Clause 69 - Transfer pricing: restriction on claims for compensation adjustments

Finance Bill – in a Public Bill Committee at 9:10 am on 10 June 2014.

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Question proposed, That the clause stand part of the Bill.

Photo of Shabana Mahmood Shabana Mahmood Shadow Minister (Treasury)

The clause deals with transfer pricing, which is an integral part of ensuring fairness in the tax system. It is designed to iron out tax inconsistencies that arise when transactions take place between connected parties. In essence, the rules exist to ensure that the right prices are charged between connected parties on international transactions, although they also apply to transactions in the UK. When transfer pricing rules are utilised—when transactions have not been carried out at arm’s length and when a UK tax advantage has accrued—the effect is to increase one party’s profit. It is sometimes possible for the other party involved in the transaction to make a claim to reflect the same price, which is known as a compensating adjustment. At present, companies and individuals can claim compensating adjustments.

One unintended consequence of the compensating arrangements has been that although, on one side of the arrangement, the taxable profit has increased, on the other side, the taxable income at the higher rate has been reduced without affecting the cash position of either party. Individuals are therefore able to extract income from their businesses at the corporate tax rate rather than the income tax rate.

The technical note on the clause states:

“Large partnerships often employ their staff through a separate service company, which the partnership owns. This arrangement can be used for a number of reasons not related to tax. However, by choosing not to pay an appropriate fee to the company for providing this service, the partnership can activate the tax rules to gain an advantage. HMRC is aware that the structure has been promoted as a method to reduce tax liability for smaller partnerships.”

The clause is therefore designed to restrict the use of compensating adjustments when they generate such income tax advantages. Specifically, the main change will prevent persons other than companies within the charge to income tax from claiming a compensating adjustment where the counterparty is a company. That means that if the compensating adjustment claim is denied but the claim would have related to excess interest paid by the counterparty, the excess interest—over an arm’s length amount—will be treated for income tax purposes as a dividend rather than interest, and will be taxed at dividend rates rather than at rates applicable to interest. The changes will take effect in relation to amounts that are referable to times on or after 25 October 2013. Any amounts accruing before that time, whether interest or service fees, are outside the scope of the clause.

We support measures to prevent schemes whose sole purpose is to avoid paying tax, so we support the clause. However, I want to ask the Minister a small number of questions. In the document on compensating adjustments by Her Majesty’s Revenue and Customs that was issued in October 2013, HMRC estimated that receipts would increase by about £70 million per annum. However, in the autumn statement, much higher figures were given, with the post-behavioural Exchequer impact in 2015-16 estimated at £125 million. Will he explain the difference between those two sets of figures and tell us the methodology used to calculate them?

Will the Minister tell us his estimate of how many of these arrangements are seen every year? Additionally, I would be grateful if he could tell us how HMRC became aware that structures promoting the reduction of tax liabilities for smaller partnerships were being set up and whether he plans to review the measure to ensure that no other avoidance schemes flourish as unintended consequences of clause 69.

Photo of David Gauke David Gauke The Exchequer Secretary 9:15, 10 June 2014

It is a great pleasure to serve under your chairmanship once again, Mr Caton. As we have heard, clause 69 makes changes to prevent individuals from exploiting transfer pricing legislation to generate an overall reduction in tax liability.

Transfer pricing legislation is designed to ensure that connected parties transact with one another at a market arm’s length rate. Although the main purpose of the legislation is to ensure that the UK receives a fair profit return on cross-border transactions, it also applies to transactions conducted between connected persons wholly within the UK.

Within the UK, if the legislation increases one party’s profits, the person at the other end of the transaction may claim a compensating adjustment, which has the effect of reducing that person’s taxable income by an amount equal to the adjustment. Wealthy individuals and large partnerships have been using the mechanism to take income from companies that they control without paying the full amount of income tax. That is achieved because the transfer pricing and compensation adjustment rules increase the profit taxable at lower corporation tax rates, but reduce the income taxable at the higher rate of income tax, which is currently 45%. The cash movement, however, is unchanged. It stays with the individuals, so they effectively obtain income that would normally be taxed at personal rates of income tax, but pay only the corporation tax rate.

The clause will remove individuals’ ability to claim compensating adjustments when the counterparty to the transaction is a company. Some modifications apply for payments of interest. When the compensation adjustment claim is denied but the claim would have related to excess interest paid by the counterparty, the excess interest over the arm’s length rate will be treated for income tax purposes as a dividend rather than interest, which means that the excess will be taxed at dividend rates, rather than rates applicable to interest.

The clause will mainly affect individuals who are making loans to a company not on arm’s length terms. Affected businesses will include those in private equity, but the measure is not targeted at that sector, and the legislation will affect a range of private companies. It will also affect companies that are under-remunerated by large professional partnerships for the services that the company performs for the partnership. The measure is expected to yield £530 million over the next five years.

The hon. Lady referred to the changes in yield numbers. The revenue estimates are subject to the scrutiny of the Office for Budget Responsibility. I confirm that the figures were certified by the OBR following the rigorous procedures that the Government have introduced. The initial estimates were revised upwards following further scrutiny, which is why we have the present number.

How did HMRC become aware of the arrangements? Marketing material was produced by some of the larger accountancy firms, which resulted in greater scrutiny by HMRC. A significant number of taxpayers have entered such schemes. There is also evidence that the schemes are increasingly being marketed as a way to avoid tax. If the Government do not act, there will be increasing losses of tax and an increased risk to the Exchequer.

The clause will prevent the compensation adjustment rules from being used to avoid tax. It supports the Government’s objectives of fairness in the tax code and I hope that it will stand part of the Bill.

Question put and agreed to.

Clause 69 accordingly ordered to stand part of the Bill.