Barbed benefits: Taxes after the end of transfer pricing

It was a shock to hear a UK government tax announcement at a Liberal Democrat party political conference. It was even more surprising that the announcement was on the specifics of an aspect of taxation affecting partnerships and LLPs.

On 17 September, Danny Alexander, chief secretary to the treasury, announced at the liberal democrats' autumn conference that the tax benefits that could arise through a partnership or LLP operating a service company would be counteracted. During the speech, there was a strong undertone that professional service firms were conducting underhand, shady tax avoidance tactics which ?the government had only fortuitously stumbled across.

The government announced on 25 October 2013 that it would introduce legislation to stop PSFs from obtaining this tax advantage from operating service companies. It said the legislation was effective immediately, even though it ?would only be introduced in parliament through the 2014 Finance Bill.

Before discussing the impact of the new legislation, it is worth looking at the history of the use of service companies and how the government created the tax issue it is now seeking to block.

Service company history

Some PSFs have used service companies to provide a variety of support functions for many years. This was seen as uncontroversial and with little tax consequence.

In the 1990s, the-then government introduced the profit-related pay regime. Firms operating as partnerships could only access the tax benefits for staff that the government was deliberately offering by setting up service companies and employing their staff through them.

As is not untypical with political fads, the profit-related pay regime was closed at the end of the decade and many firms closed their service companies soon after. Those that continued were untroubled by the UK tax regime - for a few years at least.

In the background, but not previously relevant, was the transfer pricing regime. This anti-avoidance tax legislation aimed to ensure that UK businesses could not effectively transfer profits abroad to be taxed at lower rates in other jurisdictions and escape UK taxes.

In 2004, the government found ?that the-then transfer pricing regime ?could be seen to breach EU freedom ?of establishment principles, so the ?regime was extended to apply to ?intra-UK business relationships.

At first it was unclear as to whether this extended transfer pricing regime would apply to partnerships that controlled a corporate subsidiary, such as a service company. HMRC confirmed that it did. Further, the odd outcome was that the overall tax burden on a firm would be reduced under the operation of the transfer pricing regime if it operated ?a subsidiary service company.

Some firms 'caught' by the rules questioned HMRC whether, given this outcome, it was appropriate to apply the legislation. HMRC advised them they had to. Still, some firms hesitated to follow suit and set up service companies to access this tax outcome, presuming that HMRC would get the government to amend the legislation. It did not.

The mix of corporate and income tax rates at the time meant that only the largest of firms could effectively obtain a tax benefit from operating a service company, as the cost of set-up, operation and compliance would outweigh the benefits that smaller firms could obtain.

The government then inadvertently expanded the opportunity for other firms when, from 2009, the rate of corporation tax started to be reduced and, shortly thereafter, the top rate of income tax increased. This raised the tax benefit of operating a service company and thus, ?not surprisingly, more firms set them up, ?in many cases with informal clearance ?from HMRC.

HMRC's subsequent reaction was ?to review and, in some cases, challenge the transfer pricing calculations that resulted. By 2012, the PSF market had settled down on this matter and an understanding seemed to have been reached with HMRC on the appropriate calculations to undertake.

In spring 2013, the chancellor announced a review of the tax treatment of certain partnership/LLP structures that he believed involved abusive and unacceptable tax planning. Despite HMRC having known for many years of the tax advantages the use of service companies could achieve, the consultation run by HMRC over summer 2013 did not mention or cover service companies.

While one can understand the government's wish to correct the legislation with regard to service companies operated by PSFs, the political grandstanding over the announcement is a little hard to ?take given that it had close to a decade ?to do this.

The summer's consultation on salaried members and on partnership/LLP structuring allowed for a ten-week consultation period and an anticipation ?of legislation being introduced as ?effective from 6 April 2014. For service companies, the changes came in force from 25 October 2013 after only a fortnight of 'informal consultation'.

Impact of tax changes

In looking at the detail of the changes, we need to remind ourselves of how the position used to work.

Let us take a simple example of a firm which is treated as 'large' (the relevance is discussed later) with a service company that incurs annual costs of £10m (let us assume in employing staff used by the firm) and recharges this cost to the firm with no mark-up. For simplicity, let us ?also assume a market rate mark-up would be five per cent. The partners of the firm are individuals.

In commercial terms, the service company has made no profit. However, under transfer pricing legislation, it is deemed to make taxable profits of £500,000 (£10m at five per cent). It is thus assessed for corporation tax of £115,000 (assuming a corporation tax rate of 23 per cent). The service company does not have the resources to meet this tax bill, so the partners pay the bill for the service company; 'bad news' in isolation.

The 'good news' was that, prior to 25 October 2013, the firm would have been able to claim a deduction for the £500,000 notional profit in the service company's corporation tax computation as a "compensating adjustment". If partners paid a marginal rate of tax and NIC of 47 per cent, they saved £235,000 as a result.

So, until the legislation changed, the partners in our example gained a net tax benefit of £120,000 p.a. through the application of the-then transfer pricing legislation, which equates to about 1.2 ?per cent of the business costs run ?through a subsidiary service company.

Under the new legislation, which is now in effect, individual members of PSFs are denied the ability to claim a 'compensating adjustment' in respect of any 'transfer pricing adjustment' required within the corporation tax computation of the service company. However, corporate members will still be able to claim their share of the compensating adjustment.

It is worth noting the further background to transfer pricing legislation that remains. Service companies which ?are part of a large group still have to ?apply transfer pricing adjustments in ?their tax computation if relevant (where their services are not charged out at ?a market rate).

Those in a medium-sized group only have to apply a transfer pricing adjustment if directed to by HMRC (or if they elect to do so themselves for an accounting period). Service companies within a small-sized group are broadly exempt from applying transfer pricing adjustments unless they elect for them to apply to ?a particular accounting period.

A group is large if it is not classified ?as either small or medium.

Small groups must have 50 or fewer staff (including partners) and either turnover of less than10m (£8.4m) or balance sheet assets of less than €10m.

Medium-sized groups are those with 250 or fewer staff (including partners) and either turnover of less than €50m or balance sheet assets of less than €43m.

In our example above, if the services provided by the service company ?continue to be charged with no mark-up, then the transfer pricing rules still apply and £115,000 corporation tax is payable. However, the partners cannot claim a compensating adjustment and are thus ?not able to get the benefit of an ?offsetting tax reduction.

The result is thus that, within a large group, the operation of a service company without it charging a market rate mark-up would simply result in extra tax being due. So, doing nothing in reaction to the new legislation is not an option.

Transitional options

HMRC has confirmed that the new legislation only applies to services provided at below-market rates after ?25 October 2013. So, a split-year treatment applies for accounting ?periods that straddle that date.

As of 25 October 2013, large groups effectively have the choice of either:

• ceasing to use service company arrangements; or

• continuing the arrangements but actually applying a market rate margin on the charge from the service company to the LLP/partnership.

If the latter route is followed, the service company will create reserves, which ?may then be distributed by way of dividends to the LLP/partnership. With current rates of corporation tax and the personal tax rate on dividends, there is actually a very small tax benefit arising from this outcome (about 0.02 per cent ?of the costs in the service company). But, in most cases, this will only contribute to the annual compliance costs of running the service company.

Medium-sized groups have a third option (in addition to the choices available to large groups). This is to elect to be in the transfer pricing regime for the transitional year (as before), claim the compensating adjustment to 25 October 2013 and then charge a mark-up on services from that date through to the end of the straddled accounting period. During this time, they approach HMRC to confirm that it will not insist on the transfer pricing regime applying for their next accounting period. Their service companies would then not apply a mark-up for the next accounting period and would not elect ?to be within the transfer pricing regime.

Service companies within small groups have the same options as medium-sized ones, except that they would not have ?to seek HMRC confirmation of their position for the next accounting period. This is because HMRC cannot insist ?on the transfer pricing rules applying ?in 'small' situations, except in ?exceptional circumstances.

 

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Summary of the main tax changes

• Individual firm members cannot claim a ‘compensating adjustment’ for any transfer pricing adjustment required when calculating corporation tax for a service company

• Corporate members of the firm can still claim their share of a compensating adjustment

• The new rules only apply to services provided at below-market rates after 25 October 2013

• A split-year treatment will apply for accounting periods that straddle 25 October 2013

• Small and medium-sized firms can exclude themselves from the transfer pricing regime

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End of the road?

The new tax legislation thus looks set to achieve its purpose. You can still operate a service company in a tax-neutral fashion should you wish (because, for example, you are obtaining other commercial/operational benefits), but you would not chose to run one if its only purpose was ?to generate a tax advantage.

Louis Baker is head of professional practices at UK accountancy firm ?Crowe Clark Whitehill ?(www.crowehorwath.net/uk)

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