Transfer pricing and penalties

Have you been careless recently? Spilt your coffee perhaps? Lost some papers? Forgotten to update your transfer pricing documentation?

If it is the latter you may be in for an unwelcome surprise in the form of a penalty from HMRC. This is because the UK tax penalty legislation that changed in 2007 has significant implications for transfer pricing. The likelihood is that it will be easier and more common for HMRC to argue for penalties in relation to transfer pricing enquiries as they now only have to demonstrate that the business has been careless rather than the previous higher threshold of establishing negligence.

Factor in a department under pressure to secure much needed revenues for the Government and it is clear that there is scope for significant uncertainty as to what HMRC is targeting.

It is therefore useful that new HMRC guidance provides some examples to demonstrate its views on the subject. These are contained in the HMRC International Manual at para 434040 and should help businesses understand HMRC’s application of the revised penalties regime.

The changes to the penalty legislation introduced by FA 2007 apply to returns for accounting periods starting on or after 1 April 2008 and so in practice are likely to apply to virtually all returns now being submitted. A penalty situation arises if there is an inaccuracy in a document or a return or if notification is not made that an assessment is understated.

For a penalty to be chargeable there must be a loss of tax or an increased claim to a loss or repayment and the inaccuracy is careless, deliberate, or deliberate and concealed. No penalty arises if the inaccuracy occurs despite taking reasonable care.

This contrasts with the previous legislation which provided that a penalty might be due if an incorrect return was fraudulently or negligently submitted. The main focus of this article is the ‘careless’ point, that is where there is not a deliberate attempt to make an inaccurate return.

In HMRC’s first two examples a business identifies independent comparables to benchmark an intra-group transaction which are subsequently agreed to be flawed under challenge. In this situation, the business would not be penalised, as HMRC deems that there has been an ‘honest and reasonable’ attempt to comply with the arm’s length principle.

In contrast, in Example 3, where a business has set a mark up on intra-group services with no consideration of comparable independent data, HMRC would be likely to seek penalties as the company has not made a reasonable effort to identify an arm’s-length price for the transaction.

So the key point is that to avoid penalties, businesses must consider the arm’s-length pricing for each transaction and have evidence to support their conclusion.

Simply having documentation that includes unsubstantiated comparables will not be sufficient. Also where documentation has been prepared for the UK business by a foreign affiliate, the onus is on the UK business to assess whether the documentation is adequate for UK purposes otherwise that UK company could be liable to penalties.

HMRC includes an example where interest is not charged on an inter-company debt and suggest that this amounts to negligence. This is the sort of transaction businesses typically overlook from a transfer pricing perspective. It may be wise to revisit such transactions given HMRC’s published stance.

Another HMRC example proposes that a failure to use a direct allocation method for recharging costs relating to services constitutes negligence or carelessness. This raises concerns for businesses in that relatively minor oversights in the application of transfer pricing legislation can lead to significant consequences for the business in terms of penalties.

It also indicates that simply having some transfer pricing documentation is not enough to ensure protection from penalties. Businesses should review their policies and documentation regularly to ensure that they comply with HMRC’s guidance or risk becoming involved in a penalty dispute.

Finally, an important example regarding deliberate inaccuracy demonstrates that without ‘reasonable’ technical analysis to justify the decision, HMRC would consider the use of a Transactional Net Margin Method when an internal Comparable Uncontrolled Price was available to be a deliberate inaccuracy. This could result in a penalty rate for deliberate inaccuracy of up to 70% of Potential Lost Revenue where there has been no concealment or up to 100% for deliberate inaccuracies with concealment. These penalties seem particularly high given the subjective nature of the ‘reasonable’ technical analysis required.

The changes to the UK penalty system have significant transfer pricing implications and businesses need to understand HMRC’s policy and ensure that they maintain appropriate transfer pricing documentation that is compiled in a timely manner and kept updated in order to ensure effective penalty protection.

Ken Almand is Head of Transfer Pricing at Mazars LLP and advises on all aspects of transfer pricing including planning, assurance and compliance issues. He has over 14 years’ transfer pricing experience and previously worked at HM Revenue & Custom’s International Division and Ernst and Young. Email: ken.almand@mazars.co.uk; tel: 020 7063 4094.