Policy paper

Taxing multinationals: how international transfer pricing rules work

Updated 1 March 2016

1. Transfer pricing rules

A significant proportion of global trade is made up of transactions between companies that are part of the same multinational group. The multinational group has to set the prices of these internal transactions – known as the ‘transfer price’ – in line with international tax rules, which determine how much profit is taxed in each country. This briefing explains how these complex transfer pricing rules are operated by HMRC to ensure the UK gets the tax it is due.

2. Why transfer pricing rules are important

The transfer pricing rules allocate profits to individual companies within a multinational group to which determine how much of the total profits are taxed in each country.

For example, the UK parent company of a multinational manufacturing business with operations around the world might charge its overseas subsidiaries for a range of goods and services that it provides to them, such as:

• manufactured goods
• the right to use its patents and trademarks
• business services, such as technical expertise, marketing or IT
• providing finance

3. How transfer pricing rules work internationally and in the UK

The UK’s transfer pricing rules are based on an agreed international standard developed by the Organisation for Economic Co-operation and Development (OECD). This standard has also been adopted by many other countries, including most of our major trading partners. Transfer pricing rules, far from being a recent development, have been a feature of tax systems worldwide for many decades.

The rules require multinationals to calculate their taxable profit as if transactions between companies within the group were carried out at the prices that would be charged between two entirely independent companies (known as the arm’s length price). Under these rules, a company’s taxable profit is based on a combination of:

• the activities and functions it performs (for example manufacturing, distribution, research and development)
• the assets it holds (including tangible assets such as plant machinery and intangible assets such as patents and trademarks)
• the business risks it bears

When tax administrations take different views on how the rules should apply, part of a multinational’s profits can be taxed in both countries (this is known as double taxation). The rules also enable HMRC to resolve disputes by working with other tax administrations to ensure that UK business can trade internationally without suffering double taxation, as well as agreeing how much of the profits are taxed here.

4. How multinationals manage the tax they pay

Multinationals have considerable freedom to establish business operations wherever they choose and will take a number of commercial factors into account when deciding where to locate, which may include the local tax regime.

Multinationals can reduce the amount of tax they pay if they genuinely locate economic activities in countries with low tax rates. The transfer pricing rules will determine the profits that should be allocated to those countries, which are then taxed at the tax rate charged by that country.

HMRC can, and does, challenge transfer pricing arrangements (and other forms of international tax planning) where they do not recognise profits correctly attributable to the economic activity in the UK, in accordance with the rules. This work has resulted in the collection of billions of pounds of tax that would otherwise have been lost.

5. The UK’s interaction with the OECD

The OECD is constantly updating its rules to ensure that they continue to apply effectively to current business models and to counteract circumstances where they could be abused.

The UK took a leading role in the recent Base Erosion and Profit Shifting (BEPS) project which involved countries from across the globe working together to update the international tax system.

The OECD’s final report was published in October 2015. The report provides actions for greater transparency, tackling treaty abuse, tackling excessive debt, and changes to the transfer pricing guidelines.

The BEPS project is not yet complete and there is more work on updating the guidelines.

6. The Diverted Profits Tax

In the Autumn Statement of 2014, the government announced the introduction of the Diverted Profits Tax (DPT), designed to counter aggressive tax planning by some multinationals to divert profits from the UK.

The DPT is an important new tool being used to counter profit shifting. Targeted specifically at those companies that arrange their affairs to avoid having a UK permanent establishment, or else divert profits into companies with little economic substance, it is one of our many tools used to tackle international tax risk.

The DPT aims to change the behaviour of multinationals and we are starting to see that change.

7. To find out more

Read our guidance Transfer pricing: transactions between connected companies.