HMRC has issued a technical discussion note on the planned changes to compensating adjustments, following the announcement by Chief Secretary to the Treasury, Danny Alexander, of the government's intention to close perceived loopholes in the current legislation.

The government proposes to take action to restrict the use of the compensating adjustments mechanism in the transfer pricing legislation where it generates income tax advantages. This is in response to tax advantages that can arise where such adjustments are claimed by individuals for transactions entered into with connected companies subject to a lower corporate tax rate.

The discussion note says the changes are designed to tackle two main arrangements which HMRC says exploit the rules. The first scheme relates to professional partnerships which employ their staff through a separate service company, which the partnership owns. By choosing not to pay an appropriate fee to the company for providing this service, the partnership can activate the tax rules to gain an advantage. The second scheme relates to excessive leveraging of companies by individuals where the loans are not on arm's length terms.

The government proposes to withdraw the ability of individuals to claim compensating adjustments where the counterparty to the transaction is a company. This will apply to amounts arising on or after the date the legislation comes into effect. So where either of the schemes is used, no compensating adjustments will be possible in respect of amounts of service fee income or interest arising to individuals on or after the effective date.

HMRC's technical note states that 'as there is no intention that these changes should adversely affect commercial arrangements, there will be a short opportunity for discussion on the policy proposals before the legislation comes into effect'. Any comments should be passed to Richard Rogers on 03000 585521 or by email [email protected]