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HMRC internal manual

International Manual

Transfer pricing: Types of transactions: particular elements of a transaction

There will be situations where HMRC might challenge the absence of particular elements in relation to a transaction or a series of transactions.

Interest free loans

The classic example is an interest-free loan. It does not generally make commercial sense for a company to lend money on an interest-free basis. In a situation where the facts show that the loan is not performing the function of equity, the appropriate transfer pricing response would be to impute interest to reflect the reward the company would expect to receive if it were lending money to a third party (see INTM501010 onwards for more detail on interest imputation).

In such a situation a transaction is not being imposed - the transaction is the loan between the connected parties. However, the price of the transaction - a provision (see INTM412050) - is not arm’s length. The principle can be extended to other situations as well. These will usually involve the absence of written terms covering a particular transaction between connected persons. The transaction itself will be there - once it is identified it will necessary to establish whether the company is being properly rewarded for its functions and risks involved in the transaction.

Trade marks

Consider the following example:


Overseas parent owns the trade mark, patents and associated intellectual property of a range of digital radios. The trade mark is well known in North America, and the group now wants to launch it in Europe - the UK has been chosen as the first European market. The rights are sub-licensed to a subsidiary (‘Company A’), resident in a low tax territory, who in turn sub-licence to a group company (‘Company B’) in a country with a favourable regime for paying royalties. Company B grants the UK group company (‘UK Distributor’) a 5-year licence to manufacture and distribute the goods in the UK. The licence is renewable thereafter for periods of 12 months at a time. As the trade mark is unknown in the UK, UK Distributor has to spend a lot to promote and establish the trade mark and the reputation and goodwill for the associated products in its territory, and then maintain that goodwill. This involves significant sponsorship of high profile celebrities; favourable sale and return terms and discounts to retailers; extensive advertising and promotional events.

The results for the UK Distributor are as follows:

  31/12/08   31/12/09   31/12/10   31/12/11   31/12/12   31/12/13
  £’000   £’000   £’000   £’000   £’000   £’000
Turnover 5,000   10,000   20,000   25,000   40,000   50,000
Manufacturing costs (3,000)   (5,500)   (10,000)   (12,500)   (20,000)   (25,000)
Gross profit 2,000   4,500   10,000   12,500   20,000   25,000
Brand marketing 4,000   9,000   18,000   12,000   11,000   7,000
Sales & promotion 2,000   6,000   7,000   5,000   6,000   8,000
Pre-tax loss/profit (4,000)   (10,500)   (15,000)   (0)   3,000   10,000
Royalties payable 250   500   1,000   1,250   2,000   2,500

It is not clear from these facts that the UK distributor is receiving the arm’s length reward for its activities. The UK Distributor has made extensive losses for the first four years of trading (after taking into account the royalties payable), the period covered by the initial distribution agreement.

The only intra-group transaction appears to be the royalty paid to Company B. One should review whether this transaction was arm’s length, but it does not contribute significantly to the overall loss position. Is there any other transaction?

Research into comparable companies shows that the gross profit seems broadly reasonable for the type of trade. The trading losses seem to arise because of the significant marketing, sales and promotional expenditure. One would need to review whether a third party, trading on the same terms, would have incurred such expenditure. If UK distributor had little or no chance of recovering the promotional and advertising expenditure (from anticipated increased sales) during the period of its distribution agreement it might seek reimbursement of some part of that expenditure from Overseas parent (who would, of course, also benefit from such expenditure via increased royalties). Alternatively, depending upon the exact facts and circumstances of the case, it could be considered that UK Distributor has provided a valuable service to Overseas Parent in undertaking marketing and promotional activities greater than those which an independent distributor with similar rights would undertake. This is a service, and a transaction that is subject to the transfer pricing legislation. Although there is no written agreement covering this service, this does not prevent the application of the arm’s length principle to the transaction.

This is not a question of seeking to set aside the terms of any contract between the parties involved or of introducing a hypothetical transaction. There is a transaction; it is just that the terms have not been formalised and committed to paper, and at present UK Distributor does not receive a reward for performing the service.

Finally, it would be necessary to consider the price of this transaction. A distributor who did not reasonably anticipate a net benefit to itself from the level of marketing and promotional expenditure it was incurring would expect support from the trade mark owner; it would be likely to expect support in the form of cash to help establish the brand - contributions towards the significant expenditure on promotion and brand awareness.