On 18 September 2013, HMRC issued a discussion note setting out the Government’s proposals to restrict the use of ‘compensating adjustments’ in the transfer pricing rules to create income tax advantages.
This is in response to two particular arrangements that exploit the use of the transfer pricing rules in this way.
The first is commonly used by professional partnerships that employ their staff through a separate service company owned by the partnership. The following example provided by HMRC illustrates how at present an income tax advantage can be generated:
“If a company is operating as a service provider to third parties and the total staff payroll is £100m, we would expect companies operating at arm’s length to apply a mark up to the labour costs to reflect, among other things, the functions performed. Assume for this example an appropriate mark-up might be around 5%, so £5m on a £100m payroll.
Because the partners effectively own the service company, the transfer pricing legislation will substitute an arm’s length price where the actual provision is not at arm’s length. So if payment only covers the costs of the staff wages to the service company of £100m, the transfer pricing rules will replace it with £105m for the purposes of calculating the taxable profit of the company. Following the numerical example this will mean substituting a price of £105m thereby increasing the taxable profits of the company by £5m. No cash payment is required by the partners to make good the shortfall and so the £5m remains within the partnership where it can be drawn by the partners.
The partners may make a claim for a compensating adjustment that replaces the £100m cost with a cost of £105m reducing their taxable share of partnership profits by £5m. The partners will however still receive their share of the accounting profit providing a tax benefit to the partners of the difference between the income tax and NIC on the £5M and the corporate tax rate.”
The second arrangement targeted by these rules concerns excessive ‘leveraging’ of companies by individuals. This type of arrangement is commonly used by private equity houses.
“The UK transfer pricing rules apply where companies are overly indebted due to the fact that borrowing has been provided that would not have occurred at arm’s length but for the relationship that exists between the lender and borrower. The legislation restricts interest deductions arising from this “non arm’s length” debt calculating the taxable profit as if arm’s length arrangements had been entered into rather than the actual arrangements. A compensating adjustment may be claimed by the lender so that its position mirrors that of the borrower. This effectively removes an amount of interest equal to the excess over the arm’s length amount from the charge to income tax in their hands.
This has the effect of enabling the lenders to extract money from the company without paying income tax. The lenders’ involvement in the company means that they are often taking a return on loans in place of a profit distribution.”
The Government aims to counteract the above arrangements by introducing legislation to restrict compensating adjustments where the other party is a company. The rules will apply to medium and large companies and some smaller companies where one party is in a non-qualifying overseas territory. The proposed rules will apply to amounts arising on or after the date the legislation comes into effect and HMRC has stated that there will be a short opportunity for discussion on the policy proposals before then, and they have invited comments in relation to their proposals.
Although HMRC has focussed on professional partnerships and private equity houses these proposals are likely to impact on other similar arrangements where the transfer pricing rules are being used to create a tax advantage. Accountants should therefore review these arrangements in the light of HMRC’s new scrutiny.