Calculation of profits and losses

Where the transfer pricing rules apply (see Part 1 on our website) the profits and losses of the potentially advantaged person may be adjusted. For tax purposes, profits and losses must be calculated as if the arm’s length provision had been made or imposed instead of the actual provision.

In cases where the exemptions do not apply (i.e. SME or dormant), the adjustment should be self-assessed on the income or corporation tax return of the potentially advantaged person. The potentially advantaged person is the person who has received a potential UK tax advantage as a result of the provision not being at arm’s length—for example, whose profits have been reduced or losses increased.

In order to reduce profits (or increase losses), the other party to the transaction would need to make a transfer pricing adjustment, and then a compensating adjustment should be claimed either under UK law or under a double tax agreement. Under self-assessment, documentation requirements must be met to support any adjustment made on the tax return. Failure to do this may lead HMRC to seek penalties in the event of a transfer pricing adjustment.

Invoices

A transfer pricing adjustment is only made for tax calculation purposes. Companies and other entities can charge what they wish and record such charges in their accounts. The actual charges will typically be subject to the normal requirements, for example invoicing, withholding tax and VAT.

Compensating adjustments

The disadvantaged person can usually make a compensating adjustment to its taxable profits. The amount of the compensating adjustment is equal to the amount by which the profits of the advantaged person have been increased (or losses decreased) pursuant to the transfer pricing provisions. The disadvantaged person must make a claim in order to make a corresponding adjustment. A claim can only be made after the potentially advantaged person has filed a tax return showing the adjusted profits or losses. The claim for a corresponding adjustment must be consistent with the amount of those adjusted profits or losses.

Double tax agreements

A compensating adjustment can only be claimed under the provisions of TIOPA 2010, if both affected persons (i.e. parties to the transaction) are within the charge to UK tax. However, certain double tax agreements provide for a similar compensating adjustment mechanism. Which apply automatically on a claim by the disadvantaged person (e.g. under Article 9(3) of the UK/Canada double tax agreement), or under the mutual agreement procedure (which is included in most of the UK’s double tax agreements)

Balancing payments

A balancing payment can be made between the parties where a compensating adjustment has been made, but there is no obligation to make one. While the compensating adjustment reconciles the tax position between associated entities within the charge to UK tax where one of them is subject to a transfer pricing adjustment, a balancing payment effectively reconciles the cash position between parties. No notification needs to be made to HMRC that a balancing payment has been made and can only be made to the extent that a compensating adjustment is available, which is only the case between UK companies.