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HMRC internal manual

International Manual

HM Revenue & Customs
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Transfer pricing: Types of transactions: Services: particular types

Group treasury companies

A group treasury company may provide a number of services (see INTM440060) to group companies, e.g. finance, hedging, debt factoring, etc. To the extent that the company is only providing expertise, a fee-based reward might be appropriate. For example a subsidiary may decide to hedge an upcoming purchase of goods, the price being in US dollars. The subsidiary faces a number of ways of hedging the transaction such as a forward currency contract. It asks the group treasury company to advise on the best method of hedging and to arrange the purchase of the appropriate financial instrument on its behalf.

The provision of services such as loan finance, leasing and debt factoring, and underwriting or providing financial instruments can be complex and is considered in more detail in the chapter on Intra-group funding at INTM503000 onwards.

Procurement services

Procurement services might include a fee for negotiating contracts or a charge for providing the facility to buy products at a discount.

For example, a business sells clothes which are manufactured by third parties in Mexico. All manufacturing contracts are negotiated by the parent, which also arranges for the finished garments to be delivered to subsidiaries that distribute them. The parent charges a fee of 10% of the cost of the goods purchased by the distributors. The arm’s length nature of the fee might be tested by establishing the fees independent agents would charge for finding an overseas manufacturer, together with the fees charged by independent agents for arranging delivery. Research finds that fees are charged in relation to the value of the goods and this would serve as a useful comparable.

Expanding on the example above, the group, as well as selling its own goods, sells other well known branded goods. The product mix is 50% own brands, 50% other brands. A procurement company is set up and its employees are responsible for negotiating global contracts. The group’s distribution companies buy the branded goods directly from the suppliers, but are able to buy at a discount because of the global procurement contract.

Gain share arrangements may also provide some useful insight into arm’s length behaviour. These typically share the savings on the items being procured between the purchasing company and the other companies in the group. The greater the unique expertise in the purchasing company and the greater the risk borne, the higher the relative share of profit expected by the procurement company.

Consider how a similar function to procurement services would be rewarded at arm’s length. The evidence might reveal that it was the bulk buying power of the distribution companies which dictated any discount, not the negotiating skills of the procurement company. This would limit its reward accordingly.

UK deductions for recharged expenditure

There may be an apparent tension between an arm’s length payment for the benefit of a service and another part of the UK tax code which prohibits a tax deduction for a particular class of expenditure. An obvious example is a company being recharged particular costs that are deemed to be entertaining.

A particular issue that has arisen in recent years is the recharge of the cost of share-based remuneration, in particular share options. Employees of a subsidiary may receive share options through a group scheme run by, or on behalf of, the parent company - instructions on dealing with this are dealt with under INTM440210. Here however the concern is with the recharge of employee costs where those employees are providing services to different group members. In some cases (particularly US groups) the service fee charged to subsidiaries includes a charge to cover share options.

For example, the Chairman of a group receives an annual salary of £1 million. He is also granted options each year to buy shares in the group. The number of options granted depends on both his and the group’s performance. The chairman is taxable on the difference between the grant price and the exercise price; the parent company claims a deduction for the same amount.

In the year ended 31 December 2012, the chairman exercises options on 2 million shares, paying £2 per share. He immediately sells them for £5 per share, their market value. The chairman makes a profit of £6 million and the parent company claims a deduction of £6 million.

It is group policy to recharge the chairman’s cost around the whole group, at cost plus10%, apportioned by turnover. Assume that this is the arm’s length reward for this example. When calculating the cost to the parent company, the deduction the parent company receives in respect of share options is included, even though the parent company incurs no expenditure as the new shares are issued when the options are exercised. The total costs of the chairman for the year ended 31 December 2012 are:

  Salary £1,000,000
  Retirement provision £2,000,000
  Share options £6,000,000
  Direct support costs £1,000,000
  Total £10,000,000

One subsidiary accounts for 15% of total group turnover, and so is recharged £1,650,000 (£1,500,000 plus 10%) for the year ended 31 December 2012. Assuming the salary, retirement provision and direct support costs are acceptable, this leaves the share options, some £990,000.

A recharge of such costs, based on the difference between the option and exercise price (£6 million) would not be considered arm’s length, notwithstanding the legislation governing deductions for share options. The statutory deduction is given as part of the Government’s policy of encouraging the use of share options. There is no suggestion that it is simultaneously representing an arm’s length price.

Where a company is providing services using employees who have received options, that company will receive a statutory deduction when the employees exercise the options. In pricing the services to its affiliate, however, the treatment of the deduction is not relevant. Instead a hedged cost should be recharged. If the services being provided are those that it would be proper for the company to charge at a mark-up, then the hedged costs should marked up as well.

Businesses that trade by providing services do not generally set their prices solely by reference to the cost of those services. They will take these costs into account, but will price the services by reference to many factors: what the market will bear, or at a discount in order to attract business.

However, the provision of share options is a valuable service, which at arm’s length a third party would pay for, and the logical method is to recharge the costs. Where employees are remunerated by share options there may be no actual cost to the parent company. However services provided by employees who are paid £100 cash plus 100 options are likely to be more valuable than services provided by employees who are paid simply £100 cash. The price paid should therefore reflect the existence of share options, and the question remains as to how to price the options. As explained in INTM440210 the arm’s length price will rarely be the profit made by the employee.

There is unlikely to be any actual physical cost to the parent company (whether based in UK or not). It may simply issue new shares to cover the options granted. The fact that a country has a domestic tax code which permits deductions based on the profit made by employees on exercising the options cannot be used as justification for effectively passing on that deduction to another country. A distinction needs to be drawn between statutory deductions (whether in the UK or in other countries) and the arm’s length price. Failure to make the distinction can result in the importation of a non-arm’s length price into another tax jurisdiction; and that can be resisted on general transfer pricing principles.