Following recent cases in the US, companies in the UK should expect investigations into their transfer pricing strategies by the taxman, says Thayne Forbes 

Legal agreements, reports and documents justifying a company's tax related decisions, customer contracts and customers' compliance can now count for nothing in defence against irregular transfer pricing accusations from the tax authorities. The Inland Revenue enquiries are becoming more and more innovative and commercial and are based on good analysis and understanding of complex business arrangements, particularly involving IP. It is therefore becoming much more risky for accountants in industry just to rely on a file supporting transfer pricing strategies, without too much thought to the commercial substance behind. It is now much more advisable to have these strategies fully thought through and commercially benchmarked and backed up. Otherwise there could be a big and surprising tax bill coming, as the following examples illustrate.

UPS, the shipping company, incurred a large tax liability arising from transfer pricing for its brand. This originally arose because its standard terms and conditions for parcel deliveries limited liability for loss and damage to 0 for each item. However, UPS also offered customers optional insurance giving increased cover. The relatively high profits from this insurance were remitted to Bermuda, a low tax jurisdiction. Even though the amounts for this insurance were separately agreed with customers, the US tax authorities (IRS) mounted a transfer pricing challenge. This was on the basis that the sale of the insurance was made because of the original sale of delivery services under the UPS brand. So the brand drove the sale of the insurance, but there was no charge for the use of the brand from Bermuda to the US.

Goods and services are often bundled in the market at prices which would not necessarily be at arms length for the individual components. A common reason is that a purchase decision is often made on a lead item, in this case parcel delivery. By the time extra cover for loss or damage is being considered the decision has been made and the customer will be less inclined to look for alternatives. So the price of the additional cover will be higher. There are lots of other examples of this in the marketplace, for example warranties sold with electrical appliances, and they are often referred to as bundling. Based on transaction prices the additional products or services would be much more profitable then the lead (loss leader) product. Another way of rationalising this would be to say that the loss leader's brand drives the sale of the whole bundle and if separated there should then be a royalty to the brand for its contribution to the sale. A complex detailed argument, but as a result UPS faced a tax liability of billions of dollars.

GlaxoSmithKline, the pharmaceutical company, incurred a significant liability in respect of the ownership of its IP. Because of the importance of FDA approval to the commercial success of a drug, GSK would normally bring out its new drug's in the US first. Also and most critically the significant expenditure to undertake the rigorous research over many years to prove a drugs worth was expensed in the US subsidiary. Much of the IP supporting these drugs was owned by non US GSK companies. The challenge made by the US tax authorities included the position that the process of FDA drug approval was a significant contributor to the intangible value of the drug and as this expense was attributed to US companies the transfer pricing mechanism should reflect this situation. The IRS' claim was that it did not and profits were being transferred at non-arms length prices. This was despite legal ownership of the IP not being in the US and the funding of drug development also being made by GSK companies outside the US. This meant that despite registered patents and trademarks being located in the UK this did not mean GSK could charge a full transfer price into the US. A very hard line, but it contributed to GSK paying >.4bn.

So companies and their accountants which are not analysing carefully their deployment of IP could have significant exposure. Given the importance of IP as a commercial asset, many leading edge companies isolate and focus on developing their IP. This gives many commercial benefits and from there a reduced exposure to the huge IP transfer pricing bill should follow. As in many situations, focussing on the commercial substance should reduce unforeseen tax bills.