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HMRC internal manual

International Manual

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 - Resale Method

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, all European manufacturing (including for the UK market) and most European distribution is carried out by the Belgian subsidiary in Belgium. An independent UK distributor handles a small proportion (10%) of UK distribution with the other 90% going through a UK permanent establishment of the Belgian company. All UK marketing is out-sourced to independent consultants. All UK sales are made at the list price of £10,000 including a two-year warranty funded by the Belgian manufacturer. The independent distributor benefits from 5% discount on retail price, which is the same rate of discount that he enjoys from suppliers of the other brands that he sells. Although the brands that he distributes vary from each other, the function that the distributor performs is comparable for each manufacturer being essentially a brokerage, showroom and delivery function.

Establish the resale price margin

Calculate the UK chargeable profits 

Establish the resale price margin

Under this fact pattern the sales through the independent provide a convenient internal comparable controlled transaction showing that the arms length resale price margin is 5%. If this were not the case research would be needed to establish the gross margins achieved by comparable independent distributors using the OECD transfer pricing guidelines 2.14 - 2.31. In this case, no distortion is created by the warranty being funded by the Belgian company of which the UK operations are a permanent establishment because this exercise is concerned with establishing a comparable gross profit for only the distribution functions that are carried out in the UK. At arms length, product failure costs would not rest with the distributor but would remain with the manufacturer so the distributor permanent establishment should not bear any warranty costs.

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Calculate the UK chargeable profits

90,000 sales at £10,000 £900,000,000
Resale price margin 5.0%
Gross profit £45,000,000
Less operating costs (£30,000,000)
Net profit £15,000,000
Tax computation adjustments (£500,000) e.g. capital allowances
Chargeable profits 14,500,000

Even if the Belgian company suffered disastrous claims under the warranty scheme that sent it into loss overall, that should not impact on the profits attributable to the distributor permanent establishment. The only function carried out through the permanent establishment is distribution and warranty risk does not rest with the distribution function.

See INTM267060 for example of Comparable Uncontrolled Price method

See INTM267080 for example of Cost Plus method

See INTM267090 for example of Profit Split method

See also INTM463040.