CFM56050 - Derivative contracts: tax avoidance: transfer pricing and derivative contracts

CTA09/S693

Derivative contracts not on arm’s length terms

The transfer pricing rules apply to derivatives as they apply to any other form of ‘provision’ between associated persons – although there is an important exception for exchange gains or losses on derivative contracts (see CFM56060).

Transfer pricing provisions

In broad terms, the transfer pricing rules at TIOPA/PT4 apply where:

  • there is a provision (the actual provision) between associated persons,
  • the provision differs from the provision which would have been made at arm’s length (the arm’s length provision), and
  • the actual provision confers a potential UK tax advantage to one of the affected persons.

Where the conditions are met, the profits and losses of the potentially advantaged person should be calculated for tax purposes as if the arm’s length provision had been made instead of the actual provision.

Note that there are certain exemptions for small and medium enterprises.

See INTM41200 for further details of the transfer pricing rules.

In considering whether the transfer pricing rules apply to particular arrangements involving derivatives, you should look at the general guidance on Part 4 in INTM410000 onwards, and the practical advice at INTM480000 onwards.

Application to derivative contracts

For periods beginning on or after 1 April 2004, CTA09/S693 ensures that any profit or loss imputed on a derivative contract as a result of the application of the transfer pricing rules (including any adjustment to charges or expenses in connection with the contract) is treated as a credit or debit under CTA09/PT7, and all of the rules for computing or bringing into account credits or debits on derivative contracts will apply to such amounts.

Old rules

Previously the Taxes Acts contained an anti-avoidance provision aimed at transfers of value between connected companies by means of derivatives (FA94/S165 and FA94/S166). At its simplest, company A (in the UK) could transfer value to company B (in a tax haven) by entering into a derivative contract on non-arm’s length terms. For example, B could grant an option to A, for which A pays a premium in excess of the market value of the option; or the parties could enter into an interest rate swap under which A makes periodic payments based on LIBOR, but receives fixed-rate payments at a below market rate.

This provision was not reproduced in FA02/SCH26 or CTA09/PT7.