The UK Inland Revenue has signalled a crack down on transfer pricing planning. The chairman of the Inland Revenue, Sir Nicholas Montagu, has opened 2003 with a stark warning of the UK tax authority’s intentions to crack down on tax avoidance. In particular, the Inland Revenue appears to be directing its focus on established multinationals, with investigations into big business described as "fantastically fruitful." In a recent interview, Montagu identified the use of transfer pricing systems as an area of primary concern.
Guidance was published by the Inland Revenue last year on its approach to transfer pricing investigations and summarises what multinational companies having a UK presence can expect when they fall under the scrutiny of the Inland Revenue and how they can prepare themselves.
Although the guidance on risk assessment should lead to a reduction in the more speculative type of inquiries and to a more structured and consistent approach generally, there is some concern that the guidance is not sufficiently tightly drawn to prevent spurious arguments by the tax authority as to the characterisation of certain arrangements and the requisite breadth of enquiries.
Initial Risk Assessment
The first stage of the process is the initial risk assessment undertaken by the Inland Revenue, which is to be carried out in a greater level of detail than risk assessments in other inquiry areas given the potential resource cost of a full inquiry.
This initial risk assessment process should include the following:
- a review of previous transfer pricing papers;
- a detailed examination of six years of consolidated group accounts and individual accounts of relevant UK and non-UK entities;
- consideration of group structure and identification of haven/shelter countries;
- a review of industry trends, details of the company’s place in its sector and recent group developments (new acquisitions, locations, etc.);
- a review of databases for multiple year data and potential comparables;
- a review of company returns in other jurisdictions;
- liaison with the employment taxes office regarding details of highly paid staff; and
- possible liaison with HM Customs and Excise.
Much of this information will be available to inspectors without any need to involve the taxpayer in the process. However, the guidance makes clear that the Inland Revenue will make use of its information exchange powers and rights under double tax treaties in circumstances where taxpayers cannot be persuaded to volunteer information, provided the amount of tax at stake warrants such an approach.
In determining the merits of taking an inquiry to the next stage, a cost benefit analysis approach will be adopted by tax inspectors, taking into account the level of difficulty of establishing an arm’s length price in the particular circumstances in question. There are no safe harbours in the UK transfer pricing legislation but interestingly the guidance indicates that the difficulty in establishing an arm’s length cost plus price may result in an inquiry not being appropriate where it is likely to produce only an additional £50,000 in UK profits.
The extent to which a multinational taxpayer would wish to become involved in this first stage of the inquiry is, therefore, likely to involve a judgment call as to whether co-operation would merely facilitate an Inland Revenue fishing expedition or whether it might enable the taxpayer to demonstrate convincingly the merits of, or at least the difficulty of discrediting, its case.
Particular Risk Areas
Multinational enterprises should note that the Inland Revenue has identified the following circumstances as areas of particular risk which merit further enquiry:
- tax haven entities outside the controlled foreign company rules which are profitable despite the absence of significant activity in that jurisdiction;
- mismatches between tax haven operations and profits;
- lower UK profit margins than can be identified in the group generally where there are reasons to suggest that this should not be the case;
- circumstances where the UK entity has the resources (e.g., heavy investment, highly skilled and remunerated technical workforce, intangibles) to generate a high profit;
- questionable royalties/management fees which impact substantially on the UK bottom line (e.g. in respect of brand names unknown in the UK);
- poor performance without prospect of super profits in later years to justify losses;
- changes in intra-group arrangements which purport to adjust risk profile such as distributor becoming commissionaire; manufacturer becoming contract manufacturer; research and development expertise moving from royalty to contract basis; introduction of cost sharing arrangements.
Changes in intra-group arrangements are perhaps the most significant risk area. Whilst most of the circumstances described above are unsurprising, it is clear that any commercial restructuring of intra-group reward/cost sharing structures will now invite scrutiny. This item also implies that the Inland Revenue is ready to re-characterise transactions; therefore, multinationals should take utmost care when implementing new arrangements so re-characterisation arguments can be properly resisted by reference to OECD guidelines.
As to the timing of a transfer pricing inquiry, this is to be agreed on a stage-by-stage process with a starting point of three months for each stage. Emphasis is given to collaboration, such as having regard to the ease with which taxpayers can provide information in a stipulated format, although the guidance notes that "sometimes putting the company to considerable trouble is unavoidable."
Having received initial inquiries from the Inland Revenue (following the risk assessment process described above), the taxpayer needs to respond. The guidance indicates that depending upon the circumstances and complexity of the issues identified in the initial inquiry, it would be reasonable for the company and the Inland Revenue to agree a period of anything up to six months to produce the material requested (although regard will be had to the fact that at least some of the documentation requested was required to be put in place at the time the company filed its return for the relevant period).
Again reference is made to the possible use of exchange of information powers in this context where a taxpayer claims that it does not have the relevant information within its possession or control. There is a suggestion that, in the light of these powers and the delays caused by the tax authority having to invoke such powers, multinationals may choose to volunteer the information (with an implication that to do otherwise would be obstructive).
According to the guidance, the initial enquiry is to be "focused and comprehensive." Despite this reference to focus, the guidance recommends that the inquiry extends beyond the identified risk areas, though the rationale for this is not clear. Taxpayers should, therefore, monitor the scope of the inquiries and seek explanations where an inquiry appears to be broadening beyond the identified issue.
Following the taxpayer company’s response, the inquiry could take several directions and time frames as follows:
- the Inland Revenue aims to share preliminary conclusions with the company within six months, making clear any further information requests if the inquiry is to remain open;
- there may be an interim progress meeting during the six-month period referred to above;
- following preliminary conclusions there may be a further six-month period for the taxpayer company to provide further information including facilitating Inland Revenue site visits and employee interviews;
- further conclusions will be drawn and questions raised as necessary.
Therefore, even the optimistic profile of a transfer pricing inquiry described by the Inland Revenue envisages investigations regularly exceeding 18 months in duration. The typical timeline of a transfer pricing inquiry leaves taxpayer companies open to a considerable period of uncertainty.
To minimise the disruption caused by these enquiries, multinational enterprises need to invoke straightforward project management techniques in order to anticipate, meet and defend Inland Revenue information requests in the context of a transfer pricing inquiry. This process should be commenced as early as possible, and preferably before, and in anticipation of, the initiation of an investigation by the Inland Revenue. An important part of this process will be identifying areas of vulnerability and gathering supporting evidence.
Recent case law in the UK has reaffirmed the significance of the defence of legal privilege attaching to attorney-client papers in the context of tax matters (litigious and advisory). The defence, described as a fundamental human right, is only available with respect to correspondence between lawyers and clients and, in certain circumstances, communications between lawyers and third parties (such as economists in the transfer pricing context).
Other professional service providers such as accountants do not benefit from this defence even where they are advising on matters of tax law.
Therefore, following the recent UK decision, multinational enterprises facing UK transfer pricing inquiries are well advised to identify planning papers in respect of which this defence from disclosure can be claimed and consider involving UK lawyers in their defence team.
With the introduction of CTSA (corporation tax self-assessment) in the UK in 1999, the onus of justifying transfer pricing arrangements shifted to the taxpayer. Whilst the Inland Revenue may until now have recognised a "settling in" period in respect of the new regime, the noises now emanating from the UK tax authority strike a remarkably different note and multinational enterprises need to prepare themselves accordingly.