Article by Danny Beeton. Dr Danny Beeton, PhD, is Head of Transfer Pricing-Economics, Grant Thornton UK, and Chairman, Global Transfer Pricing Committee. This article appeared in the December 2002 issue of Tax Adviser.
This article reviews:
- how a transfer-pricing enquiry is initiated, either for post-CTSA years or for any open pre-CTSA years;
- how the Revenue will conduct an enquiry including information requests and timescale;
- how the enquiry will be concluded, including the appeals process; and
- how the taxpayer should approach the enquiry.
Since the introduction of Corporation Tax Self Assessment (CTSA) for accounting periods ended on or after 1 July 1999, Inland Revenue inspectors have been much more enthusiastic than before to launch transfer-pricing enquiries. Needless to say, this is driven by the opportunities afforded for generating more tax and the opportunities presented by penalties of up to 100 per cent of any additional tax.
Just as importantly, Tax Bulletin 37, October 1998, set out a list of documents which companies were expected to maintain to support their transfer prices and, rather than formulating detailed lists of questions to taxpayers, inspectors could simply ask for the documents listed. Indeed, some were so keen that they began asking companies for these documents before they had even come to their first CTSA accounting year-end. The result of this new enthusiasm for transfer-pricing enquiries has been that in December 2001 a wave of enquiry letters were sent to companies with reference to their December 1999 year-ends (the inspector has one year after the statutory filing deadline to issue a notice of enquiry). To many companies, particularly smaller ones, this came as a significant shock and they have generally turned to specialist transfer-pricing consultants for assistance.
The purpose of writing this article is to pass on the lessons that we have learnt in assisting many clients, particularly smaller ones, in the course of transfer-pricing enquiries. Hopefully we can help companies to avoid large penalties, to reduce the demand on senior management time and perhaps to reduce the risk of a transfer-pricing enquiry in the first place.
How the enquiry is initiated
For accounting periods ended on or after 1 July 1999, the Revenue can give notice of an enquiry into transfer-pricing under Finance Act 1998 (FA 1998), Sch. 18, para. 24 (1) at any time up to twelve months from the filing date, assuming that the return has been made by the filing date and has not been amended. For ‘open’ years before that date, the Revenue can initiate a transfer-pricing enquiry by issuing a Direction under Income and Corporation Taxes Act 1998, (ICTA 1988), s. 770(2)(d). The Revenue can also make a ‘discovery assessment’ under FA 1998, Sch. 18, para. 41 up to six years after the end of the accounting period. If it is attributable to fraudulent or negligent conduct on behalf of the company, it can be up to twenty one years after the end of the accounting period - in order to initiate a transfer-pricing enquiry into a ‘closed’ year. In theory, the Revenue cannot make an assessment more than six years after the end of a chargeable period, and as such should not initiate enquiries into periods before this time. However, they have argued with some success that if a year is open from more than six years previously (even in the absence of fraud or neglect) they can make a transfer-pricing enquiry even if that was not the reason for the original enquiry in relation to which the year remains open. The implication is that a company may experience a transfer-pricing enquiry into any open year, and into any closed year if there is a possibility of a ‘discovery’ of new information by the Revenue.
How will a company be targeted for a transfer-pricing enquiry? Tax Bulletin 60, August 2002 Tax Bulletin lists the following risk factors which an inspector will assess:
- existence within the group of profitable tax haven entities;
- lower profit margins within the United Kingdom (UK) than within the rest of the group;
- presence in the UK of factors that should generate a higher profit than that observed, e.g. heavy investment, highly skilled or remunerated technical or research and development employees, and intangible assets;
- continued poor profit performance despite the above; and
- changes in contractual arrangements to adjust risk profiles.
More generally, a survey of post-CTSA enquiries found that transfer-pricing was one of the top five risk areas. For pre-CTSA years no such guidance has been published, although presumably the same factors will be referred to.
Of course, the transfer-pricing adjustments will always have an opposite (and, taxpayers will hope, equal) effect on the taxpayer with whom the UK company is transacting in the overseas jurisdiction. However, one survey found that as many as 40 per cent of taxpayers fail to achieve a full compensating adjustment on their tax assessed in the other jurisdiction in these situations.
How the enquiry will proceed
Tax Bulletin 60 sets out the typical stages in a transfer-pricing enquiry, as follows:
The initial enquiry
Even if it only relates to one transfer-pricing issue the Revenue may widen it to other transfer-pricing issues as long as the year remains ‘open’.
The company’s response
The Revenue will expect the company to be able to provide the standard documentation listed in Tax Bulletin 37 within one month, i.e. relevant commercial or financial relations, nature, terms and prices, methods used to set prices, research carried out to apply methods, adjustments made to raw benchmarking results in order to apply methods, how transactions and prices compare between related party and third party transactions including agreements, budgets and forecasts. It will allow up to six months for more detailed information. The Revenue gained significant extra powers to require documents in FA 2000.
The Revenue’s consideration of the company’s response
It may take a further six months for the Revenue to state its preliminary conclusions.
Negotiation and agreement
There is no time limit to this phase.
No corresponding guidance has been published for pre-CTSA years.
How the enquiry can be managed
Clearly it is best if a taxpayer avoids being selected for a transfer-pricing enquiry at all. This risk can be reduced by:
- asking independent experts to identify the transactions and the correct transfer-pricing methods, and researching the arm's length transfer-pricing policies;
- working with specialists to assemble documentation sets in accordance with Tax Bulletin 37; and
- only changing internal contract terms for sound commercial reasons.
If a company is selected for an enquiry, it should consider the following points in framing its response:
- the company should not attempt to bring the enquiry to an early close by making an offer of additional tax. If it does so it will lose credibility with the Revenue and may well end up having to pay more tax than it might otherwise have done;
- if the Revenue demand the company's transfer-pricing documentation within a short time frame on the basis that it should have been in place before the tax return was signed, the company should point out where extra time is required because the Revenue have asked for specific information which would not necessarily be part of a company's normal transfer-pricing documentation;
- in general, it is advisable to hand over only those documents which have been specifically requested. There is little point in distracting the Revenue from the issue at hand with superfluous information that could needlessly alter the direction of the enquiry;
- a taxpayer should avoid meeting the Revenue to discuss the case until the Revenue have clearly understood the taxpayer's arguments. Meetings are best viewed as the medium for negotiations, not information gathering. Negotiations should come much later down the line, and can often be avoided altogether if a taxpayer's arguments are well presented. Also, inspectors have been known to draw some peculiar and extreme conclusions on the basis of what they saw of a company during a brief visit for a meeting;
- a company should never make any response of any kind to notification of a transfer-pricing enquiry without first taking professional advice. A well thought out approach can pay handsome dividends if it is adopted at an early stage;
- taxpayers should stick to their guns - if their arguments are rejected early on by the Revenue they can still be accepted by them eighteen months later after additional refinement and supporting information.
The Revenue have limited resources to devote to transfer-pricing enquiries and should welcome the involvement of specialists who can focus the attention of taxpayers on the detailed transfer-pricing issues at point.
Examples of arguments have been successful for our clients in defending their transfer-pricing policies include:
- prolonged losses – consider whether there have been any external or internal shocks for the company, such as new competitors, competing products, regulation, product launches, reorganisations or changes in senior management. For a distributor, note whether sales have fallen unexpectedly below the target level to break even; for a manufacturer refer to unexpected failure to fill available capacity;
- arguably inadequate management charges – identify the ‘shareholder cost’ element which should not be recharged anyway, and if necessary note where some of this was in fact charged and can be viewed as the mark-up on costs that the Revenue are seeking;
- interest apparently not charged by a UK company – consider whether balances ‘churned’ regularly so that no interest is owing on larger balances. Show where loans performed a quasi-equity function, or where there was an off-setting balance between another UK company and a company in the other jurisdiction. There may also be an argument that the UK company performed a central treasury function, or was only a conduit for the funding;
- apparent thin capitalisation – refer to collateral as well as equity and interest cover – for example, property or inventory. Identify the arm's length range of debt:equity ratios and interest cover for comparable companies through a database search and show that the taxpayer is within the overall range on one of these measures;
- a challenge to the level of royalty - benchmark the level of the royalty against comparable royalties between third parties using a database search. Identify the routine profit for the function performed by the ‘licencee’ and present arguments as to how the residual profit should be shared with the "licensor". Identify what the royalty should be in order to produce an arm’s length return on the cost of creating the underlying intangible asset;
- general - challenge the Revenue’s economic characterisation of the transaction and/or the choice of transfer-pricing method. For example, a stripped risk distributor could be better viewed as a cost plus sales service provider in certain circumstances. A return on assets employed could be a better benchmark for a manufacturer than its gross margin. Profit should sometimes be benchmarked as a mark-up on operating expenses only rather than on total costs.
How the enquiry will be concluded
Our experience is that a good proportion of enquiries can be concluded quickly by writing one or two well argued letters explaining the company's transfer-pricing policies. The inspector may then write to announce that he has closed the enquiry and no further action will be taken.
In more complex cases with larger sums at stake, negotiations are likely. This is a distinguishing feature of the British tax system generally. Very few cases will end in a prosecution, which is a very different situation from that in United States (US) transfer-pricing disputes. For example, one commentator recently noted that the Revenue made only around seventy prosecutions a year for all issues, of which transfer-pricing was just one.
The Revenue will enter the negotiations with quite extreme demands, for example that the profits of the taxpayer should be adjusted to:
- what it used to achieve;
- what the other companies in its group achieve;
- the kind of level observed by the inspector or his colleagues in the course of their work in the taxpayer's industry; and
- the rates of profit enjoyed by the most successful companies in the taxpayer's industry, based on research carried out specifically for the enquiry by the Revenue.
The Revenue's profit benchmarks may be seriously flawed and a transfer-pricing specialist will be able to point out obvious weaknesses and identify more appropriate benchmarks. For example, in a recent transfer-pricing enquiry the Revenue argued that a mark-up on costs should be 10–15 per cent based on their ‘general expectation’. We produced research to demonstrate that five to six per cent was the arm's length benchmark and the Revenue agreed on a figure of six per cent. In another recent enquiry, the Revenue proposed to benchmark profits after the deduction of interest payments. We pointed out that this was not a recognised transfer-pricing method.
In those few cases where an amicable agreement cannot be reached, the outcome will be:
- for pre-CTSA years, an examination of the case will lead to a Direction under of ICTA 1988, s. 770. The taxpayer has the right to appeal by virtue of s. 31 and the assessment then remains open until agreed with the inspector in accordance with s. 54 or is settled by a determination of the General or Special Commissioners. Interest will be payable on deemed underpayments of tax, but there will be no further penalties. However, taxpayers may find it impossible to obtain a compensating income and tax adjustment in the other country involved because of the amount of time that has elapsed; or
- for post CTSA years, the Revenue may impose tax-geared penalties of up to 100per cent of the additional tax assessed. No corresponding adjustment can be sought for these in the other jurisdiction involved.
Another commentator recently made the remarkable observation that in serious tax investigations around 20 per cent of the companies involved collapse as a result of the stress and demand on senior management time over a prolonged period. This distraction from running the business is often more of an issue than the tax or the penalty in question, but is often overlooked by companies when deciding whether the cost of specialist advice is merited.
A transfer-pricing enquiry can make a major and prolonged demand on senior management time and divert attention away from more important business issues. Ideally, taxpayers should avoid such enquiries by working with specialists to identify and document the correct transfer-pricing policies before submitting their corporate tax returns. If they do not do so, then low profits or complex transfer-pricing policies are likely to trigger an enquiry and this must be handled with great care. Expert advisers can achieve great success in closing enquiries with little or no additional tax owing, but they must be brought in at the earliest stage. Experience has shown that there are strategies for handling the enquiry and for countering the Revenue's arguments that are more likely to meet with success. Taxpayers should make every effort to bolster their own case because there are few hard and fast rules in transfer-pricing.
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December 2002 by