As part of the introduction in 1998 of a new transfer pricing regime in the UK (schedule 28AA of the Taxes Act 1988), a statutory basis for agreeing intercompany pricing with the UK Inland Revenue was included in the Finance Act 1999 (sections 85-87) together with a supporting Statement of Practice (SP3/99) describing how the Inland Revenue would manage that advance pricing agreement (APA) process. This article considers the APA process with reference to the first agreement concluded under the new regime earlier this year. For reasons of confidentiality, the name of the multinational group for whom the agreement was concluded is not disclosed.
Case study ? background to the negotiations The circumstances involved a multinational company with significant operations in the UK (UKCo). These operations comprised a range of functions: research, product manufacturing, distribution, marketing and sales involving not only the UK but also associated group companies in over 30 other jurisdictions. A previous investigation of UKCo under the old transfer pricing regime had been resolved (the Old Agreement). It was negotiated on a unilateral basis between UKCo and the Inland Revenue in respect of UKCo's intercompany pricing covering the period up to December 31 2000, and anticipated as far as possible the adoption of the new regime. UKCo was keen to extend the Old Agreement and, through advisers, approached the Inland Revenue's International Division in December 1999 to open negotiations.
The negotiations The Statement of Practice describes four stages in the APA process: expression of interest; formal submission of application for clarification; evaluation; and agreement. In view of the work done on the Old Agreement, it was felt enough material had already been presented to satisfy at least the first stage (expression of interest) and would go a long way towards achieving the next two stages ? application and evaluation. A meeting was therefore sought to present UKCo's case for an APA commencing January 1 2001. The first meeting with the Inland Revenue took place in March with an agenda which not only included a presentation of UKCo's case for an APA, but also a review of 1999 results and prospects for 2000 to show compliance with the terms of the Old Agreement. The meeting took the form of a presentation which included financial information on the performance of UKCo's various areas of activity.
The case for an APA was straightforward. In view of the fact that there had been no change in the facts or circumstances from the time when the Old Agreement was negotiated, UKCo in effect was requesting an extension of those terms formalized in the framework of the statutory process. Two key issues were the length of the agreement and whether it should be on a unilateral or bilateral basis.
Length of agreement Paragraph 23 SP3/99 indicates that the length of the agreement will be a minimum of three and a maximum of five years. In view of the fact that this was the first APA to be negotiated between a taxpayer and the Inland Revenue, it was uncertain what approach the Inland Revenue would take, whether as a matter of policy or otherwise. In the event, UKCo's request for a five-year term was accepted. In support of the longer period, UKCo emphasized in its presentation that its industry was relatively predictable with no substantive changes envisaged either to its supply arrangements or to the external market place; the latter not being expected to materially impact on any agreement. There was also patent stability and a belief that it would be mutually beneficial both to UKCo and the Inland Revenue to have certainty for as long as possible.
Unilateral/bilateral Another important consideration was whether the Inland Revenue would be prepared to agree to a unilateral APA. Paragraph 7 SP3/99 acknowledges that an APA may be on a "unilateral basis" although the overriding preference of the Inland Revenue is for a bilateral application. For UKCo, a bilateral agreement was impractical. Indeed, in view of the number of jurisdictions (in excess of 30) involved in the intercompany contractual matrix, only a multiple series of bilateral agreements would have achieved the optimum result of eliminating the risk of double taxation, ie an adjustment made by one of the other competent authorities notwithstanding agreement reached with the Inland Revenue.
In the event, UKCo's submission was accepted ? ie that an extension to a bilateral APA would unnecessarily complicate and delay the process, a reason already anticipated in paragraph 9 of the Statement of Practice.
The first meeting concluded on a positive note after only a few hours. It was followed the next month by a formal application for a unilateral APA agreement in the form of a letter from UKCo to the Inland Revenue accompanied by UKCo's proposed draft APA agreement, economic evaluations supporting the arm's-length nature of the proposed pricing regimes, and other financial data.
One month later, the second (and final) meeting was held to review the papers and consider the terms of the draft agreement. The district inspector and senior representatives from the Inland Revenue's International Division attended that meeting. The main terms of the agreement in its final form are reviewed below, but apart from some drafting changes which were settled by e-mail and telephone between advisers and the Inland Revenue representatives over the following few weeks, agreement was reached at that meeting ? only some six months after UKCo first approached the Inland Revenue. The final agreement was signed and exchanged a few weeks later. Although the process involved only two meetings between the parties, both sides had spent many weeks preparing for the meetings, and preparing and reviewing the comprehensive set of material assembled and submitted as part of the process.
The agreement Although the annex to the Statement of Practice describes the features which the Inland Revenue believes an APA should contain, no model draft had been prepared by the Inland Revenue providing a framework for inserting detailed provisions. There is in fact no prescribed form. An agreement could be informally written, possibly in an exchange of letters. However, it was felt a more formal document was required, and therefore the draft prepared by UKCo took the form of a conventional agreement between two parties to a contract.
The body of the agreement covered the agreed percentage royalties rates, described the transfer pricing methods and included a benchmark in the form of an EBIT (earnings before interest and tax) figure of total sales from UKCo's activities, as a backstop for testing compliance with the terms of the agreement.
Not only did UKCo want certainty on its transfer pricing methods, but it also wanted compliance and monitoring time and costs to be as streamlined as possible whilst still satisfying the Inland Revenue's needs in this respect.
For this purpose, a single page pro forma spreadsheet was prepared and incorporated into the agreement providing quite simply that, where for any year the completed single page report demonstrated that the EBIT backstop had been met, no further compliance requirements or due diligence would (nor could) be required by the Inland Revenue. In this respect the agreement went further, by accepting that where over two consecutive years the average EBIT figure met (or exceeded) the EBIT backstop, UKCo's performance obligations under the APA would be satisfied notwithstanding the possibility that, in one year, that performance was potentially below the EBIT backstop. The Statement of Practice requires essential assumptions to be identified and agreed in circumstances where failure to meet those assumptions ? effectively conditions on which the agreement is predicated ? would result in the agreement no longer having effect. Two critical assumptions were identified. The first was that UKCo's relevant business activities, functions performed, risks assumed, assets employed, and financial and tax accounting matters and classifications would remain materially the same as described in supporting papers attached to the agreement. The second was that there would be no significant changes to government policy materially affecting UKCo's business in a manner that was relevant to the terms of the APA; such changes to include applicable laws, tax laws and tax treaties.
One concern about the APA arrangements, which had been identified by commentators at the time of its introduction, is the potential one-sided nature of the revocation and termination provisions. In effect, subject to agreeing otherwise, the Inland Revenue has powers to modify agreements or revoke them on a unilateral basis even retrospectively.
It is understandable that where a taxpayer has acted fraudulently or negligently in connection with the provision of information leading to or as part of the APA process, the Inland Revenue should have the unilateral right to declare the agreement nullified (ie it is deemed never to have been made). However, where in operating the agreement the taxpayer might have committed a technical or a temporary default which can be remedied, there should be some opportunity to remedy the defect before a right to revoke the agreement by the Inland Revenue is exercised.
In this case, a provision was drafted by UKCo which had the effect of requiring the Inland Revenue to give notice of its intention to revoke, stating the reasons for revocation and the date from which revocation would occur. UKCo should be allowed time to address those reasons and where possible remedy the default or revalidate any assumption which might have ceased to be valid, ie to take action to cease to be in breach of the terms and conditions in respect of which UKCo was failing to comply. A further issue concerned confidentiality. The Statement of Practice makes it clear (paragraph 54) that the Inland Revenue considers the APA information to be subject to the same rules of confidentiality as any other information about taxpayers, with any unauthorized disclosure even of the existence of an APA being a breach of confidentiality.
However, while information exchange with treaty partners is also protected from disclosure by the terms of the exchange of information article and the relevant double tax agreement, UKCo was concerned to know if and when, and also the circumstances in which, any such exchange of information might occur.
In its initial draft, the agreement provided an obligation on the Inland Revenue to inform UKCo in the event of such an exchange. This proved unacceptable to the Inland Revenue. In the event, a provision was negotiated in which the Inland Revenue acknowledged that it may, at its discretion, advise UKCo of any such exchange of information with a proviso that, should the law in the future require such disclosure on the part of government authorities of information in respect of taxpayers, there would be an obligation to do so.
A clause providing that the APA would be renewed under the same terms and conditions for an additional five-year period subject to there being no material changes in governing law or assumptions or other relevant facts or circumstances was modified, in effect to provide a commitment to consider a renewal at the time in accordance with the law and practice then prevailing.
General comments As a technical matter, the effect of reaching an agreement is to satisfy the taxpayer's obligations under the tax code in all respects as regards the matters covered by the agreement. Not only does this mean that the negotiated transfer pricing methodologies and prices are accepted as complying with the schedule 28AA provisions, but for the duration of the agreement the administrative obligations to keep and retain documentation otherwise set out in section 12B of the Taxes Management Act 1970 are complied with in accordance with the terms of the agreement.
A number of commentators have been sceptical as to whether the APA proposals are worth it. The legislation was initially criticized as being unnecessarily complex, with the ability for the Inland Revenue unilaterally to modify the agreement being seen as a weakness. One major concern was that the process would be time- consuming and protracted.
In this particular case, UKCo was pleased with the outcome, and the speed and efficiency with which negotiations were conducted and concluded. It is clear that the environment of a negotiation must be one in which both sides are willing to make concessions if they are to reach an agreement. However, it was particularly welcome to find a commercial, business-like approach being adopted by the Inland Revenue, which resulted in an agreement covering a complex series of transactions being concluded after no more than seven hours of meetings (but many more hours and weeks of preparation and document review on both sides leading up to each of the two meetings) and within a relatively short period of time.
It clearly helped that this first agreement was on a unilateral basis ? agreed to on that basis by the Inland Revenue because of the complex nature of the transactions it covered. However, taxpayers should be encouraged by this result to think that this process is a viable one which can produce the certainty needed in a very complex area, which otherwise can consume significant time and money in complying on an annual basis with wide-ranging statutory requirements.
| The UK APA procedure An APA is a formal written agreement between the taxpayer and the Commissioners of Inland Revenue allowing complex transfer pricing issues to be resolved on a prospective basis in advance of the return being made. The aim of the procedure is to help businesses resolve situations where there is considerable difficulty or doubt in determining the matters by which the arm's-length principle should be applied to intercompany pricing. When the terms of the agreement are complied with, they provide assurance that those transfer pricing issues will be accepted by both parties ? the Inland Revenue and the taxpayer ? for the period covered by the agreement. Detailed guidance on how the Inland Revenue interprets the statutory provisions (sections 85-87 FA 1999) and how it intends applying the legislation in practice are found in the Statement of Practice (SP3/99) which sets out the administrative arrangements for APAs. An APA can either be unilateral or bilateral. The Inland Revenue encourages applications for bilateral APAs whenever this is possible in relation to cross-border transfer pricing issues, since these offer assurance that the method for dealing with the transfer pricing issues will be accepted by the tax administration for both countries, thus avoiding potential double taxation. The Inland Revenue will be prepared to consider a unilateral APA, but where such a request involves foreign related parties resident in a country with which the UK has a double tax agreement containing an exchange of information article, the Inland Revenue will notify the treaty partner of the request, and will provide information relating to the request under that article. The Statement of Practice makes it clear that APAs will only be considered in complex cases, and that those will usually be ones where there is no reliable market comparables which can be established to enable transfer pricing methods to be accurately employed in accordance with the OECD transfer pricing guidelines. The Statement of Practice proposes a four-stage process. First, the taxpayer can submit an expression of interest, in effect asking the Inland Revenue to clarify certain points in advance of making a formal application and to discuss informally the proposed method for dealing with the transfer pricing issues to which it will relate. The Inland Revenue will normally want the identity of the taxpayer to be disclosed, but if the taxpayer wishes to preserve anonymity until a decision in principle is made to proceed with the application, the Inland Revenue will be prepared to discuss the case, provided that all other relevant information is supplied. The next stage is the submission of the formal application, followed by its evaluation, and finally the formal written agreement. The Inland Revenue proposes the term of agreement will be between three and five years. The Inland Revenue will also consider applying the principles of the APA to past audit years on a rollback basis. The agreement will not formally cover prior years leading up to the time when the formal application was submitted, but may for practical purposes apply the principles of the APA agreement to those earlier unresolved years providing the facts in those years are similar. The agreement, once reached, will be binding on both parties for as long as it remains in force. The Inland Revenue anticipates that the agreements will include regular compliance requirements for the taxpayers to show that the assumptions made in reaching the agreements remain unchanged. |
