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As noted in CFM38440, the basic transfer pricing rule requires the profits or losses of a person to be calculated for tax purposes as if the arm鈥檚 length provision had been made rather than the actual provision if, by comparison with the arm鈥檚 length result, the actual provision confers a potential tax advantage (within the meaning of TIOPA 2010/S155) on that person.

To determine whether a potential tax advantage is conferred, and determine if the transfer pricing rules apply, one is required to:

1. Compute the profits or losses for tax purposes on the basis of the actual provision.
2. Compute the profits or losses for tax purposes on the basis of the arm鈥檚 length provision.

In each case the calculation is based on applying all other corporation tax rules, except for a few statutory provisions specified at S155(5) and S155(6).

If the profit is greater or the loss is smaller applying step 2 rather than step 1, there is a 鈥減otential advantage鈥� and the profits or losses for tax purposes are calculated as if the arm鈥檚 length provision had been made, thus denying the advantage.

This follows the principle that if the taxable profit, assuming the arm鈥檚 length transaction had occurred, is greater than the taxable profit from the actual transaction (the potential advantage condition) then TIOPA10/Part 4 requires the arm鈥檚 length provision to be substituted for the actual provision in computing the taxable profit of the potentially advantaged person (INTM412020).

Application of transfer pricing to unallowable purpose cases

Under the unallowable purpose rules, where the purposes for which a company is a party to a loan relationship include an unallowable purpose, debit amounts attributable to that unallowable purpose are disallowed. CTA09/S441(4)-(5) provide that an amount which is not brought into account, because of the operation of the unallowable purpose rule, is not to be brought into account for corporation tax purposes either as a loan relationship amount or otherwise. This means there is no mechanism to relieve a debit for tax once the unallowable purpose rules have deemed it should not be brought into account.

In some circumstances, it may be necessary to consider the interaction between the transfer pricing rules and the unallowable purpose.

(1) Whole of loan relationship debit attributed to unallowable purpose

Where the whole of a loan relationship debit is attributable to an unallowable purpose it will be disallowed and will not be brought into account in calculating the company鈥檚 taxable profit.

Consequently in this scenario, the potential tax advantage condition within TIOPA 10/Part 4 cannot be met in respect of this debit as no debit will be brought into account in calculating either the profits and losses on the actual provision. As such, no potential advantage will be conferred under the actual provision.

Example

A company, UKCo, borrows from an overseas company, OverseasCo (a member of the same group) to fund a tax avoidance scheme. The loan is for 拢100m and carries interest of 4% per annum. From an examination of the particular facts it is concluded that the actual loan has an unallowable purpose and all of the interest payments are attributable to this purpose. It is also determined that UKCo is thinly capitalised and that, acting at arm鈥檚 length, it would have only have borrowed 拢60m at 4%.

In this situation the transfer pricing rules do not apply as there is no potential tax advantage. The unallowable purpose rules negate the whole of the tax advantage that would otherwise have arisen from the transaction not being at arm鈥檚 length.

(2) Loan relationship debit part attributed to unallowable purpose

If a loan relationship debit does have an unallowable purpose, but the application of the unallowable purpose rule does not disallow all of the debits, then it might fall to be adjusted under TIOPA 2010/Part 4. The just and reasonable apportionment and transfer pricing adjustments will depend on the specific facts.

(3) Imputed debits under a compensating adjustment

The above considerations concern the question of whether or not the transfer pricing rules are engaged. Such considerations fall away in situations where the transfer pricing rules are already engaged on another person and a company makes a compensating adjustment claim under TIOPA10/S174 (see INTM412130)

Example

A company Y Ltd borrowed 拢100m from X Ltd on interest free terms and with the amount repayable on demand. Under the transfer pricing rules it is determined that acting at arm鈥檚 length X Ltd would have lent Y Ltd 拢100m at interest of 4%. It is also determined that Y Ltd is borrowing purely to fund a tax avoidance scheme. X Ltd and Y Ltd are UK companies within the same group.

In this situation the transfer pricing rules are engaged in respect of X Ltd as its actual profits are understated compared with the arm鈥檚 length provision. As a result, X Ltd must impute interest of 拢4m per annum.

Y Ltd could look to make a compensating adjustment claim to put it in the same position as if it had borrowed from X Ltd on the arm鈥檚 length terms. As a result, Y Ltd will need to assume it has borrowed 拢100m from X Ltd at 4%, and apply all of the tax rules to this. So in particular it would be necessary to apply the unallowable purpose rule to this arm鈥檚 length provision. Given that the financing is being taken out to fund a tax avoidance scheme it would be expected that the whole of the 拢4m interest expense should be disallowed under the unallowable purpose rules.