Corporate and commercial lawyers are increasingly being required to draft and review documentation that may have an impact on the tax structuring of an intra-group transaction. It is particularly important that in-house legal functions are aware of transfer pricing issues and how they affect arm’s-length terms and the drafting of legal documentation. In this briefing, we will review transfer pricing from a corporate and commercial perspective, and set out the measures to be taken by in-house legal functions. Transfer pricing is no longer simply a tax and accounting issue. Now, more than ever, accurate documentation to reflect arm’s-length arrangements is essential to the effectiveness of a group’s transfer-pricing strategy. National and international groups need to understand how transfer pricing affects their business, and how documentation and commercial agreements can support the group’s tax position.
Since its ‘2006 Review of Links with Large Business’, HM Revenue & Customs (HMRC) has strengthened its approach to transfer pricing enquiries. Most recently, HMRC established yet another specialist team and, on 5 January this year, the new financial transfer pricing team was formed. This team is tasked with investigating intra-group financing arrangements and, where possible, challenging the tax returns of group companies. Accordingly, corporate and commercial lawyers of an in-house function should document all intra-group arrangements and should also review and monitor such arrangements, particularly in respect of the pricing, the allocation of risk and the conduct of the parties.
Furthermore, corporate and commercial lawyers need to be aware of how their documentation may be scrutinised by HMRC. From this month, HMRC’s new penalty regime for companies will apply to errors in transfer-pricing documentation, and such errors may be traced back to the legal documentation. HMRC is expected to enforce the new penalty regime more vigorously than the previous system. The new penalties will apply to both careless and deliberate errors in transfer-pricing documentation, and the level of penalty can be up to 100% of the tax at stake, depending on the nature of the error and the conduct of the relevant party.
what is transfer pricing and how does it affect legal documentation?
Transfer pricing encompasses all aspects of the pricing of arrangements between related parties. In essence, the transfer-pricing rules allow tax authorities to make adjustments for tax purposes to the price paid for goods, services and finance supplied between related parties. They are entitled to treat such arrangements as being on ‘arm’s-length’ terms (including price) and to adjust accordingly for tax purposes. Such an adjustment will affect the taxable profits of the relevant entities that are subject to tax.
Example
UK parent company A has two subsidiaries, B and C. Subsidiary B is resident in Germany and subsidiary C is resident in the UK. Subsidiary B manufactures widgets, some of which are sold to subsidiary C and are then distributed in C’s local market. Clearly, the higher the price charged by B, the higher B’s profits will be and potentially more tax will be payable in Germany. A high price may similarly reduce C’s profits and potentially reduce the amount of corporation tax payable in the UK. HMRC may apply transfer-pricing principles to disallow part of the cost incurred by C that is otherwise to be taken into account in reducing C’s taxable profits.
The price payable by C to B for the widgets in question will not depend solely on the specification of such widgets. Other factors will also be relevant, such as product liability, warranties, indemnities, limitations of liability, whether C is agreeing to minimum purchase volumes, which entity bears the credit risks in relation to sales made by C, and so on.
Similar considerations apply to other relationships between group companies and certain joint venture companies, such as research and development services, licensing of intellectual property, agency/commissionaire arrangements, back-office services, credit facilities, and the provision of security to third parties.
Transfer-pricing methods
Several different methods may be used for establishing or justifying an appropriate price in any given situation. The choice of method is a tax issue based on the economic analysis of the actual transaction. Here are some of the methods most commonly used (to identify what is arm’s length):
Comparable uncontrolled price (CUP)
By reference to the prices agreed between unconnected parties for comparable goods or services in the external market.
Cost plus
The cost to the supplying company of obtaining or providing the relevant goods or services and adding an appropriate mark up.
Resale price
The final selling price of the goods or services outside the group, minus an appropriate gross margin.
Profit split
First, a functional analysis is carried out to establish the functions performed by each member of the group, the assets used by each member and the respective risks assumed. Following this analysis, each party is allocated a share of the group’s overall profit or loss (profit split) that it would have expected to receive on that basis (typically assessing the issue at the time when the relevant arrangements were set up).
Transactional net margin method (TNMM)
The net margin achieved by unconnected entities on similar transactions, based on criteria such as turnover, cost or capital employed. That margin is then applied to the company’s income or expenses to identify the pricing for its intra-group arrangements.
Transfer-pricing documentation
A wide range of guidance has been published on the documentation required to be produced by group companies to avoid penalties and minimise the risk of an enquiry or investigation. The Council of the European Union’s (the Council) resolution of 27 July 2006, on a code of conduct on transfer pricing documentation (2006/C176/01), sets out guidelines on the documentation required to support a transfer-pricing analysis. This has been broadly followed by HMRC in the recent publication by the financial transfer-pricing team in ‘Revenue & Customs Brief 01/09’.
Finance is only one sector where transfer pricing applies. At a more general level, HMRC sets out guidance in the ‘International Manual’s section on Schedule 28AA: Self Assessment obligations – Record keeping: transfer pricing documentation (INTM433030)’ (the Manual). The Manual’s emphasis is on the accounting analysis, which forms the bulk of the tax work in assessing pricing arrangements. The Manual states that there are four main types of documentation required from a transfer-pricing perspective to demonstrate that intra-group arrangements are at arm’s length:
- primary accounting records;
- tax adjustment records;
- records of transactions with associated businesses; and
- evidence to demonstrate an ‘arm’s-length result’.
The Manual makes several specific suggestions for demonstrating an arm’s-length result, including ‘[setting] out the contractual or other understandings between the associated businesses and the risk assumed by each party’. This is the only requirement in the Manual to refer to ‘contractual… understanding’.
However, the Organisation for Economic Co-operation and Development (OECD) recently published a discussion draft for public comment called ‘Transfer Pricing Aspects of Business Restructurings’ (the OECD Discussion Draft). The relevance of the OECD to HMRC is that, under paragraph 2(3) of Schedule 28AA of the Income and Corporation Taxes Act 1988, HMRC must construe that schedule in accordance with the OECD Model Tax Convention on Income and Capital, as interpreted by the OECD transfer-pricing guidelines.
The OECD Discussion Draft places a strong emphasis on contractual terms being set down in written documentation. It states that contractual arrangements are the starting point for determining which party to a transaction bears the risk associated with it.
There are a variety of risks in every contractual arrangement. There may be exchange-rate risks, inventory risks and credit risks that need to be accounted for in arm’s-length terms. For example, a manufacturer may claim that exchange-rate risks are assumed by a related foreign distributor of the manufacturer’s goods. This arrangement may be investigated by HMRC if the transfer price appears to have been adjusted to protect the distributor from such exchange-rate risks. Another example is where the risk in bad debts appears to be assumed by one company in a bilateral arrangement, but that company may be indemnified by a third party in the same group.
The OECD has expressly stated that the parties’ conduct should generally be taken as the best evidence concerning the true allocation of risk. One factor that can assist in this determination is the examination of which party has control over the risk. Group companies will need protocols to ensure that control over risks is consistently monitored and that the conduct complies with the contract. Such measures may include ensuring that employees or consultants, engaged by the company allocated the risk, are responsible for managing and administering the risks on a day-to-day basis.
Actions to be taken by legal functions
This broadly falls into two categories. First, ensuring that legal agreements are in place and that they support existing intra-group arrangements. Secondly, ensuring that legal considerations are properly taken into account in any proposed restructuring projects.
Documenting existing arrangements
For many groups the documentation of intra-group supplies, licences and facilities has been low on the list of priorities. Understandably, greater emphasis has been placed on regulatory compliance, transactions with third parties and the risk of third-party claims. In addition, many groups are run by reference to global functions or lines of business, rather than the legal entities involved. This can further undermine the focus placed on legal agreements between group entities.
It is not unusual to find groups where no written intra-group agreements are in place, or where the agreements that are in place are simply inappropriate. An example of this is an intra-group loan agreement that is repayable on demand, but the borrower does not have sufficient liquid assets to meet such a request. This is unsatisfactory from the perspective of corporate governance and directors’ duties, let alone from a transfer-pricing perspective. There has been little or no external sanction for such failings to date. However, the renewed emphasis by HMRC on using transfer-pricing rules to challenge a group’s tax position, and the OECD’s stance to review contractual documentation as the starting point for any transfer-pricing analysis, clearly highlights a substantial risk and emphasises the importance of adequate transfer-pricing documentation.
Contractual documentation should reflect actual characteristics of the arrangements and the allocation of the risks involved. The group’s legal team should advise directors and the tax team as to whether the risk issues involved have been correctly analysed. For instance, whether each individual legal entity is in a position, both financially and operationally, to control and bear the risks that have been allocated to it.
Given the rapidly changing global economy, there is a significant danger to companies that documentation that was once on arm’s-length terms may now be out of date. It will be helpful to regularly review the actual conduct of the parties to compare whether the initial arrangements are being followed and whether the same contractual terms would be agreed today.
Restructuring projects
When considering a proposed group restructuring, each company affected must independently assess the reasons behind carrying out the necessary steps for the restructuring to be complete. The OECD Discussion Draft clearly states that it is not sufficient for any proposed steps to benefit the group as a whole, but that each company must have its own commercial rationale.
For instance, it would not usually make commercial sense from the perspective of a single corporate entity to transfer to another corporate entity a profitable activity for no remuneration. In extreme cases, HMRC will seek to ignore such transactions altogether. The test that HMRC applies in practice is likely to relate to the corporate benefit of individual entities. HMRC is also very keen to see contemporaneous evidence of decision-making. Accordingly, a suitable place to document this assessment is very likely to be a board memorandum, or in an equivalent document referred to in board minutes.
As noted above, remuneration and risk/indemnification go to the root of the arm’s-length nature of a restructuring transfer. The level of remuneration or the extent of indemnification should be carefully analysed and documented.
A further consideration to be assessed and documented, for any transfer of an activity as part of a restructuring, is whether the transferring party should pay or receive any compensation for ‘loss potential’. Loss potential may include detriments suffered as a result of the restructuring, such as the cost of renegotiations of contracts. The level of any compensation will also be affected by any indemnity given by the transferee or guarantee from a third party. Again, this should all be documented.
Conclusion
The dynamic nature of large groups of companies, the flexibility of intra-group arrangements and the enhanced focus by HMRC, all contribute to making transfer pricing a significant risk for corporate groups. Although the process of adopting a transfer-pricing strategy is often driven by the tax function of the relevant groups, the in-house legal function should ensure that the following issues are satisfactorily addressed in the context of any proposed arrangements:
- commercial drivers;
- legal privilege and communications;
- identification of assets;
- identification of rights and risks attached to assets;
- existing contractual arrangements that will be affected (including termination or variation rights);
- terms of new contractual arrangements;
- remuneration, compensation and indemnification;
- terms of transfer of contractual arrangements (such as business sale or other agreements);
- third-party rights (such as lenders, chargees, trades unions, works councils or commercial counterparties);
- protocols on the practical allocation of risk; and
- authorities and consents.
By Paul Sutton, partner, and Andy Jackson, senior solicitor, McGrigors LLP.
E-mail: paul.sutton@mcgrigors.com; andrew.jackson@mcgrigors.com.
