In September, HMRC relaunched its efforts to prevent big multinationals in the UK from using illegal transfer pricing measures to avoid paying taxes in Britain. Companies are now being encouraged to engage with HMRC’s new compliance facility – or risk incredibly large penalties.
The UK Government has resumed its crackdown on large companies that are suspected of shifting profits overseas in an attempt to try and reduce their corporate tax bills – with warnings of investigations and very large penalties on the way for any business that is seen to have failed to comply with existing rules.
Her Majesty’s Revenue and Customs (HMRC) relaunched the campaign in September 2020, and has subsequently been writing out to a range of multinational enterprises (MNEs) across the UK requesting financial decision-makers within large businesses to review the government’s arrangements on transfer pricing and ensure those arrangements are being observed and adhered to.
These regulatory arrangements were introduced by HMRC in January 2019 after the tax authority ruled that some MNEs based in the UK had adopted cross border pricing arrangements that were ‘based on incorrect fact patterns’ and weren’t necessarily consistent with the international guidelines on transfer pricing that were set by the Organisation for Economic Co-operation and Development (OECD).
Translation: quite a few big multinationals are suspected of moving company money overseas to subsidiaries and faraway markets in order to reduce their tax bills here in the UK.
The rules unveiled by HMRC last year included a new compliance facility, as well as clear cut measures on various fines and penalties corporates would have to pay if they are found to be in breach of the UK’s transfer pricing rules.
Yet in order to fully understand these measures and what HMRC’s fresh crackdown means for large UK companies, it’s worth first revisiting the basics on transfer pricing, how the government’s compliance facility works and what’s going to happen next for MNEs in the UK.
What is transfer pricing?
Transfer pricing is an accounting practice in which one division within a company charges another internal division for goods or services provided. This is fairly common practice amongst MNEs that operate in different markets and countries – particularly if the foreign business entities in question are being run as semi-independent entities.
For example, a manufacturing company based in the UK might choose to “buy” £50,000 worth of raw materials from a Chinese-incorporated subsidiary company that it owns rather than purchase raw goods here in Britain.
In the company books, that means the parent company is now £50,000 poorer having spent that money on essential business expenses. But in reality, one could argue that money hasn’t truly gone anywhere because the company selling those raw materials is technically owned by that British-based MNE in the first place.
This is theoretically legal in most tax jurisdictions – and in some cases it makes perfect sense. But there are rules on how much a company is allowed to charge for goods or services rendered.
Generally speaking, transfer prices are based on fair market prices. But in recent years, HMRC has grown increasingly concerned that more and more MNEs aren’t basing transfer prices on fair market value. Instead, UK-based multinationals are undervaluing contributions or resources here in the UK and overvaluing those from abroad – which effectively means too much money is being transferred overseas within big companies.
The problem is that when this extra money gets transferred abroad, it’s no longer taxable here in the UK. But because the parent company sort of gets to keep that money anyway as a result of its ownership of various subsidiaries, that means MNEs are getting to have their cake but eat it, too. That’s called ‘profit diversion’, and it’s considered a tax avoidance scheme that’s illegal under many circumstances.
What are HMRC’s transfer pricing arrangements?
After ruling that a sizable proportion of multinationals here in the UK were abusing existing transfer pricing rules, HMRC decided to introduce its all-new Profit Diversion Compliance Facility (PDCF).
Launched in January 2019, the facility was created in order to provide British MNEs with a reasonable way in which to disclose cross border transfer arrangements that might technically clash with the UK’s Diverted Profits Tax (DTP) legislation or the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations.
By using the facility, companies are able to bring HMRC up to speed on their respective tax affairs without getting investigated or punished as long as a full and accurate disclosure is made.
In terms of what’s legally permissible, the UK’s transfer pricing rules generally allow transfer pricing interactions assuming they’re based on the internationally recognised ‘arm’s length principle’.
Under this principle, entities related via management, control or capital are required to agree to the same terms and conditions for internal trade that non-related entities would utilise for comparable and uncontrolled transactions. Simply put, this means that transfer pricing is normally considered legal as long as a company is paying its parent or subsidiary the exact same amount it would pay an external vendor or supplier.
As long as a UK-based MNE meets this principle when transferring money abroad, the terms and conditions of said transaction are considered to be ‘at arm’s length’.
But if a UK-incorporated business is using favourable transfer prices in a transaction with a related firm that aren’t comparable to external market prices, it means that the transaction is non-compliant. As a result, it may clash with the UK’s DTP law and qualify as tax avoidance.
Before small business owners with suppliers or workers abroad start to panic, it’s worth noting that there are transfer pricing exemptions for small and medium sized enterprises (SMEs).
Under the SME Exemption, your business counts as ‘small’ if it has less than 50 employees and your annual turnover or balance sheet is under €10 million. You’re running a ‘medium’ business if you have no more than 250 workers and your turnover is under €50m per year or your balance sheet total is under €43m.
However, if your company is not exempt and you’re found to be in breach of the UK’s transfer pricing rules, the penalties can be severe.
The maximum penalty a company can face for non-compliant transfer pricing is a 70% of Potential Lost Revenue (PLR) penalty. But this 70% fine only applies where there has been no attempt at concealment.
If you’re found by HMRC to knowingly engage in non-compliant transfer pricing transactions and deliberately reported inaccuracies or tried to conceal the arrangements, HMRC can impose a fine worth 100% of its projected loss in tax revenue.
Because such a fine has the potential to wreak havoc on a company’s bottom line, the PDCF unveiled in January 2019 was viewed by many as a fair opportunity for large companies to engage with HMRC and own up to any inaccuracies without risk of big fines or unsettling investigations.
Instead, companies are able to register with the facility, file reports to HMRC and arrange to pay any outstanding adjustments as and where required.
What does HMRC’s new transfer pricing campaign mean for UK companies?
At the start of 2020, HMRC’s big push for the PDCF initiative was temporarily suspended as a result of the COVID-19 pandemic. But in September, HMRC resumed its campaign encouraging UK MNEs to register for the PDCF by sending a round of so-called ‘nudge’ letters.
Reports indicate a large concentration of these nudge letters are now being sent to financial services and asset management companies in particular – but a fairly wide range of sectors have been affected in recent months.
It’s important to note that these transfer pricing prompts are not being sent at random. In fact, they’re based on carefully calculated risk assessment profiles. As a result, analysts are warning UK companies that, should they receive one of these nudge letters, they must carefully consider their transfer pricing practices and register for the PDCF.
In many cases, HMRC is expected to follow up on non-registrants with an investigation at some stage in the coming months – and its nudge letters do go on to warn that ‘it will be too late to make an unprompted disclosure once we open an investigation’.
So, where does that leave UK multinationals?
First and foremost, it’s worth pointing out once more that transfer pricing is fairly common business practice that is perfectly legal in a number of situations. But when it is abused or used incorrectly, transfer pricing that fails to adhere to the so-called arm’s length principle upheld by the OECD inevitably does lead to tax avoidance here in the UK.
Regardless of whether that tax avoidance has been intentional or unintentional, it’s now clear HMRC is stepping up its efforts to investigate and penalise non-compliance. That’s why non-exempt companies that engage in any type of transfer pricing should voluntarily register with the PDCF and engage with HMRC to iron out any inaccuracies.
Not only could use of this facility help companies to avoid catastrophic fines, but it can also offer businesses some much-needed peace of mind and affirmation in knowing that their existing transfer pricing arrangements are 100% compliant and perfectly legal.
Want to learn more about corporate taxation in the UK?
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