by Jonathan S. Schwarz

This material must be read in conjunction with the Responsibility Statement

CONTENTS

INTRODUCTION

RECENT TRANSFER PRICING LITIGATION
TRANSFER PRICING AND SELF-ASSESSMENT
The Tax Return
Enquiry into Company Tax Returns
Returns Amended During Enquiry
Completion of Enquiry
Supervision by the Board
Resolution by Agreement
Applications to Close Enquiries
Amendment of Return After Enquiry

OTHER ASSESSING POWERS
Correction of Returns
Determinations
Discovery Assessments and Determinations
Time-Limits
Appeal Process
Disputes About Record Keeping
Information Strategy

CONCLUSION



"In order to ensure peace, it is necessary to prepare for war" (Sun Tzu).

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INTRODUCTION

There were almost no decided cases on transfer pricing under the pre-Finance Act 1998 legislation. The two cases that came before the Courts involved the mechanism for assessment in Glaxo Group Limited v IRC [1996] STC 191 CA and the long debated issue as to whether interest was covered at all by the legislation which came before the Special Commissioners in Ametalco v IRC [1996] STC (SCD) 399. Since the legislation had been around for over 50 years, this is somewhat surprising, particularly given the fact that other jurisdictions do see cases brought in this area. One conclusion that might be drawn from this is that transfer pricing issues tend to be resolved by negotiation. Another reason for the lack of case law was the lack of rights given to taxpayers in the former law and, indeed, the absence of a proper legal framework for transfer pricing generally. Section 770 and its accompanying provisions contained little other than a formulation of the arm’s length rule, along with accompanying information powers.

From this perspective, the new regime is a considerable improvement on its predecessor. In particular, the explicit statutory reference to the OECD Transfer Pricing Guidelines puts the guidelines on a more sound legal foundation, which will facilitate the proper application of those rules on a legal basis, subject to the appeals process. This will, in many cases, give taxpayers an additional weapon in defending attacks on their transfer pricing arrangements in appropriate cases. However, in considering dispute resolution and the appeals process, it is vital to recognise the fundamental changes which are an essential requirement of a self-assessment system.

The new regime does increase the possibility of disputes. Firstly, the self-assessment of the arm’s length rule means that every single taxpayer within its scope must address the issue. Secondly, the new legislation suffers from a lack of clarity in several important respects which are bound to give rise to differences of interpretation. Thirdly, the self-assessment process is by its nature more adversarial.

RECENT TRANSFER PRICING LITIGATION

There have been no cases recently on the transfer pricing legislation. However, Sch 28AA and its predecessor are only part of the armoury available to the Inland Revenue to attack non-market value transactions. The use of other instruments is illustrated by the Special Commissioners decision Rochester (UK) Limited and Another v Pickin SCD 160 [1998] STC (SCD). In that case, the UK company which was controlled by a Canadian parent agreed to purchase seeds from a Dutch supplier for the purpose of extracting oil. After some years the Dutch supplier agreed to supply the seeds to a newly incorporated Swiss company, which made arrangements for the extraction of the oil, which it then supplied to the UK and Canadian companies. The Inland Revenue considered that arrangements had been fraudulently made for the Swiss company to be inserted in the chain as a device to enable the UK company to pay excessive prices for the oil supplied by the Swiss company, thereby evading UK tax on the UK company’s profits. They also argued that certain payments made by the UK company to the Swiss company relating to medical research were for no consideration. The UK company was assessed on the basis of the part of the price paid to the Swiss company which exceeded a reasonable price for the oil and for the payments relating to medical expense on the basis that they were not incurred wholly and exclusively for the purpose of the UK company’s trade within TA 1988, s74(1)(a). They were therefore not deductible and remained profits of the UK company.

Much of the case considered assessments out-of-time and the Special Commissioners concluded that the Revenue had failed to discharge the burden of proving fraudulent or negligent conduct in relation to the out-of-time assessments. In relation to the in-time assessments, the Special Commissioners found that the payments had been made as part of a commercial arrangement and that they had been made wholly and exclusively for the purposes of the trade of the UK company.

Although the Inland Revenue failed in this instance, the case is illustrative of several aspects of modern transfer pricing practice. Firstly, the facts and documentation determined the outcome of the case. Secondly, other statutory weapons available to the Inland Revenue to tackle non-arm’s length and related party transactions may be used. Thirdly, the Inland Revenue will test cross-border structures and arrangements thoroughly. The tax at stake in this case in relation to the transfer pricing aspects was approximately £900,000 spread over seven accounting periods. It illustrates therefore that the Inland Revenue will pursue these issues even in relation to relatively small businesses.

TRANSFER PRICING AND SELF-ASSESSMENT

The Tax Return
This paper concentrates on the corporate self-assessment rules largely contained in Finance Act 1998 ("FA98") Schedule 18. Every company tax return for an accounting period must include an assessment (a "self-assessment") of the amount of tax which is payable by the company for that period (FA98 Schedule 18, paragraph 7(1)). Similar rules apply for income tax.

A company tax return must include a declaration by the person making the return that the return is to the best of his knowledge correct and complete (FA98 Schedule 18 Paragraph (3)(3)). No specific reference to the arm’s length rule is intended to be required on the return. When signing the declaration on the return form, the taxpayer however will need to consider whether any provision was made or imposed in its dealings with associates which was other than that which would have existed between independent enterprises. If so it must consider the tax effect of that provision. If the effect of the "actual provision" is to confer a tax advantage (as defined) on the taxpayer it will be required to adjust its tax computation accordingly. (Consultative Document: Reform of the Transfer Pricing Legislation, paragraph 5.6).

Enquiry into Company Tax Returns
The most likely context in which transfer pricing disputes will arise is in relation to enquiries. This is the examination function carried out by the Inland Revenue to monitor compliance in the context of self-assessment.

The Inland Revenue may enquire into a company tax return if they give notice to the company of their intention to do so generally within twelve months from the filing date (FA98 Schedule 18 para (24)(1)). Other rules apply to returns filed out of time and to amended returns. A return which has been the subject of one notice of enquiry may not be the subject of another, except one given in consequence of an amendment (or another amendment) by the company of its return. Enquiries may be of a general nature or into particular aspects of a return.

An enquiry into a company tax return extends to anything contained in the return, or required to be contained in the return (FA98 Schedule 18 para 25(1)). The effect of the statement in the consultative document referred to above is that, because it is implicit by signing the return that all transactions conform to the arm’s length rule, transfer pricing will always be a proper subject of an enquiry. The substantive examination of inter-company dealings would then proceed in a way not dissimilar from current practice.

Self-assessment procedures set out a number of possible options that may assist taxpayers in relation to enquiries.

As is the present case as a matter of practice, a transfer pricing enquiry can be settled by agreement with the Revenue. Specific statutory rules relating to such agreements apply to transfer pricing enquiries only. This is because if the matter is not settled by agreement which conforms to the requirements of FA98 Section 110(5) and (6), the sanction of the Board of Inland Revenue is required for any final assessment of liability. This is a matter to which we shall return.

Returns Amended During Enquiry
The self- assessment regime permits a company to amend its return when an enquiry is in progress. The amendment does not restrict the scope of the enquiry but may be taken into account (together with any matters arising) in the enquiry (FA98 Schedule 18 para 31(1)). Such an amendment does not take effect until after the enquiry is completed so far as it affects the amount of tax payable stated in the self-assessment or, any amount that affects or may affect the tax payable by the company for another accounting period, or the tax liability of another company for any accounting period.

An amendment whose effect is deferred in this way takes effect on the completion of the enquiry if the conclusions in the closure notice state either that the amendment was not taken into account in the enquiry, or that no amendment of the return is required arising from the enquiry. In any other case, the amendment must be taken into account by the company in amending its return in accordance with the conclusions in the closure notice and takes effect as part of those amendments. This rule is likely to be of limited use in transfer pricing enquiries where the conclusion is seldom black or white, but rather a matter of degree. Thus, a range of outcomes is possible which makes amendment difficult.

Completion of Enquiry
An enquiry is completed when the Inland Revenue by notice (a "closure notice") inform the company they have completed their enquiry and state their conclusions. The notice takes effect when it is issued (FA98 Schedule 18 Paragraph 32(1)).

Supervision by the Board
The new transfer pricing regime is mandatory in that it applies to all transactions contemplated in the new Taxes Act 1988 Schedule28AA. In the absence of the direction requirement formerly in Taxes Act 1988 Section770(2)(d), to ensure consistency of treatment and to monitor transfer pricing enquiries centrally, the sanction of the Board of Inland Revenue will be required to finalise enquiries in this area.

The Board’s sanction is required for:-
(a) an amount to be brought into account by virtue of the general arm’s length rule in Taxes Act 1988 Schedule 28AA paragraph 1(2);
(b) any adjustment in respect of the disregarding or reduction of any exchange loss, or of any exchange gain under the main benefit and arm’s length tests in relation to foreign exchange gains and losses in Finance Act 1993, Section 135, 136, 136A or 137; or
(c) any adjustment in respect of any deduction from, or addition to, any amount under the arm’s length test in relation to financial instruments in Finance Act 1994 Section 167.

The Board’s sanction is required for:-
(a) the giving of a closure notice;
(b) the giving of a notice amending a partnership statement (under Taxes Management Act 1970 Section 30B(1)); or
(c) the making of a discovery assessment (FA98 Schedule 18).
If any of these notices is given without having been approved by the Board, or a copy of the approval having been served on the taxpayer at or before giving of the notice or assessment it shall be deemed to have been given or made in the terms (if any) in which it would have been given or made ignoring that determination. The effect of a notice given without Board approval is that the transfer pricing adjustment contained in it is disregarded (FA98 Section 110(2)).

The Board’s approval must be given specifically in relation to the case in question and must apply to the amount determined but may be given before or after the making of the determination in any form or manner as they may determine (FA98 Section 110(3)).

Resolution by Agreement
The Board’s sanction is not required if an agreement has been made between an officer of the Board and the taxpayer that is in force at the time of the giving of the notice and includes the amount determined (FA98 Section 110(5)). Such an agreement must be made or confirmed in writing. It comes into effect thirty days after the making of the agreement if made in writing, or thirty days after confirmation in writing. The taxpayer has thirty days to serve a notice repudiating or resiling from the Agreement (FA98 Section 110(6)).

Where there is no agreement between the taxpayer and the Revenue on a transfer pricing dispute, a notice of closure will be given with the approval of the Board.

Applications to Close Enquiries
The company may apply to the Commissioners for a direction that the Inland Revenue give a closure notice within a specified period. Any such application is heard and determined in the same way as an appeal. The Commissioners hearing the application are required to give a direction unless they are satisfied that the Inland Revenue have reasonable grounds for not giving a closure notice within a specified period (FA98 Schedule 18 para 33(1).

Amendment of Return After Enquiry
The company then has 30 days after the enquiry is completed in which to amend the return in accordance with the conclusions stated in the closure notice. It must also make any amendments of other company tax returns delivered by it which are required to give effect to the conclusions stated in the closure notice (FA98 Schedule 18 para34(1)).

If after the end of that period of 30 days the Inland Revenue are not satisfied that the return is correct and complete, and that any necessary amendments have been made to any other return delivered by the company that are required to give effect to the conclusions stated in the closure notice, they may, within the following period of 30 days, by notice to the company make such amendments of that return or those returns as they consider necessary (FA98 Schedule 18 para 34(2)). It is at this stage that an appeal may be brought against any such amendment of a company’s return.

Notice of appeal must be given:-
(a) in writing,
(b) within 30 days after the amendment was notified to the company,
(c) to the officer of the Board by whom the notice of amendment was given.


OTHER ASSESSING POWERS

The Inland Revenue have powers to amend returns and make assessments other than in the context of an enquiry.

Correction of Returns
The Inland Revenue may amend a company tax return so as to correct obvious errors or omissions in the return (whether errors of principle, arithmetical mistakes or otherwise). A correction is made by notice to the company (FA98 Schedule 18 para16(1)).

Determinations
If no return or only returns are only for some accounting periods are delivered in response to a notice requiring a company tax return, the Inland Revenue may determine to the best of their information and belief the amount of tax payable by the company (FA98 Schedule 18 para 36(1)). A determination under these provisions has effect for enforcement purposes as if it were a self-assessment by the company (FA98 Schedule 18 para39(1)).

Discovery Assessments and Determinations
Discovery assessments can still continue to be made where the Inland Revenue discover that an amount which ought to have been assessed to tax has not been assessed, an assessment to tax is or has become insufficient, or relief has been given which is or has become excessive (FA98 Schedule 18 para 41(1)).

If the Inland Revenue discover that a return delivered by a company for an accounting period incorrectly states an amount that affects, or may affect, the tax payable by that company for another accounting period, or an amount that affects, or may affect, the tax liability of another company they may make a determination (a "discovery determination") of the amount which in their opinion ought to have been stated in the return (FA98 Schedule 18 para 41(2)).

The ability of the Inland Revenue to reopen an assessment in the context of transfer pricing was considered by the Special Commissioners in Newidgets Manufacturing Limited v Jones (SpC 197). In that case, a UK company was the wholly-owned subsidiary of a foreign parent. A manufacturing licensing agreement was concluded between the foreign parent and the UK company whereby the UK company paid a royalty in consideration of the grant of exclusive rights to manufacture widgets in the UK under technical information provided by the foreign parent and the non-exclusive right to use the technical information in the manufacture of spare parts. The royalty was calculated as a percentage of the ex-works selling price. The Inland Revenue were provided with a copy of the agreement and subsequent amendments. The company deducted royalties it had paid in calculating its profits. Assessments issued against it in relation to the accounting periods in question were settled by agreement pursuant to TMA 1970 Section 54, and by letter the inspector agreed the UK company’s tax computations in respect of the accounting periods.

The Inland Revenue subsequently took the view that the grant of rights had not been at arm’s length and issued directions pursuant to TMA 1988 Section 770(2D) to adjust prices and raised a further assessment for the accounting periods in question.

The taxpayer appealed on the ground that the inspector had sufficient information before him to come to a final and conclusive agreement with the taxpayer and that the Revenue were not entitled to raise the further assessments. The Revenue’s response was that unless the taxpayer had stated expressly or impliedly that the agreement had not been made at arm’s length, then the inspector did not have sufficient information to make a final and binding agreement under TMA 1970 Section 54.

The Commissioners found no evidence that the taxpayer had supplied misleading information and that there had been ample information available to the inspector to make a final determination. The inspector had intended to make a final determination and it was not open to the Revenue as a result to re-open the matter by issuing a direction. The purpose of Section 54 was to protect the taxpayer by producing finality. This is what the taxpayer sought and it appeared objectively from the evidence that the inspector had been willing to grant finality. The Revenue’s argument, that the bar on re-opening closed years could only apply where the inspector’s attention had been drawn to the fact that arm’s length prices had not been operated, was not accepted. They argued that since transfer pricing had not been referred to in Section 54 agreements, they were entitled to re-open the matter. One of the issues before the Special Commissioners was whether the company’s accounts complied fully with the relevant standards. It was found that the obligation to disclose, whether or not transactions were carried out at arm’s length (which the accounts and computations did not do) did not arise until 1995 after the years in question. This decision will give some comfort to taxpayers that the rules relating to discovery are no different in transfer pricing than in other areas, an issue which the Inland Revenue appeared to be advancing.

Any objection to a discovery assessment or determination on the ground that the Inland Revenue were not entitled to make such an assessment or determination can only be made on an appeal against the assessment or determination.

A discovery assessment for an accounting period for which the company has delivered a company tax return, or a discovery determination, may be made if at the time when the Inland Revenue ceased to be entitled to give a notice of enquiry into the return, or completed their enquiries into the return, they could not have been reasonably expected, on the basis of the information made available to them before that time, to be aware of the situation giving rise to the discovery (FA98 Schedule 18 Paragraph 44(1)).

Information is regarded as made available to the Inland Revenue if it is contained in a relevant return or claim by the company or in documents accompanying any such return or claim, or if it is contained in any documents, accounts or information produced or provided by the company to the Inland Revenue for the purposes of an enquiry into any such return or claim, or if it is information the existence of which, and the relevance of which could reasonably be expected to be inferred by the Inland Revenue from information made available, or are notified in writing to the Inland Revenue by the company or a person acting on its behalf.

Time-Limits
The time limit for making enquiries into company tax returns is generally twelve months from the filing date. This may be extended in the case of late filing or amended returns. In the case of assessments, the general time limit is six years after the end of the accounting period. In the case of fraud or negligence on the part of a company, an assessment may be made up to 21 years after the end of the accounting period to which it relates.

Appeal Process
As a general rule, appeals and applications in relation to transfer pricing must be by notice in writing. The notice of appeal must specify the grounds of appeal. On the hearing, the Commissioners may allow the appellant to put forward grounds not specified in a notice and take them into consideration if satisfied that the omission was not wilful or unreasonable (FA98 Schedule 18 Paragraph 8).

An appeal against a decision relating to a transfer pricing adjustment is to the Special Commissioners. An appeal in relation to a notice to produce documents or information, or to close an enquiry are, however, to the General Commissioners. An election to appeal to the Special Commissioners is provided under FA98 Schedule 18 Paragraph 90. This election may be contested by the Inland Revenue by referring the election to the General Commissioners who must direct the election to be disregarded unless they are satisfied that the appellant has arguments to present or evidence to adduce on the merits of the appeal.

Disputes About Record Keeping
Companies must keep such records as may be needed to enable them to deliver correct and complete returns, and preserve them for six years from the end of the period for which a return may be required. The period may be extended in certain circumstances (FA98 Schedule 18 para 21(1).This duty may be satisfied by the preservation of the information contained in them, except certain specified records (FA98 Schedule 18 para 22(1)). The penalties for a failure to keep records are relatively minor. No special penalties apply to transfer pricing documentation.

Taxes Act 1988 Sections 772(1) to (7) were repealed by the Finance Act 1998. The Government indicated in the Consultative Document that it intended to dispense with the specific information powers for transfer pricing. The general information powers in relation to enquiries were considered appropriate, in addition to the information gathering powers of Taxes Management Act 1970 Sections 20 to 20C and Regulation 10 SI 1994 No.1811. The Consultative Document also indicated that the use of information powers will be monitored centrally in order to ensure consistency. Cases will be referred to International Division where taxpayer appeals against a notice to produce documents in the transfer pricing context and before seeking the consent of a Commissioner to issue a notice under Sections 20 to 20C, or before requesting the Commissioners to issue notices under Regulation 10. If the Government feels that these information powers are inadequate, the specific information powers may be reintroduced. The matter will also be referred to International Division where information or assistance is sought from a treaty partner using the exchange of information Article in a relevant treaty. Where a penalty for failing to keep records is sought to be imposed, International Division will be informed.

If the Inland Revenue give a notice of enquiry to a company, they may by notice require the company to produce such documents in the company’s possession or power, and to provide them with such information, in such form as they may reasonably require for the purposes of the enquiry. The notice may be given at the same time as the notice of enquiry. It must specify the time (which must not be less than 30 days) within which the company is to comply with it (FA98 Schedule 18 Paragraph 27).

Such a notice does not oblige the company to produce documents or provide information relating to the conduct of any pending appeal by the company.

An appeal may be brought against a requirement imposed by a notice to produce documents or provide information. Notice of appeal must be given:-
(a) in writing,
(b) within 30 days after the notice was given to the company,
(c) to the officer of the Board by whom that notice was given.

These appeals are heard and determined in the same way as an appeal against an assessment. On such an appeal, the Commissioners must set aside the notice so far as it requires the production of documents, or the provision of information, which appears to them not reasonably required for the purposes of the enquiry, and must confirm the notice so far as it requires the production of documents, or the provision of information, which appears to them reasonably required for the purposes of the enquiry.

A notice which is confirmed by the Commissioners (or so far as it is confirmed) has effect as if the period specified in it for complying was 30 days from the determination of the appeal. The decision of the Commissioners on an appeal under this paragraph is final and conclusive.

Information Strategy
The effective use of professional legal privilege may be important in managing a transfer pricing dispute. A clear approach in determining in advance what material is properly within professional privilege, or constitutes audit papers or communications relating to obtaining tax advice, is necessary to ensure that there are no surprises when information is demanded and that the appropriate confidentiality can be maintained if disputes arise over documentation.


CONCLUSION

The recent activity in modernising the UK transfer pricing regime cannot be viewed in isolation. It is part of a worldwide trend which has been led by the United States which finalised its transfer pricing regulations in 1994 followed by the revised OECD Model Guidelines published in 1995. There are few countries that have not paid attention to either introducing the arm’s length principle or beefing up their rules and transfer pricing administrations in recent years. While the major themes are common, the manner in which the rules are interpreted and applies is far more uniform. Transfer pricing will require attention in any international business activity in the decades to come.


© Jonathan Schwarz 2001