HMRC’s focus
HMRC recognises in its internal guidance that “business is not just concerned with the sale of tangible goods...The sale or exploitation of intangible property is equally important” and that “questions of intangible property are perhaps the most complex in transfer pricing”.
Accordingly, in HMRC guidelines, cases involving intellectual property are the only transaction type to be specifically mentioned as indicative of “particular complexity”. HMRC also lists among the indicators of high risk a situation in which "a UK company that is a member of a group has acquired, created or enhanced an asset that is used by other group members, perhaps by incurring expenditure on research and development leading to the creation or enhancement of intellectual property".
Intangible property has been identified as an area of transfer pricing focus by HMRC and this has resulted in some controversy, although there is very little transfer pricing case law in the UK.
The high level of responses from UK entities to the OECD’s invitation for comments on the scoping of its Revised Discussion Draft on Transfer Pricing Aspects of Intangibles of 30 July 2013 also indicates that this is a significant issue for many UK businesses.
Existing legislation
There are no specific tax regulations on the transfer pricing aspects of intangible property and general rules must be applied.
The current UK transfer pricing rules are contained in the Tax (International and Other Provisions) Act (TIOPA) 2010 Part 4. TIOPA provides that the transfer pricing rules are to be construed so as best to secure consistency with the OECD’s Transfer Pricing Guidelines (TPG).
The basic transfer pricing rule requires that a “provision...has been made or imposed as between any two persons...by means of a transaction or series of transactions”. Prima facie, this is clearly wide enough to include transactions relating to intangible property. HMRC recognises in its internal guidance that the UK transfer pricing rules apply to transactions relating to intangible property.
Intangible assets created by a company, or acquired by a company from an unrelated party, on or after April 1 2002 are subject (for corporation tax purposes) to the income-based regime set out in Part 8 of the Corporation Tax Act 2009 (CTA 2009) (the Part 8 Regime). Disposals of intangible assets pursuant to the Part 8 Regime generate an income gain or loss (even where the intangible asset would otherwise be a capital asset) and such disposals are subject to the UK transfer pricing rules in the same way as other transactions relating to the intangible asset.
Disposals of intangible assets that do not fall within the Part 8 Regime generate a chargeable gain or loss pursuant to the Taxation of Chargeable Gains Act 1992 (TCGA 1992). Such disposals will fall outside the UK transfer pricing rules. Nevertheless, where an acquisition or disposal of any such intangible assets is made “otherwise than by way of a bargain made at arm’s-length” it will be deemed to be made for consideration equal to the market value of the asset - a sort of capital gains transfer pricing rule.
The Government introduced new CFC legislation in TIOPA 2010 Part 9A Chapters 1‑22 which applies for accounting periods ending on or after January 1 2013. The broad objective of the CFC reforms was to refocus the code to catch profits which have significant connections with UK activities; the focus is on cases of mismatch between the location of profit and the location of the functions that give rise to profit.
This is the first occasion on which UK tax legislation adopted the “significant people functions” (SPFs) and “key entrepreneurial risk‑taking functions” concepts in the OECD’s 2010 Report on the Attribution of Profits to Permanent Establishments.
The UK Patent Box was introduced in Finance Act 2012 and is formally a new Part 8 of CTA 2010. It achieves (computationally by applying the full corporation tax rate to income reduced by a special deduction) an effective 10% rate of corporation tax to profits from patents and certain other forms of qualifying intellectual property (IP) from April 2013. The reduced rate applies to a proportion of profits derived from the following:
· licensing or sale of the patent rights;
· sales of the patented invention or products incorporating the patented invention;
· use of the patented invention in the company’s trade; or
· infringement and compensation.
The process for determining the profits within the scope of the regime involves three transfer pricing related aspects, namely the inclusion of income from a notional arm’s-length royalty paid for the use of the patented invention in processes or the provision of services (the income from which would otherwise be excluded), the exclusion of a “routine return” of 10% to certain expenses, and the exclusion of a notional arm’s-length royalty for any marketing intangibles which contribute to income.
On October 15 2013 the European Commission published a report on the UK Patent Box which concluded that some aspects of it breach the EU Code of Conduct on Business Taxation, which aims to prevent one Member State from introducing tax measures that would cause business to favour that state over other Member States. In particular, the Commission was concerned that the Code had been breached in two ways, the first being that a company can qualify for the benefits of the Patent Box without having (in the Commission’s view) any real economic activity or business in the UK and the second being that the relieved profits are not computed on internationally accepted principles. More recently the EU Code of Conduct Group has been charged with reporting back to ECOFIN in June 2014 on whether patent boxes, such as the UK’s, constitute harmful tax regimes, and the Directorate General for Competition has requested information from certain Member States in what may be the first stage of a state aid investigation.
On March 19 2014, HMRC published a Technical Note entitled “Guidance on Avoidance Schemes Involving the Transfer of Corporate Profits”. This explained the new legislation to be inserted into Chapter 1 of Part 20 of CTA 2009 to prevent multinationals from moving profits around the group to avoid UK tax; it would do this by providing that where there is a payment in substance of the profits of a company to another company in the same group, directly or indirectly, then the former company will be assessed as though the transfer had not taken place (paragraph 6). In example 2 the Note explains that franchise arrangements could be within the measure if the payments were based on profits not turnover, but only if there was a tax avoidance motive. In Example 3 the Note explains that royalty payments based on profit might also be within the measure if a significant part of the profit was transferred, but again only if they had a tax avoidance motive.
Relevant case law
In the most significant transfer pricing case to reach the UK courts to date (DSG Retail Limited (DSG) v Revenue & Customs Commissioners (2009 TC00001), the transaction in issue was the “provision” of an (informal and unenforceable) intangible asset. HMRC argued successfully that the business restructuring had resulted in the (informal and unenforceable) “provision” of a business opportunity by one related party to another, namely the opportunity for that party to enter into contracts with unrelated parties (on terms which would not have been entered into in the absence of the first party’s arrangements with the same unrelated parties); that this second party had not properly rewarded the first for this provision through the taxpayer’s transfer pricing arrangements; that the appropriate reward should reflect the relative bargaining power of the two parties; and that as the balance of risks between the related parties was “exceptional” (in that it was very different from what might have been expected at arm’s-length) then an “exceptional” transfer pricing method could be applied, namely the profit split.
Further, in February 2010, AstraZeneca announced that it had agreed to pay HMRC £505 million ($832 million) to settle a long-running tax dispute over transfer pricing which is thought to involve intangible property.
In October 2010, Asda, a supermarket chain, announced that it had settled a long-standing dispute with HMRC over deductions for royalty payments to Asda’s US parent, Wal-Mart. As a result, Asda recognised a reduction of royalties for prior years of £114.9m, and a corresponding net increase in its tax liability, in its 2009 accounts. In December 2012 Starbucks announced that it would pay £10m of corporation tax for each of the next two years on an entirely voluntary basis, regardless of the profits earned, and without having discussed this with HMRC.
In response to serious concerns expressed by the Public Accounts Committee, the UK National Audit Office (NAO) commissioned an examination of five large tax settlements, and reported on its findings and their conclusions on June 14 2012 (HM Revenue & Customs: Settling Large Tax Disputes, Report by the Comptroller and Auditor General, HC188, Session 2012-13).
The report summarises the three transfer pricing settlements which the NAO had selected for review, two of which related to intangibles. In the first settlement a UK company had transferred IP to related parties in other jurisdictions. HMRC had been investigating the tax effects of the reorganisations for nearly ten years, and had started to prepare for litigation, when the taxpayer asked HMRC to negotiate on the disputed issues. The resultant “rapid negotiation process” lasted four months, at the end of which a settlement was reached. HMRC argued that the UK company undercharged its non-UK related parties for certain services, and that the actual transactions could be recharacterised to reflect different transactions that would have occurred at arm’s-length. The recharacterisation argument involved ignoring the fact that the overseas subsidiaries owned the IP rights. “However, it did not pursue this extreme argument in the rapid negotiation process” (Appendix One, paragraph 4). The outcome of the transfer pricing issue was that the taxpayer was assessed on additional profits in the hundreds of millions. This was made up of several elements. For the first few years after the IP transfers, HMRC successfully argued that the overseas subsidiaries were still receiving substantial assistance from the UK companies. To take account of this assistance, the taxpayer agreed to a share of the profits of the overseas companies being added to the profits of the UK companies. It also agreed to an upwards adjustment to the “cost plus” percentage price that was being charged by the UK companies. HMRC successfully argued that there was a special feature of the services being provided by the UK companies, and the taxpayer agreed to the taxable profits of the UK companies being adjusted upwards to account for this.
In the second settlement HMRC argued that the lump sum and contingent payments made by a non-UK related party were below arm’s-length market rates. HMRC also argued that if the taxpayer and the related party had been independent parties, they would not have entered into the licensing agreement at all; there would have been a different contractual arrangement. However, HMRC did not pursue the recharacterisation argument in the accelerated negotiation process with the taxpayer. The transfer pricing adjustments agreed for this period increased the corporation tax, and interest, payable by several hundreds of millions of pounds. The independent reviewer appointed by the NAO concluded that it was reasonable for HMRC not to have pursued the recharacterisation version of the transfer pricing argument because it “had not been tested in litigation” (Appendix One, paragraph 28).
Legal versus economic ownership
An important issue in any tax jurisdiction is the view taken on the right of an enterprise to share in the return from intangible property that it does not legally own ( “economic ownership” for Article 9 OECD Model Tax Convention purposes). As one would expect, given that the UK transfer pricing rules must be construed in accordance with the TPG, HMRC recognises the distinction between legal ownership and economic ownership of intangible property. However, the activity that is required to create this economic ownership remains unclear.
For the purposes of UK tax law, it should not be sufficient to say that because of a company’s unusual contribution or activities in relation to intangible property alone, the company should have a proprietary interest in the intangible property and therefore acquires economic ownership. Such unusual activities may lead to the repricing of a transaction by HMRC, but should not lead to a recharacterisation of the transaction and hence of the ownership of the intangible property. This analysis is supported to a certain extent by the DSG case, where (as noted above) HMRC argued that the business arrangements of the companies should be ignored and another arrangement assumed for the purposes of calculating the UK tax payable. However, the Commissioners concluded that it was appropriate only to apply a different transfer pricing method from that used by the taxpayers, as opposed to recharacterising the transaction.
Contradictions to law
Nevertheless, HMRC’s internal guidance on the application of UK transfer pricing rules to transactions relating to intangible property is somewhat contradictory. HMRC’s guidance leaves open the possibility that HMRC may assert that some form of economic ownership is created by excessive marketing or other contribution alone.
The possibility of recharacterisation is also hinted at in HMRC’s discussion of the transfer pricing implications of contract research and development (R&D) techniques - where a non-UK company (possibly in a tax haven) owns the fruits of R&D but contracts a UK company (where the infrastructure/expertise lies) to undertake the R&D. HMRC states that:
“...if the [UK company] is carrying out innovative research, taking a concept from scratch or at a very early stage from someone else within the group [inspectors] should consider carefully whether a cost plus method of setting the transfer price is appropriate. A profit split method, or some hybrid whereby the UK recharges its expenditure at cost only, but is also entitled to a royalty on any eventual sales [may be more appropriate].”
It is possible that HMRC is merely acknowledging that the relative bargaining power of the UK company (due to, for example, its ability to carry out innovative research) means that the transaction should be repriced since an independent party would have negotiated a greater share of any future upside of the R&D (or marketing and advertising expenditure). This repricing could take the form of an imputed arrangement to share the additional profits accruing to the enhanced intangible asset (but with no contention that “ownership” of the intangible would also be shared). However, the reference to “profit split” might indicate that HMRC is leaving open the possibility of recharacterising the transaction so that the UK company is deemed for tax purposes to acquire a form of economic ownership of the international property.
Indeed, although HMRC says that it adheres to the “exceptionality” standard in paragraph 1.64 of the TPG (in that transactions should only be recharacterised (as opposed to merely repriced) in exceptional circumstances), in its approach to the DSG case HMRC demonstrated that it may seek recharacterisation (in that case unsuccessfully) if it does not consider arrangements to be commercial.
Definition
The scope of what can be included in “intangible property” is defined in a range of ways, including by legal and regulatory provisions, administrative practice, and the results of tax audit and case law. Inferences about the definition can also be drawn from the arguments given by HMRC to support its position.
In its internal guidance, HMRC defines intangible property in very wide terms: “from a transfer pricing point of view, intangible property is any property that is not tangible but is none the less still clearly property that could be exploited”.
The concept of “ability to exploit” is likely to be interpreted widely - including an ability to prevent others from exploiting something, at least for a period of time. For example, know-how and customer lists can be protected through non-disclosure clauses and non-compete agreements when employees leave, but this will not give full, or lasting, protection.
For the purposes of the Part 8 Regime, intangible assets are defined by reference to accounting treatment. Broadly speaking, for accounting purposes intangible assets are those non-financial fixed assets that do not have physical substance but which are controlled by the party (through custody or legal rights) and can either be disposed of separately without disposing of a business of the entity or (for the purposes of IAS 38 only) arise from contractual or other legal rights. In addition, goodwill and intellectual property are specifically included within the Part 8 Regime.
HMRC’s definition of intangible assets for transfer pricing purposes is clearly much wider than that for accounting purposes and, indeed, for other UK tax purposes.
Ongoing developments
In a March 2014 response to the OECD’s BEPS Action Plan (HM Treasury and HMRC, “Tackling Aggressive Tax Planning in the Global Economy: UK Priorities for the G20-OECD Project for Countering Base Erosion and Profit Shifting”, 19 March 2014), the UK government signalled a willingness to adopt supplementary rules to deal with digital transactions and the fragmentation of functions and assets, the latter possibly taking the form of a treatment based on the over-capitalisation of IP-owning companies.
The paper also referred (in paragraph 3.56) to the existing UK Disclosure of Tax Avoidance Schemes rules and in paragraph 3.57 suggested that transactions within the ambit of any future transfer pricing anti-abuse or special measure “could usefully be subject to mandatory disclosure rules”.
The authors are respectively head of transfer pricing economics and tax partner in Freshfields’ London office. For further information please use the following email addresses or visit the website below:
danny.beeton@freshfields.com
murray.clayson@freshfields.com
