INTM432112 - Schedule 28AA: how it works - Exemptions: small and medium sized enterprises

Election to remain subject to transfer pricing rules

The definition of small and medium enterprises 

Linked Enterprises

Partnership enterprises

Third party business creation investment

Simplification

For the calculation of profits arising on or after 1 April 2004, there is an exemption from transfer pricing rules for the vast majority of transactions carried out by a business that is a small or medium sized enterprise.

The term small and medium sized enterprise is defined using the European recommendation (2003/361/EC). This definition is discussed further below. It broadly applies an employee headcount ceiling and a financial ceiling to an enterprise or, where the enterprise is part of a group or association, to that group.

The exemption does not apply where a business has transactions with or provisions which include a related business in a territory with which the UK does not have a double tax treaty with an appropriate non-discrimination article. Such transactions remain subject to transfer pricing rules.

An appropriate non-discrimination article is one that ensures the nationals of a contracting state may not be less favourably treated in the other contracting state than nationals of that latter state in the same circumstances (in particular with respect to residence). HM Revenue & Customs regards the following double taxation treaties as containing an appropriate non discrimination article as at 1^s t April 2008 (except where stated otherwise).

The Treasury has the power to make regulations adding to the list of territories that qualify even if the double taxation treaty in question does not contain an appropriate non-discrimination article, or to exclude territories even if the treaty in question does contain such an article.

Election to remain subject to transfer pricing rules

There may be occasions where a business wishes to apply transfer pricing rules even though it would qualify for exemption. A business can elect that the exemption will not apply. An election can be made for a specified chargeable period and will cover all transactions or provisions made in that period. It will be irrevocable.

There are no supplementary pages to a tax return which relate to transfer pricing; businesses make computational adjustments in their returns in cases where transactions as recorded in their accounts are not at arm’s length. A business wishing to make an election to remain subject to transfer pricing rules should do so as part of its computation of taxable income in its return.

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The definition of small and medium enterprises

The European Commission published a revised recommendation on 6 May 2003 concerning the definition of micro, small and medium sized enterprises (2003/361/EC). This and a related User Guide are available on the EU website 

The definition applies to any entity engaged in an economic activity, irrespective of its legal form and includes entities subject to IT as well as CT.

An entity qualifies as either small or medium if it meets the staff headcount ceiling for that class and one (or both) of the financial limits as set out in the following table (referred to as the qualification data in these notes). Where the entity is a member of a group, or has an associated entity, these limits apply to the whole group and not the specific entity.

Staff includes employees, persons seconded to work for a business, owner managers and partners. Where staff do not work full time during the year they should be counted as an appropriate fraction.

The measures of turnover and balance sheet total are net of VAT and otherwise have their ordinary meaning for accounting purposes. In particular, balance sheet total means total assets (eg as defined by CA85/S247) and should not be taken as net of any liabilities. The recitals to the EU recommendation make it clear that the use of a balance sheet threshold is required to identify the economic position of an enterprise using a measure for its relative size or wealth. It would make a nonsense of this approach to allow assets to be reduced by liabilities not available to all companies. Conversion to sterling should be made at the average exchange rate for the period of account whose profit is being computed or the exchange rate on the date the account was drawn up if this produces a fairer result. As with any of the thresholds, companies close to the limit should not rely on changes to the exchange rate but should plan in advance to meet the requirements (if any) which changing designation requires.

The Commission recommendation recognises that in two situations the staff and financial data of connected and associated enterprises must be included with that of the enterprise seeking exemption. It refers to these as:

• linked enterprises

• partnership enterprises.

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Linked Enterprises

A linked enterprise is an enterprise which has the right to control the affairs of the enterprise seeking exemption. This control can be either direct or indirect and take many forms including shareholding, voting rights and contractual rights. As with many control tests, it will be possible for more than one enterprise or group of enterprises to control another at any one time. ‘Linked enterprises’ are enterprises which have any of the following relationships with each other:

• an enterprise has a majority of the shareholders' or members' voting rights in another enterprise;
• an enterprise has the right to appoint or remove a majority of the members of the administrative, management or supervisory body of another enterprise;
• an enterprise has the right to exercise a dominant influence over another enterprise pursuant to a contract entered into with that enterprise or to a provision in its memorandum or articles of association;
• an enterprise, which is a shareholder in or member of another enterprise, controls alone, pursuant to an agreement with other shareholders in or members of that enterprise, a majority of shareholders' or members' voting rights in that enterprise.

For the purposes of calculating the data for an enterprise, all data for any second enterprise that is linked to an enterprise must be aggregated as well as all the data for any linked enterprises or partnership enterprises of that second enterprise. All the staff, turnover and balance sheet entries must be taken into account regardless of the extent to which control is effected: the aggregation will be the same under 51% control as it would be under 100% control. For groups of companies this will have the effect of aggregating all data.

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Partnership enterprises

Enterprises will be counted as partnership enterprises where one of them holds 25% or more of the capital or voting rights of the other but they are not linked enterprises. However where linked enterprises jointly hold rights these must be aggregated to see if the 25% threshold has been passed. This definition will include partnership enterprises in which an enterprise has invested as well as those which invest in it. The Commission recommendation does not separately define capital or voting rights. However as noted in paragraph [13] above these should be interpreted widely.

If an enterprise has partnership enterprises, a proportion of the data from those enterprises must be aggregated with those of the enterprise when considering the qualifying data. The data to be aggregated will be proportional to the percentage interest giving rise to the partnership relationship. However if those partnership enterprises have their own linked or partnership enterprises, the data from those enterprises must be aggregated first before applying the percentage holding.

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Third party business creation investment

There are certain categories of investor who provide a positive role in business creation. The Commission recommendation recognises that there will be limited circumstances where an interest in a small enterprise should not result in the loss of its small or medium sized status. It identifies four groups which seek to make longer term returns (if any) from their non controlling investments in smaller businesses:

public investment corporations, venture capital companies, individuals or groups of individuals with a regular venture capital investment activity who invest equity capital in unquoted businesses (‘business angels’), provided the total investment of those business angels in the same enterprise is less than EUR 1,250,000;

• universities or non-profit research centres;
• institutional investors, including regional development funds;
• autonomous local authorities with an annual budget of less than EUR 10 million and fewer than 5 000 inhabitants.

These groups are the only prescribed circumstances where ownership by a public body will not result in the loss of small or medium enterprise status.

These investment enterprises do not have to be taken into account as partnership enterprises. Additionally these enterprises will not constitute linked enterprises solely by reason of their ability to exercise a dominant influence by virtue of the terms of their investment, provided that they do not involve themselves directly or indirectly in the management of the enterprise. This treatment does not extend to cases where the investment enterprise is linked to the enterprises in which it had invested under the other tests detailed in paragraph [13] above.

The recommendation does not provide additional definitions for these classes of investor. It is, however, necessary for there to be an investment business which regularly makes such investments in enterprises that would not otherwise be linked or partnership enterprises. A holding company or individual that seeks to make a return through controlled subsidiaries will not qualify.

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Simplification

There are two instances where additional rules have been provided to assist clarification of the recommendation. Firstly the definition of linked enterprise could result in a small or medium enterprise loosing its qualifying status when it goes into liquidation or administration. To remove this uncertainty the new rules make it clear that rights in the capacity as liquidator or administrator should not be taken into account when looking at partnership of linked enterprises. These rights would not extend to situations where arrangements with the official in question extend beyond that which is normal for the practice of their office.

Secondly the Commission recommendation provides a complex test for SME status which requires consideration to made of more than one year before historical status can be altered. This test has been simplified. Qualification as an SME will be determined solely by reference to the period for which a return is being made.