Standing Committee E
Tuesday 9 June 1998
[Mr. John Butterfill in the Chair]
(Except Clauses 1, 7, 10, 11, 25, 27, 30, 75, 119 and 147)
The Chairman: Before we resume, I want to make it clear that while I am in the Chair it is in order for members of the Committee to remove their jackets. I intend to remove mine because it is much too hot.
Transfer pricing etc: new regime
Amendment proposed [this day]: No. 203, in page 255, line 42, at end insert--
Question again proposed, That the amendment be made.
The Chairman: I remind the Committee that with this we are taking amendment No. 208, in page 256, line 23, at end insert--
"(7) The further condition is satisfied where the potential advantage in 5(1) above is offset in full by any adjustments made by the profits of the disadvantaged person on the making of the claim by virtue of paragraph 6(2) below".
Mr. David Heathcoat-Amory (Wells): Before we stopped for lunch, I was explaining that life insurance companies have expressed alarm at being caught by the schedule. That was unexpected and happened without consultation. We tabled the amendments to reflect that concern. One or two are technically defective and others have misprints. In that way, we are following the example set by the Government who have tabled defective clauses and schedules--indeed, I have just heard that schedule 18 has nine mistakes, which I assume will be corrected by Government amendments. It is not surprising that practitioners outside the House are beginning to say that this is the worst drafted Bill with which they have had to deal.
As the insurance companies have discussed their concerns with the Inland Revenue, the purpose behind the amendments must be clear to the Treasury. It is obvious that we are trying to simplify the operation of the schedule, which deals with transfer pricing, by disapplying it in cases where there is no overall loss to the Revenue and the adjustments cancel each other out. For example, many insurance companies use a separate service company in their group. That company, which employs staff, recharges costs to the main operating company. Some people may see that as suspicious. Indeed, Labour Members, who are suspicious of business matters that they do not understand, may think that a separate service company has something to do with tax avoidance. That is not the case.
Separate service companies are often used for reasons of efficiency. It is usually good business practice to centralise services and then recharge to members of the group. That is good for policyholders and shareholders alike. However, what is perhaps more relevant is that the Insurance Companies Act 1982 does not permit an insurance company to do anything other than provide insurance. The main insurance company cannot provide services to other members of its group, such as a bank or a unit trust manager. The main company fits in with the Government's regulatory requirements by providing services through a separate member of the group.
What catches the eye of those interested in transfer pricing is that service charges do not include a mark-up. The service company could run at a loss or a modest profit, and the insurance company, which is charging for services, could run at an artificial profit. Because the latter incurs a lower effective rate of corporation tax, the overall tax charge on the group could be thought to be lower than intended by Parliament.
The amendment would provide that when the adjustments required under the legislation have no overall effect, they should be disapplied. In the example that I gave, if the profits of the service company were to be increased by requiring a mark-up on its charged-out services and the insurance company's profits were correspondingly reduced, and if the marginal rate of corporation tax in both cases was the same, the increase in one company would cancel the reduction in the other and the Exchequer would be no better and no worse off. The whole paperchase, compliance costs and administrative burden could be avoided if the amendment were accepted and the requirements in the schedule were disapplied. That would be a modest step towards recognising that the provision is a new and unwelcome burden on insurance companies. If the Exchequer will be no worse and no better off, I see no reason why the Government should not accept the amendment this afternoon.
The Paymaster General (Mr. Geoffrey Robinson): As I suggested to Mrs. Dunwoody, who was in your position this morning, Mr. Butterfill, it might be for the convenience of the Committee as this is an important substantive clause if I read some general background information which will be of interest to the amendment before us and other proposed amendments to the schedule. I shall then deal specifically with the matters raised by the right hon. Member for Wells (Mr. Heathcoat-Amory).
Clause 106 and the schedule modernise the United Kingdom's pricing legislation. The Government have two key policy objectives in this area: to bring the transfer pricing regime within self-assessment and to align the UK rules more closely with the internationally agreed formulation of the arm's length principle in the Organisation for Economic Co-operation and Development model tax convention. The clause and its supporting schedule will achieve both aims.
[Mr. Geoffrey Robinson]
The clause represents the fruits of a lengthy consultation process which began under the previous Government. A round of informal consultations was held early in 1996 and following that, further work was done to address concerns identified by taxpayers and representative bodies. That led to the publication in October last year of a consultative document, together with draft clauses. The Revenue then entered into a formal phase of consultations, in the course of which they met with large numbers of taxpayers, tax practitioners and representative bodies. The provision now before the Committee reflects the outcome of those consultations and a number of important changes have been made to respond to concerns raised. I am pleased to report that the Government's willingness to consult on these important proposals was widely welcomed, and the Revenue also found the consultative process very useful.
The new rules will apply for chargeable periods ending on or after the appointed day for corporation tax self-assessment, which we have already announced will be 1 July 1999.
The existing transfer pricing legislation--section 770 of the Income and Corporation Taxes Act 1988--was enacted in 1951. Since then, international trade and commerce have become much more extensive, sophisticated and dynamic. The time has come when we need new transfer pricing legislation which takes these developments into account and will stand us in good stead well into the next century.
The term "transfer pricing" describes the process by which associated persons, principally members of multinational groups of companies, transfer goods, services, finance and intangible assets between one another. There is broad international agreement that, for tax purposes, such transactions should be evaluated in accordance with the arm's length standard. In other words, the profits or losses that are reported in tax returns should be those that would have accrued to the taxpayer had the terms of transactions with associates been the same as those that would have been agreed if the party had been unconnected and dealing independently with one another.
One of the Government's principal objectives is to modernise the UK's domestic transfer pricing rules. Under current legislation, the basic pricing rule is formulated in a narrowly transactional manner, which has become outmoded and which is increasingly unable to cope with the complexities of modern international business. The new rule is aligned as closely as possible with the internationally accepted formulation of the arm's length principle, which is contained in article 9 of the Organisation for Economic Co-operation and Development model and which is therefore fully in tune with international best practice. It is encouraging that that approach received widespread support in consultations, following publication of the draft clauses last October. However, I am aware that concerns have been expressed about the language that was used to achieve that objective, and I want to deal with those concerns.
We appreciate that taxpayers and tax professionals are familiar with the wording of article 9, and that they would have preferred to see it "copied out" into UK law. However, we took the view--on the basis of the advice that we received--that a rule incorporated into UK legislation in the same terms as article 9 of the OECD model might be misunderstood and interpreted more narrowly than was intended. There seemed to us to be a risk that the courts could construe such a proposal as being narrower than article 9 under the OECD model. To meet that difficulty, the basic pricing rule has been drafted in broad terms, although its effect is intended to be the same as that of article 9 under the OECD model.
As a counterbalance to the broad formulation of paragraph (1), paragraph (2) requires that paragraph (1) be construed consistently with the OECD model, which effectively limits the scope of paragraph (1). It cannot be interpreted as being wider than article (9).
In bringing forward those proposals, the Government have adopted a balanced approach, in which an element of deregulation is accompanied by measures that will help to encourage taxpayers to comply voluntarily with their obligations. In that regard, the Government are conscious of the potential costs of complying with the new regime. In framing our proposals, we have sought to keep the burden on taxpayers to the minimum that is necessary to secure a fair and effective regime.
Several measures are directed towards that end. First, the integration of transfer pricing within self-assessment means that taxpayers will no longer have to consider a separate set of management rules for transfer pricing. Secondly, the Government have decided to dispense with specific information powers for transfer pricing and to rely on the general powers that are provided by the Taxes Management Act 1970. Thirdly, the Government have decided not to impose a requirement on taxpayers to disclose information about transfer pricing in a tax return. That contrasts with what happens in some other major industrialised countries, which impose wide-ranging tax return requirements in that regard. Fourthly, the widening of the exemption from the legislation for transactions between two UK taxpayers means that many taxpayers will be unaffected by the new rules. Fifthly, the Revenue will provide guidance on the kinds of records that taxpayers will be expected to keep to meet their record-keeping obligations relating to transfer pricing.
As a matter of principle, we consider it to be fair and reasonable that taxpayers should be required to keep adequate records to support and justify their returns and self-assessments if called on to do so. That is reflected in the record-keeping requirements that are laid on taxpayers in relation to self-assessment.
Broadly, the record-keeping requirements for transfer pricing purposes will be based on the general rules that are provided for self-assessment. The nature of transfer pricing may, in certain circumstances, require taxpayers to keep particular kinds of records. In essence, that means documenting intra-group pricing methodology and the reasons for believing that that produces results that are compatible with the arm's length principle. The Government are satisfied that business will not be over-burdened. The Revenue will not adopt a prescriptive approach in that regard, and it will provide guidance on the broad principles that will be applied.
The Revenue believes that there will be no significant additional costs to taxpayers who already comply with the arm's length standard. Significant tax revenues are at stake. The proposal will help to protect the Exchequer and to maintain fairness in the tax system. Taxpayers who have hitherto not taken the trouble to observe the arm's length principle for tax purposes or who have deliberately manipulated prices should not expect to be shielded from the impact of additional costs to improve compliance standards. The new transfer pricing regime is consistent with the Government's objective of making the tax system as fair and effective as possible. We want to encourage taxpayers to comply voluntarily, and we believe that the vast majority seek to comply. No compliance regime can be effective, however, without a system of penalties to deter and, where necessary, penalise non-compliance.
One side effect of the existing direction mechanism is that penalties cannot be charged in transfer pricing cases. With the integration of transfer pricing into self-assessment, however, the general penalty provisions will apply to transfer pricing as they do to other taxation issues.
In consultations, taxpayers have expressed some concerns, which I also want to address. No automatic or no-fault penalties will be exercised for transfer pricing irregularities. Penalties will be employed only where a loss of tax has arisen from the submission of an incorrect return, statement or declaration attributable to fraud or neglect. Moreover, the onus will be on the Revenue to demonstrate that there has been such fraud or neglect. If a taxpayer has made an honest and reasonable attempt to address further transfer pricing issues, and can demonstrate what action has been taken, penalties will not arise even though a judgment may be required.
Equally, the Government and the Revenue accept that transfer pricing is not an exact science--as the right hon. Member for Wells said--and in most circumstances there will be an acceptable range of outcomes. If the provision made between the parties falls within the acceptable range, there will be no question of penalties. In theory, the maximum penalty is 100 per cent. of the tax loss to the Crown, but the board of the Inland Revenue has discretion to mitigate penalties and routinely does so. In mitigating penalties, the board considers the extent to which the taxpayer has disclosed any irregularities, the degree of cooperation afforded by the taxpayer and the size and gravity of any offence.
The Revenue will publish guidance on how the penalty provisions will be applied in transfer pricing cases, and the imposition of such penalties will be supervised by the Revenue's head office to ensure that the rules are applied fairly and consistently.
I hope that you will agree, Mr. Butterfill, that that is a useful account for the record. It will form the backdrop to our discussion of the various groups of amendments. The right hon. Member for Wells moved his amendment in the most reasonable terms. I should like to address certain points that he raised.
On the question of consultation, we consulted with the Association of British Insurers as soon as we became aware of certain problems--they will be dealt with under the third group of amendments. Although there was not enough time to fully discuss all aspects, I assure the right hon. Gentleman that we were aware of the problems and the Revenue was anxious to consult with the ABI and other representative bodies on them. There was no intention not to consult, although some matters came to attention later than they should have done in such a lengthy period of consultation.
The right hon. Member for Wells referred specifically to the question of life insurance companies having to observe certain regulatory constraints. I want to give him a formal assurance again that the Government recognise that the special regulatory constraints to which life insurance business is subject can dictate the way in which a group's activities are structured and the pricing of intra-group transactions. In such circumstances, the Inland Revenue is prepared to accept that recharging cost is likely to be a normal commercial practice and will not seek to adjust the company's tax liabilities on the basis that normal management services provided by another company should be appraised at more than cost. That is a specific assurance on the point that he raised about a management company dealing with a life insurance company and providing services across the board.
Excluding UK-based companies from the provisions of the transfer pricing arrangements--major deregulation and simplification has already occurred--leaves two areas in which life insurance companies can benefit in a way that would not be extended by the proposed legislation and that would amount to avoidance. They are included in the legislation for two reasons. The first relates to the treatment of a management, insurance or services company and an insurance business. The second concerns the system that allows them to spread management charges forward over seven years for any acquisition. It could be open to them, inadvertently or deliberately, to make the whole of those charges relievable for tax in year one instead of over the seven years.
For both those reasons, we have decided to include life insurance companies in the legislation. The problem addressed by amendments Nos. 203 and 208 does not arise where there is no net tax difference between the two companies in the example given by the right hon. Gentleman. It would be rare for that to occur in life insurance companies. The obligation on one company to levy a charge on another to rectify the situation would involve a small additional compliance cost. The right hon. Gentleman's amendments, which are technically deficient, would impose an additional conditional burden on the industry. A net tax-neutral arrangement between two companies, where the tax arising in one is totally offset by tax relief in the other, would be so unusual that we see no need for the amendments. If that were to occur, the compliance cost would be so small that the matter does not need to be addressed.
[Mr. Geoffrey Robinson]
I am pleased to say that more recent discussions with the ABI and other representatives bodies have led us to look more favourably on other amendments. I look forward to hearing the Opposition's self-satisfaction when we reach them. I hope that my response has been sufficient.