Budget transfer of profits proposals: the lunatics appear to be taking over the asylum

Part of the Budget papers included a paper headed “Guidance on avoidance schemes involving the transfer of corporate profits” – at first glance, it looked like guidance on the total return swap scheme that was blocked in December 2013. But … it goes a bit further.

In fact, the paper says that the “Government considers that it is not acceptable for groups to move profits around the group in this way to avoid UK tax. The measure aims to prevent this by providing that where there is a payment in substance of the profits of a company to another company in the same group, directly or indirectly, then the former company will be assessed as though the transfer had not taken place.”

Well, ok as a principle. Still, we have transfer pricing rules, controlled foreign companies rules and all the rest of it, which apparently aren’t enough. The proposals say that if profits go from company A to group company B, then company A won’t get a tax deduction for the “profit transfer” – the payment to company B (all of it, not just any excess over commercial arm’s length amounts). It is supposedly limited to situations where “all or a significant part of the profits” of the business of company A are transferred – but what if company A is in a start-up phase, and paying royalties to a parent company? That might well involve a significant part of the profits in early years.

One of the main purposes of the arrangements has to be to secure a tax advantage for any person – is compliance with transfer pricing rules a tax advantage? The definition of tax advantage isn’t restricted to UK taxes, or UK tax compliance (a tax advantage can include avoiding a possible assessment to tax – such as that which is possible where transfer pricing rules aren’t applied. It’s a bit of an extreme interpretation, but it’s arguably within the definition in s1139 CTA 2009).

So, a UK company pays arm’s length royalties to its US parent because the IRS will otherwise assess the US parent to tax on the benefit provided to the UK company; the UK company business is at an early stage, and the payment is most (or even all) of the profit. Under these rules, HMRC could try and deny the deduction for the royalties, it seems …

That’s ridiculous.

More ridiculous, there’s no requirement that the payment be cross-border, so you could get the payment denied where it’s between two UK companies (yes, this is an extreme interpretation of the law … but if it can be so interpreted then it might be so interpreted).

The guidance does say that the “clause will deny tax deductions for amounts that in substance represent distributions of the profits of the company, because in substance they are paid after profits have been earned rather than being deductions incurred in the making of profits. By contrast, payments incurred in earning the profits do not result in a profit transfer since these expenses need to be deducted in determining what the profits are.”

But that’s not what the legislation says; it denies deduction for an entire payment, not the profit transfer element, and there’s nothing in there to say that it doesn’t apply to payments made to earn profits. The legislation needs a proper definition of “profits transfer” if it’s supposed to work this way – at the moment, royalties incurred in earning profits could still be denied a deduction.

Taxed by law, untaxed by guidance is not appropriate – in these or any circumstances.

(PS: I’d be delighted to be told I’m wrong. I think I’m just taking a slightly extreme view of the legislation, but not a wholly incorrect one).

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