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The government has announced plans to restrict the use of the compensating adjustments mechanism in the transfer pricing legislation where it generates income tax advantages.
HMRC are aware of two major schemes that exploit the rules. The first arrangement involves large partnerships that employ staff through a separate service company, which the partnership owns.
The government has announced plans to restrict the use of the compensating adjustments mechanism in the transfer pricing legislation where it generates income tax advantages.
HMRC are aware of two major schemes that exploit the rules. The first arrangement involves large partnerships that employ staff through a separate service company, which the partnership owns.
The structure can be used for a number of reasons not related to tax – but the partnership can activate the tax rules to gain an advantage by choosing not to pay an appropriate fee to the company for providing the recruitment service.
The scheme has also been promoted as a method to reduce tax liability for smaller partnerships.
The second arrangement is often used by private equity houses, and concerns excessive leveraging of companies by individuals.
People participating in a company make loans not on arm’s length terms. The lending will typically result in the business being excessively leveraged with debt. UK transfer pricing rules apply where companies are overly indebted due to the fact borrowing has been provided that would not have occurred at arm’s length, but for the relationship that exists between the lender and borrower.
The legislation restricts interest deductions arising from a “non-arm’s length” debt, calculating the taxable profit as if arm’s length arrangements had been entered into, rather than the actual ones.
A compensating adjustment may be claimed by the lender so that its position mirrors that of the borrower, effectively removing an amount of interest equal to the excess over the arm’s length amount from the charge to income tax in their hands, and enabling the lenders to extract money from the company without paying income tax.
The lenders’ involvement in the company means they are often taking a return on loans in place of a profit distribution.
The government intends to withdraw the ability of individuals to claim compensating adjustments where the counterparty to the transaction is a company. The change will apply to amounts arising on or after the date the legislation comes into effect.
Where either of the schemes is used, no compensating adjustments will be possible in respect of amounts of service fee income or interest arising to individuals on or after the effective date.
It is not intended that the changes adversely affect commercial arrangements; there is opportunity for discussion of the proposals before the legislation comes into effect. Comments should be given to HMRC’s Richard Rogers by email or phone on 03000 585 521.
