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HMRC internal manual

International Manual

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HM Revenue & Customs
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Thin capitalisation: practical guidance: knowledge and negotiation: getting to know similar businesses - comparables

The basic transfer pricing legislation at TIOPA10/S147 requires that the actual provision be compared with what would happen at arm’s length. Looking at comparable businesses operating at arm’s length can give some indication as how close the transactions under review are to meeting the arm’s length standard. There is guidance on approaches and potential pitfalls with transfer pricing comparables in the chapter starting at INTM485000. In most cases it is very difficult to find a single comparable which can do this, because so many factors are at work in lending and borrowing decisions, but the results of other businesses can shed light on common factors affecting a particular sector or industry. These can indicate how a business within that sector might be likely to behave if it was operating at arm’s length from its sources of funding.

Even businesses in the same sector may appear very different, especially if only the bare figures are analysed. Two businesses in the same sector may present very different funding profiles, for example, if one has been gradually growing over a number of years while the other has recently undertaken the takeover of a competitor.

At the individual company level, it may be difficult to identify reliable comparables. Comparables submitted in support of proposals for a thin cap agreement often include companies working with different business models, for example where data on private equity buy-outs is submitted in support of more traditional long-term businesses. Commercial databases used to find comparables will perhaps not distinguish buy-outs from long term deals. Comparables are also often offered which are for businesses which, from HMRC’s’ perspective, may have the same issues as the company under review, that they are also part of a larger group and involved in funding relationships which are not arm’s length. Given that most transfer pricing work involves multinational groups, this difficulty is to be expected

Useful comparables for thin cap cases are perhaps more difficult to find than for transactions in goods and services, despite the apparent simplicity of funding transactions. This is because, amongst other things:

  • the type of information which is available publicly is unlikely to reveal much about the underlying strategy and direction of the business; funding is often inextricably linked to issues that are commercially sensitive, such as acquisition goals.
  • HMRC can only make use of publicly available information, and cannot share knowledge gleaned in the course of other enquiries. However, it is advantageous to be able to discuss particular business sectors in an informed way. HMRC has specialists who can offer insight and experience on particular sectors.
  • comparables are usually presented to HMRC in quantity and in a fairly superficial way, without detailed comparison of factors such as position in the market, risk profile, product range and durability, acquisition strategy, success of current strategies, and depth of innovation.
  • a range of values drawn from comparables is often presented to HMRC as an “arm’s length range”, but that range is sometimes very wide and a company’s place in that range determined by statistics rather than facts. If the company’s advisors produce a range for interest cover for a number of “comparables” running from 0.5:1 to 8.7 and opt for 4.6:1 for their client, because that figure sits in the middle of the range, it is unlikely to be valid? This emphasises the risk that numbers of superficially drawn comparables may be unhelpful, and a more careful, selective process may be more persuasive.
  • finding another UK borrower in a similar situation at the same time is rare. There is no standardisation of funding arrangements in the way that there is for a service provider or a distributor.

This is not to decry the search for comparable uncontrolled transactions, but transfer pricing remains an art not a science. Examples may often be found that will act as a helpful starting point in discussions, but they can often do little more than indicate characteristics of borrowing in certain business sectors at particular times.

If a group or company is serious about its contention that the terms of a connected party loan are at arm’s length, it should be prepared to demonstrate its case. It may do this by presenting comparables, and these need to be carefully analysed, tracing from start to finish the process by which the evidence was produced, examining critically the assumptions which underpin the selection and the reasons for inclusion or exclusion. The process by which comparables are produced is in practice often too mechanistic.

Any presentation of comparables to HMRC should be accompanied by details of

  • the sources of data - which commercial databases were used, etc
  • what search terms were employed in the selection - key words, industry codes (such as the Standard Industrial Classification (SIC) codes which allocate a four digit code to each industry type
  • how the search was limited by factors such as turnover parameters e.g. all companies with turnover between £10m - £50m
  • how anomalies were weeded out e.g. multinationals (where their own transfer pricing may cloud the issue), and non-comparable business models such as private equity and PFI for intra-group funding cases.

All assumptions should be reviewed.

Advisors also approach the problem from another angle: by creating a “synthetic” credit rating for pricing debt. This involves attributing a credit rating to the borrowing unit and then looking for comparable debt issue at that rating. This is covered at INTM524170.

It is unfortunately relatively easy for HMRC to question the validity of a set of comparables for reasons set out. These criticisms are perfectly valid, but do tend to undermine the basis of a set of comparables. Greater selectivity might produce a smaller but more robust set. In the end, the best method is often a close examination of the circumstances of the particular case, but informed by knowledge of broader characteristics of the business sector concerned.

HMRC offices have access to publicly available commercial databases of company information which can be used as the starting point in looking for comparables. However, some degree of expertise is needed to be able to use them effectively.

When a potential set of comparables has been found, HMRC may already have information on the companies concerned which will be helpful in determining how close the comparables really are. However, only publicly available information can be used in discussion or negotiation of cases. An internet search may confirm the availability of at least some of the information from public sources, especially in the case of large multinational groups, significant mergers and takeovers, major contracts, etc, but greatest of care should be taken not to divulge commercially sensitive information.