Transfer pricing: secondary adjustments

The Government has released a consultation document seeking views on a proposal to introduce a system of secondary adjustments in relation to non-arm’s length transactions. The proposals, set out in the document “Introduction of secondary adjustments into the UK’s domestic transfer pricing legislation”, would put in place a very significant second layer of deemed taxation on transactions that are subject to “primary” transfer pricing adjustments. In essence, the cash benefit received by a group company benefitting from the non-arm’s length arrangement would be deemed to be a loan from the UK counterparty and would be subject to deemed interest payments whilst outstanding.

Background

The Government is concerned that, whilst existing transfer pricing legislation reverses the tax effect of non-arm’s length intra-group arrangements, it still leaves outstanding the actual cash benefit of those arrangements. For example, if Company A pays Company B £10m for widgets with a market value of £5m, then it will only get a deduction for £5m. However, Company B will have received £10m cash and will continue to benefit from that receipt.

The Government notes that the OECD transfer pricing guidelines allow for “secondary adjustments” in such cases and that many other jurisdictions have taken up this option, including the US, Canada, France and other EU Member States. Such secondary adjustments are designed to remove the actual cash benefit of the transfer pricing transaction.

Two types of “secondary adjustment” discussed in the OECD guidelines are deemed dividends and deemed equity contributions. However, the consultation notes that, since the UK does not impose a dividend withholding tax, treating the excess payment as a constructive dividend would not (in the absence of new rules) have any effect. Equally, the Government notes that treating the excess as an additional equity contribution would have a limited impact in the UK.

As a result, the Government proposes to treat the benefit received as a constructive loan on which interest would be deemed to arise. So, in the example above, Company A would be deemed to have made a loan of £5m to Company B and interest would be deemed to arise for tax purposes (and be taxable in the hands of Company A) on that deemed loan.

As regards the detailed design of the secondary adjustment, the Government proposes that:

• it should apply automatically to any primary transfer pricing adjustment above a specified level (perhaps £1m) and whether or not the primary adjustment arose within an Advance Pricing Agreement (APA) or otherwise
• the deemed loan should arise between the same parties subject to the primary transfer pricing adjustment
• the loan should be deemed to have arisen at the end of the accounting period to which the primary adjustment relates
• the deemed loan should be subject to an interest rate to be set “by reference to a predetermined market adjusted rate” 
• the deemed loan and imputed interest should continue to apply until the date on which the excess profits are repatriated by way of physical recognition of the funds in the UK entity due to a transfer between the counterparties to the primary adjustment (essentially a payment of cash or cash in kind). Such a repatriation would not be taxed in the UK.

The consultation document seeks feedback on all these design features as well as additional wider issues, such as the impact of such a rule on the UK’s wider tax legislation. A particular issue is whether it would be necessary to apply the rules to UK to UK transfer pricing situations. The consultation also seeks feedback on the need for an anti-avoidance test, which, given that the secondary adjustment is itself a further anti-avoidance measure, may seem somewhat excessive.

The consultation notes that, for double tax relief purposes, a secondary adjustment is not catered for in the OECD Model Tax Treaty. Whilst the Model Treaty Article 9(2) permits corresponding adjustments in the country where the counterparty to a primary adjustment is located, the same is not true of secondary adjustments. Therefore, in the absence of specific provisions in a treaty or agreed adjustments under a Mutual Agreement Procedure (MAP), no countervailing adjustment will be available to the counterparty and there is the danger of non-relievable double taxation being created.

Commencement

As this is an early stage consultation, the document does not set out any timescale for taking forward the proposed measures. However, it does discuss, and perhaps surprisingly leave open, the possibility of the secondary adjustment rule applying to all accounting periods on which the enquiry window has not yet closed, such that a transfer pricing position has not yet become final (and not just adjustments for periods beginning/ending after the legislation is brought into force). This would be surprising element of retrospection to introduce into such a major change in the law.

Comment

The consultation is open for comments until 18 August 2016 and any comments should be sent to secondaryadjustments.consultation@hmrc.gsi.gov.uk.