Consultation on introduction of secondary adjustments into transfer pricing rules

Consultation on introduction of secondary adjustments into transfer pricing rules

Fri 03 Jun 2016

Under the UK’s transfer pricing rules, the pricing of transactions between connected persons can be adjusted for tax purposes if it is not at arm’s length in order to counter the resulting UK tax advantage.  Owing to the system of compensating adjustments for wholly domestic transactions and the exemption for SMEs, transfer pricing is most often an issue faced by international groups. So, for example, if a UK company pays an overseas group member an amount exceeding the arm’s length price for goods, management services, loan interest or other ‘provisions’, then the UK corporation tax deduction for the expense will be adjusted (reduced) to reflect the amount that would have been paid between independent enterprises (the arm’s length amount).  Thus, if £10 million was paid for goods for which the arm’s length price would only have been £8 million, then the UK tax deduction will be limited to £8 million.  This type of adjustment is referred to as the primary adjustment.  Transfer pricing is a one way street: it only operates to increase UK taxable profits.

 However, although the effect of the primary adjustment is that the pricing has been adjusted for UK tax purposes that is currently the end of the story as far as the UK is concerned.  So, in our example, the overseas group company has still received £10 million for (say) goods that were only realistically worth £8 million, meaning it has £2 million more cash than it would otherwise have had, if arm’s length pricing had been applied. It is this additional financial benefit of non-arm’s length pricing that HMRC is now considering addressing, in the consultation document ‘Introduction of secondary adjustments into the UK’s domestic transfer pricing legislation’ issued on 26 May 2016, which runs until 18 August 2016. The particular concern is that if the overseas group member is in a low tax territory, then the additional cash it has received can accumulate and be used to generate additional income in that territory – in other words, the primary adjustment has only partially righted the effects of the ‘wrong’ pricing. What is therefore proposed is that a secondary adjustment is made, which will apply a tax charge on the additional cash arising as a result of non-arm’s length pricing (the £2 million in our example).

The government’s preferred option is that the secondary adjustment should be achieved by treating the excess profits/ cash as a deemed loan – so in our example the UK company would be deemed to have loaned the overseas group member £2 million, and interest income would be imputed on that deemed loan.  In principle this could then apply in all cases where transfer pricing adjustments are made, but it seems likely that a de minimis threshold will be set (the consultation document gives the example of the threshold being possibly set where all primary adjustments exceed £1 million, regardless of whether those adjustments are self-assessed or assessed by HMRC).  These proposals therefore look likely to be targeted at larger businesses, to act as an additional deterrent to the use of aggressive transfer pricing, perhaps in the wake of recent criticism over the settlements HMRC has reached with certain multinationals.

Other ways of effecting secondary adjustments considered in the consultation paper are treating the excess profits as constructive dividends, or as deemed equity contributions, but these are not favoured by the government.

However, the problem with creating a fiction is where do you draw the line?  In this case, if there is a deemed loan, then when was the loan made, what interest rate should be applied, and when will it end?  The proposal for the latter is that the deemed loan would cease to exist once the cash is repatriated to the UK – and there again, more complexity arises under this fiction as the repatriated cash must not be taxed again in the UK, since the primary adjustment has already done just that.  There is a genuine concern that these proposals will lead to economic double taxation, which is why base erosion anti-avoidance needs to be tackled on a consistent, agreed basis internationally, as indeed the OECD has been trying to achieve.


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