Transfer pricing: Types of transactions: transfer of trading stock
Transfer of stock: transfer pricing rules
In most trades, where different companies are involved in the chain of manufacture, distribution, retailing, etc, of product, stock is routinely sold from one company to another at each stage of manufacture or development. In some such cases normal accountancy practice may be that the transfers occur at the open market value. This value will also generally apply for tax purposes. Extending transfer pricing rules to domestic transactions is unlikely to have a significant impact in these cases.
But there are some situations where tax rules and accounting practices diverge. Firstly, there is the situation where one company ceases to carry on a trade, and transfers its trading stock to a related party which intends to carry on that trade, either as a new trade, or as an extension to its own existing trade. Secondly, normal accountancy practice may permit stock to be valued at the lower of cost or net realisable value (see BIM33115).
The common feature of such situations is that accounting rules permit the transfer of stock to take place at the ‘book value’ rather than the open market value where the latter would be a higher figure.
Until the introduction of transfer pricing rules applicable to wholly domestic transactions, the tax rules applying to the treatment of trading stock on the cessation of a trade were dealt with in ICTA88/S100, now re-written as CTA09/S162 onwards. There is an arm’s length rule at CTA09/S166 where the parties are connected, but with the capability to elect in S167 for a lower value where the price actually paid and the original acquisition value are both less than the arm’s length price. For tax purposes the higher of these two alternative values is utilised.
Where CTA09/S162 onwards is not in point, because there is no cessation of trade by a company, then, apart from the transfer pricing rules, tax will follow generally accepted accounting practice. This would permit the transfer to be recorded at the actual price paid for the stock, rather than requiring an arm’s length or market value to be used.
In the first type of case outlined, the extension of the transfer pricing rules to such situations and the disapplication of the valuation rules by CTA09/S162(2) would, absent any other provision, prevent connected parties to whom the disapplication applies from obtaining the same benefits as connected parties to whom the disapplication does not apply can receive from an election under CTA09/S167. In the other cases, the application of the transfer pricing rules would, where the book value of stock was less than the arm’s length price, recognise a profit for tax purposes that had not yet been realised by the group. This is because the timing of the taxation of an adjustment to the profits of the transferor would not necessarily be matched by the effect of the compensating adjustment that the transferee would be entitled to claim under TIOPA10/S174.
TIOPA10/S174(2)(a) requires the disadvantaged party to recompute their profit as if the arm’s length provision had applied. Thus the uplift in the profit of the transferor would be matched by an increase in the purchase price of the stock held by the transferee. However, where that stock is still held at the end of the transferee’s accounting period, the compensating adjustment will also increase the credit made to the profit and loss account in respect of the value of trading stock carried forward. So there is no net reduction in taxable profits from the compensating adjustment until the stock in question is sold, resulting in accelerated taxation of profits.
TIOPA10/S174(4) and S180 addresses the majority of these situations. After first applying the transfer pricing rules to the transferor company, it permits a compensating adjustment that is effective to the transferee where the stock is still held at the end of the accounting period in which the transfer takes place. This is achieved by not including the value of the transfer pricing adjustment in the closing value of transferred stock for tax purposes.
The rule in TIOPA10/S180(2) ensures that the deduction available to the transferee cannot be taken before the transferor is taxed on the uplift in its profits, for example because of mismatched accounting periods.