The Future Lawyer Weekly Briefing – W/C 26th February 2024

Transfer Pricing: An Aspiring Lawyer’s Guide to Tax 

A series introducing law students to the real world of tax.  

Transfer pricing is the practice of moving assets and profits from one subsidiary to another located in a lower-tax jurisdiction with the effect of reducing tax liability. Apple, for instance, had shielded €110.8 billion EU profits from taxation by transferring them to Ireland, where it was charged a near-zero corporate tax.  

New UK regulations on transfer pricing means that multinational corporations will need to rethink their tax strategies, giving law firms an opportunity to advise on the new developments.  

Shifting profits and eroding bases

How does transfer pricing, artificially or legitimately, reduce tax liability?  

Suppose Orange Inc., a multinational corporation, wishes to reduce its tax burden. Orange may set up a subsidiary based in a tax haven and transfer the ownership some of its intellectual properties to the subsidiary. Orange then pays the subsidiary some of its profits for the management of the intellectual property, effectively reducing its taxable profits.  

Multinational corporations save up to billions through this process often referred to as profit shifting and base erosion. Suppose Orange makes £10 billion in profit, 20% of which is subject to taxation in its resident jurisdiction. If Orange transfers £5 billion of its profits to a 10% tax region, it will pay £500 million in the tax haven and £1 billion in its resident jurisdiction. Had Orange not made the transfer, its tax liability would be £2 billion.  

Arm’s length principle

In general, transfer is allowed if it is priced at an “arm’s length”, i.e., the amount transferred between subsidiaries equals amount that would be charged to an unrelated party. For instance, for Orange Inc., paying £5 billion is not an arm’s length transaction because Orange would have paid less to an independent party for the upkeep of its assets. 

In the UK, transfer pricing is governed by Part 4 of the Taxation (International and Other Provisions) Act 2010 which aims to prevent profit shifting via inter-company transactions.  

In 2015, UK introduced the Diverted Profit Tax, currently charged 5% higher than standard corporate tax, to defer profits shifting. Diverted Profit Tax applies in two scenarios: (i) where multinationals structure operations to avoid creating a “permanent establishment” in the UK, and (ii) where transfers artificially boost tax deductions.  

Therefore, what constitutes a commercially substantial transfer and what gives rise to a permanent establishment (usually meaning a fix place of business) remain litigious areas. 

Tax disputes

According to HM Revenue and Customs, additional tax revenue from transfer pricing disputes, agreements, and enquiries amounts to £9.7 billion from 2017 to 2023.  

In Glencore Energy UK Ltd v HMRC [2017], Glencore and HMRC disagreed on what constituted taxable diverted profits. The contentious transfer of profits was the payment of insurance premium from Glencore UK to its Swiss parent, amounting to 80% of Glencore’s UK profits. HMRC argued that the payment was less than the commercial rate, so the transaction was not conducted at arm’s length. Glencore appealed the case on purely procedural grounds.  

Renewed regulatory scrutiny

The government intends to crackdown on abusive transfer pricing practices by legislating an upcoming Finance Bill, considered in a recent consultation released in January.  

The consultation raises the following points: 

• Whether to integrate Diverted Profit Tax into standard corporate tax, with the aim with uniformity and consistency with tax treaties with other countries; 
• The need to clarify the test for a commercially substantial transfer; and 
• Redefining “permanent establishment” to ensure alignment with the international framework and to avoid double-taxing multinationals.  

Law Firm’s Involvement

Currently, law firms offer the following services: 

• Advise on the pricing or margin charged by the related parties in a transfer, where the transfer could be fees for services or royalty payments 
• Ensure that these transactions are at arm’s length  
• Advise on intercompany agreements and the tax implications of restructuring 
• Negotiate agreements (e.g., Advance Pricing Agreements) with HM Revenue and Customs, establishing the method of determining transfer pricing for future transactions 

Considering the potential regulatory changes to transfer pricing, law firms will need to adapt their advice to reflect the changes and devise new tax-efficient strategies in guiding their clients through the transition period.  

Article by David Zheng