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International Manual

HM Revenue & Customs
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Non-residents trading in the UK: profits of the PE: Case studies exploring the various transfer pricing methods that could be used in attributing profits to a permanent establishment - Comparable Uncontrolled Price

A Ruritanian company has developed an environmentally friendly electric car that can be charged up from a normal household electricity supply. The car has a recommended retail price of £10,000* and quickly becomes the product of choice in many European countries including the UK where 100,000 cars are sold in the year of enquiry.

Initially the group manufactures the car through a few subsidiaries strategically positioned around the world. The cars are then sold either through third party distributors in each sales territory or through group distributors if commercially beneficial to the group. Distributors buy stock at a discount from RRP.

*For the purposes of this case study sterling is used throughout. Also attribution of capital to the permanent establishment is not required as no interest is charged in any case.

In this example, the main European manufacturer is a Belgian subsidiary of the Ruritanian company but stock for the UK market is manufactured at a car plant in the Midlands because costs are much cheaper there than in Belgium. There is no UK subsidiary and the plant is a permanent establishment of the Belgian subsidiary. But the group is taken by surprise in the UK when demand quickly outstrips manufacturing capacity. So it grants licenses to independent UK manufacturers who are keen to use their idle capacity created by the shift in demand from their own products. The Belgian company (and so the UK PE also) sources all parts and materials from unconnected parties and manufactures under a license from the Ruritanian parent allowing it to exploit the patented technology for a 3% license fee on turnover. Stock is sold by the Belgian company (and so the UK PE also) to third party distribution sales outlets across Europe including the UK.

The CTSA return for the UK permanent establishment includes the Belgian company accounts and a tax computation for the UK PE on the basis of apportioning whole entity profits to the PE in line with UK turnover.

  Whole company UK PE
Turnover 9,500m 950m
Cost of sales (4,835m)  
License fees (285m)  
Gross profits 4,380m  
Operating costs (4,000m)  
Net profit 380m (4%) 38m

Initial fact finding

You should try to obtain the facts about the actual costs of the UK operation. The Belgian company is likely to have these details anyway. This information is highly relevant to the calculation of profits chargeable in the UK.

Identify any controlled transactions

One of the first steps in using the comparable uncontrolled price method is to identify any controlled transactions; i.e. transactions between connected parties. In adapting transfer pricing to the PE scenario this can have two perspectives:

Firstly - are their controlled transactions at the whole entity level? - e.g. the license fee paid by the whole entity to the parent. If this were not at the equivalent of arms length, then the profits of the whole entity could require adjustment before attribution of (adjusted) profits to the UK PE were considered. In this case we know that the license fee is arms length because independent third party manufacturers pay the same in essentially the same circumstances. It follows that as the UK PE is exploiting the license in its manufacturing operations, that the UK PE profits should include a deduction for license fees too in accordance with the license agreement.

Secondly - what are the controlled transactions at an intra-entity level? - That means that if you hypothesise that the PE and the rest of the Belgian company were separate entities, how would the PE be rewarded for what it does - in this case manufacturing under license and selling to third parties at an agreed discount from RRP.

Identify a comparable uncontrolled price for UK controlled transactions

An important distinction is that the UK PE, as a hypothesised separate entity, should be compared to independent comparables in the UK. The Belgian company itself also does the same operations as the UK PE, but it does this in a different country with different local factors bearing upon its cost of sales and operating expenses. In the fact pattern of this case we know that there are independent manufacturers in the UK who do the same as the UK PE. Subject to taking care to use only information that is in the public domain or in the possession of the entity of which the PE is part, they would be the most appropriate independent comparables. There may of course still be differences in the way that those other UK manufacturers tackle their operations compared to the UK PE. The guidance at INTM463030 is relevant on how to allow for such differences. Following the OECD transfer pricing guidelines at 2.6 - 2.13 the other UK manufacturers should only be used as comparable uncontrolled prices if reasonably accurate adjustments can be made to eliminate the effect on net profits of any differences. Of course, the results of the rest of the Belgian entity would make an interesting ‘sanity test’ but no more than that.

Establish a comparable uncontrolled price

After eliminating any differences the range of comparable uncontrolled prices across the UK manufacturers is 5% - 5.8% net operating profit. You negotiate that the UK PE operations are most suited to a direct comparable at the lower end of that scale.

Calculate the UK chargeable profits

The CTSA return was compiled on the basis of an apportionment of the Belgian company’s profits related to UK turnover. In some cases that may be a convenient simple method that does not produce a distorted outcome. But in this case it was not acceptable because of the differences between the rates of PE local costs and entity local costs. The PE chargeable profits are recomputed on the basis of a 5% net operating profits to £47.5m.

See INTM267070 for example of Resale method

See INTM267080 for example of Cost Plus method

See INTM267090 for example of Profit Split method

See also INTM463020.