UK Transfer pricing audits have been increasing steadily over the past decade. The trend is expected to continue in 2010, with some 1,000 outstanding cases at present related to UK transfer pricing. However, despite increased audit activity, the UK tax authorities are taking a measured approach to the selection of audits. This is encouraging for the many businesses that are making reasonable efforts to comply with the UK legislation.
In this issue of Tax Advisor Update, A&M explains the ‘gate’ process undertaken by UK Tax Inspectors in selecting and pursuing UK transfer pricing audits. Being aware of these procedures will help businesses decide on which resources to allocate to this area of UK taxation.
UK Tax Authority Gate Process
The process can take up to 18 months; also, the process will be smooth if handled appropriately.
Gate 1- Business Case
A Tax Inspector must contact the central Transfer Pricing Unit on identifying a transfer pricing issue that may necessitate an enquiry. A trained and experienced ‘Transfer Pricing Specialist’ Inspector will then be assigned to the case to help with a detailed risk assessment, and work on the issue to determine whether or not an enquiry is justified. This is a critical area to understand; the Inspector must be able to justify the selection and pursuance of a transfer pricing case. A business case must then be submitted to the Transfer Pricing Unit for approval before Gate 2 can commence.
The Tax Authorities have advised that each business case follows a set template and ’sets out inter alia the case background, the risk assessment work undertaken, the reasons for and against enquiry (supported by a scoring of transaction, behavioural, and quantum risk and a resource forecast), and any special features. Critically, it also includes the recommendation of the Inspector which may be for opening, not opening or deferring an enquiry.’
Note that Tax Bulletin 60 issued in August 2002 requires Inspectors to follow a risk-based approach in selecting audits; the recent guidance discussed in this update incorporates the Tax Bulletin 60 provisions. Experience in recent years has shown that Inspectors are following the process more closely.
Gate 2 - Enquiry Decision
Once the business case has been submitted to the Transfer Pricing Unit, its members then decide whether or not an enquiry is to be opened.
The Panel’s decision is recorded on the business case template and will state reasons on whether or not the Inspector recommendations should be followed or not supported.
Gate 3 - Action Plans
Once approval to open an enquiry has been given, the case team will issue a formal ‘CTSA’ (Corporation Tax Self Assessment) enquiry notice and the 18-month (or 36-month) clock begins.
Each transfer pricing enquiry must have an ‘Action Plan’ that will vary according to the circumstances of the case. Tax Authority templates acknowledge that a transfer pricing enquiry generally comprises three phases:
- Detailed fact-finding during which information and supporting documentation is obtained and interim analysis is carried out;
- Review of findings, development of arguments and exchange of views with the business; and
- Resolution of the case, which commences with a , and proceeds through a concession or negotiation to settlement of the case or, where agreement is not possible, to litigation.
We have been involved in drawing up Action Plans in collaboration with the Tax Authorities and the business to ensure minimum disruption.
Gate 4 - Six-Month Review
A formal review will be undertaken by the case team in partnership with the Transfer Pricing Specialist every six months. The review is recorded on the same template used for Gates 1 and 2 and must be submitted to the Transfer Pricing Unit on or before the six-month anniversary of the start of the enquiry or of the last review.
The review should contain:
- A summary of progress since the start of the enquiry (or the last review)
- Details of any factors inhibiting progress and what has been / will be done to counteract them
- A brief synopsis of what further work the team intends to carry out
- An assessment of whether the enquiry is likely to settle according to the timetable set out in the Action Plan; if not, determining what revision is required (including an explanation if it is felt the case has become complex and justifies a 36-month timescale)
- A re-evaluation of the tax at risk
- A statement regarding the potential for culpability
Communication with the Tax Authorities during these reviews can be critical for the provisioning of potential tax adjustments and penalties.
Once the facts have been collected and the analysis performed, the case must be referred to the Central Transfer Pricing Unit to decide how it should be settled. The Tax Authorities Solicitor’s Office will provide an indicative opinion on whether litigation steps should be taken.
One of the following decisions will be made:
- Close the case without adjustment;
- Settle by negotiation; or
- Proceed to litigation.
Where the decision is to negotiate a case, the Transfer Pricing Unit will authorise the Case Team or the Transfer Pricing Specialist to settle according to clearly defined parameters.
In Short, Be Proactive
In transfer pricing audit procedures, UK Tax Authorities advise:
’As far as transfer pricing is concerned, it is generally more likely that the cases in which significant amounts of tax are at stake are those that result from manipulation rather than insufficient attention to the arm’s length principle ... Where there is no, or minimal, opportunity to secure a tax advantage through manipulation, and the business has clearly taken some steps to apply transfer pricing rules, there is less likely to be a need for HMRC to initiate a transfer pricing enquiry.’
The system for selecting audits seeks to benefit businesses that are not involved in aggressive structures and are reasonably compliant. Be proactive in advance of a potential audit and at the early stages of an enquiry. Providing the necessary information in a timely and open manner can ensure that enquiries do not get out of Gate 1. It is also necessary to consider the following:
- Non-statutory meetings with your Inspector to discuss transfer pricing issues
- Statutory certainty agreements to reduce the likelihood of audit
- The importance of international co-ordination of audits
Indicators of High Risk
According to guidance for UK Tax Inspectors, the following are possible indicators that a high level of risk may be present in a particular case:
- Cost-benefit analysis, i.e., resource requirements versus tax at stake
- Multinational companies
- Low group effective tax rates
- Low UK results versus group results
- Existence of tax havens and tax shelters in the group
- Persistent UK losses
- Significant management fees paid from UK
- Significant IP charges paid from UK
- Significant R&D spend
- Existence of cost share agreements
- ‘Innovative Business Structures’ arising from M&A, restructuring, launch of new products, expansion in new markets, etc.
- Significant intra-group loans
- Regulatory requirements, involving customs valuations, anti-dumping duties, currency exchange or price controls, or cash flow incentives within a group affecting when profit is reported or how dividends are financed
Indicators of Low Risk
According to guidance for UK Tax Inspectors, the following are possible indicators that a low level of risk might be present in a particular case:
- UK transfer pricing adjustment would have a negative impact group effective rate
- Existence of third-party comparables
- Shareholders interests would be prejudiced by the diversion of profits outside of the UK
- A detailed examination of six years’ consolidated accounts and of the accounts of appropriate entities
- A review of the group’s Internet site
- A summary of the business and the important markets
- A review of trade press and Internet for industry trends and details of where the taxpayer is placed within the sector
- A search using a commercial database (such as FAME or AMADEUS) to supply trends and comparables on the particular business sector
- An analysis of recent developments within the group (such as new acquisitions, new markets, disposals, etc.)
- A review of the group structure and identification of group companies operating in tax havens or countries which offer tax shelters
- A review of the controlled foreign company (CFC) position to establish which overseas companies are claiming the benefit of the exempt activities test and motive test to avoid an apportionment of profits under the CFC legislation
- A review of the overseas parent accounts and returns made to government bodies
- Liaison with Tax Authority payroll districts for details of highly-paid UK staff
- Liaison (in appropriate cases) with Indirect Division (VAT, Customs & Excise)
- A review of any previous transfer pricing enquiry papers
The 2007 Varney Review of Links with Large Business defines a policy goal to clear transfer pricing cases within 18 months (36 months for more complex cases).
UK Tax Authorities - International Tax Manual.
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