SPEED READ After ten years of false starts, HMRC finally seems positioned to pursue a wide range of transfer pricing enquiries. It has the resource to do this, much of that resource has been released from the first ‘wave’ of major disputes, and case-law and changes to the OECD guidelines will encourage HMRC to think that this a fruitful area to pursue. Resolving transfer-pricing disputes requires clear technical TP analysis. But enquiries are conducted by HMRC officers, under the same pressures as other HMRC officers, and acting in the same regulatory framework. Disputes will typically be best resolved by a combination of that analysis, and a clear strategy for dealing with HMRC.
HMRC finally seems positioned to pursue a wide range of transfer pricing enquiries
Against a backdrop of economic downturn and lower tax receipts, tax authorities around the world are fiercely fighting for their right to tax company profits. HMRC is no exception.
There is no doubt that profits can easily flow overseas. HMRC can also feel that it has done much to reduce the ‘loss of tax’ attributable to highly structured transactions exploiting loopholes in the UK corporation tax code.
These things cause an increasing perception that the biggest risk to the UK corporation tax base is for profits to be taxed not in the UK but elsewhere.
Tax directors have worried for at least ten years about HMRC finally taking transfer pricing audits more seriously. In all that time, no widespread action has really materialised, and there have been a number of false starts. HMRC’s internal guidance in itd International Manual still states, rightly, that ‘a transfer pricing enquiry … should not be undertaken lightly’ (INTM 461020).
But at the time of publication of this special edition we seem to be at a watershed where, finally, transfer pricing enquiries are likely to become more frequent, more focused, and of higher quality.
Why now?
A combination of factors applies here.
First, in recent years, HMRC has very significantly increased itd transfer pricing expertise. This expertise is now for the first time at a level where sustained, regular and fruitful challenges are plausible and even inevitable. There has been some key recruitment from the private sector.
With the establishment of specialist teams in early 2008 (forming what is now HMRC’s Transfer Pricing Group, TPG), HMRC has started to manage and focus its own experience. And as HMRC has set about resolving the very large number of open enquiries for past periods, the experience and knowledge within TPG appears to have grown exponentially.
Second, HMRC’s resources to open and pursue new enquiries are increasingly being released from the first wave of heavy-duty enquiries. Perhaps the most high profile of these engagements was the Dixons litigation (DSG Retail Ltd v HMRC [2009] UKFTT 31 (TC)) which at three weeks was the longest corporation tax Tribunal hearing of recent years.
Moreover, in February 2010, AstraZeneca announced that they had settled their transfer pricing enquiry with HMRC – anecdotally, it was listed for a Tribunal hearing of up to six weeks. These engagements are resource intensive for HMRC, and when an issue reaches conclusion, HMRC staff are ready and willing to turn their attention to other taxpayers.
Third, substantive developments in the technical transfer pricing rules have significantly increased the scope of HMRC’s ability to pursue enquiries.
Since the current rules were introduced in Finance Act 1998, in the vast majority of cases the establishment of an arm's-length price has been based on the comparable uncontrolled price (CUP) method, selecting comparables from commercial databases, or if no comparable was available, a ‘cost plus’ or ‘resale minus’ method.
The dominance of these methods has been driven by their relatively simplicity to operate, a perception that there was no value in being overly critical of the worth of potential comparables as HMRC had shown no appetite to scrutinise comparability, and OECD guidelines which treated alternative (‘profit-split’) methods as suitable only in the rare cases where these, traditional, methods were not available. However, things have changed.
In DSG Retail Ltd, the Tribunal firmly authorised HMRC to decide whether ‘comparable’ transactions are in fact a good guide to the arm’s-length price in any specific case. The Tribunal also insisted on the use of the alternative (and much more complex) profit-splitting approach, known in the OECD Guidelines as the transactional net margin method.
The revised OECD Guidelines – adopted on 22 July 2010 – have also indicated that tax authorities should be sceptical of comparability, and removed the order of priority between transfer pricing methods (in which the CUP approach was effectively the default approach), thereby reinforcing HMRC’s already perceived right to challenge the use of the CUP method.
The OECD changes should only apply for the future.
But taken together with DSG Retail Ltd, they will also undoubtedly colour HMRC’s approach to historic periods. The prospect of a revised approach from HMRC following DSG Retail Ltd on both scores – the approach to comparables and the proposal to give genuine practical consideration to game theory and bargaining power as part of TNMM – is already reflected in the Manuals (eg, INTM 467085).
Because of this HMRC now has the tools and the expertise to genuinely review and challenge methodologies, rather than (as they would see it) simply negotiating over percentage mark-ups and whether a particular transaction is properly seen as inter-quartile within the relevant comparables. Experience in other areas of tax strongly suggests that these developments will mean that HMRC very rapidly becomes more motivated to raise transfer pricing enquiries.
Recognising the anti-avoidance backdrop
When will disputes arise? The true question in any transfer pricing enquiry is whether the particular transaction is remunerated on an arm’s-length basis. But transfer pricing enquiries are typically worked by HMRC officers with extensive general training and, whatever the pricing, a prolonged enquiry can be expected whenever conventional ‘red flags’ are raised.
In particular, it is important to remember that the transfer pricing rules are increasingly playing an anti-avoidance role in HMRC’s thinking. If HMRC has reason to believe that the company is manipulating pricing to minimise UK (or even worldwide) tax liabilities, then it will inevitably push the company much harder.
One common example is that HMRC will always question closely the TP policies of a loss-making UK subsidiary of a profitable multinational group. Anecdotally, press reporting of the disclosure in Starbucks’ September 2009 accounts that its UK entities are the subject of a substantial ongoing transfer pricing audit, suggests that this is a relevant issue in their fact pattern.
HMRC is quite explicit about this. INTM 461020 instructs HMRC officers that where there is ‘no, or minimal, opportunity to secure a tax advantage through manipulation’ then provided the business has taken ‘some steps’ to apply transfer pricing rules they should be more reticent in opening an enquiry.
Challenges of this sort may be presented as a technical argument about whether the company has adopted the right pricing. They can frequently be defused by a clear commercial explanation of why the mismatch has arisen.
The explanation may be from market data or even information specific to the company, for instance, the loss of a major client. Without comfort that there is no avoidance, HMRC is likely to be much less open in discussions and much less forthcoming in negotiations, and a technical issue may well escalate into a dispute.
Resolving the dispute and settlement
It takes two to resolve a dispute, and HMRC’s position has been clearly stated in the Litigation and Settlement Strategy, first adopted in July 2007. This remains very firmly in place. Accordingly, HMRC can and will only settle contentious issues – transfer pricing or otherwise – for an amount of tax which is supported by intellectually coherent reasoning. But there is a growing recognition that HMRC cannot litigate everything.
In practice, HMRC is becoming increasingly willing to engage in discussions to explore, identify and agree what might be an intellectually coherent approach, and this is particularly possible in transfer pricing.
On the other hand, with the UK’s existing budget deficit, taxpayers cannot expect HMRC to voluntarily give up tax that they may be reasonably entitled to collect, and HMRC remains resource-constrained. In practice, to settle a dispute the taxpayer will generally have to ‘take the horse to water’.
There is always the option of sitting back and hoping HMRC simply allows the issue to wither and die, but for all the normal reasons the taxpayer’s position weakens with every passing year, and this approach risks playing strongly into HMRC’s hands.
Particularly given the new model approach to transfer pricing enquiries, and the likely continuity on the Transfer Pricing Board, it seems unlikely that HMRC will allow an enquiry to die on the vine once a business case has been made to open it in the first place.
For taxpayers taking the initiative, one very successful approach is to press HMRC to take a decision: a robust example might be an application for closure notice to override progress through the TP Stage Gates if that progress has stalled.
Another successful approach is explicitly to make it easy for HMRC to agree to the taxpayer’s technical position, leaving them in no doubt that they have reached the right conclusion, and are not missing something. It may involve presenting factual information in a way that separates the information from any advocacy, perhaps in witness statements. It may also involve making an expert economist available for discussions at an early stage.
Importantly, the best tactic for a taxpayer looking to resolve a dispute quickly is almost always a combination of these two approaches: strategic pressure and close substantive engagement. HMRC even acknowledges this in the Litigation and Settlement Strategy: ‘handling cases in a way that prepares for litigation assists in reaching agreed settlement’.
In our experience, that is almost universally true and, with transfer pricing enquiries set to escalate, there is no reason to think transfer pricing disputes are, or will become, any different.
Rupert Shiers is a Partner in Tax Disputes and Investigations at McGrigors LLP. He has advised on TP issues reaching back to 1998 when the current rules were introduced. He is a member of the CIOT Management of Taxes Sub-Committee. Email: rupert.shiers@mcgrigors.com; tel: 020 7054 2737.
SPEED READ After ten years of false starts, HMRC finally seems positioned to pursue a wide range of transfer pricing enquiries. It has the resource to do this, much of that resource has been released from the first ‘wave’ of major disputes, and case-law and changes to the OECD guidelines will encourage HMRC to think that this a fruitful area to pursue. Resolving transfer-pricing disputes requires clear technical TP analysis. But enquiries are conducted by HMRC officers, under the same pressures as other HMRC officers, and acting in the same regulatory framework. Disputes will typically be best resolved by a combination of that analysis, and a clear strategy for dealing with HMRC.
HMRC finally seems positioned to pursue a wide range of transfer pricing enquiries
Against a backdrop of economic downturn and lower tax receipts, tax authorities around the world are fiercely fighting for their right to tax company profits. HMRC is no exception.
There is no doubt that profits can easily flow overseas. HMRC can also feel that it has done much to reduce the ‘loss of tax’ attributable to highly structured transactions exploiting loopholes in the UK corporation tax code.
These things cause an increasing perception that the biggest risk to the UK corporation tax base is for profits to be taxed not in the UK but elsewhere.
Tax directors have worried for at least ten years about HMRC finally taking transfer pricing audits more seriously. In all that time, no widespread action has really materialised, and there have been a number of false starts. HMRC’s internal guidance in itd International Manual still states, rightly, that ‘a transfer pricing enquiry … should not be undertaken lightly’ (INTM 461020).
But at the time of publication of this special edition we seem to be at a watershed where, finally, transfer pricing enquiries are likely to become more frequent, more focused, and of higher quality.
Why now?
A combination of factors applies here.
First, in recent years, HMRC has very significantly increased itd transfer pricing expertise. This expertise is now for the first time at a level where sustained, regular and fruitful challenges are plausible and even inevitable. There has been some key recruitment from the private sector.
With the establishment of specialist teams in early 2008 (forming what is now HMRC’s Transfer Pricing Group, TPG), HMRC has started to manage and focus its own experience. And as HMRC has set about resolving the very large number of open enquiries for past periods, the experience and knowledge within TPG appears to have grown exponentially.
Second, HMRC’s resources to open and pursue new enquiries are increasingly being released from the first wave of heavy-duty enquiries. Perhaps the most high profile of these engagements was the Dixons litigation (DSG Retail Ltd v HMRC [2009] UKFTT 31 (TC)) which at three weeks was the longest corporation tax Tribunal hearing of recent years.
Moreover, in February 2010, AstraZeneca announced that they had settled their transfer pricing enquiry with HMRC – anecdotally, it was listed for a Tribunal hearing of up to six weeks. These engagements are resource intensive for HMRC, and when an issue reaches conclusion, HMRC staff are ready and willing to turn their attention to other taxpayers.
Third, substantive developments in the technical transfer pricing rules have significantly increased the scope of HMRC’s ability to pursue enquiries.
Since the current rules were introduced in Finance Act 1998, in the vast majority of cases the establishment of an arm's-length price has been based on the comparable uncontrolled price (CUP) method, selecting comparables from commercial databases, or if no comparable was available, a ‘cost plus’ or ‘resale minus’ method.
The dominance of these methods has been driven by their relatively simplicity to operate, a perception that there was no value in being overly critical of the worth of potential comparables as HMRC had shown no appetite to scrutinise comparability, and OECD guidelines which treated alternative (‘profit-split’) methods as suitable only in the rare cases where these, traditional, methods were not available. However, things have changed.
In DSG Retail Ltd, the Tribunal firmly authorised HMRC to decide whether ‘comparable’ transactions are in fact a good guide to the arm’s-length price in any specific case. The Tribunal also insisted on the use of the alternative (and much more complex) profit-splitting approach, known in the OECD Guidelines as the transactional net margin method.
The revised OECD Guidelines – adopted on 22 July 2010 – have also indicated that tax authorities should be sceptical of comparability, and removed the order of priority between transfer pricing methods (in which the CUP approach was effectively the default approach), thereby reinforcing HMRC’s already perceived right to challenge the use of the CUP method.
The OECD changes should only apply for the future.
But taken together with DSG Retail Ltd, they will also undoubtedly colour HMRC’s approach to historic periods. The prospect of a revised approach from HMRC following DSG Retail Ltd on both scores – the approach to comparables and the proposal to give genuine practical consideration to game theory and bargaining power as part of TNMM – is already reflected in the Manuals (eg, INTM 467085).
Because of this HMRC now has the tools and the expertise to genuinely review and challenge methodologies, rather than (as they would see it) simply negotiating over percentage mark-ups and whether a particular transaction is properly seen as inter-quartile within the relevant comparables. Experience in other areas of tax strongly suggests that these developments will mean that HMRC very rapidly becomes more motivated to raise transfer pricing enquiries.
Recognising the anti-avoidance backdrop
When will disputes arise? The true question in any transfer pricing enquiry is whether the particular transaction is remunerated on an arm’s-length basis. But transfer pricing enquiries are typically worked by HMRC officers with extensive general training and, whatever the pricing, a prolonged enquiry can be expected whenever conventional ‘red flags’ are raised.
In particular, it is important to remember that the transfer pricing rules are increasingly playing an anti-avoidance role in HMRC’s thinking. If HMRC has reason to believe that the company is manipulating pricing to minimise UK (or even worldwide) tax liabilities, then it will inevitably push the company much harder.
One common example is that HMRC will always question closely the TP policies of a loss-making UK subsidiary of a profitable multinational group. Anecdotally, press reporting of the disclosure in Starbucks’ September 2009 accounts that its UK entities are the subject of a substantial ongoing transfer pricing audit, suggests that this is a relevant issue in their fact pattern.
HMRC is quite explicit about this. INTM 461020 instructs HMRC officers that where there is ‘no, or minimal, opportunity to secure a tax advantage through manipulation’ then provided the business has taken ‘some steps’ to apply transfer pricing rules they should be more reticent in opening an enquiry.
Challenges of this sort may be presented as a technical argument about whether the company has adopted the right pricing. They can frequently be defused by a clear commercial explanation of why the mismatch has arisen.
The explanation may be from market data or even information specific to the company, for instance, the loss of a major client. Without comfort that there is no avoidance, HMRC is likely to be much less open in discussions and much less forthcoming in negotiations, and a technical issue may well escalate into a dispute.
Resolving the dispute and settlement
It takes two to resolve a dispute, and HMRC’s position has been clearly stated in the Litigation and Settlement Strategy, first adopted in July 2007. This remains very firmly in place. Accordingly, HMRC can and will only settle contentious issues – transfer pricing or otherwise – for an amount of tax which is supported by intellectually coherent reasoning. But there is a growing recognition that HMRC cannot litigate everything.
In practice, HMRC is becoming increasingly willing to engage in discussions to explore, identify and agree what might be an intellectually coherent approach, and this is particularly possible in transfer pricing.
On the other hand, with the UK’s existing budget deficit, taxpayers cannot expect HMRC to voluntarily give up tax that they may be reasonably entitled to collect, and HMRC remains resource-constrained. In practice, to settle a dispute the taxpayer will generally have to ‘take the horse to water’.
There is always the option of sitting back and hoping HMRC simply allows the issue to wither and die, but for all the normal reasons the taxpayer’s position weakens with every passing year, and this approach risks playing strongly into HMRC’s hands.
Particularly given the new model approach to transfer pricing enquiries, and the likely continuity on the Transfer Pricing Board, it seems unlikely that HMRC will allow an enquiry to die on the vine once a business case has been made to open it in the first place.
For taxpayers taking the initiative, one very successful approach is to press HMRC to take a decision: a robust example might be an application for closure notice to override progress through the TP Stage Gates if that progress has stalled.
Another successful approach is explicitly to make it easy for HMRC to agree to the taxpayer’s technical position, leaving them in no doubt that they have reached the right conclusion, and are not missing something. It may involve presenting factual information in a way that separates the information from any advocacy, perhaps in witness statements. It may also involve making an expert economist available for discussions at an early stage.
Importantly, the best tactic for a taxpayer looking to resolve a dispute quickly is almost always a combination of these two approaches: strategic pressure and close substantive engagement. HMRC even acknowledges this in the Litigation and Settlement Strategy: ‘handling cases in a way that prepares for litigation assists in reaching agreed settlement’.
In our experience, that is almost universally true and, with transfer pricing enquiries set to escalate, there is no reason to think transfer pricing disputes are, or will become, any different.
Rupert Shiers is a Partner in Tax Disputes and Investigations at McGrigors LLP. He has advised on TP issues reaching back to 1998 when the current rules were introduced. He is a member of the CIOT Management of Taxes Sub-Committee. Email: rupert.shiers@mcgrigors.com; tel: 020 7054 2737.