMRC will use formal powers as necessary to progress the enquiry in line with the timescale in which HMRC aims to complete the enquiry.

Norton Rose comment:

The guidelines emphasise the importance of businesses adopting an open and co-operative approach to achieving the targets set out in the timetable and action plan, but offer little in the way of binding commitments by HMRC. It is to be hoped that HMRC will not use the guidelines as another means of extracting further information out of businesses, without fully taking into account the burdens this places on the key personnel involved in running a business.

If the guidelines are to reduce the time taken to resolve transfer-pricing enquiries and provide a degree of certainty as to how and when matters will be concluded, a degree of co-operation and flexibility in implementing the guidelines is required from both business and HMRC. Each should be clear in their objectives and recognise early on in the process whether a matter is likely to be resolved amicably or whether it will be necessary to resort to litigation. If the latter is the case, businesses should be prepared to take professional advice at the outset, so that a step taken early on does not backfire. Inevitably, this will involve some investment in legal and other advice, but it could yield rewards later in front of the Special Commissioners or the higher courts.