INTM489405 - The Unassessed Transfer Pricing Profits Examples: Examples 1 and 2 - Royalties diverted to a tax haven

Example 1 – Royalties diverted to a tax haven lacking economic substance

 

Facts

  • Company A is an overseas parent with two subsidiaries, Company B (in the UK) and Company C (in a zero tax territory).
  • The group generates the majority of its revenue from the sale of widgets based around valuable intellectual property (IP). All IP is developed in Company A, through valuable and substantial research and development (R&D) activities. No R&D activities are carried out by Company B or Company C, and those companies do not control the economically significant risks associated with the IP.
  • The group has manufacturing entities in many jurisdictions. Company B manufactures and distributes branded widgets in the UK.
  • Company A owns the IP for its own territory and under a license agreement Company C owns the IP for the rest of the world. Company C sub-licenses the IP to Company B. Company B pays royalties of £100m per year to Company C for the use of IP in its manufacturing and distribution activities.
  • Company C itself has no full-time staff and the only functions it performs are to own the IP and some routine administration in relation to the royalty payments it receives.

Analysis

  • The provision is the sub-license of IP from Company C to Company B.
  • HMRC considers that under the transfer pricing requirement the arm’s length royalty payable by Company B for the IP would be £80m per year.
  • Therefore the unassessed transfer pricing profits are the difference between the £100m royalty payments, and the £80m arm’s length price for the royalties.
  • As a result of this provision there is an Effective Tax Mismatch Outcome (ETMO) for each of Company B’s accounting periods. The surplus £20m unassessed transfer pricing profits are deducted in Company B’s tax computation, but the royalty receipt that corresponds to the unassessed transfer pricing profit is not taxed in the hands of Company C. For the purposes of this example we have assumed that there is no UK withholding tax suffered by Company C on the royalty income.
  • Applying the Tax Design Condition (TDC), it is reasonable to assume that the series of transactions by which the provision was imposed was designed to reduce Company B’s liability to UK tax. The provision has been imposed through the series of transactions by which the IP is developed by Company A, but is licensed for rest-of-the world manufacture and distribution by Company C.
  • The insertion of Company C into the transactions does not add economic or commercial value. Company B does not perform the development, enhancement, maintenance, protection and exploitation functions (DEMPE) in relation to the IP, and the arrangements appear to be contrived to justify the inappropriate transfer pricing.
  • Considering the other options realistically available, it is reasonable to assume that at arm’s length Company B would have entered into a licence agreement for the use of IP with Company A directly and paid £80m per year in royalties. Therefore in this example the UTPP conditions are met.


Example 2 – Royalties diverted to a tax haven with economic substance


Facts

The facts are the same as Example 1, but with the following changes:

  • Company B pays royalties of £80m per year to Company C for the use of its IP in its manufacturing and distribution activities.
  • In the past, IP for the widgets was owned in numerous jurisdictions including in the UK. The IP was transferred to Company C and Company A in a rationalisation of the IP holding structure for the widgets business line. The group had non-tax reasons for wanting to hold the IP in one place (it is simpler and more efficient in terms of the number of people needed to support the operation). The group had both tax and non-tax reasons for choosing the zero tax jurisdiction as the place where the global IP would be held. Alongside the economic tax saving, it was relatively low cost and the group had an existing presence there.
  • Company C has a team involved in the management of the IP that includes patent specialists as well as highly qualified engineers in the particular industry who have the knowledge and experience to generate new ideas for development. This team collaborates with a team in Company A on coordinating R&D activity across the globe for the widgets business line, and on new areas of development.
  • The teams in Company C and Company A, and a separate financing team (located in the parent jurisdiction) review the final proposals. Company C and Company A jointly fund the R&D activities on a cost sharing basis.  All major decisions for the IP are reviewed and concluded by the board of Company C who are all employed by Company C.

Analysis

  • The provision is the license of IP by Company C to Company B. The provision has been imposed through a series of transactions by which the IP is jointly developed by Company A and Company C, but is licensed for global manufacture and distribution by Company C.
  • HMRC considers that under the transfer pricing requirement, £80m is the arm’s length amount for the royalty fee.
  • Given that Company B is now paying the arm’s length amount, then there are no unassessed transfer pricing profits. Therefore the UTPP rules will not apply.
  • If Company B had continued to pay £100m in royalty fees such that there were £20m of unassessed transfer pricing profits, then the provision could give rise to an ETMO because if the £20m was recognised in Company B’s tax return then it would be subject to UK corporation tax, whereas the payment is not taxed in the hands of Company C.
  • The TDC is not a main purpose or principle purpose test - for it to apply it only needs to be the case that one of the substantive reasons behind the design of the arrangements giving rise to the unassessed transfer pricing profits is to reduce the liability of Company A to UK tax.
  • There are cost savings attached to the rationalisation and the lower operational costs in Company C. However, it is still reasonable to assume that one of the purposes behind the choice for Company A to pay an excessive amount of royalties to Company C, and the choice to relocate the IP development opportunities from other jurisdictions including the UK to Company C, may have been to reduce UK tax liability. Therefore, the TDC could be met and more fact finding would likely take place to decide whether on balance it’s more likely that the arrangements were predominantly designed to achieve the commercial efficiencies or whether tax savings was a key consideration.