SMEs have historically been exempted from UK transfer pricing rules. This year’s new rules have extended the rules to all UK businesses, including SMEs. What are the new rules, how do they work, and how we as North London Accountants can help SMEs prepare for them?
In recent years, there have been major changes to UK tax legislation to ensure that large international businesses cannot take advantage of differences between domestic and international tax rules. Amazon is an obvious example we’re all familiar with.
As part of HMRC’s ongoing efforts to close tax loop holes and ensure that taxpayers and businesses are declaring and paying the correct amount of tax, in April last year the government introduced new legislation governing anti-profit fragmentation.
The new rules are intended to deal with cross-border structures which result in a tax mismatch between jurisdictions – in particular, where UK value or profit is transferred offshore or undervalued, leading to that value or profit being realised in a lower tax jurisdiction.
In short, the new rules are designed to close a tax-avoidance loophole that can lower a company’s overall tax liability.
Under the new legislation, UK taxpayers are now obliged to prove that all cross-border transfer pricing arrangements have been priced at arm’s length. In other words, they must demonstrate that the arrangements have been priced on the terms that would apply if there was no relationship between the UK company or person and the overseas company or person.
The UK has had a transfer pricing regime for many years, but SMEs have always been exempt. The big takeaway from the new legislation as far as SMEs are concerned, is that the new rules extend the transfer pricing rules to all businesses, regardless of size.
Under EU definitions, an SME is any business with less than €50 million and fewer than 250 employees. By this definition, 99% of businesses in the UK are SMEs, so the transfer pricing net has been cast as wide as possible.
HMRC’s intention is clear: it wants to increase its share of the global tax cake (and eat it).
Background to the new transfer pricing rules
The Diverted Profits Tax was introduced in 2015 as an anti-avoidance mechanism to target large businesses which were either avoiding paying UK tax, or which were structuring their transactions to divert profits from the UK to a lower tax jurisdiction. While Amazon is a highly publicised example, it was happening for decades in many other industries as well.
The new measures were first floated in Chancellor Philip Hammond’s 2017 Autumn Budget, and then following a consultation period, the legislation was formally introduced in the Finance Bill 2018-19, published in November 2018.
How do the new rules work in practice?
The new rules apply to transactions undertaken by UK resident companies, partnerships and individuals if:
- There is a transfer of value or profit derived from a UK transaction to an entity in another, lower tax, jurisdiction; and
- The transfer results in a tax mismatch – a tax mismatch occurs where the tax paid overseas is less than 80% of the tax which would be paid if the profits were taxed in the UK; and
- A UK-related individual (e.g. a sole trader, shareholder or partner) has arranged for the profits to be diverted and can continue to ‘enjoy’ them; and
- The profit allocated to the entity in the lower tax jurisdiction is deemed excessive in relation to its activities in that jurisdiction.
In general, value or profit can be diverted if increased costs are attributed to the UK from overseas, or if UK profits have been reduced on overseas transactions.
The new rules are less onerous than feared…
As implemented, the new rules have dropped the original proposal for taxpayers to notify HMRC of any schemes or structures that result in profit-splitting (‘fragmentation’). This is a good thing, since it could have forced taxpayers to notify HMRC even if no tax was due.
Furthermore, it had been feared that the legislation would require taxpayers to make an advance payment of any tax due. This has also been dropped from the final legislation.
The new legislation effectively includes a motive test, in that it must be reasonably concluded that the main purpose, or one of the main objectives, of the transaction was to obtain a tax advantage.
It will be interesting to see how this will play out in practice, since it can be difficult not to attribute the existence of a tax advantage as a motive. Time will tell…
Overall, the changes from the draft proposal mean that the new rules are significantly less onerous than what was originally proposed.
…but they’re still bad news for SMEs
Perhaps the most significant implication of the new rules is that they have extended the scope of the UK’s transfer pricing rules to all businesses, regardless of size. This is a fundamental change for SMEs (which, remember, comprise 99% of all UK businesses) that have previously relied on the transfer pricing exemption.
Now, any business (including SMEs) that conduct transactions with a related party in a lower tax jurisdiction is required to demonstrate that those transactions have been priced on an arm’s length basis. If they are not – or if it cannot be sufficiently proven that they are – they risk incurring a penalty in the form of a tax adjustment if it is deemed the business can enjoy the benefits of the diverted profits.
What kind of transactions will be caught by the new rules?
They might include transactions with:
- Countries with tax rates that are 80% of the UK tax rate (or lower). These include the Channel Islands, Ireland, Cyprus and Qatar.
- Jurisdictions that have beneficial tax regimes and lower tax rates for smaller businesses. These include Hong Kong, Singapore, Albania and Croatia.
- Countries that provide for a lower tax rate or additional deduction for a particular revenue stream, such as intellectual property income or R&D expenditure.
For all of these, it is now important to consider the arm’s-length principle and be able to prove sufficiently that the transaction does not result in a tax advantage through a tax mismatch.
Before 2019, UK SMEs could have priced any transactions in these jurisdictions without worrying about whether transfer pricing. Going forward, however, all businesses will now need to produce and maintain evidence that the arrangements are indeed arm’s length.
How do the new transfer pricing rules impact SMEs?
All UK businesses now need to think about whether they need to make any tax adjustments to remain compliant. In particular, we recommend that SMEs review (or seek professional advice on) the following, in order to help protect themselves from being caught out by the new anti-profit fragmentation rules:
- Review all current transactions and structures to see if there is any tax mismatch, which may potentially lead to the increase in overseas tax being less than 80% of the reduction in the UK taxation as a result of the transaction.
- If a mismatch does arise, consider whether the ‘enjoyment’ condition is satisfied – in other words, can a UK entity benefit from the profits which are not taxed in the UK.
- If both conditions are met, consider whether the transaction is at arm’s length and therefore not ‘excessive’ when compared to the underlying business activities.
- Finally, we the company should consider and provide evidence, as necessary, that the main purpose, or one of the main purposes, of the transaction was not to obtain a tax advantage and, therefore, why the anti-fragmentation provisions do not apply.
With the new rules now in effect for the current tax year, all UK businesses should review any transfer pricing arrangements they may have, in order to determine whether these new rules apply, and how best to prepare for them.
Has your business been affected by the new transfer pricing rules? What do you think the long-term effect of the new legislation will be? If you would like to speak to us about how to manage your transfer pricing arrangements, feel free to contact us for a no-obligation consultation.