DSG Retail Limited v HMRC. Implications for transfer pricing in the UK

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2 Introduction DSG Retail Limited ( DSG ) v HMRC, decided on 23 April 2009, was only the third ever transfer pricing case to be heard in the UK. This was the first UK case to go to litigation for many years and, given that HMRC has also now established a dedicated Transfer Pricing Group, this is perhaps evidence that HMRC is taking an increasingly active approach to transfer pricing. Moreover, HMRC s success in arguing against DSG s profit allocation will give it greater confidence in pursuing tax receipts, at least until another UK case goes to court. DSG v HMRC is, as with all transfer pricing enquiries, to some extent limited to its facts, and has a particularly involved back story. It does however set out a number of principles that any financial services group should consider when structuring its profit allocation. Facts The DSG case concerns the sale of extended warranties in respect of electrical goods at the point of sale. DSG International plc is the parent company of DSG Retail Ltd ("DSG"), Mastercare Coverplan Service Agreements Ltd ("MCSAL") and Mastercare Service and Distribution Ltd ("MSDL") (collectively "the Group"). The Group is the largest retailer of electrical goods in the UK, comprising the well-known outlets Dixons, Currys and PC World. When purchasing electrical goods, such as a television, a washing machine or a computer, the customer would be given a twelve month manufacturer's warranty as part of the sale contract. At the same time DSG would also offer the customer an extended warranty of one or several years for a fixed premium in respect of the goods. The warranties were insured via an arrangement that involved the Group's captive insurance subsidiary Dixons Insurance Services Ltd ("DISL"), which was established in the Isle of Man on the advice of the Group's insurance brokers Willis Corroon plc. DISL is exempt from tax in the Isle of Man under the Income Tax (Exempt Insurance Companies) Act Until 1997, DISL was licensed to carry on reinsurance business, but not insurance business, by the Isle of Man regulator. Since DISL could not directly access the UK market, from 1986 to 1997 the warranties were insured by a third party UK company, Cornhill Insurance plc ("Cornhill"); this period is referred to in the case as "the Cornhill period". During the Cornhill period, warranties were sold in DSG's stores through Coverplan Insurance Services Ltd ("CIS") as agent for Cornhill. A gross and net warranty price was set for each class of products. MSDL, which did repairs and kept product data, received an administration fee that was deducted from the net contract price. The remainder of the net price formed the premium paid to Cornhill. The difference between the gross contract price and the net price formed CIS's sales commission. Cornhill was not prepared to accept more than 5% of the risk in respect of the warranties. Cornhill reinsured the remaining 95% of the risk with DISL. Accordingly 95% of Cornhill's income premium was ceded to DISL. In return DISL paid Cornhill a ceding commission of 1.5% of the amount ceded to DISL. Significantly, DSG had no direct contractual arrangement with DISL. The arrangements during the Cornhill period are illustrated in Figure 1. 2

3 Figure 1. The Cornhill period ( ) Electrical goods DSG Customers Arranges warranties Insurance warranties CIS Gross contract price Repairs and administration Commission MSDL Administration fee Cornhill Reinsurance Ceding commission Ceded 95% of premiums Key: DISL Member of the Group Third party intermediary 3

4 Figure 2. The ASL period (1997 onwards) Electrical goods DSG Customers Arranges contracts Service contracts MCSAL Gross contract price Repairs and administration Commission MSDL Administration fee ASL Insurance Commission 95% of premiums Key: DISL Member of the Group Third party intermediary 4

5 In 1993, the scheme was extended for another five years and Cornhill agreed to increase the sales commission it paid to CIS. Importantly however, Cornhill accepted no increase in the ceding commission it received from DISL. In the November 1996 budget there was a proposal to increase insurance premium tax ("IPT") from 2.5% to 17.5% from 1 April This increase would have reduced Cornhill's and, in turn, DISL's premiums by 15%. To avoid this increase in IPT the Group decided to start offering its UK customers service contracts rather than insurance contracts. Cornhill was not prepared to enter into service contract business and so in April 1997 the Group ceased business with Cornhill and engaged a different third party company, Appliance Serviceplan Ltd ("ASL") to issue the service contracts to DSG's customers through MCSAL as agent for ASL. ASL was an Isle of Man company. ASL's liability was insured by DISL, which changed its regulatory authorisation to write insurance rather than reinsurance. The period from April 1997 onward is referred to in the case as the ASL period. The economic effect of the arrangements in the ASL period, illustrated in Figure 2, was similar, though not identical, to that in the Cornhill period. (The theory in relation to IPT was that the only insurance contract from April 1997 onwards would be one between two Isle of Man companies and which would therefore be outside the scope of UK taxation. This argument was sustained before the VAT and Duties Tribunal in DSG International Insurance Services Ltd (2007) IPT 0013.) Law The relevant legislation covering the Cornhill period was section 770 of the Income and Corporation Taxes Act Section 770 applies to the sale of property between two parties, one of which controls the other or both of which are controlled by the same entity, where the actual price of the sale is different to that which would have been agreed by independent persons dealing at arm s length (the arm s length price ). Section 770 dictates that the parties income, profit or loss is to be computed for tax purposes as if the sale had been at the arm s length price. Section 773(4) extended the application of section 770 from the sale of property to the giving of business facilities of whatever kind. UK transfer pricing legislation underwent a significant change in 1998 with the introduction of a new section 770 and the addition of Schedule 28AA. Schedule 28AA is applicable for accounting periods ending after 30 June 1999, and is thus the governing legislation for the latter part of the ASL period. Schedule 28AA applies where a provision exists as between any two persons by means of a transaction or series of transactions and there is a relationship of common control between the persons. If the actual provision differs from the provision ( the arm s length provision ) that would have been agreed as between independent enterprises and confers a potential advantage in relation to UK taxation on one or both of the affected persons, Schedule 28AA prescribes that the profits and losses of the potentially advantaged person (s) are to be computed for tax purposes as if the arm s length provision had been made or imposed instead of the actual provision. Schedule 28AA gives express direction to take guidance from the OECD Transfer Pricing Guidelines, whereas section 770 does not. In the case however the commissioners refer to the Guidelines as the best evidence of international thinking on the topic and deem them applicable to the same circumstances as section 770 as well as Schedule 28AA circumstances. 5

6 Arguments and decision 1. DSG had conferred a business advantage on DISL by entering into the insurance/service contracts with third party companies. Although DSG had no direct contract with DISL, HMRC successfully argued that DSG had contracted with the third parties only on the mutual understanding that the third parties would be reinsured/insured by DISL. 2. Cornhill s profit had been squeezed by the 1993 contractual changes whilst DISL s profit remained unchanged. The Commissioners held that the Group had given DISL a "business facility" in 1993 whereby Cornhill s position relative to DISL was disadvantaged and section 770 was potentially applicable. 3. HMRC argued that DISL s non-arm s length profits continued into the ASL period when DISL was given the opportunity to enter into an attractive insurance contract. The Commissioners held that an analysis of the transactions as a whole showed that they were entered into following an understanding between the Group, ASL and DISL and that they were seen as a series of interlocking agreements. Although the series of contracts itself could not be seen as a provision, it was the means by which the arrangements were given effect; therefore, for the purposes of Schedule 28AA a provision had been made as between DSG and DISL. 4. DISL was said to have benefitted from the "point of sale" advantage that was created in and belonged in DSG's stores. HMRC successfully argued that, had the parties been transacting at arm's length, DISL would have had to pay DSG something in return for the opportunity of entering into an attractive reinsurance/insurance arrangement. In the ASL period, this would have been in addition to the payment made to MCSAL. 5. In determining the adjustments that should follow, the Special Commissioners considered the profits that each party to an extended warranty insurance/ reinsurance agreement might expect to make if they were independent persons dealing at arm s length. The OECD guidelines on the comparable uncontrolled price ( CUP ) method of determining an arm s length price were given high regard in the decision; although DSG put forward a number of potential comparables however, all were rejected on the grounds they contained differences such as market conditions and product differences for which reliable adjustments could not be made. It was eventually decided that in the absence of suitable comparables, the profit split method was the most appropriate pricing method available and that a suitable approach was one which determined an arm s length return on capital for DISL and allocated the residual profit to DSG, since DISL was entirely dependent for its profits on the point of sale advantage in DSG s stores and the strong DSG brand. 6. The case was adjourned for the parties to formulate an appropriate profit split. On 25 June 2009 DSG released a press statement stating it has reached a private settlement with HMRC. Implications of the decision An important lesson to be learned from the case, particularly as far as financial services groups are concerned is that engaging a third party intermediary in a business arrangement does not exclude the arrangement from transfer pricing considerations. HMRC will construe the arrangements as a whole, and if it can show that the third party was engaged by a group entity only on the understanding that the third party would, in turn, enter into a contract with another entity from the group the transfer pricing legislation will apply. Overall however, the key implication of the decision must be that HMRC will now be more confident than ever in bringing transfer pricing cases to litigation and challenging multinational enterprises' pricing methodologies. 64

7 Contacts Michael Stirling Head of Transfer Pricing t: +44 (0) e: Asa Atherton Transfer Pricing Executive t: +44 (0) e: 75

8 This publication is not a substitute for detailed advice on specific transactions and should not be taken as providing legal advice on any of the topics discussed. Copyright Field Fisher Waterhouse LLP All rights reserved. Field Fisher Waterhouse LLP is a limited liability partnership registered in England and Wales with registered number OC318472, which is regulated by the Law Society. A list of members and their professional qualifications is available for inspection at its registered office, 35 Vine Street London EC3N 2AA. We use the word partner to refer to a member of Field Fisher Waterhouse LLP, or an employee or consultant with equivalent standing and qualifications. 8