On 1 April 2019, the UK introduced new anti-profit fragmentation legislation intended to counter cross border structures which result in a tax mismatch. The rules are intended to apply where UK value is transferred or undervalued, resulting in that value being realised in a lower tax jurisdiction.
The rules place an obligation on taxpayers to prove that the arrangements are priced at arm’s length which means pricing the arrangements on the terms that would apply if there was no relationship between the UK person or company and the overseas person or company. SMEs are generally exempt from UK transfer pricing but the new rules effectively extend the UK transfer pricing rules to SMEs.
The new measures were first introduced in the Autumn Budget of 2017, followed by a consultation that ran from April to June 2018.
The draft legislation and a response document were published in July 2018. After a period of consultation the legislation was introduced in Clause 16 and Schedule 4 of the Finance Bill 2018-19, including material changes to make it less burdensome with regards to measures such as self-notification and upfront tax payments.
The legislation introduced new anti-avoidance rules, effective from April 2019, in order to tackle ‘profit splitting’ arrangements intended to shelter taxable profits from UK tax.
The rules apply if:
- There is a transfer of value derived from a UK trade to an entity in a lower tax jurisdiction; and
- The transfer results in a tax mismatch – broadly the extra tax payable overseas is less than 80% of the reduction in UK tax; and
- A UK related individual (for example, a sole trader, shareholder, partner) has arranged for the profits to be diverted and can continue to ‘enjoy’ them; and
- The profit allocated to the entity in the low tax jurisdiction is excessive with regard to its activities.
The new rules have dropped the previous proposal for taxpayers to notify HMRC of schemes that result in profit fragmentation, as this could have resulted in taxpayers having to notify HMRC even if no tax was due. Likewise, a proposal to require taxpayers to make an advance payment of any tax due has been dropped.
The legislation has introduced a quasi-motive test into Schedule 4 paragraph 2(2)(b) which states that arrangements are not profit fragmentation arrangements if it is not reasonable to conclude that the main purpose, or one of the main purposes, for which they are entered is to obtain a tax advantage. It remains to be seen how this will play out in practice, as it can be hard not to attribute the existence of a tax advantage as a motive.
Overall, these measures mean that the new rules are significantly less onerous from a compliance perspective than what was originally proposed.
Arguably, the practical impact of the new rules is to extend the scope of UK transfer pricing rules to all UK businesses potentially caught by them. Essentially, a business that is conducting transactions with a related party in lower tax jurisdictions will have to show that those transactions are indeed arm’s length in order to avoid suffering a potential one-sided tax adjustment in instances where it is deemed the business can enjoy the benefits of the diverted profits.
One example is where a small UK business makes use of technologies held by a small subsidiary undertaking based in a lower tax jurisdiction (not uncommon) and pays royalties to that subsidiary undertaking. The royalty payment will be a deductible expense for tax purposes in the UK and will therefore need to be priced at arm’s length. This is to avoid the UK business being deemed to have transferred value in the form of excessive royalty payments that are then realised (via a generally tax exempt dividend payment) in the small subsidiary undertaking resident in a lower tax jurisdiction.
Another example is where a small UK business pays for procurement services provided by a small Singapore based subsidiary that it recently set up to help it source products from the Asia region. The income of the Singapore subsidiary will typically be quite small. This will mean it benefits from the tax exemptions available for businesses in Singapore, where the first approximately £100,000 of income may be exempt from tax, thereby resulting in a tax mismatch. The procurement fees paid by the UK business to the Singapore entity will be tax deductible expenses in the UK. Under the new rules, the procurement payments will have to be priced at arm’s length in order to avoid the UK business being deemed to have transferred value in the form of excessive procurement payments that are then realised (via a generally tax-exempt dividend payment) in Singapore.
Both examples show SMEs that would have ordinarily been exempt from transfer pricing altogether, or considered very low risk for UK transfer pricing, which could previously have priced transactions without having to consider whether the pricing is arm’s length. Going forward they will now need to gather and maintain evidence that the arrangements are arm’s length.
The result of meeting the conditions
Should the conditions apply, then tax adjustments may need to be made to the tax computations of the UK businesses which:
- Relate to the relevant expense, income, profits or losses of the UK resident entity;
- Are based on the arm’s length principle; and
- Must be just and reasonable.
For value transfers, the new rules came into effect on 1 April 2019 for corporation tax, and 6 April 2019 for income tax. This includes profits accruing on or after those dates on existing structures.
With the rules commencing directly following Q1 2019, UK businesses should, as best practice, self-assess their structures in order to determine whether these new rules apply.
Batanayi Katongera is partner and head of Transfer Pricing at MHA MacIntyre Hudson