Article by Erica Parkes, a Partner – Transfer Pricing, KPMG London.
Published in December 2001 issue of Tax Adviser.
What is the Inland Revenue’s approach to enquiries under the new transfer pricing regime? It is now around two years since this regime was introduced in conjunction with Corporation Tax Self Assessment (CTSA), but only recently have Inspectors started to issue enquiries into CTSA returns. The nature of those enquiries differs from those made before the introduction of CTSA and already some significant patterns are emerging.
The most significant change is that the Revenue recognises that it is now the taxpayer’s obligation to document its justification of its transfer prices and all the Inspector needs to do is ask for that documentation.
It is apparent that some of the questions being asked by the Revenue about justification and documentation go right to the heart of a taxpayer’s CTSA obligations. The taxpayer is obliged to retain documentation that enables it to make a correct and complete return of income. In many cases the taxpayer will not be able to determine whether its transactions are conducted at arm’s length without carrying out a review of all its intragroup transactions with appropriate benchmarking.
As a result of some preliminary analysis of financial reports, searching questions are being asked by Inspectors with an apparent awareness that these taxpayers may be potential targets for the imposition of penalties. In this article we consider these and other emerging patterns. Also some suggestions and implications for structuring the response to the Revenue are considered.
The UK transfer pricing regime
Transfer pricing deals generally with the pricing of goods and services transferred between branches, companies and other legal entities in different tax jurisdictions. The UK regime extends to transactions between associated parties in the same jurisdiction where non-arm’s length pricing might reduce the UK tax take. Accordingly, transactions between a UK resident company and the overseas branch of an associated UK company are subject to the regime.
The scope of the transactions is comprehensive. It includes provision of goods, services, financial transactions (e.g. loans, guarantees) and intangible property (whether or not it can be legally registered).
UK companies are now required to adjust intragroup pricing to comply with the arm’s length basis for accounting periods ending on or after 1 July 1999. CTSA has shifted the transfer pricing burden of proof from the Revenue to the taxpayer.
Analysis of the Revenue’s transfer pricing enquiries
We have carried out an analysis of letters we received from the Revenue where the letter contained references to transfer pricing. This analysis covered letters received during the year to date and was undertaken on a national basis.
No standard enquiry
Currently there appears to be no standard approach to transfer pricing with queries varying widely in nature and approach. Some common avenues of enquiry do, however, exist.
The need to establish an understanding of the group structure and how other members of the group were performing compared to the target company is apparent from Inspectors’ requests to supply details of relationships to other group members, the international group structure or copies of accounts for the immediate or ultimate parent company. This occurred in just under 25 per cent of cases.
The Inspector, in excess of 75 per cent of all cases, sought to obtain more information about transactions which were known to be or appeared to be with associates. This reflects the traditional practice for tax queries with details being requested about the nature of specific items shown in the accounts.
Specific Intragroup Transactions
However a number of specific areas of interest can be identified. In 40 per cent of the letters, queries were directed at financing issues such as the appropriateness of the interest rate on intragroup debt, whether such a loan would have been made between non-associated parties and whether intragroup accounts were paid on a timely basis.
This focus on financing issues is to be expected given that Income and Corporation Taxes Act 1988, (ICTA 1988), s. 209(2)(da) which seeks to disallow a deduction for interest where a loan is not made on reasonable commercial terms, existed prior to the introduction of the transfer pricing regime. (It now co-exists with the transfer pricing regime.) Also it is probable that such enquiries are made by the Revenue because financing transactions are usually discrete and easy to identify, and perhaps because it regards the arguments about arm’s length pricing in such situations as fairly straightforward. In other words, low-lying fruit.
An associated area of focus was the request, in 20 per cent of letters, for an analysis of debtors and creditors. Presumably this is used to make some assessment of credit terms and as a check that all material related-party transactions are identified and considered.
Other main areas of focus were sales and purchase transactions, and management and other consultancy services, including research and development.
It was not unusual for Inspectors to request more detailed information about the terms attaching to specific intragroup transactions.
Requests to advise on all intragroup transactions
Information was requested about the nature and/or quantum of all intragroup transactions in just over ten per cent of cases. For example
May I have a breakdown of the nature and value of transactions between XXX and other group companies.
Payments to connected companies … May I know to whom any sums were payable, for what service and the amounts involved?
I would like to have details of all transactions of whatever nature between XXX and connected parties.
In the absence of detailed transfer pricing work carried out prior to filing the tax return, some taxpayers will need to devote significant resources to compiling a response to such questions.
Arm’s length benchmark
Justification for the taxpayer’s transfer pricing methodology was sought in over 50 per cent of cases. This relatively high proportion may seem somewhat surprising to taxpayers. However, really it isn’t surprising. The Revenue has been waiting for the time when it could simply ask the taxpayer to justify the pricing it has adopted under self-assessment instead of having to shoulder the burden of demonstrating that the pricing might not be arm’s length. This is the vital difference between the old and new approaches.
This high percentage of requests for justification does indicate that Inspectors have grasped the concept of an arm’s length benchmark. In half of these enquiries, the arm’s length basis was specifically referred to. In the remaining cases, the thrust of the enquiry was still directed to the commerciality of the transactions with associates.Taxpayers were asked for details of methods and how their prices were determined and justified, how the price was arrived at and the basis on which it was determined ,– to provide evidence that the charges were commercial, and so on.
In a handful of cases, the Revenue asked for an explanation of why the taxpayer decided that a transfer pricing adjustment was not required in order to bring transactions into line with uncontrolled transactions. For example: How did you satisfy yourself that no adjustments would be required to the return in respect of ICTA 1988, s. 770?
Care needs to be taken in responding to such searching questions. Inadequate responses are likely to increase the likelihood of tax-based penalties if a transfer pricing adjustment is later determined to be required.
It is possibly too early in the process to see much in the way of queries about the applicability of specific transfer pricing methodologies. However, the quantum of the margin applied in the cost plus method and the adequacy of the gross margin percentage were the subject of interest in a number of cases.
Request for Documentation
Intra-group agreements and/or transfer pricing studies were requested in one third of cases. Substantially all of these requests related to documentation of specific transactions such as loans, management services, purchases and intangibles with the majority being for loan documentation.
In a small number of cases, the Inspector sought a copy of the taxpayer’s transfer pricing comparability study or computation.
Cautionary warnings were given to a small number of taxpayers about the level of profitability or continuing losses and apparent lack of documentation arising from earlier enquiries. In some cases, these warnings reminded taxpayers of their transfer pricing obligations under CTSA and again, in some cases, meetings were requested to explore the taxpayer’s transfer pricing arrangements.
Summary of enquiries
The Revenue’s approach to transfer pricing enquiries is still evolving. At this stage there is considerable variation in the focus of individual Inspectors. However some trends are emerging as follows:
- the concept of arm’s length as a basis to benchmark transactions is understood although each Inspector approaches the issue in his or her own way;
- requests about specific intragroup transactions are occurring in the majority of cases in line with the usual practice for queries relating to other areas of taxation;
- loan transactions continue to have a high focus probably because the Revenue are familiar with these due to ICTA1988, s. 209(2)(da) which existed prior to the transfer pricing regime and CTSA. Also funding transactions are easy to spot and may be regarded by the Revenue as a straightforward avenue to obtain an adjustment; and
- documentation is being requested although generally in relation to specific transactions and loans. However already we are seeing requests for full transfer pricing reviews.
Some of the requests, such as those requiring justification of pricing policies or details about the nature and quantum of all intragroup transactions will involve the taxpayer in considerable work.
How to deal with a transfer pricing enquiry
Comments here are not a substitute for detailed advice, but, as a result of our analysis of letters from the Revenue, we make the following suggestions:
- Because transfer pricing is a complex area, frequently with large sums at stake, especially where adjustments are made in respect of a number of years, care must be taken with any response to the Revenue. Therefore extreme caution is called for - particularly if an Inspector asks how prices are set or justified. What appears to be a general background query, included in an enquiry letter with a range of more specific queries, can go to the very heart of the arm’s length test and the transfer pricing regime. Careful responses are always required to questions about pricing methodology and justification in order to minimise penalties if a subsequent adjustment is made.
- Depending on the management accounting system, the transfer pricing queries may involve much work to collate the information. To avoid unnecessary work we suggest that taxpayers discuss the possibility of a de-minimis threshold particularly where the Inspector’s requests are all-embracing rather than targeted to particular material transactions.
- It is also not unusual for Inspectors to request information about the terms of intragroup transactions. This is usually straightforward for loans as the terms are frequently documented in a loan agreement. However the terms of trade applying to other services or goods transactions are not always stated fully on the invoice; they may exist in a number of documents held in different parts of an organisation. They may also draw upon normal trade practices. Again we suggest that the taxpayer request a de minimis level by seeking consent to detail the material terms only in the initial response. However, extreme care and judgement is needed as some terms, such as the right to use an embedded intangible, may be very material to the pricing but are not always top of mind for those negotiating the day to day transactions with associates.
We have endeavoured to illustrate the need for careful responses to the Revenue. This is because taxpayers are now exposed to penalties of up to 100 per cent of any tax shortfall where the return is not in accordance with the arm’s length principle and it can be shown that the return was submitted fraudulently or negligently by the taxpayer and UK tax is effectively lost as a result.
Tax Bulletin Issue 38 sets out the Revenue’s view on fraudulent or negligent conduct. In short, this publication suggests that a taxpayer will need to use its commercial knowledge and judgement to make arrangements and set prices which conform to the arm’s length standard or alternatively to make an adjustment to comply with this standard in the tax return. The taxpayer must also be able to show by means of good quality documentation that it made an honest and reasonable attempt to comply with that standard and to seek professional help when needed.
Hopefully taxpayers have borne these requirements in mind when preparing and filing their tax returns and will continue to do so when responding to the Revenue queries.
Where to from here?
It is still early days for both taxpayers and the Revenue in adapting to transfer pricing under the CTSA regime. No doubt the Revenue’s focus will develop over time as has been the case where transfer pricing has been introduced in other jurisdictions.
It will be interesting to see what approach the Revenue takes to taxpayers’ responses that are being made in these early stages.
However the message from the first round of the Revenue enquiries is very clear: The fact that in 50 per cent of enquiries the taxpayer was asked to justify its prices against the arm’s length standard underscores the fundamental change in approach from the Revenue under CTSA. It is now the taxpayer’s obligation to justify its transfer prices and to keep the documentation that supports the taxpayer’s view that it filed a correct and accurate return. All the Revenue needs to do is ask for the justification and documentation.
020 7235 9381
December 2001 by