HMRC recently issued guidelines on how to avoid common pitfalls and follow what HMRC considers to be best practice in transfer pricing compliance. The guidelines contain a detailed description of HMRC's perception on the role of "UK risk leads" and "transfer pricing specialists". The compliance guidelines also highlight HMRC's view of common indicators of high-risk approaches to transfer pricing policies.
HMRC's stated aim is to "reduce uncertainty" by:
- providing greater clarity of HMRC's expectations as to how a UK business should manage its transfer pricing compliance risk (through the roles of UK risk leads);
- raising awareness amongst transfer pricing specialists of HMRC's expectations in the context of functional analysis, comparability analysis and documentation; and
- highlighting common risk areas that HMRC are likely to scrutinise.
Role of UK risk leads
The guidelines describe UK risk leads as individuals who are responsible for managing the overarching transfer pricing compliance risk for UK businesses that are subject to or likely to be subject to transfer pricing rules. UK risk leads are not necessarily transfer pricing specialists, but senior individuals in financial, risk or tax roles within the UK business, such as UK tax compliance managers, UK finance directors or controllers, or senior accounting officers. The UK risk leads' role in transfer pricing compliance is mainly to ensure that they understand the policies and ensure that there is enough evidence to support the conclusions for each period. The UK risk leads have oversight over the documentation and analysis but may outsource some or all of the work to transfer pricing specialists.
The guidelines acknowledge that the underlying processes for each UK business will vary depending on its size and complexity, exposure to transfer pricing risk and materiality of transactions but provides general guidance on HMRC's perception on best practice approaches for UK risk leads.
- Compliance planning and scope: UK risk leads should understand the group's transfer pricing compliance model and how it affects UK assurance. This implies that UK risk leads are responsible for reviewing transfer policies and intragroup agreements that apply to the UK business, determine the scope of compliance activity based on what has changed since the previous period and how material and risky those changes are, and establish checks and controls to monitor financial processes upfront. UK risk leads should ensure that any cross-border transaction terms are correctly implemented according to the relevant documentation such as the group's transfer pricing policy in order to avoid implementation risk, as this can ultimately create a compliance risk for the company.
- Implementation and monitoring checks: periodically, UK risk leads should monitor and check for implementation errors and business change and address any issues or errors as soon as possible. HMRC emphasises the implication of the UK "one way street system", where changes are a result of checks deferred until after the annual accounts are closed and only made as "computational" adjustments, any downward transfer pricing adjustment that would reduce taxable profits or increase loses would not be permitted under the "one way street system" that HMRC operates.
- Transfer pricing analysis and documentation: whilst HMRC acknowledges that the transfer pricing analysis and documentation would typically be conducted by a transfer pricing specialist, the guidelines emphasise that UK risk leads should ensure that the scope of work that is outsourced to transfer pricing specialists is sufficient and accurate, and that transfer specialists have a good knowledge of the UK business and its transactions. UK risk leads are responsible for reviewing the output from transfer pricing specialists including reviewing the functional analysis and benchmarking conclusions, which includes checking that third party transactions of a similar nature have been flagged to transfer pricing specialists and considered as a basis for pricing.
- Filing an arm's length return: UK risk leads should ensure that the actual profits or losses for the period are priced by reference to the arm's length principle and supported by a transfer pricing study.
Role of transfer pricing specialists
Transfer pricing specialists are described as individuals who are responsible for setting transfer pricing policies, defining the scope of the transfer pricing workstream, performing the functional analysis and comparability analysis, and preparing transfer pricing documentation for the UK business.
HMRC's experience from transfer pricing audits is that often transfer pricing documentation is poorly evidenced, too vague, or based on a weak functional analysis. HMRC's view is that it is the responsibility of the UK risk leads and transfer pricing specialists to collectively ensure that the budget, scope and timing of the compliance work are adequate and that the work is delivered promptly. However, HMRC does recognise that factors such as budgets/internal resources, multi-territory approaches and access to UK data and knowledge can affect this process.
HMRC recommends some best practices for transfer pricing specialists to reduce compliance risks.
- Compliance planning and scoping: transfer pricing specialists and UK risk leads should work together to identify and discuss any business and policy changes, new transactions, internal controls and processes that may affect transfer pricing.
- Common issues with functional analysis: the functional analysis should reflect the UK business activities and the economically relevant characteristics of the transaction. This is an area where HMRC often sees errors. Verification of the functional analysis by UK risk leads is important as there are carelessness or negligence penalty implications if HMRC is successfully able to find faults.
- Common issues with comparability analysis: HMRC often finds problems with the descriptions, or the quality of the benchmarks used in comparability analysis. These may stem from unclear explanations of how the final comparables set was selected, how it meets the UK comparability factors, or how reliable the benchmarking sources are.
- Common risks in calculations and adjustments: a factor to consider is whether the accounting policies of the company subject to the transfer pricing analysis are comparable to those of the benchmark, or whether adjustments are needed.
- Documenting the functional analysis: HMRC emphasises the importance of documenting evidence and decisions in their guidelines. If HMRC cannot easily assess from the documentation whether an arm's length return has been filed, this can lead to an increase in transfer pricing risk.
HMRC's insight into "high risk" transfer pricing aspects
HMRC has also provided some useful guidance on aspects of a transfer pricing policy that they perceive to be high risk. This guidance provides an insight into aspects that HMRC is likely to focus on in a transfer pricing enquiry.
HMRC identifies the following common risk indicators.
- Intangible assets ownership and exploitation risks arise when returns from exploiting intangible assets, like intellectual property, are attributed to a legal owner lacking the capability to develop, enhance, and exploit these assets, or who outsources key functions and risks to other affiliates.
- Above market intragroup services risks occur when UK staff in global or regional roles control key functions or risks or create profit-earning activities for the group but are not appropriately rewarded.
- Transfer pricing target margin model risks are present when target margin policies deliver a fixed return to UK businesses and similar affiliates without corresponding changes to their functions, assets, and risks.
- Cost-based reward for services risks emerge when a margin on cost is used to reward a principal under a service contract without proper analysis of the cost base, allocation keys, comparability adjustments, and profit level indicator.
- Sales-based reward for services risks are created when the arm's length reward is defined and measured with reference to sales, without proper analysis of the sales base, comparability adjustments, and profit level indicator.
We note that the high risks identified by HMRC relate to the pricing of transactions that require a significant level of judgement and are therefore highly subjective. In the context of enquiries, it may often be the case, therefore, that there is a difference in opinion between HMRC and the taxpayer in terms of the pricing of "high risk" transfer pricing transactions. Having up to date transfer pricing documentation based on a detailed functional analysis and value chain analysis could assist in mitigating a proportion of this risk.
Our take on the guidelines
These compliance guidelines provide a useful insight into the level of detail that HMRC expects with respect to transfer pricing compliance, and into the approach HMRC is likely to take and the evidence they will expect to see in the context of transfer pricing enquiries.
It would be prudent for UK businesses to reassess their internal
transfer pricing compliance processes in light of these guidelines.
Indeed, for many businesses having this detailed compliance-focused
guidance from HMRC will be helpful and welcome. In practical terms,
however, it will likely be difficult for UK businesses to apply
every aspect of these best practice guidelines, particularly taking
into account that transfer pricing is an art not a science, and the
application of transfer pricing principles requires a significant
level of judgement.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.