Danny Alexander pledges to crack down on use of transfer pricing adjustments as "tax loopholes"

According to Danny Alexander, HM Revenue and Customs (HMRC) has evidence that these rules are being "exploited" by partners and shareholders who enter into transactions with connected companies. He said that the “vast majority” of private equity partners were exploiting the rules, which he described as "loopholes".

HMRC has published a technical note on the proposals (3-page / 262KB PDF) and is seeking views on an informal basis. HMRC says that, as the change should not "adversely affect commercial arrangements", formal consultation is not required, but the changes will not come into force until the end of a period of informal consultation.

The proposals have been attacked by the British Private Equity and Venture Capital Association (BVCA), which accused Alexander of "party conference politics". BVCA director general Tim Hames said that it was "strange" to hear the well-established rules "entering the public arena in the language of newly discovered tax avoidance".

"The description of the tax measures which provided this shelter as 'loopholes' and linking them explicitly with the private equity industry has understandably incensed the BVCA," said tax expert Tom Cartwright of Pinsent Masons, the law firm behind Out-Law.com. "It is noticeable that HMRC's technical document on the matter specifically states that it is not targeted at the private equity industry."

"The problem with these proposals is that they will potentially lead to double taxation in perfectly innocent situations. Compensating adjustments ensured this did not happen by allowing the counterparty a matching deduction on their taxable profits where the paying entity had a deduction disallowed. This will in turn increase the pressure on HMRC to agree the transfer pricing positions of any company with shareholder debt to ensure that tax mismatches do not occur - it is questionable whether they have the resources to do this," he said.

Compensating adjustments fall within the transfer pricing regime, which exists to ensure that transactions made between connected parties are taxed in the same way that they would have been had the connection not existed. They allow one party to adjust its tax bill to match the changes imposed on the other side by virtue of the legislation. The proposals would remove the compensating adjustments mechanism for transactions between companies and individuals who would otherwise be liable to income tax.

In its technical note, HMRC said that some partnerships had used the transfer pricing corresponding adjustment rules by employing staff through a separate service company, owned by the partnership. As the partners do not pay the 'arms length' fee to the company for providing this service, the transfer pricing compensating adjustment rules are triggered. In similar cases, individuals that lend money to companies in which they are shareholders can trigger the transfer pricing rules.

The effect of triggering the rules is that the company is taxed on a greater amount of profits at the corporation tax rate, currently 23%; and, as a result of the corresponding adjustment rules, the partners are taxed on a reduced amount of profits, at the higher income tax rate of up to 45% - yet the full amount of profit remains in the hands of the partners.

In a statement, the BVCA said that it was involved in "continuous dialogue" with the Treasury and HMRC on the issue of loans made by private equity partnerships. It would continue to work with ministers and officials throughout the informal consultation period, it said.

"These are straightforward commercial transactions – they are not structures designed to enable individuals to avoid tax," said Tim Hames.

"The Government is, of course, entitled to amend or end such arrangements as it wishes. What it may discover, however, is that this is not a black and white question but a far more complicated matter with implications that extend well beyond the private equity industry. This is about legitimate commercial logic, not 'avoidance'," he said.

Editor's note 20/09/13: This story was updated to reflect the correct higher income tax rate.