Transfer pricing: operational guidance: working a transfer pricing case: penalties: negligence or carelessness
Negligence or Carelessness: examples
In most cases the question of negligence or carelessness will arise because HMRC contends that a business has not given sufficient thought to establishing and supporting an arm’s length transfer pricing policy. However, CTIAA Business International have also seen examples where it has been argued that a business has been negligent or careless where an arm’s length transfer pricing policy has not been properly implemented, leading to certain transactions taking place on non-arm’s length terms.
The following examples are designed to give a broad understanding of how HMRC will interpret negligence or carelessness in transfer pricing cases. They are not exhaustive and it cannot be stressed too strongly that each case can only be properly judged on its facts and merits. The examples address only the issue of what constitutes negligence or carelessness in transfer pricing cases and do not replace the general guidance on penalties found in the Compliance Handbook. See INTM483110 for an overview of penalties in transfer pricing enquiries, including the different periods to which the terms negligence and carelessness apply.
Example 1: No penalty following transfer pricing adjustment
A company which provides services to other group members charges out its services at cost plus 8%. It can show that at the time the rate was set it had run a check of available industry data, and had found what it considered to be a comparable uncontrolled price supporting the 8% rate. In discussion with HMRC, the company agrees that the comparable it used was flawed, and that the weight of evidence points towards a price in the 10% - 15% range.
HMRC accepts that the company had made an honest and reasonable attempt to comply with the arm’s length principle. There is an adjustment but no penalty.
Example 2: No penalty following transfer pricing adjustment
A company which provides services to other group members charges them at cost plus 5%. This accords with a policy in place throughout the group and is documented in correspondence involving members of the main Board, the Finance Directorate and the Tax Department, and in a group agreement. The company includes an adjustment in its computation, bringing the effective rate of charge-out up to 8%. It did so after searching available industry data for possible comparable uncontrolled prices, this search being made at the time the tax computation was being prepared. The company sees this information as supporting its opinion that 8% accorded with the arm’s length principle, but it later agrees that the price should have fallen in the 10%-15% range.
Once again, HMRC accepts that the company had made an honest and reasonable attempt to comply with the arm’s length principle, and there is an adjustment but no penalty.
Example 3: No attempt to determine and apply arm’s length price
As in Example 1, a company which provides services to other group members charges out its services at cost plus 5%. The 5% rate is documented in various correspondences within the group, including a service agreement. It is established in discussion with HMRC that the arm’s length range for the services in question is 10% - 15%. The company cannot show from its records that it even considered whether its own 5% rate complied with the arm’s length principle. HMRC would view any tax lost as a result of the undercharge as having been lost through negligence or carelessness and would wish to consider a penalty. This is because the company has not made a reasonable effort to identify an arm’s length price for the transaction, or provide evidence that transactions have taken place on arm’s length terms.
Example 4: No attempt to price transaction
A UK company provides financial assistance to an overseas subsidiary suffering from a temporary cash flow problem. The UK company pays a number of suppliers on behalf of its subsidiary and also provides extended credit terms on the supply of goods. Although the arrangement is originally intended as a short term one, it continues over a number of years, and significant unpaid balances build up. These are shown as long term debtors in the UK company’s balance sheet. No interest is charged to the overseas subsidiary.
On conclusion of a transfer pricing enquiry, it is agreed that a proportion of the debt should be interest bearing. HMRC would also wish to consider whether the UK company has been negligent or careless in not seeking to apply an arm’s length price to a transaction reported in the accounts and will consider whether to seek a penalty. HMRC would argue that culpability arose at the time when the advances were classified as being long term debtors, and that the company was negligent or careless at that time in not identifying that a transaction had taken place between connected parties and considering how the transaction would be treated at arm’s length.
Example 5: No attempt to support arm’s length price
A group establishes a shared service centre in France and applies a charge for the services provided to its European subsidiaries based on a percentage of their turnover. The total fees charged cover the costs of operating the shared service centre and leave it with a modest profit. A transfer pricing enquiry establishes that there is no support for the level of the service fee. The methodology applied was chosen for ease of use and because the finance director had experience of applying a similar approach in a previous post. The enquiry establishes that a significantly lower UK recharge is appropriate, having regard to the extent to which the UK company benefits from the services.
HMRC would also wish to consider whether the UK company has been negligent or careless in not seeking to determine and document an arm’s length price for a transaction taking place which has significant value and which recurred.
In considering the application of a penalty to cases where documentation to cover a transaction has been prepared by an overseas affiliate, HMRC will not expect that the UK company should duplicate work undertaken elsewhere in the group as that would increase compliance costs. Where a UK company relies on documentation prepared elsewhere in the group, the onus will be on the UK company to determine that the documentation is adequate for its purposes, and that it supports the arm’s length nature of the transaction. Issues which we would expect the UK company to consider would include whether the documentation:
- Demonstrates that valuable services are provided
- Identifies and excludes shareholder costs and other expenses which should not be charged
- Uses an appropriate allocation key to apportion costs between different recipients of services
- Uses an appropriate methodology to support the pricing approach adopted
- Includes comparables or other supporting evidence to support the transfer prices used
In this case, a review of the documentation revealed a number of problems, including:
- The UK company could not demonstrate that it received a number of classes of service which it was charged for
- No attempt had been made to use a direct allocation method to recharge costs relating to significant projects undertaken for individual recipients
- The allocation key chosen (turnover) was not linked to the benefit of the services received by the UK company
HMRC argued that these flaws in the approach adopted (and particularly the first two) constituted negligent or careless behaviour.
Example 6: Transfer pricing policy not properly applied
A UK company paid royalties to overseas associated companies to access intangibles and also purchased finished goods from other group companies. A transfer pricing enquiry agreed certain amendments to the policy applied and it was agreed that these would be applied going forward.
Subsequent enquiries established that there were numerous examples of transactions not being priced in accordance with the new transfer pricing policy. In addition to adjusting the UK company results to reflect an arm’s length position, HMRC would also wish to consider whether the UK company has been negligent or careless in not pricing transactions according to its established transfer pricing policy, and in failing to take steps to establish that arm’s length prices are consistently applied within the business.
Under the new regime a higher maximum penalty will be applied for deliberate inaccuracies. The maximum penalty is 70% of Potential Lost Revenue (PLR) where there has been no attempt at concealment, and is up to 100% for deliberate inaccuracies with concealment
The following examples are not based on real cases, but are indicative of the sorts of circumstances where HMRC would consider that a deliberate inaccuracy has occurred. As with all considerations relevant to penalties, the facts and circumstances of each case will be crucial in determining whether an inaccuracy has occurred due to negligence or carelessness or whether it is deliberate. In the case of a penalty following a transfer pricing adjustment the key factors which would indicate a deliberate error would include a business knowing that the facts presented in a transfer pricing report do not accurately reflect the transaction which has been undertaken, or knowing that prices applied are clearly not at arm’s length.
A transactional net margin method is used to justify a level of profit where there is a very clear internal comparable uncontrolled price available indicating a higher level of profit at arm’s length.
HMRC accepts that there will be instances where there is room for discussion, about which is the most appropriate method to apply or where there is disagreement about whether a transaction is suitably comparable to be of use in setting arm’s length prices. HMRC would, however, argue that an inaccuracy was deliberate if a clear comparable uncontrolled price (CUP) had been omitted and there was no reasonable technical analysis to support why it had been disregarded.
A company develops valuable intangibles in its own right - that is, its activities are not undertaken on a sub-contract basis on behalf of other group members. It takes all key decisions concerning the development and evaluation of the intangibles and funds the necessary research. Products sold incorporating these intangibles generate substantial profit as a result of the unique nature of the intangibles. A cost plus methodology is used to allocate a markedly non-arm’s length income to the owner of the intangibles.
HMRC would consider that the application of a price which is clearly not at arm’s length because it leaves the owner of a very valuable intangible with a routine level of reward has given rise to a deliberate inaccuracy.
As in example 8, a UK company owns and has developed valuable intangibles. The parent company produces a transfer pricing report to support the application of a cost plus reward to the UK company. The functional analysis included in the report contains a number of material inaccuracies and does not reflect the way in which the UK business operates.
HMRC will consider that the inaccuracies are deliberate where it is clear that the UK directors have accepted the report knowing that the business does not operate in the way it is described in the functional analysis and where the application of the transfer pricing policy produces a UK tax advantage.
A deliberate and concealed inaccuracy should be reported to the Evasion Referral Team (ERT): see alsoCH27150. It occurs where a document containing a deliberate inaccuracy is given to HMRC and active steps have been taken to hide the inaccuracy either before or after the document has been sent to us. As well as deliberately recording an inaccuracy, the person has to take active steps to cover their tracks by making arrangements to conceal the inaccuracy.
CH81160 contains examples of the types of actions which HMRC will regard as concealment. In the transfer pricing arena, these could include:
- invoice routing, for example the purported sale or purchase of goods through a tax haven company with no activity undertaken by that company even though contracts exist showing the contrary. As a result, non-arm’s length prices are paid and profits arise to a company which are clearly out of line with the profile of risks, functions and assets.
- creating false invoices to support inaccurate figures in the return
- backdating or postdating contracts or invoices where there is no evidence that the recorded arrangements were in place during that period
- creating false minutes of meetings or minutes of fictitious meetings
- destroying books and records so that they are not available.