Recently announced amendments to compensating adjustments legislation will affect service companies from 25 October 2013.
The Government announced on 17 September 2013 that it would take action against arrangements involving the 'compensating adjustment' rules - part of the transfer pricing code - whereby tax advantages can be secured by individuals extracting profit from connected companies while paying tax only at corporation tax rates. A brief period of technical consultation was announced which has now concluded.
HMRC has announced that legislation changes will take effect from 25 October 2013 and two new pieces of legislation have been introduced relating to the following arrangements:
- Service companies operated by professional firms; and
- Excessive leveraging of companies by individuals.
The current transfer pricing legislation
Transfer pricing legislation concerns the prices charged in transactions between connected parties. Where the actual price differs from the price that would have occurred had that connection not existed, the legislation replaces the actual price with the "arm's length price". Whilst the rules are mainly designed to ensure that the right prices are charged between connected parties on international transactions they also apply to transactions within the UK.
If these rules are used in the UK to adjust prices to increase one party's profit, a claim can be made to reflect the same price for the other party. This adjustment is known as a 'compensating adjustment'. When applied to professional firms and their service companies, the transfer pricing and 'compensating adjustment' rules can increase the profit taxable at corporation tax rates and reduce the income taxable at the higher rate of income tax, but without affecting the cash position of either party.
The changes to the transfer pricing legislation
The main change will prevent persons (other than companies) within the charge to income tax from claiming a compensating adjustment where the counterparty is a company. Therefore, this will apply to partnerships or LLP’s where there is a compensating adjustment between them and their connected service company.
The changes will take effect in relation to amounts or service fees that relate to the period on or after 25 October 2013. This means that any amounts accruing before that time are outside the scope of the new legislation.
For accounting periods which straddle the 25 October 2013 HMRC have indicated that a compensating adjustment will potentially be available for the period up to 25 October 2013. No compensating adjustment will be available after that date and therefore to fall outside the scope of the new measure the service company should re-price its service fees to arm’s length prices with effect from 25 October 2013.
Where a small or medium sized enterprise has elected into the transfer pricing legislation, the same tax treatment will apply. The election for the transfer pricing rules will only apply for the period specified in the election and so the revised tax treatment need not apply for future periods where no election is made.