Tax change may impose penal tax charge on transactions between a company and its shareholders

HM Treasury gave more detail of the change affecting non-arm’s length transactions between a company and its controlling shareholders. When the company suffers a disallowance on a non-arm’s length transaction with its shareholders under the transfer pricing provisions the shareholders can exclude an amount equal to the disallowance from their taxable income. This category of so called “compensating adjustments” will cease to exist. 

Compensating adjustments are an important feature of the transfer pricing rules. They are needed to prevent double taxation.  Take a simple example. Suppose one company in a group sells its product to another at a price below the price it would sell these same goods to an unconnected company. For tax purposes the selling company’s taxable profits will be calculated as if it had sold the goods at market price. The accounting profit in the purchasing company will be based on the low price it paid. So that the group does not pay tax on more than the actual profit it makes the buying company claims to reduce its taxable profits by the same amount.

In the company to company scenario there is usually no overall increase or reduction in the amount of tax – merely shifting the tax bill from one company to another unless losses are involved. However if a company charges less than a market rate to its shareholders (or if the shareholders charge the company too high a price) then the overall tax bill will be reduced because of the difference in tax rates between individuals and companies. The company will pay more tax at corporation tax rates (which is 23% at the moment and due to fall to 20%) whereas the individuals’ tax and NI saving can be as much as 47%. 

The change will deny individuals income tax relief on all affected transactions from a date yet to be announced, but which could be as soon as this autumn. The technical note refers specifically to two scenarios which will be targeted:

• Excessive interest received by individuals on loans to highly leveraged companies; and
• Service companies used by partnerships.

Why will the tax cost be higher than expected?

The Government’s examples tell us that the tax benefit they want to counteract is the difference between the corporate and income tax rates – which is approximately 25%. The Treasury say the company will pay more tax at approximately 20% but the compensating adjustment gives the individuals tax free income that would otherwise be taxed on them at 45%. Whilst this is indeed the current benefit, the change proposed does not simply negate that benefit. Rather the change is to prevent the individual from claiming the compensating adjustment whilst the company will continue to suffer an upwards adjustment to its profits. The net result if these changes go ahead as proposed is a one sided adjustment.

The Treasury give an example of a £15m adjustment which they say achieves a net reduction in tax payments of £3.75m. As proposed the change will not merely eliminate this saving. In the circumstances of this example, after the change there will be a net tax cost of £3m: the company will still suffer a stand alone adjustment increasing its tax bill by £3m.

In our view this implication of this change may not been fully considered or the Government want to impose a penal tax charge on companies transacting with their shareholders in this way. 

If you have a structure that uses the transfer pricing rules to gain an advantage we recommend you review it now. Depending on the actual detail of how this change is effected, you may have to alter the terms of, or possibly unwind, the structure before these changes become law.

Transactions between companies will be unaffected by this change.