This landmark case is the first in the UK to discuss in detail the appropriate methodology for a transfer pricing adjustment, providing insight into how the UK Courts and HMRC will apply UK transfer pricing legislation to determine the correct transfer pricing method.
The case concerned a dispute between HMRC and a group of companies which form the largest retailer of electrical goods in the UK, comprising Dixons, Currys and PC World. DSG Retail Ltd (DSG) was the retail company. DSG had a subsidiary, CIS. CIS, acting as agent for Cornhill Insurance plc (Cornhill), offered DSG’s customers extended warranties on electrical goods. Cornhill paid CIS a sales commission.
From May 1986 to April 1997 Cornhill was the insurer of the extended warranties sold to DSG’s customers, retaining 5% of the risk and reinsuring 95% with a subsidiary of DSG that was incorporated in the Isle of Man, DISL. Cornhill ceded 95% of the risk premiums it received to DISL under the reinsurance contract, and in return DISL paid Cornhill a ceding commission of 1.5% of the premiums ceded to it. DSG had no direct contractual relationship with DISL.
In 1993, the arrangements were extended for five years and the profit commission arrangements with CIS were altered so that Cornhill paid CIS a greater commission. Crucially, Cornhill agreed not to seek a corresponding increase in ceding commission from DISL.
From 1 April 1997, the rate of Insurance Premium Tax (“IPT”) on the goods that DSG sold rose dramatically from the then standard rate of 2.5% to 17.5%. To avoid IPT, DSG restructured the arrangements so that instead of an insurance policy issued by Cornhill, customers were sold a service contract with ASL, an Isle of Man company independent of DSG. The fee charged for the repair contract did not attract IPT because it was not an insurance transaction. ASL insured its risk with DISL.
As a result of the agreements in place, a large proportion of the profits accumulated tax-free in the Isle of Man subsidiary, DISL. HMRC sought to bring a larger share of the profits into charge in the UK by invoking the transfer pricing rules and contending that the arrangements were not consistent with the arm’s length principle. HMRC argued that an analysis of the transactions as a whole indicated that the DSG group had made an indirect provision to DISL of a business facility whereby Cornhill’s position relative to DISL was disadvantaged. Cornhill’s profit had been “squeezed” by the 1993 contractual changes whereas DISL’s profit had not. HMRC argued that DISL’s non-arm’s length profit continued from 1997 under the new ASL arrangements in the form of an opportunity to enter into an attractive insurance contract. Applying arm’s length terms, the DSG group would have required payment from an independent party to enter into the same arrangement.
From a transfer pricing perspective, the following issues were relevant:
- was there a provision between DSG and DISL for the purposes of Schedule 28AA ICTA?
- did the actual provision differ from the provision that would have been made between independent enterprises?
- did the provision confer a potential advantage in relation to UK tax?
- what adjustment is required?
As the period under enquiry included years prior to the introduction of Schedule 28AA ICTA, the prior provisions in section 770 ICTA were also considered.
The transfer pricing method used
DSG argued for the use of comparable uncontrolled prices, and relying on transfer pricing reports produced by a number of accounting firms, put forward a number of comparables in support of its argument.
HMRC rejected the comparables for reasons such as:
- time – the first comparable proposed concerned an agreement made in 1982 when the market for extended warranties was quite different to the market in 1997.
- product – the second comparable proposed concerned an agreement related principally to satellite equipment.
- termination – the second comparable was terminable on one week’s notice which was interpreted as demonstrating that the parties were not contemplating a long term relationship, unlike the DSG arrangements.
- terms – DSG sought to rely on a 1994 report from the Office of Fair Trading, “Extended Warranties on Electrical Goods”, which gave the commission rates paid by three unidentified retailers. There was no evidence as to whether the rates agreed were between arm’s length parties or what the other terms were.
- bargaining position – DSG put forward a comparable involving a bargain between equals. This comparable was rejected because this was not the position with DISL.
On the basis that no comparables could be identified, HMRC’s expert witness set out a profit split approach whereby DISL’s profits would be compared to a notional “normal rate of return on investors’ capital”, based on the capital asset pricing model. A “bottom up” approach was preferred whereby it was assumed any profits in excess of capital needed for solvency requirements was paid out as a dividend each year. Solvency requirements were based on those contractually agreed with Cornhill.
It was held that there was clearly provision between DSG and DISL despite there being no direct contractual relationship between these entities. It was clear that in negotiations with Cornhill and with DSG’s bargaining power, DISL had been given an advantage in order to provide tax benefits to the group.
The Special Commissioners concluded that the arrangements were not at arm’s length and that DSG set a price that “confers a potential advantage in relation to United Kingdom taxation” because DSG’s profits did not include income it would have received for its provision of the business facility if DSG and DISL were dealing at arm’s length. They also rejected the comparables put forward by DSG and supported the use of the type of profit split formula suggested by HMRC.
It was determined that DSG’s profits should be adjusted to that of an arm’s length arrangement based upon the above mentioned profit split method. Determination of the actual quantum of the adjustment was referred back to the parties to enable a settlement to be negotiated, but the tribunal held that the adjustment should take the form of a commission payable by DISL to DSG.
Perhaps of most interest for taxpayers are the arguments HMRC employed to challenge the comparables and the tribunal’s receptivity to HMRC’s arguments on pricing methodology which, although based upon the OECD Guidelines, may upset the traditional hierarchy of suggested transfer pricing methods as set out in the OECD Guidelines. It validates the use of profit based methodologies where reliable comparables cannot be found.
What is apparent from the case is that transfer pricing issues are never clear-cut; this particular hearing lasted 15 days and involved a lengthy and complex analysis of the contracts and transactions involved. It has been suggested that it signals a change in HMRC’s previous reluctance to litigate transfer pricing issues, which serves to highlight the importance for groups to re-examine their transfer pricing policies and consider whether the most appropriate pricing methodology has been used. It also reinforces the importance of performing a sound economic analysis of commercial agreements.
DSG Retail Ltd & Others v HMRC TC 00001