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HMRC internal manual

International Manual

HM Revenue & Customs
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Transfer pricing: Types of transactions: setting aside a provision between connected parties

When setting aside a provision may be appropriate

Normally, a transfer pricing examination will involve identifying the actual provision made or imposed between associated persons, then performing a comparability analysis in order to ascertain whether that provision has been priced at an arm’s length price.

Exceptionally, there may be circumstances where, following an initial examination of the actual provision, the tax administration will apply the arm’s length principle to determine the arm’s length profits based on an alternative characterisation or structuring of a transaction or arrangement, for example, where the provision simply would not have been made, or would not have been structured in the way it has been, had the parties been unconnected.

Some guidance is given in the OECD’s Transfer Pricing Guidelines as to the two exceptional circumstances where, in applying the arm’s length principle, it may be appropriate to disregard the actual structure of a controlled transaction. The two circumstances (at paragraph 1.65) where it would be appropriate to proceed on the basis that the provision as structured would not have been made had the parties been unconnected are:

  1. Where the economic substance of a transaction differs from its form. The example quoted by the OECD Guidelines is where an interest-bearing loan which at arm’s length would not have been lent in that form; in such a case the debt might be re-characterised as capital.
  2. Circumstances where, although the form and substance of the transaction are the same, the arrangements behind the transaction, when viewed in their totality, are different to what one would expect to find at arm’s length and the actual structure adopted practically impedes trying to establish an arm’s length price. The OECD Guidelines provide the example of a sale for a lump sum payment of unlimited entitlement to all future intellectual property rights arising from a long-term research contract. In such a case, while it might be correct to accept the form and substance are the same (i.e. the sale of intellectual property), the terms of the transaction in its entirety - in this case the way in which it is sold for a lump sum - is open to question. It may, for example, be appropriate to adjust the conditions to reflect those of a continuing research agreement.

It is important to remember, however, that the examples given under each circumstance are illustrative rather than exhaustive. Since the Guidelines were first published, radical changes in technology and telecommunications in particular have enabled businesses to re-engineer radically their business processes and operations, and relocate certain parts of their business to locations with a low tax regime using email and the internet to communicate instantly with the remaining part of the business. With such business restructurings becoming more common, a new chapter (Chapter IX) was introduced in the 2010 edition of the Guidelines which deals with transfer pricing aspects of business restructurings: there is additional guidance specifically on the application of paragraphs 1.64 -1.69 within part IV of that chapter.

Additional guidance is provided on the second “exceptional” circumstance, within paragraph 1.65, and its two cumulative criteria:

  • In assessing the commercial rationality of an arrangement, it is not sufficient that the arrangement makes commercial sense for the group as a whole; the arrangement must be on an arm’s length basis at the level of each affected party (paragraphs 9.178 and 9.182)
  • If an arm’s length price can be determined, taking into account the comparability analysis of both parties to the transaction, then the structure or characterisation of the transaction should not be ignored. In this context the arm’s length price is the price which gives an arm’s length expected profit given the functions actually performed, assets actually used, risks actually undertaken and the profitability of realistically available alternatives (paragraph 9.180)
  • The presence of a tax motive does not, in itself, justify non-recognition of the arrangement under paragraph 1.64-1.69 (paragraph 9.181)
  • The consequences of non-recognition are the substitution of an alternative characterisation or structure that comports as closely as possible with the facts of the case (paragraph 9.187)

A common restructuring arrangement seen is the kind of commissionaire structure that is discussed in INTM441040 where a UK company that used to act as a fully-fledged distributor, now acts as an agent of an overseas principal. An examination of the transfer pricing of such an arrangement should, initially, focus on the arrangements as actually structured, examining the financial reward payable to the (now) agent as well as any compensation for the restructuring itself. However, the facts and circumstances may be such that it is appropriate to consider whether the terms and conditions of the provision in their entirety would have been agreed between unconnected parties.

It is important to note that this is a very difficult area and it would be necessary to ascertain all the facts and circumstances of a case, together with any evidence that such arrangements would not have existed between third parties, before concluding that a provision should be set aside. Any evidence of the provision and the price that would have existed would also have to be considered. In all such instances, consult the Transfer Pricing Team at CTIAA Business International.