VGDC80030 - Avoidance and disclosure: avoidance - valuation of core expenditure

S1217CL Corporation Tax Act 2009 (CTA 2009)

The extent to which Video Games Tax Relief (VGTR) is available is dependent on the amount of core expenditure on a video game. The minimum amount of core expenditure that is European expenditure must be 25%.

Furthermore, because the rate at which surrenderable losses can be exchanged for a tax credit is higher than the rate of Corporation Tax, it may be the case that the core expenditure is overstated artificially.

To prevent the size of the budget being artificially distorted, in determining the size of a video game’s core expenditure:

  • where goods or services included within the video game core expenditure are being supplied as a result of transactions entered into (directly or indirectly) between connected persons, and
  • the amount of core expenditure might have been expected to be less, or greater, if the transaction had been between independent parties, then
  • the amount of the expenditure should be established by reference to what the arm’s length value would have been had the parties been unconnected.

The rules for connected persons which should be applied for this purpose are those set out in S1122 and S1123 CTA 2010.

Staff-month rates and production fees

Video game development companies may be charged by fellow group companies or other connected parties at inflated rates for supply of workers and other production services. Because the group has only incurred the underlying costs in practice, when development companies include the inflated charges in their relief claims, they are in effect receiving relief for the profit element of the charge.

This is the case where the profit element of the amount receivable from a 3rd party financier is included within the intra-group charge, and where a group self-funds a project and makes intra-group charges at an anecdotal ‘industry rate’ which includes a profit margin.

Charges between connected parties including an inflated mark-up on underlying cost which exceeds the rate HMRC would expect to see between independent parties are not eligible for Video Games Tax Relief. VGTR is designed to give relief for expenses that have genuinely been incurred by claimants.

HMRC accepts a reasonable mark-up on underlying staff costs to reflect the indirect cost of overheads such as office electricity and training costs. However, this mark-up should never exceed a genuine arm’s length rate.

HMRC does not set a specific ‘acceptable’ percentage mark-up, since the rate should be reflective of market rates which will naturally vary by industry and service provided.

To reach an arm’s length value, claimant companies should:

  • Conduct a robust transfer pricing analysis, applying the OECD Transfer Pricing Guidelines (VGDC80060); or
  • Identify suitable third party comparables of production fees and man-month rates charged in transactions between external, independent parties.

In both cases, HMRC expects the claimant company to be able to demonstrate that its method produces a just and reasonable mark-up rate, such as may be expected between unconnected parties in an arm’s length transaction.

If HMRC considers that a claim to VGTR includes inflated intra-group or connected party charges, HMRC will consider all options available to challenge it. This includes, but is not limited to, transfer pricing challenges and use of the general anti-avoidance provision at s1217CL CTA09 (VGDC80050). HMRC considers that charges which are inflated at a rate that cannot be shown to be reflective of an arm’s length value by transfer pricing analysis or third party comparables would be disallowed by s1217CL.

To help with the processing of claims, HMRC encourages customers to make additional disclosures in their VGTR claims where possible, detailing the mark-up rates used for connected party transactions and the underlying direct costs and overheads.