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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 - Cost Plus

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 cars for the UK market are manufactured by the Belgian subsidiary and UK distribution is through a UK subsidiary. The only unusual feature is that when the cars are imported at the UK port some engineering completion to the basic production vehicle is needed before the product is suitable for use in the UK. The steering mechanisms have to be finished off in a right hand drive format and the power system finished off to conform to UK standards. The manufacture of the cars is completed in this way in a factory area at the channel port warehouse/distribution centre by engineers employed by the Belgian company. When the vehicles are complete they move into the UK distributor company’s stock at discounted retail price. No CTSA return has been made for the UK operations.

In this case, the engineering operations in the factory at the channel port are agreed to be a permanent establishment of the Belgian company and chargeable profits need to be computed. The nearest separate entity analogous situation to the dealings between the PE and the rest of the Belgian entity would be the sale of semi-finished goods between unrelated parties. The OECD transfer pricing guidelines, at 2.32, recommend cost plus as the transfer pricing method most suitable in these circumstances.

Establish the cost base
Establish the margin
Calculate the UK chargeable profit

Establish the cost base

No separate accounts have been prepared for the UK permanent establishment but the costs of the UK operations are quite simple to identify being largely the engineers’ payroll and parts/materials but also tools and the overheads of the factory area recharged to the Belgian company by the UK distributor subsidiary.

The total UK costs amount to £50m per year.

The guidance at INTM463050 on establishing the cost base applies equally to this PE attribution case. Particularly relevant is the instruction to consider what might have happened in a similar commercial situation between separate entities transacting at arms length. This factor impacts not only on how the equivalent costs might have arisen, e.g. whether transactions like this would have taken place at all (the commercial facts in this case suggest they would) but is also likely to have an effect on the margin of reward that would be expected at arms length - i.e. regardless of how the single entity chose to arrange their affairs, if this had been between unconnected separate entities, would a contractor command a high reward for this work or a routine reward?

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Establish the margin

It is unlikely that independent parties in the real commercial world seeking to agree a reward from one to the other for a service performed would use cost plus in isolation from aiming for an overall outcome from convenient use of that method. For example, it would not be in the payer’s interest to encourage the supplier to inflate his costs above the commercial necessities for the task required. What you are trying to achieve by using this method is the cost plus that equates most closely to the margin that independent operations with similar functions would make. In this case, it is appropriate to use general vehicle engineers as a valid comparable and (as an illustration only) it is established that independent comparables fall into a range of 8% to 12% margin on costs after comparability adjustments between the field and the UK PE operation have been taken into account. Because this case involves a specialised but repetitive and routine operation a lower margin within the range is agreed.

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Calculate the UK chargeable profit

Costs £50m X 108% = Turnover £54m
Costs £50m
Chargeable profits £4m

In this way, it can be seen that the UK permanent establishment has received a reward of £400 after costs for each car finished off. This is another way of approaching the calculation of the cost plus margin, i.e. if comparable independents make a £400 profit on each repetitive task, how does that translate into margin achieved on their costs?

See INTM267060 for example of Comparable Uncontrolled Price method

See INTM267070 for example of Resale method

See INTM267090 for example of Profit Split method

See also INTM463050.