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Date of publication: January 2012
Any company trading with connected parties, such as other group companies or other companies with common owners, has an obligation not to distort its taxable profits by entering into an "un-commercial" trading relationship.
This means that companies trading within a group need to give careful consideration to the value placed on inter-group transactions and the company needs to be able to justify that the value is reasonable.
This applies to groups of companies wholly within the UK, as well as international groups, although international transactions are likely to receive closer scrutiny.
Transfer pricing applies to physical movement of goods or stock between companies, as well as services and support provided by one company or its staff to another, and also to transfers of intellectual property.
As with interest payments (see below), payments in respect of intellectual property may be subject to withholding tax, depending upon the tax treaty position. Withholding taxes have to be deducted by the payer company, but can normally be offset against tax by the recipient.
The good news is that the requirements are fairly limited unless you are a "Large Company". The requirements when you are not large are merely to ensure that you have fair arms length basis for all transactions, but the level or reporting or evidence to support this basis is minimal.
For large companies there are formal valuation and documentation requirements specifying documents which would need to be produced in the event of a tax enquiry. Smaller companies my benefit from considering the requirements for larger entities as an example of best practice. These formal requirements also apply to any company of any size trading with a related business in a country that does not have a tax treaty with the UK featuring a non-discrimination clause.
Large companies are those with over 250 employees and either turnover in excess of €50m or a balance sheet total in excess of €43m. Medium sized companies (over 50 employees and over €10m turnover or balance sheet total) can also be directed by HMRC to apply the formal transfer pricing requirements.
There are five acceptable valuation methods under transfer pricing principles. These used to be hierarchical with the first method being obligatory unless it was impractical, in which case the second method could be used, and so on down the list. However a more flexible approach is now being taken as HMRC recognise the difficulties inherent in transfer pricing valuations. Preference is still given on the whole to methods 1 to 3 as being the most objective.
Historically HMRC have disallowed tax relief on interest payments which were considered to be excessive on the basis of the ratio of equity to debt in the financing structure of the company. Companies with high debt to equity were said to be thinly capitalised and interest relief would be restricted on inter-group interest payments.
This approach has now been largely replaced with one which focuses on the commercial borrowing power of the entity. If an entity, considered on it's own without support from the parent company, would be likely to be able to raise the level of debt from banks or the capital markets then the interest should all be allowable for tax relief. If not, relief will be withdrawn in relation to the proportion of the loan which is considered excessive and "un-commercial".
It is important to bear in mind that interest payments made overseas can be subject to withholding taxes of 20%.
Even where a tax treaty allows for withholding tax relief to reduce or remove the charge, permission must be sort from HMRC by the company receiving the interest before the treaty rate of withholding tax can be applied.
Tax relief on interest payments is restricted for companies where the UK company's borrowing exceeds their overall international borrowing. The restriction applies only to large companies (see above), and only where the UK net debt is above £3m and the UK net finance charge (exclude foreign currency fluctuation) is above £500,000.
This guide does not contain a full statement of the law and it does not constitute legal advice. Please seek legal advice if you have any questions about the information set out above.