Transfer pricing: how to avoid penalties

Les Secular of True Partners Consulting advises on how small and medium companies can prove adherence to annual transfer pricing requirements

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Small and medium-sized companies are typically exempt from transfer pricing, but need to prepare adequate documentation if they are to avoid penalties

It’s that time of year again when the letters from the tax authorities land on your desk asking whether you have adhered to their annual transfer pricing requirements.

Although transfer pricing documentation does not have to be filed with the UK tax authorities together with the corporation tax return, they can ask to receive a copy of such documentation within 30 days. Failure to supply it can lead to two penalties. There is a flat fee of £3,000 per annum if there is no supporting documentation and an adjustment-based penalty if the documentation is found to be inadequate. The adjustment-based penalty is 10 percent of the adjustment irrespective of whether tax arises or not. These penalties are in addition to the ‘normal’ tax penalties if there is an error on a tax return that leads to additional tax payments. Even should there be no tax arising, companies cannot eliminate the transfer pricing penalties through uses of loss brought forward, carried back or through the use of group relief. As such, companies in loss situations can still find themselves facing a transfer pricing penalty.

Exceptions to the rule
Although small and medium companies are exempt from the transfer pricing requirements they must bear in mind that there are also exceptions to the exemptions. First, the determination of whether a company is small or medium must be looked at on a worldwide basis, as well as the number of employees and company turnover. Balance sheet values must also be computed including all connected and linked parties.

Although small and medium companies are exempt from the transfer pricing requirements they must bear in mind that there are also exceptions to the exemptions

Second, the exemption for small companies does not apply if there are transactions with a connected party in a tax haven (usually a country that does not have a tax treaty with the UK). Third, even though medium-sized companies are exempt, the UK tax authorities can remove the exemption at any time through the issue of a direction and the company will find itself subject to the full requirements.

Medium-sized companies should be at least preparing a group policy document that refers to the transactions undertaken and the rationale for charging or non-charges, thus being initially prepared should the direction be issued.

Documentation needs
In terms of what documentation should be available, the UK tax authorities have adapted the OECD guidelines. They consider that documentation should include: all commercial and financial transactions; the nature and terms (including prices) of those transactions together with a comparison of arrangements with third parties; the method or methods by which the nature and terms of relevant transactions were arrived at, including any study of comparables and any functional analysis undertaken; and how the company adheres to arm’s length behaviour or, where it does not, what adjustment is required to the tax return and how it has been calculated.

To demonstrate arm’s length behaviour where there are not similar internal transactions with third parties, it is necessary to provide external evidence, which often requires benchmarking analysis.

As tax officers receive more training on transfer pricing and more companies seek to expand their activities overseas, the level of challenges and disputes will increase. Companies should be prepared and no longer wait and see how the land lies.

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