Transfer-pricing and employee share plans: Working Draft of Guidance for accounting periods beginning after 31 st December 2004

Transcription

1 Transfer-pricing and employee share plans: Working Draft of Guidance for accounting periods beginning after 31 st December 2004 I attach a working draft of revised guidance on the application of transfer pricing rules to the intra-group provision of share plans. A number of stakeholder groups and individual stakeholders have asked to have the opportunity to comment before a draft is firmed up for release as guidance to taxpayers, and at this stage the draft is being circulated solely for purpose of obtaining feedback to inform work on the draft. Taxpayers should not place any reliance on the draft at this stage, as it is subject to change in the light of comments received. While recipients are free to pass this draft onto others who may also want to have the opportunity of seeing or commenting on it, recipients are asked to make the current status of the draft clear to anyone else it is sent to. I should be grateful if you could let me have any comments by 24 June Our intention is to publish a revised version of the guidance on the HMRC web site for the general information of taxpayers as soon as possible after that, subject to any work required in the light of comments received. Please feel free to telephone me to discuss the draft. Peter Faherty International Business Tax Group, HMRC Peter.Fahety@hmrc.gsi.gov.uk Tel:

2 Transfer-pricing and employee share plans: Working Draft of Guidance for accounting periods beginning after 31 st December This guidance explains how transfer-pricing rules apply to the intragroup provision of employee share plans. It also considers the implications of Financial Reporting Standard 20 (FRS20) and Schedule 23 of Finance Act 2003 (corporation tax deductions for the cost of employee share schemes). For accounting periods starting on or after 1 January 2005, it replaces all previous guidance on the application of transfer pricing rules to employee share plans. (This new guidance is not applicable for earlier accounting periods.) 2. There are some changes from earlier guidance. For example, previous guidance distinguished between plans using solely newly issued shares and other plans, while this guidance does not. Where employee share plans involve share options this new guidance no longer allows intra-group transfer prices to be based on the costs of borrowing to hedge the options, and any actual or imputed payment for the options will constitute a cost of providing shares for the purposes of FA03/Sch The changes have been made to take account of developments since earlier guidance was originally prepared, including the introduction of FRS20 and dialogue with stakeholders. Earlier guidance can still be applied in respect to accounting periods starting on or before 31 December 2004, but not for accounting periods starting after then. Contents (all as links) Overview: a typical scenario Overview: Why transfer-pricing issues arise Overview: Summary of treatment of equity settled transactions from 1/1/05 Accountancy background: Changes from 1 Jan 2005 Background: Transfer-pricing Understanding the Transaction, the arms length bargain and methodology The Provider s tax position The Employer s tax position Transfer-pricing background: Employer - Corresponding adjustments Other situations: Cash settled transactions 2

3 Employee Benefit Trusts Examples FAQs Overview: a typical scenario 4. An employee share incentive plan can take a number of different forms, including shares, share options, and phantoms (cash payments based on the rise in share prices over a period). The term share-based payment is used here to cover the range. 5. In a group situation the employing company ( Employer ) is commonly a subsidiary and the shares that are used are usually those of the group holding company or parent or sometimes of an intermediate holding company. In most group cases the scheme will be provided by the holding company or parent to its subsidiaries, enabling share-based payments to pass to its employees (if any) and to employees of group members. In this guidance the group member providing the scheme is called the Provider. Overview: Why transfer-pricing issues arise 6. However the arrangements for administering and delivering an employee share plan within a group are set up, a facility is being provided, and transfer pricing rules will apply. Case law (Special Commissioners decision in the case of Waterloo plc (1) Euston Ltd (2) Paddington Ltd (3) v Commissioners of the Inland Revenue, 2001)(SpC 301) establishes that the facility should be priced accordingly for the purposes of applying transfer pricing rules, with the Provider receiving or imputing receipts that reflect the full value of the facility it is providing. Overview: Summary of treatment of equity settled transactions from 1/1/ If the Provider of the share plan facility is the company whose shares are being used in the plan, there are two elements comprised in the facility being provided: An element that is the provision to the employees of the Employer of shares or share options. Any payment for such a provision will usually have to be taken to reserves in the Provider s accounts. If so, this amount will not appear in the Provider s profit and loss account or need to be included in the Provider s tax calculation (this is referred to below as the Share Award ); and An element that comprises administration services involved in the operation of the share plan. Any payment for the provision of this element should be reflected in the taxable income of the Provider (this element is referred to below as the Administration Services ). 3

4 6.2 Where a payment from the Employer to the Provider is imputed under transfer pricing rules, the tax treatment of the imputed receipt is exactly the same as that of an actual receipt. 6.3 The value of the whole facility for transfer pricing purposes should reflect what the Provider would expect to receive for providing the overall facility to a third party and what the Employer would expect to pay to obtain the facility from a third party. Looking at each element: A company providing a Share based payment for a third party would expect to receive the value of the share awards (eg share options) provided, and the Employer would expect to have to pay that amount to a third party, and; A company providing share scheme administration services would expect to recover its costs plus a modest profit margin, and the Employer would expect to pay that amount to obtain such routine administrative services. 6.4 In general terms, the value of a facility as a whole may differ from the sum of the values of its parts. However in this particular case there is no reason why the Provider would expect to receive more or less than the sum of the value of the Share Award and the Administration Services provided, or why the Employer would expect to pay more or less than this amount. 6.5 The corporate tax deductibility of costs incurred by the Provider in providing the share incentive plan will fall to be considered under the normal Corporation Tax rules. The costs relating to administration services elements will normally be an allowable deduction under CT rules and FA03/Sch23 does not affect this. 6.6 FA03/Sch23 sets out how relief is given for tax purposes for the costs of providing the shares. FA03/Sch23 sets out who can claim the relief, the period in which relief will be available and the amount of the relief. 6.7 In a group situation it will normally be the Employer who will be able to claim (in its CT computation) any statutory deduction available under FA03/Sch23. Accountancy background: Changes from 1 Jan Financial Reporting Standard 20 (IFRS2) Share-Based Payment was issued by the Accounting Standards Board in April Reporting entities are required to apply it for accounting periods beginning on or after 1 January 2005 (for listed companies) or 1 January 2006 (for unlisted entities). 8. Under FRS20 the reporting entity is required to reflect the fair value of the share-based payment in its profit and loss account at the time the award is made using Appendix B of FRS When applying transfer pricing rules, if it becomes necessary to calculate the value of the Share Award component of the overall facility 4

5 provided to the Employer then the approach set out in Appendix B of FRS20 should be used for this purpose also (but see paragraphs 13 and 14 below). Transfer-pricing Understanding the Transaction, the arms length bargain and methodology 10. In a group situation, usually, the Provider will not only set the scheme up and administer it but will also make shares available as and when necessary. 11. For transfer pricing purposes, intra group payments (or imputed payments) should reflect the price that would have been paid at arm s length between independent third parties. The actual intra group charge (if any) recorded in accounts of each party will not necessarily reflect the arms length price. The price of the facility for transfer pricing purposes should reflect its overall value, in terms of what the Provider would expect to receive for providing the whole facility to a third party and what the Employer would expect to pay to obtain the facility from a third party. Considering each of the key elements of the facility: A company providing Share Awards to a third party would expect to receive the value of the awards provided, and the Employer would expect to have to pay that amount to a third party. If it is necessary to calculate this value, Appendix B of FRS20 provides a basis for this calculation (but see paragraphs 13 and 14 below). A company providing share scheme administration services would expect to recover its costs plus a modest profit margin, and the Employer would expect to pay that amount to obtain such routine administrative services. Generally, the provision of such administration services on their own would be likely to fall within the scope of guidance in INTM on Centrally Provided Services and this guidance can be used as a basis for valuing this element of the facility. The Provider s tax position 12. Where the Provider makes a charge to the Employer, the Provider s tax calculation should generally follow the accounting treatment required for this. If there is no charge, or the charge is different to the arm's length amount, then a transfer-pricing adjustment may be required. 13. If the accounting treatment of any charge or part of a charge relating to the provision of the Share Award requires that it should have no impact on the Provider s accounting profit (because it has to be taken to reserves), then the normal consequence of applying tax rules will be that this amount has no impact on the Provider s taxable profits either. 14. In such circumstances there should be no need for transfer-pricing purposes to calculate the value of this element of the facility. Only the remainder of the value of the facility will affect the Provider's tax computation (typically, the value of the administration services). 5

6 15. Any charge, or part of a charge, relating to this remaining element of the facility will typically be taken to the profit and loss account under accounting rules and normal tax treatment would apply. 16. A condition for applying the treatment set out in this section is that the Provider must treat expenditure in relation to the supply of its own shares into the plan (e.g. market purchases of shares) in a consistent way. I.e. if no transfer pricing adjustment is made in respect of the value of share awards on the basis that charges for such awards must be accounted for in reserves, then any related share purchases should also be accounted for in reserves. The Employer s tax position 17. Where the Employer makes an intra-group payment for the employee share scheme facility on an arms length basis, or imputes such a payment to implement a claim for a compensating adjustment, the interaction with FA03/Sch23 needs to be considered. 18. FA03/SCH23 gives a specific statutory corporation tax deduction, in computing the taxable profits of a business of whatever nature, for providing employees with shares that satisfy certain qualifying conditions. FA03/Sch23 sets out the amount of the relief, when the relief is given and to whom the relief is available. FA03/Sch23/Para25 also states that no other deductions can be claimed in respect of the costs of providing the shares either by the Employer or any other company. 19. For the avoidance of doubt, if the Provider makes a charge to the Employer, then the amount of this charge relating to the share award element of the facility falls to be disallowed under Paragraph 25 of Schedule 23 as the cost of providing shares. (Instead, the Employer may become eligible to make a statutory deduction under Schedule 23.) 20. The remaining part of the charge, for administration services is not affected by FA03/Sch23/Para25, and therefore the question of whether or not it is deductible for Corporate Tax purposes falls to be considered under normal tax rules. 21. In any case where a charge is made for a facility of this nature and the value of the Share Award element cannot be distinguished from the value of the Administration Services, then the whole amount will be treated as the cost of providing shares and will be disallowed under FA03/Sch23/Paragraph25. Transfer-pricing background: Employer Compensating / corresponding adjustments 22. Where the Provider is required to make any transfer pricing adjustment in their tax computation, the Employer may be able to claim a compensating adjustment and calculate its taxable income on the basis that it had made a payment equal to the charge that the Provider is assumed to have made. If 6

7 the provision is made cross border the Employer may be able to claim a corresponding adjustment under a Double Taxation treaty. 23. Where a compensating or corresponding adjustment is made there should be no difference to the result for tax purposes whether an arm s length payment is made or transfer pricing and compensating / corresponding adjustments are made. In particular, the impact of FA03/Sch23 and taking the share award element to reserves will be the same as if an equivalent actual payment had been made. Other situations: Cash settled transactions 24. A share plan may provide for employees or employers to choose to settle the transaction with cash payment instead of actual shares, or may only provide for cash payments to be made (eg phantoms calculated on the basis of the increase in share price). 25. In all such cases the facility provided is essentially of the same value to the Employer as if employees received shares, so for the purposes of transfer-pricing the value of the facility as agreed between the Provider and the Employer should be the same. 26. So the same methods as outlined earlier above should be used to calculate the value of the facility in all these cases, even if awards can be settled in cash, or have to be settled in cash. 27. While for transfer pricing purposes the actual or imputed arm s length payment from the Employer to the Provider should be the same whether the instrument is settled in shares or cash, the tax consequences could be different. 28. For instance, the implications of FA03/Sch23 may be different Schedule 23 is not relevant to phantoms (cash payments only), for example. [Note: we would particularly comments from stakeholders on any issues arising in relation to the application of the general approach set out in this draft guidance to the treatment of options that may be settled in shares or cash.] Employee Benefit Trusts 29. A parent company may be a settlor of a Trust that makes share-based payments to employees of another group member. In assessing the nature, extent and value of the facility provided by the settlor company in such a case, it is important to consider all the elements of the facility that may be provided. This may include: the establishment of any trust and plan administration (which will typically comprise Administration Services); provision of Share Awards; and, any issuing of new shares. 7

8 30. At one extreme, if the Provider is wholly financing the trust s provision of a share plan to employees of group subsidiaries, then the Provider should receive or impute (under transfer pricing rules) the same receipts as it would if it provided the share plan itself and no Trust was involved. In such circumstances, the delivery of the share plan to the Employer by the trust is part of the overall facility. Where the Employer makes some payment direct to the Trust, reducing the financing required from the Provider, this would need to be taken into account in pricing the facility. 31. At the other extreme, the Employer might enter directly into arrangements with the Trust that are indistinguishable from the arms length arrangements that would exist between the Employer and a completely independent scheme administrator delivering a share plan for the Employer. There may be no significant financial or other involvement by the settlor company, beyond establishing the trust. In such a case, the arm s length pricing of the facility provided to the Employer by the settlor company would need to take account of the limited functions and risks resting with the settlor company. 32. Even if the Employer sets up its own Trust and operates its own share plan, transfer pricing rules will apply if the Employer makes a payment to the Trust to enable it to subscribe for newly issued shares in a different group company (as opposed to buying the shares in the open market). This is because a provision would be made between connected parties through a series of transactions - indirectly the Employer would be paying the other group company to supply shares. (Though if the payment by the Employer and the receipt of the other group company cannot affect the tax calculation of either (eg because FA/Sch23 denies a deduction for the employer and there is no income receipt for the other Group company), then there may be no tax consequence). Example Gismo PLC has 7 UK subsidiaries. Each operates a share plan of which that of Gismo Sales Ltd is typical. Gismo Sales has 100 employees, all of whom are eligible for inclusion in the group scheme that grants 3-year options annually if performance is satisfactory. The options are over shares in Gismo PLC as all subsidiaries are 100% owned and the group wants that to continue. Gismo PLC also administers the group scheme for all employees. From 1 st January 2005 Gismo Group must account for the cost of providing options to group employees under FRS20/IFRS2. Intra-group no accounting entries have ever been made. On 1 st January 2005 all 100 employees of Gismo sales Ltd are granted options over 1000 Gismo Group shares: exercisable in 3 years at the current price of 1. Gismo Group consolidated accounts account for the fair value of options for 80 employees, as in the past only around 80% of options have been exercised in due course. No intra-group charges are made. 8

9 The Gismo group is aware a transfer-pricing adjustment is needed. In the expectation that the amount received by Gismo PLC for share options would have to be accounted for in reserves if an intra-group payment were made, the group decide that the tax computation of Gismo PLC should include a taxable adjustment calculated on the cost of providing the administrative services plus a margin. Allowable deductions for Gismo PLC are the costs of providing the administrative services. Following Schedule 23 of Fa2003 no group company claims anything for the cost of providing shares, as this will be claimed in the year of exercise by the employing company, Gismo Sales Ltd. Gismo Sales Ltd claims an allowable deduction for the value of the administrative services provided calculated on the same basis. No adjustment is needed in their tax computation in 2005, 2006 and 2007 for the cost of providing shares as the deduction is governed by Schedule 23 of FA2003. So in their 2008 tax computation they will expect to claim a statutory deduction under Schedule 23 for those options that are exercised by their employees. This deduction will match the spread that will be chargeable on their employees, i.e. the difference between the market value when options are exercised and the cost of these under the option, 1 x FAQs Q1. Should any subsequent tax adjustment be made where share options provided by one group company to employees of another do not vest? A. At arm s length the terms of the transaction between the Employer and the Provider could be expected to make some provision for circumstances where options do not vest (perhaps in the form of some kind of payment back to the Employer). However, if the employer has made no deduction for any payment to the Provider for the options (eg because FA03/Sch23 was expected to apply), and any such payment has not given rise to taxable income for the Provider (because it had to be accounted for in reserves), then the position can just be left as it is. Only if one party would obtain a tax advantage without any repayment being made (eg because they have obtained a deduction for payment for the options) would it be necessary to consider what repayment could have been expected at arm s length (eg perhaps based on the value of the options at the time when it is established that they will not vest). Q2. Can companies choose to apply this guidance in respect of open tax returns for accounting periods starting before 1 January 2005? A. No. 9