CREC052000 - Eligible expenditure: connected party transactions
Section 1179DU and section 1179FM Corporation Tax Act (CTA) 2009
If a production company incurs expenditure on a transaction with a connected party, that expenditure is excluded up to the amount of the connected party profit, unless the transaction is priced as if it was at arm’s length.
Connected party profit
Connected party profit exists where a payment has been made to a connected party (“C”) in exchange for supplying goods and/or services, and the payment exceeds the expenditure that has been incurred by C in making that supply.
Example
SM Films Ltd is a film production company that hires SM VFX Ltd to carry out the visual effects work on its latest film. SM VFX Ltd is a subsidiary of SM Films Ltd.
SM VFX Ltd incurs expenditure of £2 million in carrying out the visual effects work. It charges SM Films Ltd £5 million. The connected party profit is therefore £3 million – the amount by which the payment by SM Films Ltd exceeds the costs incurred by SM VFX Ltd.
End of example
‘Connected’ has the meaning given by s1122 CTA 2010. It is generally when two entities are under the same ultimate ownership, or when one entity controls another. Full guidance is available at CREC052100.
At arm’s length
A transaction is entered into as if it was at arm’s length if it makes ‘the arm’s length provision’, which has the same meaning as in Part 4 TIOPA 2010 (INTM412010). This essentially means that the payment made as part of a transaction must be set as if the connected parties were unconnected. If the connected party were an independent third party, what would they have charged for the goods or services supplied?
The payment that would be made as part of an arm’s length provision can include a mark-up or an element of connected party profit, but the company must be able to justify this amount as one that would be charged between independent parties.
The easiest way for a company to justify an amount is to provide evidence of similar amounts paid in comparable transactions between independent parties.
Example
Company A is a production company and Company B is a company which owns studio space for shooting films and TV programmes. Company A and Company B are connected. Company B rents the studio space out to both Company A and unconnected third parties.
If the amount paid to rent the studio by Company A is at a similar rate to the amount paid by a third party and Company A can provide evidence of this, then any profit element to the transaction would be justified, and the expenditure would not be restricted.
End of example
A production company may also be able to justify a profit margin or mark-up by reference to an industry standard. For example, if there were a standard profit margin charged by most sound mixing companies in the industry, a production company would be able to justify paying the same or a similar profit margin to a connected party for that service.
A full transfer pricing analysis is useful evidence, but it is not a requirement.
Although the arm’s length provision has the same meaning as in the transfer pricing legislation, Part 4 TIOPA 2010, companies claiming Audio-Visual or Video Games Expenditure Credits (AVEC/VGEC) which are not otherwise within the scope of the transfer pricing legislation do not have to meet its other requirements. For example, a small company which applies the arm’s length principle to its connected party transactions for the purposes of AVEC/VGEC will still fall within the exemption from transfer pricing for small and medium-sized enterprises in section 166 TIOPA 2010.
Reasonable amounts
Different transfer pricing methods can give different arm’s length values. As long as the method used is reasonable, the arm’s length exception applies and no expenditure is excluded.
It is possible that, as part of a transfer pricing enquiry, HMRC may impose a transfer pricing adjustment on a connected party transaction while also accepting that the original provision was charged at a reasonable value. If the adjustment covers expenditure on which the production company has claimed AVEC/VGEC, the company should amend its claim to reflect the value agreed with HMRC. Assuming the new value is lower than the original, the company will only lose entitlement to credit on the difference between the two amounts, not the entire connected party profit.
However, if HMRC makes a transfer pricing adjustment and does not accept that the original payment reflected the arm’s length provision, then the arm’s length exception is deemed to no longer apply and the connected party profit is excluded in full.
Series of transactions
If a company pays a connected party for a supply using a series of transactions, the effect of the legislation is to look through the series of transactions to the original supplier, and use the original supplier’s cost to calculate connected party profit.
For example, film production Company A hires sound crew from a subsidiary, Company B. Company B charges Company A £100,000. Company B does not employ the sound crew directly, but hires them from its own subsidiary, Company C. Company C charges Company B £80,000. It costs Company C £60,000 to supply the crew, in wages and other expenses.
The connected party profit is £40,000: the difference between the £100,000 Company A paid and the £60,000 cost to the original supplier, Company C. The amount paid by Company B is ignored.
This rule applies no matter how long the series of transactions is.
It also applies even if some of the parties in the sequence are unconnected, provided the company claiming relief is connected to at least one party in the series and each transaction in the series forms part of the same scheme or arrangement.
For example, in the scenario above, the rule would still apply if:
Company A was connected to Company B but not Company C
Company A was connected to Company C but not Company B
The arm’s length exception only applies to a series of transactions if the value of each individual transaction in the series is set as if the parties involved were at arm’s length.
Amount of excluded expenditure if arm’s length exception does not apply
If the arm’s length exception does not apply, only the connected party profit amount is excluded expenditure, not the whole amount of the transaction.
Consider the earlier example of SM Films Ltd. Assuming the £5 million incurred by SM Films Ltd was not an arm’s length price, the £3 million connected party profit is excluded expenditure which is ineligible for relief. However, the remaining £2 million is not excluded expenditure and is eligible for relief (assuming it meets the other qualifying criteria).
Disclosure
Expenditure on connected party transactions is only allowable as qualifying expenditure if the transactions are disclosed to HMRC. The disclosure must be made in the additional information form (CREC081000) covering the period in which the expenditure has been brought into account as a debit.
If a transaction is not disclosed, expenditure incurred on that transaction will not count towards an expenditure credit.
Using the additional information form, companies must:
declare whether their claim includes any expenditure on transactions with connected parties, i.e. is any amount paid or owed to a connected party included in qualifying expenditure for the period
provide the number of connected parties it has transacted with in transactions included in the claim
provide the combined value of those transactions
Companies must also upload a document containing details of all connected party transactions included in their claim. Details must include:
The name of the connected party
The date of the transaction
The value of the transaction, as included in the claim (so either the arm’s length cost or the cost to the supplier)
A description of the goods and/or services provided
There is more detail about the requirements in Chapter 8 of this manual.