UNITED KINGDOM- TRANSFER PRICING AND CONTROLLED FOREIGN COMPANIES
transfer pricing becomes central to the operation of the UK’s new Controlled Foreign Companies (CFC) and Patent Box rules. Statistics from HMRC on UK transfer pricing enquiries. Pragmatism from a tax authority on transfer pricing – Whatever next?!
2012 heralds some significant changes to the UK tax environment for corporates. Two particular such points – the new CFC rules and the proposed Patent Box regime – have clearly already had an impact on investment decisions by a number of groups. The announcements by WPP (that they are likely to re-domicile back to the UK) and by GlaxoSmithKline (that they are to invest more than GBP 500 million in manufacturing in the UK, creating up to 1,000 new jobs) are evidence that the UK is attracting large scale investment as a result of its tax policies. Transfer pricing plays a critical (if not central) role in the application of these new rules.
HMRC has also recently provided insight into both the UK’s tax yield from transfer pricing enquiries and other measures of HMRC performance in dealing with transfer pricing issues. In addition, HMRC has set out how it is investing in ‘real time working’ to reduce the incidence of taxpayer controversy and give greater certainty to business.
The relevance of transfer pricing to the new CFC and Patent Box regimes
Transfer pricing principles are critical to both the application of the new CFC rules and the Patent Box (the latter of which is examined elsewhere in this edition).
The new CFC regime potentially requires the consideration of ‘Significant People Functions’ - a concept drawn from transfer pricing principles applied in the OECD Report on the Attribution of Profits to Permanent Establishments - as a means of measuring the extent to which there is a ‘significant mismatch between key business activities undertaken in the UK and the profits arising from those activities which are allocated outside the UK’ in identifying circumstances where there has been an ‘artificial diversion of UK profits’ to which an attribution under the CFC rules might apply.
HMRC update on transfer pricing enquires
HMRC has released statistics on the transfer pricing yield and the time taken to resolve transfer pricing enquiries. As shown in the table opposite, transfer pricing appears to be one of the most lucrative means of raising additional corporation tax from large businesses.
The focus of HMRC has historically been on the largest and most complex businesses, given that there was inadequate resource available to deal with transfer pricing enquiries more broadly.
Over the past five years, HMRC has invested heavily in training transfer pricing specialists. This, and more clearly targeted governance for the pursuit of transfer pricing enquiries, has allowed HMRC to more successfully target what it regards as ‘high risk’ transactions in groups of all sizes, using dedicated transfer pricing support nationally. This investment has resulted in a 650% rise in tax yield from businesses over four years. We expect this trend to continue.
The average time taken to resolve a transfer pricing enquiry in 2011 was 24.4 months.
How about other tax authorities?
Multinational businesses now face transfer pricing legislation in most jurisdictions. Whilst many other tax authorities incorporate the OECD Transfer Pricing Guidelines in their local law, each tax authority will have their own subjective interpretations of the rules in terms of preferences for different methodologies and on economic substance versus legal form.
In terms of pragmatism in dealing with taxpayers on transfer pricing issues, however, it seems that HMRC are highly rated by corporates. 98% of corporates surveyed at a recent leading transfer pricing conference felt that other tax authorities were more difficult than HMRC to deal with on transfer pricing matters. The US, India, Germany, Italy and Brazil were cited as being countries where significant transfer pricing challenges are likely to arise, which goes to show how important it is to get both global and local transfer pricing advice.
What are the implications of HMRC’s developing approach for businesses?
There are still a sizeable number of groups that do not have adequate transfer pricing documentation in place. The statistics above highlight that this position is unlikely to remain tenable from an internal risk perspective.
Where there has been inadequate support for a transfer pricing policy, we have seen HMRC enforce transfer pricing adjustments over multiple years, with potential penalties of up to 100% of the adjustment. Given this risk, we are routinely seeing auditors requesting copies of transfer pricing reports before issuing a clean opinion.
So the first step is to make sure all group policies can be supported and documented from both UK and overseas transfer pricing perspectives in order to minimise transfer pricing risks.
HMRC’s investment in certainty for businesses
HMRC realises that transfer pricing is a large cost to business in terms of resource and potential double taxation. It is moving resource into real time working with businesses to give better certainty.
HMRC is offering the opportunity for businesses to talk through their transfer pricing documentation with their Inspector.
HMRC has made it clear that it is happy to provide guidance to businesses on their prepared documentation and the methodologies that they have used. This can allow businesses to informally agree or adjust their position to take into account HMRC’s comments. This informal approach provides a quick and relatively inexpensive means of lowering a group’s UK transfer pricing audit risks, with consequent financial and resource savings.
Having a discussion with an Inspector can lower UK transfer pricing risk. It can also lower overseas transfer pricing risks, where HMRC agrees to support a position in the event of a dispute with an overseas tax authority.
However, it does not provide any legally binding agreement on HMRC or absolute certainty on overseas matters.
HMRC has had an Advanced Pricing Agreement (APA) programme for many years that provides for bilateral agreement on transfer pricing matters between different tax authorities. In 2010, HMRC updated its guidance on APAs to allow businesses to join the programme, regardless of size, provided the transfer pricing issue is sufficiently complex. The number of APA applications has increased by 53% in a year from 2010 to 2011 based on these changes.
Where a group has major transaction flows with related parties cross-border where there is prospective transfer pricing risk, an APA can provide certainty for a number of years, eliminating potential double taxation and allowing transfer pricing provisions in the accounts to be released. It could also act as support for transfer pricing enquiry defence in other territories.
An APA tends to work best with businesses with a relatively stable business model, as they will take on average 20-22 months to be concluded and require an investment in internal resource and professional advisory fees.
Year 2007\8 2008\9 2009\10 2010\11 2011\12
Total* 509 1,595 1,039 436 1,000 current estimate
Large Business Service* 494 1564 973 273 No data
Local Compliance* 25 31 66 163 No data
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TRANSFER PRICING AND THE PROPOSED PATENT BOX REGIME
The UK’s proposed Patent Box regime will apply an effective 10% rate of corporation tax to profits derived from patents with effect from 1 April 2013.
Advanced planning may assist in maximizing profits which may fall within the new regime. This is part of the Government’s drive to provide an additional incentive for businesses to retain and commercialise existing patents and develop new innovative patented products in the UK.
The relevance of transfer pricing to the new Patent Box regime
Transfer pricing principles are critical to the application of the Patent Box rules.
The Patent Box regime utilises transfer pricing concepts to allocate income to the Patent Box. HMRC expects the Patent Box to lead to a detailed focus on transfer pricing, given its critical role in the allocated part of income between that subject to the full corporate rate and that subject to the effective 10% Patent Box rate.
Companies eligible for the Patent Box
A company can elect into the Patent Box regime if it owns or has a licence over patents granted by the UK Intellectual Property Office, European Patent Office or patent offices in certain EU member states. The profits qualifying for the Patent Box regime are those deriving from the item protected by the patent and can also apply to profits derived from any product incorporating the patent item (no matter how insignificant the cost of the patented item in relation to the total cost of the product incorporating it). The calculation of the tax basis for those profits qualifying for the regime also means that certain other nonpatented technical intellectual property may benefit from the 10% effective tax rate.
Rate of tax
Relief is given through an additional deduction in the company’s corporation tax computation, the effect of which is to reduce the rate of tax on relevant Patent Box profits to 10%. The relief is optional.
Worldwide profits from these patents (not just those generated in the UK or EU) will be included.
There are two principal qualifying conditions:
- First, the company must have made a significant contribution to the creation or development of the item protected by the patent or a product incorporating this item. In a group situation, provided the company holding the patent in the year of claim actively manages its portfolio of qualifying rights, another group company can undertake (or have undertaken) the qualifying development (even if this is – or were – outside of the UK).
- Secondly, if the claimant company licences in patent rights it must have exclusivity which is at least country-wide.
The conditions mean that, say, a non-UK company which actively manages an item protected by a patent (or incorporating it) can still qualify for the Patent Box if the patent or licence to it has been created or developed by a non-UK group company and subsequently transferred to it.
Calculation of Patent Box profits
The calculation of Patent Box profits will generally be based on formulae which, once established, can be used in successive periods. Opportunities exist for a more bespoke calculation if this is beneficial. Details of the calculation are shown below.
Patent pending period
There may be a number of years between application for a patent and its grant. Relief will be claimed in the accounting period of grant by recognising, at that point, qualifying income and profits in the period from application to grant (subject to a maximum period of 6 years).
Commencement of the Patent Box regime
The proposed commencement date for the new regime is 1 April 2013.
The full benefit of the regime will be phased in over five years from 1 April 2013 by applying a percentage to the relevant IP profits on a sliding scale, with 60% of such profits included in FY 2013, 70% in FY 2014, 80% in FY 2015 and 90% in FY 2016.
Stage 1 – Calculate Relevant Intellectual Property Income
This is income from sales of the patented item or an item incorporating it, licence fees and royalties, patent disposals and infringement compensation.
Profits from the sale of products made via a patented process (where the products are not themselves covered by a patent) are also included in the Patent Box regime. Companies may calculate a notional arm’s length royalty for the use of the patent and include this notional income in the calculation.
Stage 2 – Allocation of profits
Profits are allocated to the Relevant IP Income and other income on a pro-rata basis or through a ‘just and reasonable’ apportionment of expenses (it would seem sensible to do so based on transfer pricing principles).
Stage 3 – Remove the routine return
It is assumed that, in the absence of unique IP and other intangible assets, a routine return of 10% would still be achieved on that company’s personnel, premises, plant and machinery and miscellaneous expenses. This routine return is eliminated from the pool of patent profits (with an alternative approach available for smaller claims) leaving ‘Qualifying Residual Profit’. However, the cost base of the company to which the 10% mark up applies excludes costs of other group companies providing services to the Patent Box company and, therefore, the basis on which that mark up applies will depend on the nature of the group’s operational structure.
Stage 4 – Remove the marketing return
The residual profit is then subject to a final adjustment to eliminate the return achieved on marketing assets (including know how, trademarks, and company names and logos) by deducting a notional marketing royalty. This is intended to exclude from the regime the substantial profits which can be generated using established brands.
For small claims this adjustment is calculated on a formula basis. For larger claims a notional marketing royalty must be calculated (using transfer pricing principles) and deducted from the residual profit.
How we can help
We can assist in planning for the new Patent Box regime, including:
- Helping to identify qualifying IP and revenue streams;
- Discussing the merits of electing into the regime;
- Establishing where qualifying patents should be held;
- Analysing the different bases for calculation and planning opportunities to maximise the claim;
- Developing transfer pricing methodologies and tools for data collection for computing income and expenses at the various stages;
- Assisting with compliance obligations.
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