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HMRC internal manual

International Manual

HM Revenue & Customs
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Thin capitalisation: practical guidance: knowledge and negotiation: formulating an arm's length position - comparables and OECD guidance

The arm’s length range

As discussed in INTM514020, there is no single, correct answer to the question of what constitutes the arm’s length position in a particular case, and for thin capitalisation it is particularly difficult to establish an arm’s length price by the use of comparables, since there is scope for many variations, and it may be difficult to agree on the relative weight of any differences. Nevertheless, where comparables of reasonable accuracy do exist, they may be used as a starting point for discussing the position in a particular case. They may, for example, narrow down the range of possible values to one which can usefully be discussed.

Bear in mind the advice of the OECD Transfer Pricing Guidelines at section 3.61:

If the relevant conditions of the controlled transactions (e.g. price or margin) are within the arm’s length range, no adjustment should be made. If the relevant conditions of the controlled transaction (e.g. price or margin) fall outside the arm’s length range asserted by the tax administration, the taxpayer should have the opportunity to present arguments that the conditions of the transaction satisfy the arm’s length principle, and that the arm’s length range includes their results. If the taxpayer is unable to establish this fact, the tax administration must determine how to adjust the conditions of the controlled transaction taking into account the arm’s length range. It could be argued that any point in the range nevertheless satisfies the arm’s length principle. In general, and to the extent that it is possible to distinguish among the various points within the range, such adjustments should be made to the point within the range that best reflects the facts and circumstances of the particular controlled transaction.

In fact, if the company is making an advance agreement application, it should be a case of the company providing evidence of the arm’s length range, not of HMRC having to make assumptions because the evidence is not there. Careful choice of comparables therefore narrows down the range of possible answers, but only close analysis of the transaction(s) in question can lead to an acceptably accurate conclusion.

Would a transaction between connected parties have taken place at all?

The legislation at TIOPA10/S152 considers whether, at arm’s length, a transaction would have taken place at all, reflecting the position taken in the OECD Transfer Pricing Guidelines.

Section 1.65 of the Guidelines recognises two particular circumstances in which it may be appropriate to disregard the structure of a controlled transaction. The first circumstance arises where the economic substance of a transaction differs from its form:

‘An example of this circumstance would be an investment in an associated enterprise in the form of interest-bearing debt when, at arm’s length, having regard to the economic circumstances of the borrowing company, the investment would not be expected to be structured in this way. In this case it might be appropriate for a tax administration to characterise the investment in accordance with its economic substance with the result that the loan may be treated as a subscription of capital.’

The second circumstance is where, although the form and substance of the transaction are the same, the arrangements made with regard to the transaction, viewed in their totality, are different from those that would have been made by independent entities behaving in a commercially rational manner. This means of course that in certain circumstances it is possible that all costs associated with a company’s debt may be disallowable.

1.67 of the OECD Guidelines indicates that associated enterprises are able to make a greater variety of arrangements between them than independent parties can, because there is no conflict of interests.