OTR70015 - Orchestra Tax Relief: calculation: qualifying expenditure and transactions with connected parties
An additional deduction can only be claimed on core expenditure that is qualifying expenditure. Expenditure qualifies if it is part of the separate trade and is not excluded expenditure. Excluded expenditure is expenditure on research and development and expenditure that represents connected party profit (unless the arm’s length exception applies).
Expenditure on research and development
Expenditure that could qualify for any of the R&D tax reliefs is excluded expenditure for the purposes of Orchestra Tax Relief (OTR). The R&D tax reliefs include R&D expenditure credits, SME tax credits, and the newer merged scheme and credits for R&D-intensive SMEs.
For the purposes of this rule, it does not matter whether the production company actually makes a claim to R&D relief in respect of the expenditure. As long as the expenditure could be subject to an R&D claim, i.e. it meets the qualifying criteria of one of the R&D reliefs, it is excluded expenditure for the purposes of OTR.
Guidance on the R&D reliefs can be found at CIRD80000.
Connected party profit
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 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
An orchestra production company (Company A) uses Company B for venue management services during its latest concert series. Both companies are subsidiaries of the same parent company, so they are connected parties.
Company B incurs expenditure of £40,000 in carrying out its management services. It charges Company A £60,000. The connected party profit is therefore £20,000 – the amount by which the payment by Company A exceeds the costs incurred by Company B.
‘Connected’
‘Connected’ has the meaning given by section 1122 of the Corporation Tax Act (CTA) 2010. Broadly:
A company is connected with another company if:
the same person has control of both, or a person (person A) has control of one and persons connected with person A, or person A and persons connected with person A, have control of the other; or
a group of two or more persons has control of each company, and the groups either consist of the same persons or could be regarded as consisting of the same persons by treating (in one or more cases) a member of either group as replaced by a person (person A) with whom person A is connected.
A company is connected with another person if that person (person A) has control of it or if person A and persons connected with Person A together have control of it.
Any two or more persons acting together to secure or exercise control of a company are treated in relation to that company as connected with one another and with any person acting on the directions of any of them to secure or exercise control of the company.
A person is connected with:
an individual if that person is the individual’s spouse or civil partner, or is a relative, or the spouse or civil partner of a relative, of the individual or of the individual’s spouse or civil partner
any person (person A) with whom person A is in partnership, and with the spouse or civil partner or relative of any individual with whom person A is in partnership
It is also possible to be connected via settlements and trusts – see section 1122(6) CTA 2010.
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 an orchestra production company and Company B is a company which owns a concert venue. Company A and Company B are connected. Company B charges fees to both Company A and unconnected third parties for holding performances in the venue.
If the amount paid to hire the venue by Company A is at a similar rate to the amount paid by a third party for a comparable hire period, 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 freelance musicians 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 OTR 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 OTR 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 OTR, 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, orchestra production Company A hires supplementary instrumentalists from a subsidiary, Company B. Company B charges Company A £100,000. Company B does not employ the instrumentalists 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 instrumentalists, 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 about venue management services. Company A paid Company B £60,000, of which £20,000 was connected party profit. Assuming the £60,000 incurred by Company A was not an arm’s length price, the £20,000 connected party profit is excluded expenditure which is ineligible for relief. However, the remaining £40,000 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 (OTR20030) 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, and
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 2 of this manual.