INTM610100 - Profit Fragmentation Arrangements: Arm’s Length Transfer
Paragraph 2(1)(c) Schedule 4 Finance Act 2019 says that arrangements are Profit Fragmentation arrangements if the value transferred is greater than it would have been if it had resulted from provision made or imposed as between independent parties acting at an arm’s length.
The principle of “arm’s length” is the same in general terms to that used in the transfer pricing legislation (S147 TIOPA 2010), albeit that Profit Fragmentation legislation does not give statutory effect to the OECD transfer pricing guidelines. More guidance on transfer pricing principles generally can be found in HMRC’s International Manual at INTM410000.
This condition seeks to determine whether the transfer of value would have taken place between independent parties acting at arm’s length, or whether either no transfer of value or a lesser transfer of value would have taken place. If the transfer of value takes place at a price and on terms that reflect those that would be agreed between independent parties acting at arm’s length then the arrangements will not be Profit Fragmentation Arrangements and the Profit Fragmentation legislation will not apply.
The Profit Fragmentation rules can apply in circumstances when the parties are not connected within the usual definitions covered in the transfer pricing rules. The use of the additional ‘independent parties’ wording, makes it explicit that this rule cannot be avoided by arguing that because there is no formal connection between two parties, anything they do is at an arm’s length.
Example 10 – Arm’s Length Value – Reduction of Income Received
This example illustrates what is meant by a transfer of value being greater than it would have been if made between parties acting at arm’s length in the context where the resident party reduces the amount of income they take into account. As with other examples in this guidance, it is likely that accounting principles, other legislation or case law would ensure the appropriate amount of profits are charged to UK tax: the following example illustrates how Profit Fragmentation rules would apply if that were not the case.
C Ltd. is a UK-resident company which provides consultancy services to UK and non-UK clients out of its offices in London. O Ltd. is an offshore company that provides limited ancillary services to consulting businesses. C Ltd. makes arrangements with O Ltd. whereby O Ltd. will provide limited ancillary services to C Ltd. if C Ltd. agrees to have its non-UK clients make payments in return for the services C Ltd. provides as follows:
- 20% to C Ltd., and
- 80% to O Ltd.
C Ltd. provides services with a value of £1m to a non-UK client. In line with the above agreement, in return for these services the non-UK client pays £200,000 to C Ltd and £800,000 to O Ltd.
C Ltd. has not made any direct payments out of the UK but there has been a transfer of value out of the UK. This is because C Ltd. has provided services with a value of £1m and only received £200,000 – this means there has been a transfer of £800,000 of value out of the UK. The services provided by O Ltd. do not warrant such an inflated return.
A provision has been made between C Ltd. and O Ltd. for these arrangements to take place. Had this provision been made or imposed between independent parties acting at arm’s length then O Ltd. would have received nothing. The value paid from the non-UK client to C Ltd. would have been the value of the services provided – so £1m. This means that there would be no transfer of value out of the UK as the amount paid into the UK (£1m) would be equivalent to the value of the services provided out of the UK (£1m).
In these circumstances the value transferred out of the UK (£800,000) clearly exceeds the value that would have been transferred out of the UK had the provisions been made or imposed between independent parties acting at arm’s length (£0). In these circumstances paragraph 2(1)(c) would be applicable.
Example 11 – Arm’s Length Value – Inflation of Expenses Paid
This example illustrates what is meant by a transfer of value taking place at greater than it would have been if made between parties acting at arm’s length where excess expenses are paid by the resident party. As with other examples in this guidance, it is likely that accounting principles, other legislation or case law would ensure the appropriate amount of profits are charged to UK tax: the following example illustrates how Profit Fragmentation rules would apply if that were not the case.
C Ltd. is a UK resident company which provides consultancy services out of its offices in London. C Ltd. carries out all its IT support functions in-house but makes a payment of £50,000 per year to O Ltd., an offshore company which provides limited services, which it describes as IT costs.
C Ltd. has made a payment of £50,000 to an overseas party but has received limited services, which for the purpose of this example have a value of £5,000, in return. This means there has been a transfer of £45,000 of value out of the UK.
Had the provision been made or imposed between independent parties acting at arm’s length the value paid from C Ltd. to O Ltd. would have been the arm’s length amount which in this case would be £5,000 as O Ltd. has only performed limited services. This means that there would be no transfer of value out of the UK as the amount paid out of the UK (£5,000) would be equivalent in value to the value of the services provided in to the UK (£5,000).
In these circumstances the value transferred out of the UK clearly exceeds the value that would have been transferred out of the UK had the provisions been made or imposed between independent parties acting at arm’s length. In these circumstances paragraph 2(1)(c) would be applicable.
Self-Assessing an Arm’s Length Transfer
If all of the other conditions are met and neither of the Exception Conditions is satisfied (as described at INTM610140) businesses will need to determine whether the transfer of value that takes place is at a value that would have resulted from a provision made or imposed as between independent parties acting at arm’s length.
Customers should prepare and retain such documentation as is reasonable and proportionate given the nature, size and complexity (or otherwise) of their business or of the relevant transaction (or series of transactions). Evidence to demonstrate an “arm’s length” result would need to be made available to HMRC in response to a legitimate and reasonable request in relation to the customer’s tax return.
Further guidance on record keeping for transfer pricing purposes can be found in HMRC’s International Manual at INTM483030.