TRANSFER PRICING THE PROBLEM

1
TRANSFER PRICING -THE PROBLEM

• Multinational groups - commonplace, profitable,
  powerful, straddle tax borders
• Cross border trading widespread
• Variation in tax rates encourages global tax
  planning
• Tax rates used by governments as incentive to
  encourage inward investment

2
TAXING CROSS-BORDER TRANSACTIONS

• How do different countries, which see themselves
  as having taxing rights, share those rights?
• How should allocation between equity and loans be
  treated?

3
POLITICAL NECESSITIES
They were routes which might in other
circumstances have been considered, to put it
no higher, distasteful. We have, particularly in
recent decades, needed foreign capital and have
been obliged to change the rules of the game in
order to attract it Inland Revenue
International Handbook Mar 1996
4
TAXING RIGHTS
General approach is that taxing rights on
profits accrue primarily in the country in which
they are earned but those profits are diminished
by payments of interest which are to be taxed
wholly or mainly where the recipient is resident.
5
KEY INFLUENCERSON TRANSFER PRICING

• Organisation for Economic Cooperation and
  Development (OECD)
• Internal Revenue Service (IRS)
• Inland Revenue
• Self assessment (more care needed now at filing
  stage)
• European Commission
• International Charities

6
ROLE OF DOUBLE TAX TREATIES

• OECD Model Convention influenced by early UK
  Treaties
• Article 7 - arms length attribution of profits
  to a PE
• Article 9 - adjustment of profits where they have
  been affected by common control
• Competent authority role

7
US TRENDS

• Record keeping showing contemporaneous pricing
  methodology now required (enforced by penalties)
• Advance Pricing Agreements
• Input to debate on accounting principles
• Focus on intangibles
• Use of economists and statisticians
  introduced into UK by FA 1999 s85

8
85 Advance pricing agreements etc(1) This section
applies in relation to any chargeable period
where(a)     the Board have made a written
agreement with any person (the
taxpayer)(b)     the agreement relates to one
or more of the matters mentioned in subsection
(2) below and to that chargeable period(c)    
the agreement is one made as a consequence of an
application by the taxpayer to the Board for the
clarification by agreement of the effect in the
taxpayer's case of provisions by reference to
which questions relating to any one or more of
those matters fall, or might fall, to be
determined and(d)     the agreement contains a
declaration that it is an agreement made for the
purposes of this section
9
.(2) Those matters are(a)     the attribution of
income to a branch or agency through which the
taxpayer has been carrying on a trade in the
United Kingdom, or is proposing so to carry on a
trade(b)     the attribution of income to any
permanent establishment of the taxpayer (wherever
situated) through which he has been carrying on,
or is proposing to carry on, any business(c)    
the extent to which income which has arisen or
may arise to the taxpayer is to be taken for any
purpose to be income arising in a country or
territory outside the United Kingdom(d)     the
treatment for tax purposes of any provision made
or imposed (whether before or after the date of
the agreement) as between the taxpayer and any
associate of his
10
PRESENT DAY CONCERNS

• Importance of intangibles (particularly
  intellectual property) and finance
• Valuation difficulties
• Electronic paperless trading
• Hidden costs (eg provision of parent company
  guarantees)
• Secondary issues of pricing adjustments

11
DIFFERENT APPROACHES

• Arms length pricing
• Profit split approach

12
ARMS LENGTH APPROACH

• If the taxpayer were a third party rather than a
  connected entity what profits would he have
  earned from carrying out his current intra-group
  operations?
• Comparative method (ie look at other parties)
• Cost plus, profit margins etc (ie look at the
  actual transactions)

13
PROFIT SPLIT APPROACH

• Ignores actual transactions
• Looks at global profits of entire group and
  allocates them across the various countries in
  which it operates
• Allocation could be based on assets, turnover,
  headcount, capital employed etc

14
CONSEQUENCES OF PRICING ADJUSTMENT

• More tax in jurisdiction making the adjustment
• Double taxation of the profit increase
• Potential conflict between tax jurisdictions
• Mutual agreement procedure
• Question of corresponding adjustment
• Issue of secondary adjustments

15
REVENUE WEAPONS

• Use of criminal law (eg R v Charlton 67 TC 500)
• Use of case law
• Ramsay/Dawson
• Challenge residence status (ie check the facts)
• Transfer pricing legislation
• CFC legislation

16
REGINA v CHARLTON

• UK company bought tyres from abroad for resale
• formed a Jersey company which bought from the
  overseas suppliers and sold on (at a profit) to
  the UK company
• the key advisers were prosecuted and found guilty
  of cheating the Revenue
• all received prison sentences

17
CASE LAW

• Watson v Hornby 24 TC 506
• Sharkey v Wernher 36 TC 275
• Petrotim v Ayres 41 TC 275

18
WATSON v HORNBY

• chick hatchery business (taxed under Sched D) and
  poultry farm (taxed under Sched B)
• what was correct transfer price from hatchery to
  farm?
• held to be market value (as contended by taxpayer)

19
SHARKEY v WERNHER

• horses transferred from stud farm (taxed under
  Case I) to private racing (not taxed)
• held (as argued by Revenue) that transfer should
  be at market value for tax purposes

20
PETROTIM SECURITIES

• company sold securities which it held as trading
  stock at substantial under value to associated
  company
• held (as argued by Revenue) that transfer should
  have been at market value for tax purposes

21
TA 1988 S770A and Sched 28AA

• Legislation first introduced in 1951
• Followed Revenue unease about relying on domestic
  case law and Treaties
• Substantially untested in Courts
• Threat is enough

22
FA 2004 Changes(from 1 April 2004)

• Applies to transactions within the UK (following
  concern that UK to UK exemption was
  discriminatory)
• Small and medium sized companies exempt
• Thin capitalisation rules incorporated into
  general transfer pricing rules

23
SCHED 28AA - para 1BASIC RULES

• Actual provision
• Affected persons
• One participating in control of the other (or
  third person participating in control of both)
• Transaction or series of transactions
• Arms length provision
• Potential Advantage

24
(1) This Schedule applies where   (a)    
provision (the actual provision) has been made
or imposed as between any two persons (the
affected persons) by means of a transaction or
series of transactions, and   (b)     at the time
of the making or imposition of the actual
provision     (i)     one of the affected
persons was directly or indirectly participating
in the management, control or capital of the
other or   (ii)     the same person or persons
was or were directly or indirectly participating
in the management, control or capital of each of
the affected persons
25
(2) Subject to paragraphs 5A, 5B, 8, 10 and 13
below, if the actual provision   (a)     differs
from the provision (the arm's length provision)
which would have been made as between independent
enterprises, and   (b)     confers a potential
advantage in relation to United Kingdom taxation
on one of the affected persons, or (whether or
not the same advantage) on each of them,the
profits and losses of the potentially advantaged
person or, as the case may be, of each of the
potentially advantaged persons shall be computed
for tax purposes as if the arm's length provision
had been made or imposed instead of the actual
provision.
26
TRANSACTION

• Includes arrangements, understandings and mutual
  practices whether or not legally enforceable
• Series of transactions includes reference to a
  number of transactions entered into in pursuance
  of the same arrangement

27
POTENTIAL ADVANTAGE(para 5)

• Where the effect of the actual provision being
  used instead of the arms length provision leads
  to smaller profits or larger losses for tax
  purposes

28
SCHED 28AA para 2 - OECD

• Schedule to be construed to ensure consistence
  with OECD model treaty (if appropriate) and OECD
  transfer pricing guidelines

29
2(1) This Schedule shall be construed (subject
to paragraphs 8 to 11 below) in such manner as
best secures consistency between   (a)     the
effect given to paragraph 1 above and   (b)    
the effect which, in accordance with the transfer
pricing guidelines, is to be given, in cases
where double taxation arrangements incorporate
the whole or any part of the OECD model, to so
much of the arrangements as does so.(2) In this
paragraph the OECD model means   (a)     the
rules which, at the passing of this Act, were
contained in Article 9 of the Model Tax
Convention on Income and on Capital published by
the Organisation for Economic Co-operation and
Development or   (b)     any rules in the same
or equivalent terms.
30
In the context of thin capitalisation the
application of the arms length principle
requires an Inspector to form a judgement as to
what amount of interest-bearing debt the company
or companies would and could have borrowed on a
stand alone basis from a third party lender who
was entirely unconnected with that company or
group of companies. INTM541020
31
In addition to the different treatment for tax
purposes of interest and dividends, the UK has
generous rules for the application of interest
deductions, both before and after the corporate
debt legislation. One reason for this is that the
UK has no sourcing rules for interest, which
means that interest deductions can be given
against income generally, not just against income
generated by the money borrowed. So, for example,
a UK company can borrow to finance a subsidiary
company in another territory and the interest may
be allowable notwithstanding the fact that no
taxable income may arise for a number of years,
if at all, from the investment in the subsidiary
company. In some countries, such as Australia,
deductions for interest payments can only be
given when those payments can be matched against
the income stream arising from the particular
investment. INTM541030
32
DEBT/EQUITY RATIOS

• Thin capitalisation is problem for inward
  investment
• Thick capitalisation is problem for outward
  investment

33
THIN CAPITALISATIONFrom April 1994

• TA 1988 Sched 28AA 1A
• Now incorporated in transfer pricing rules
• Treatment of excess interest as a distribution
  now abolished
• Legislation considers whether in the absence of
  the special relationship the loan would have been
  made at all and if so the amount and terms it
  would have had

34
Equity UK to be entirely funded by equity of
10 million Year 1 pre-tax profits 3
million CT _at_ 30 900,000 Dividend
900,000 Debt UK funded entirely by debt 10
million _at_ 9 pa Year 1 pre-interest and
pre-tax profits 3 million Interest due 900,000
CT 2.1 million _at_ 30 630,000 INTM541040
35
1A(1) This paragraph applies where (a)   both
of the affected persons are companies, and
(b)   the actual provision is provision in
relation to a security issued by one of those
companies (the issuing company). (2) Paragraph
1(2)(a) above shall be construed as requiring
account to be taken of all factors, including
(a)   the question whether the loan would have
been made at all in the absence of the special
relationship (see sub-paragraph (6) below),
(b)   the amount which the loan would have been
in the absence of the special relationship, and
(c)   the rate of interest and other terms which
would have been agreed in the absence of the
special relationship,
36
Corresponding adjustments

• If interest is disallowed under thin
  capitalisation rules
• And lender is UK company
• Lender can claim to reduce taxable profits by the
  interest disallowed TA 1988
  Sched 28AA para 6C INTM562040