UK transfer pricing rules apply to capital transactions such as issuing shares, court finds

by Liz Hughes, Grant Thornton UK LLP  

A decision of the UK Upper Tribunal, released 2 October, includes some interesting remarks as to how the UK transfer pricing rules apply to share transactions and will have an impact on corporate income taxation.

The key takeaways from the case, Union Castle Mail Steamship Company Limited v. the Commissioners for Her Majesty’s Revenue and Customs, can be summarized as follows:

1. The courts are increasingly finding against tax planning.
2. Taxpayers need to understand that the legal definition of terms such as ‘loss’ may be distinct from questions of accounting application.
3. The UK transfer pricing rules can apply to share transactions if those transactions have an income tax effect.
4. The courts find the application of the UK transfer pricing rules (i.e., what is the arm’s length price or range of prices to apply) to be a complex area that is reliant on the facts and circumstances of the case and may require expert evidence.

The Upper Tribunal decision responds to appeals by Union Castle and HMRC, to the decision of the First-tier Tribunal, which was released in July 2016.

The Upper Tribunal found against the taxpayer on its appeal and upheld HMRC’s appeal.

The majority of the commentary in the ruling is about whether Union Castle suffered a £39m ‘loss’ and if that loss ‘arose from’ a series FTSE-based derivative contracts that the business had entered into.

“Derecognition” of the derivative contract value

The original case before the First-Tier Tribunal centered on a challenge made by HMRC to Union Castle’s 2009 tax return disallowing a deduction for £39m debit claimed by Union Castle relating to the partial “derecognition” of the cash-flows associated with a number of derivative contracts. 

The derecognition came about because, some years after acquiring the derivative contracts, Union Castle issued bonus A shares to its parent company. Caledonia, which carried a dividend equal to 95% of the cash-flows arising on the close-out of the contracts. 

The transfer of the majority of the economic benefit from the contracts to Caledonia meant that Union Castle had to write off (or partially ‘derecognise’) some of the value of the contracts in its accounts, resulting in a £39m debit to its profit and loss account.    

At the heart of the appeal was the question of whether the £39m debit was a “loss,” as that term is defined by Schedule 26 of the Finance Act 2002 (the derivatives contracts rules), and whether the transfer pricing rules should apply to the issue of bonus A shares by Union Castle.

The First-Tier Tribunal denied the £39m deduction on the basis that Union Castle had not suffered a loss because, despite what the accounts showed, the business was still entitled to the cash flows from the derivative contracts before and after it had issued the bonus A shares. The subsequent payment of 95% of these cash flows by way of a dividend on the bonus A shares did not alter the economic nature of the derivative contracts, the First-Tier Tribunal said.

UK derivative contract “losses”

The First-Tier Tribunal decided that there was no loss arising to Union Castle from the derivative contracts because Union Castle remained entitled to the cash flows under the contracts; it had simply chosen to give those cash flows away via the bonus A shares.  The court’s position was that Union Castle had not suffered a reduction in its resources and therefore had suffered no real loss. 

The Upper Tribunal disagreed. The Upper Tribunal concluded that the First-Tier Tribunal could have been influenced in that position by its earlier decision in Abbey National Treasury Services plc v Revenue and Customs Commissioners [2015].

In this appeal hearing, the Upper Tribunal commented that the First-Tier Tribunal was wrong in its conclusion on Abbey National because the court had conflated the meaning of ‘loss’ with the questions of whether a loss arises from a derivative contract and whether the accounting treatment fairly represents the profit and losses arising from the derivative contracts.

For the Upper Tribunal, the loss arose because there had been a reduction in the net worth of Abbey National. On that basis, the First-Tier Tribunal was wrong to hold that the debit attributable to the derecognition of 95% of the value of the derivative contracts was not a loss within the meaning of the derivatives tax code.

UK transfer pricing rules

The First-Tier Tribunal concluded that the issue of the bonus A shares did not amount to a ‘provision’ as that term is used in Schedule 28AA ICTA88 (the UK transfer pricing rules that applied at the time) and therefore the transfer pricing rules could not be applied to the transactions and no adjustments could be made to the ‘pricing’ of the bonus A shares.

The Upper Tribunal disagreed on this finding. The Upper Tribunal noted that there was nothing in Schedule 28AA that excluded capital transactions from being the subject of the UK transfer pricing rules. For the Upper Tribunal, the UK transfer pricing rules tell taxpayers what adjustments to taxation they should make, but the rules do not tell taxpayers the nature of the ‘provision’ that falls within the rules.    

The Upper Tribunal goes on to note that the issue of shares meets the requirements of making or imposing conditions in commercial and financial relations as required by Article 9 of the OECD Model Convention.

Furthermore, the Upper Tribunal concluded that the OECD Guidelines apply to debt financing, including debt financing that has some equity characteristics.

These points taken together meant that the Upper Tribunal concluded that the share transactions, which have an effect on income taxation, should be within the UK transfer pricing rules.

The transfer pricing ‘answer’

Readers of this article who are looking for the answer to the question, ‘what is the arm’s length price for the provision of the bonus A shares’, will be disappointed. 

The Upper Tribunal said that if the transfer pricing issue had been material, they would have remitted the case back to the First-Tier Tribunal to determine what would have been arm’s length terms that would have been agreed between independent parties in comparable circumstances.

In so doing, the Upper Tribunal has neatly ‘side-stepped’ the question of valuation of the bonus A shares and avoided a complex piece of analysis that they said would require consideration of “competing arguments” and may require “expert evidence” to resolve.

Final take-aways

Taxpayers should note that the Upper Tribunal found that the UK transfer pricing rules can apply to ‘capital transactions’ (e.g., the issuing of shares and the payments of dividends) and adjustments can be made to those ‘provisions’ if they have an income tax effect.

Transfer pricing is a complex area of the UK’s tax code and expert advice should always be sought on the application and implementation of the transfer pricing rules.

–-Liz Hughes, a partner with Grant Thornton UK LLP, advises on all aspects of transfer pricing with a focus on the pricing of debt and the financial services sector and can be reached at [email protected] or +44(0)207 728 3214.