Common compliance risks (part 2)

Question 1

Who should read this part

Accepted Answer

This part should be read by individuals who have experience in transfer pricing compliance. It is relevant to in-house tax and external transfer pricing specialists, that are involved in:

setting transfer pricing policies
defining the scope of transfer pricing compliance work
performing the transfer pricing analysis
preparing transfer pricing documentation on behalf of UK businesses

When scoping and preparing transfer pricing documentation, specialists should also read part 1 (managing compliance risk for UK businesses).

Question 2

Why it is important

Accepted Answer

HMRC frequently encounters transfer pricing documentation which is too high level, insufficiently evidenced or for which functional analysis is not two-sided in nature. In these circumstances, we are unable to assess whether an arm’s length return has been filed. We recognise there are several factors which can impact the quality of transfer pricing documentation, including:

the impact of compliance budgets on appropriate scope and depth of work
the timing of compliance work
the use of multi-territory approaches
appropriate access to UK business data and resources knowledgeable of the UK business

Where contemporaneous fact finding and analysis is not undertaken to an appropriate depth on a timely basis, compliance risk can be created. The resulting tax return may not reflect the commercial reality of UK activity and an arm’s length return. The impact on businesses could include:

additional compliance costs of an enquiry
unforeseen transfer pricing adjustments
penalties for non-compliance

How much time and resource to commit to specialist compliance activity remains a business choice. In setting out HMRC expectations and best practice these guidelines set out approaches that minimise transfer pricing compliance risk. It is based on high quality examples of compliance observed by HMRC. Risk can include the risk of error, adjustment, audit and penalties.

Not all expectations or best practice approaches will be relevant for all businesses. The degree to which businesses adopt recommendations, conduct work, evidence filing positions and evaluate and mitigate any high risk indicators will vary. This is based on:

the size and complexity of the business and group
the risk profile of the business such as level of business change
materiality of transactions in scope

However, specialists should use these guidelines to work with the business to make informed decisions and develop a strategy regarding:

scope and depth of specialist compliance activity
when the compliance work will be undertaken
level of UK business resource and involvement in UK compliance
best practice approaches to reducing any compliance risks identified

The content in this part sets out common quality issues HMRC observe for transfer pricing documentation. It also highlights common issues with approaches to fact finding, analysis, documentation and adjustments. Best practice suggestions for specialists to reduce resulting compliance risk are included for these areas:

2.1 Compliance planning and scoping
2.2 Common issues with functional analysis
2.3 Common issues with comparability analysis
2.4 Common risks in calculations and adjustments
2.5 Documenting the functional analysis

Financial transfer pricing risks are not covered in depth within these guidelines. However, many of the best practice suggestions remain relevant regardless of the type of transaction. Limited reference to specific compliance risk areas, including financial transfer pricing, should not be taken to imply that HMRC does not believe these areas contain risk.

Reading ‘Common compliance risks’ provides additional general support for your functional analysis, in particular, part 2.2 (common issues with functional analysis). Throughout this part, the term ‘functional analysis’ describes the analysis of functions, assets and risks required under Organisation for Economic Co-operation and Development Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD TPG). ‘Comparability analysis’ describes the comparison of price and conditions under OECD TPG based upon accurate delineation, and suitable benchmarks.

Question 3

2.1  Compliance planning and scope

Accepted Answer

In HMRC’s experience, a key factor affecting the quality of documentation is compliance work being of an appropriate scope and depth. The start of the compliance lifecycle referred to in part 1 (managing compliance risk for UK businesses) is a good time to reflect on developments since the prior year. Specialists should work with UK risk leads to identify business and policy changes and agree scope and timing of compliance work.

Best practice approaches for planning of transfer pricing compliance work by specialists might include, but are not limited to, these upfront planning and scoping considerations:

relevant changes to UK transfer pricing rules or OECD TPG relevant to the UK business impacting scope and the compliance plan
new transactions within the scope of transfer pricing rules
review of part 3 (indicators of transfer pricing policy design risk) for approaches that may require a change in approach or explanation
identification of any new transfer pricing policies to be implemented in the period
impact of transfer pricing issues arising in prior periods that may impact the current period
identification of material transactions, trigger events — read part 1.1.3 (scoping compliance activity for developments since the prior period) or transactions material per se for local file purposes that impact compliance scope
collaboration with UK risk leads on the timing and level of their involvement with the compliance process to allow them to perform their risk management responsibilities
level and efficacy of internal controls, processes and checks to be relied upon for effective policy implementation and monitoring for business change or trigger events
group transfer pricing compliance model consequences for the level of UK business and UK risk lead involvement due to the degree to which work is controlled offshore or outsourced

Whilst the precise role of transfer pricing specialists will vary due to different group transfer pricing compliance model approaches and tax risk control frameworks, ensuring that the UK risk leads, and wider finance and tax function understand key developments affecting the appropriate scope of UK compliance work is key.

Specialists are also encouraged to make sure that UK risk leads clearly understand the risk and benefits of different compliance approaches, budgets and resourcing options. Best practice areas for discussion relevant to UK compliance standards might include:

risk benefit profile of scope encompassing the best practice planning and scoping considerations, in terms of enquiry risk, adjustment and penalty regimes
important benefits of contemporaneous fact finding, analysis and documentation before accounts are finalised in allowing upward and downward adjustment, avoiding one way street issues and double taxation
requirement to make a transfer pricing adjustment in their UK tax return if an increase in taxable profits or reduction in allowable losses would arise from an arm’s length return being applied to transactions
relevance of transfer pricing to SAO duties
significant risk associated with conducting compliance activity after the return is filed in terms of enquiry risk, adjustment, penalties and interest including behavioural aspects

Question 4

2.2  Common issues with functional analysis

Accepted Answer

Accurate delineation of a transaction involves the consideration of the 5 economically relevant characteristics. These are:

contractual terms
functional analysis
character of the property or service
economic circumstances
business strategy

This part focuses on functional analysis because we observe high levels of inaccuracy in the analysis of this economically relevant characteristic that result in errors in accurate delineation. An analysis of all 5 economically relevant characteristics remains essential to accurately delineate a transaction. The focus on functional analysis in these guidelines should not be interpreted as giving it more importance than any other comparability factor.

It is important that the facts included within the functional analysis accurately reflect the UK business activities and relative contributions in a group context.

Specialists should make sure that UK risk leads are aware of the importance of verifying the functional analysis and how this relates to behavioural considerations for penalties. HMRC INTM483120 — working a transfer pricing case — penalties — negligence or carelessness example 9 provides a useful illustration for awareness purposes.

The credibility of documentation is influenced by the level of underlying work conducted by the authors of the report. The scope and depth of analysis and evidential standard are also key. This part provides best practice suggestions on approaches to performing a functional analysis based upon the facts, in areas where HMRC often encounters a quality issue including:

2.2.1 Timing of functional analysis
2.2.2 Multi-territory functional analysis prepared centrally
2.2.3 Re-use or roll forward of functional analysis
2.2.4 Reflecting business change in functional analysis and delineation conclusions
2.2.5 Functional analysis — risk analysis
2.2.6 Functional analysis — intangibles
2.2.7 Evidencing people functions

Emphasis is on the standard of functional analysis and sufficiency of the facts and evidence relied upon in performing analysis. Technical conclusions reached are not the focus of these guidelines.

Approaches to functional analysis should be proportionate to the materiality of the potential risk. Both the extent to which the issues in this part apply to the functional analysis by specialists for the UK business and the level of further analysis or supporting information required as a result will vary from business to business.

Specialists should make sure the UK risk lead and wider tax functions understand how different approaches to functional analysis affect their risk profile.

The OECD TPG sets out the objectives of a functional analysis and provides guidance on its focus and content. HMRC INTM484040 — examining transfer pricing reports — information in a report — functional analysis provides more commentary on the role of functional analysis. This part, on best practice practical approaches to transfer pricing functional analysis, does not attempt to summarise INTM484040 and should not be used as a substitute.

2.2.1 Timing of functional analysis

UK businesses who adopt the suggestions outlined in part 1 for planning and scoping compliance approaches, and monitoring for business change, are more likely to:

identify relevant facts and supporting information in real time
comply with Senior Accounting Officer (SAO) duties surrounding tax figures within the accounts

In practice, HMRC notes that most analysis occurs after the finalising of statutory accounts, in the months before the filing deadline for tax returns. This could still provide contemporaneous supporting evidence of an arm’s length return, but limits scope for downward adjustment under the ‘one way street’ principle. Double taxation can arise unless Mutual Agreement Procedure (MAP) claims can be made, extending the length and cost of compliance for the UK business.

In contrast functional analysis conducted after the tax return is filed carries implicit risks. UK businesses will be unable to support their conclusions at the time of filing their return. This has implications for penalties for incorrect returns where issues are later identified.

Such late analysis should still be objectively performed and not seek to retrospectively justify a filed position. Where it forms the basis for a conclusion that the pricing or results of the UK entity are non-arm’s length, adjustments may not be possible to the tax returns at that stage. This may be because either the UK is tax disadvantaged or time limits have passed, resulting in double taxation unless Mutual Agreement Procedure (MAP) claims can be made.

2.2.2 Multi-territory functional analysis prepared centrally

Transfer pricing functional analysis might be performed centrally to cover many regional or global territories. Centralised analysis can be conducted in-house, at a head office location or by a centralised third party provider. The provider performs analysis for a typical entity and standardised content is created for use in multiple territory transfer pricing reports. An example of a typical entity might be a large market operating company.

This approach is reasonable if facts and analysis include enough UK entity ‘localisation’. The localisation leverages knowledge of the UK entity to produce compliant transfer pricing analysis and documentation. The degree of localisation required will vary based upon the facts and circumstances of the UK entity relative to the content of the ‘typical’ entity functional analysis.

Where a centralised analysis approach is taken, HMRC considers best practice to include these approaches to support the UK position:

performing a documented review by the UK risk lead of the facts supporting the functional analysis
checking the relevance of facts and analysis to the UK entity, to identify any inaccuracies and omissions
adding supplemental information, with fact finding specific to the UK entity business and UK related party transactions, to cover areas omitted or not sufficiently represented
confirming that the localised multi-territory functional analysis accurately reflects the UK entity through testing of key facts relied upon, for example:
- by comparing the UK headcount by grade and function against the business description and functional analysis — part 2.2.7 (evidencing people functions) includes helpful suggestions for businesses

HMRC INTM483120 — working a transfer pricing case — penalties — negligence or carelessness example 5 provides a useful illustration for awareness purposes.

2.2.3 Reuse or roll forward of functional analysis

Sometimes, functional analysis prepared for a previous financial period is reused in the current period. This approach is often referred to as a ‘roll-forward’ exercise. The extent to which factual and financial data is updated determines the extent to which the analysis relies on content produced for a prior period.

If transfer pricing analysis from a prior period is rolled forward without any update, an annual check will be necessary. Such checks aim to make sure that the facts and analysis are still consistent and valid.

Compliance risk can arise and the credibility of the declaration that the tax return is correct undermined where:

functional analysis is relied upon without such annual checks
the same comparables are used for more than 3 years without an updated search being performed despite annual checks

In seeking to reuse and roll forward transfer pricing analysis from a prior period, HMRC considers best practice to support the filed position to include:

updating of key UK entity data relevant to the controlled transactions such as headcount data, reporting lines, organisation and function charts and numerical or entity financial data that changes annually and informs the analysis or factual statements relied upon
updating of key data relating to the counterparty to the transaction such as headcount and functions
a critical review in conjunction with UK risk leads to determine whether the functional analysis remains accurate and relevant

Reuse or roll-forward of prior period functional analysis adopting best practice suggestions assumes both that:

there has been a detailed and robust functional analysis of both parties in an earlier period delineating the UK entity transactions on which the reuse or roll forward is based
the business activities of the parties and the comparables are unchanged

Where this is not the case, re-use or roll forward is unlikely to represent an acceptable approach.

HMRC recommends that specialists document the annual work undertaken to establish business continuity including where it is concluded that no update to the functional analysis and delineation is required.

2.2.4 Reflecting business change in functional analysis and delineation conclusions

In HMRC’s experience, issues can arise where substantive fact finding, and consideration of the impact on transfer pricing analysis and conclusions does not cover business changes or restructuring during the period, or is performed too late to allow the filed return to reflect the impact on the transfer pricing position.

Functional analysis for which it is immediately evident that it is incomplete, is a common prompt for considering a formal enquiry. This may be evident through a cursory examination of:

readily available public information such as investor information, press releases and corporate websites
sources of information available to HMRC such as country-by-country reporting, payroll data and patent box or Research and Development expenditure credit (RDEC) claims

Advantages exist to identifying and analysing business change prior to the year end financial close to allow for accurate delineation and for transfer prices to be set or changed real time — read part 1 managing compliance risk for UK businesses. In addition to discussing business changes or trigger events identified by risk leads, specialists can monitor for relevant changes in business facts and circumstances that may impact the transfer pricing position in a timely manner in these ways:

changes visible from financial reports and business records
changes visible from public information sources
business restructurings

Where business restructuring has occurred, transfer pricing documentation should aim to set out the impact on the UK business functions, assets and risks, delineation and its intra-group transactions.

Changes visible from financial reports and business records

Best practice suggestions for specialists monitoring for business change using financial reports and business records can include, but are not limited to:

review of headcount reports, for example, to check for new or ceased UK functions and teams and changes to activity weighting
review of actual and forecast third party turnover for goods and services transactions, for example, for unexpected changes in volume or value that may indicate an internal supply chain change driven by new products, services or channels to market
review of actual and forecast financial reports of intra-group transactions, for example, for unexplained or unexpected changes in volume, value, nature or activity mix that may impact delineation
review of accounting records of the UK cost base, for example, to identify unexplained or unexpected changes in the value or nature of Research and Development (R&D) costs, operating expenditure, a new cost or profit centre
review of accounting records of the UK asset base, for example, to identify unexplained or unexpected changes to intangible or fixed assets that may indicate changes in asset ownership, creation or value
review of intra-group debtors and creditors, for example, to identify excessive trade balances that are effectively interest free loans
review of records and explanations for exceptional profit and loss (P&L) items, for example, to identify highly material or one-off events that may impact the transfer pricing position
review for changes to stock option or share based payment schemes that may need to be reflected in a comparable full cost of employment for transfer pricing purposes
understanding the basis behind accounting restatements, disclosures and notes or similar changes in the reporting of operating items such as provision movements or reimbursed expenses

Changes visible from public information sources

Best practice suggestions for specialists monitoring for business changes to business strategy, products and services, value drivers and risk, using public information sources include, but are not limited to:

review of Annual Reports, group accounts or US Securities and Exchange Commission 10-K filings
review of business reviews and analyst presentations
associated analyst presentations
review of intellectual property (IP) registration reports to check for any new group IP of UK origin or inventorship
developments at key competitors that may have changed the market value perception of certain group intangibles or functions informing what is economically significant
monitoring for significant changes in share price that may indicate material developments or risk realisation
monitoring key changes on company and group websites
monitoring group press releases, especially with regard to restructuring or expansion activities, merger and acquisition activity, licenses and strategic collaborations involving key assets

Businesses, and the substance of intra-group arrangements, can change quickly over time. It is therefore important for specialists to work with businesses to regularly check for signs that new or amended transfer pricing approaches may be needed. These should be reflected in the current compliance plan.

Business restructurings

HMRC often receives transfer pricing documentation that lacks depth and supporting evidence for business restructuring affecting the UK. This is especially true of business restructuring involving transfers of intangible assets.

HMRC consider business restructuring or reorganisation impacting the UK business an area that requires deeper analysis and contemporaneous supporting documentation. It is included both in the list of trigger events set out in part 1.1.3 (scoping compliance activity for developments since the prior period), and areas ‘always material’ within local file guidance — (read INTM450104 — materiality of a category of controlled transactions).

Functional analysis often includes actual or purported changes to the function, asset and risk profiles of the UK and counterparties to transactions as a result of the restructuring. Best practice approaches include an explanation of the elements of the restructuring affecting the UK business. This should be supported by source evidence and suggested areas of analysis include, but are not limited to:

restructuring impact on function, asset and risk of UK and counterparty
new or ceased intra-group transactions as a result of the restructure
the decisions and intentions regarding the restructure
the business justification for the internal restructuring and any associated third party transactions, to include but not limited to the impact on the UK entities in the group
options realistically available to the UK business
documented forecasts and underlying assumptions relevant to the value of any asset transfer
analyses and documents for third party acquisitions or disposals (or transfers) to the extent relevant to the business restructuring

2.2.5 Functional analysis — risk analysis

HMRC often encounters issues with the description and factual support of risk analysis. Facts should be determined and evidenced which support the economically significant risks identified for the group, in particular the material tested transaction with specificity. This is a key component of forming an understanding of the economically relevant characteristics of the parties to that transaction.

Read INTM485025 — Accurate delineation of the actual transaction — Risk for additional helpful support.

A common driver of compliance risk for UK businesses under enquiry is where a mismatch exists between:

risk analysis descriptions in transfer pricing documentation
facts established under enquiry regarding how risk in reality arises and is managed or controlled

Taking the time as part of the functional analysis to test and understand the parties actual role in relation to economically significant risks is recommended.

Specialists are expected to use the full OECD risk analysis framework beyond determination of the contractual assumption of risk in performing risk analysis. Best practice considerations for specialists include these approaches:

setting out the facts relied upon in determining economically significant risks
identifying the key decision forums or processes relevant to the taking on or laying off of economically significant risks and the role of the UK within them
limiting the use of narrative risk labels such as describing parties as ‘responsible for risk’, ‘bearing risk’ or ‘de-risked’ in favour of fact-based analysis of how those parties operate to assume risk in terms of conduct — for example, by providing evidence of their capability to control, and actual performance of control of the risk
evidencing their financial capacity to assume such risks
identifying examples of typical and exceptional business responses to economically significant risks and their impact on business performance — for example, typical planned risk mitigation procedures, strategic planning to manage and exploit risk, exceptional in-year risk, opportunity responses and issue resolution

Some approaches to risk analysis that specialists should seek to avoid include where:

analysis of the economically significant risks of the group relevant to the controlled transactions with the UK, is either:
- omitted
- included as a cursory exercise, lacking full risk analysis
- lacking robust consideration of the extent to which the UK entity effectively controls or manages such risks, contractually assumed elsewhere
economically significant risks are bundled together in the analysis of risk control which is inappropriate if the individual risks are controlled by different people and in different ways
relevant facts to the functional analysis using a development, enhancement, maintenance, protection and exploitation (DEMPE) functions framework is not applied to the control over risk analysis with respect to intangibles

A guaranteed return or insulation from exposure to downside through transfer pricing reward mechanisms does not determine the risk profile of a UK business in and of itself, which is still required to be analysed in informing method selection and an arm’s length return.

2.2.6 Functional analysis — intangibles

As part of any functional analysis, facts should be obtained on intangible assets owned by the UK entity. Facts should also be obtained on intangible assets owned by group entities outside the UK, if the UK entity exploits them or contributes towards their development and they are central to the UK entity or group performance.

HMRC often encounters functional analysis where analysis and supporting information for intangible assets is of insufficient depth to support the filed position without further enquiry. As set out in part 1 (managing compliance risk for UK businesses) — transactions relating to intangible assets are an area recommended for greater depth of analysis. HMRC INTM483120 — working a transfer pricing case — penalties — negligence or carelessness example 9 provides a useful illustration for awareness purposes.

Best practice suggestions for specialists performing functional analysis of intangible assets includes, but is not limited to, detailed descriptions of:

research and development functions and functions creating valuable intangible assets
product development or innovation processes and associated stage gates or decision points through to launch and how the UK entity interacts with them
the role of the UK in the DEMPE of economically significant self-developed or acquired intangible assets such as intellectual property, customer lists, rights, software and similar
UK activities, supported by data, relevant to the current commercial exploitation of intangible assets inside and outside the UK, within the wider regional or global context
historic facts (pre-dating the current financial period) relevant to current intangible asset commercialisation activities
identifying intangible assets with sufficient specificity, rather than grouping together under generic headings
where intangibles are bundled and licensed internally, separate DEMPE analysis of the UK functions, assets and risks for different classes of assets where UK involvement varies — for example, where UK has limited role in software platform development but contributes most of the platform content for a specific business area

Where inconsistencies exist between descriptions provided for transfer pricing purposes and descriptions provided for R&D reliefs or patent box claims, HMRC’s view of the risk profile of the UK business will be increased.

2.2.7 Evidencing people functions

For many UK businesses, their people functions should feature highly in any functional analysis. This is through descriptions of functions or teams represented in the business. It may also be through the importance of specific roles in the value chain and decisions to take on or lay off risk.

Mismatches between functional analysis within transfer pricing documentation and facts established through a review of UK staff and functions are a common cause of compliance risk for UK businesses.

HMRC wishes to share best practice suggestions that support high quality functional analysis in both:

employee functional profiles
functional interviews

Employee functional profiles

In HMRC’s experience building and documenting a factual understanding of the functional organisation, employee profile and local management structure is key to high quality functional analysis. Employee profiles can provide an efficient completeness check for functions that simple questionnaires may not identify. They can also highlight roles which can inform risk analysis, or which need separate consideration for comparability analysis or method selection.

HMRC recognises that this can be challenging, particularly for diversified groups with multiple functions, divisions or business units. Suggested evidence sources which can help specialists analyse and document UK functions and how they fit with wider group functions include:

local organisation charts and details of individuals to who local management reports and the jurisdictions in which such individuals maintain their principal offices
group staff grading structure relevant for UK functions (from HR manuals or system records) with descriptions of what a grade represents in narrative or number of reports below c-suite
details of the number of UK employees (or UK secondees) by grade and function or department
job titles for senior staff working in the UK with grade and reporting line
role specification for heads of function, department, business unit or division led out of UK covering details of teams and countries or areas they are responsible for — for example, HR job adverts or job descriptions and functional interview notes
role or remit and core membership composition of strategic decision making forums relevant to the UK transfer pricing position, such as terms of reference, example minutes
project operating models, for example, project teams and employee membership by grade where these represent important functions of the UK business
profiles of bonus schemes by department such as details of staffing grades that are eligible for share or separate bonus incentives and UK awards received in global context
profiles of the people impact of business restructuring or reorganisations such as communications materials, redundancy or Transfer of Undertakings (Protection of Employment) between entities, ads for new roles created

Functional interviews

In HMRC’s experience the quality of functional analysis that does not describe the UK with specificity can be significantly improved through functional interviews, especially where taking a multi-territory report approach. Interviewees should be commercial staff in the business who have day to day experience and a thorough understanding of operating the relevant functions — read INTM484040 — examining transfer pricing reports — information in a report — functional analysis.

This is particularly useful where evidencing the importance, weighting or impact of roles and functions is proving difficult through objective data sources. Features of best practice approaches to functional interviews include:

use of multiple interviewees, from different parts of the global business, to provide a more rounded perspective of an issue
interviews conducted contemporaneously, identifying and retaining contemporaneous records and documentation to corroborate responses
free scripted discussion on relevant areas to be evidenced avoiding yes or no questions and confirmation bias in questioning
original copies of the interview notes retained, with any amendments limited to reflect interviewee review points explicitly agreed with them, so that they can be made available to HMRC upon request

UK businesses with contemporaneous and objective interview evidence are better equipped to support their conclusions in the event of a later enquiry at which point key individuals may have left the company.

Question 5

2.3  Common issues with comparability analysis

Accepted Answer

HMRC frequently encounters issues with descriptions in documentation comparability analysis or stand alone benchmarking studies being too brief or incomplete. Lack of detail can arise in descriptions of:

how the final comparables set was arrived at
how UK specific comparability factors are met
what work has been done to establish them as the most reliable

This part aims to help specialists conduct and document comparability analysis to a high standard. It includes HMRC’s view of best practice approaches in a number of areas including:

2.3.1 General comparability analysis documentation observations
2.3.2 Centralised comparability analysis
2.3.3 Reuse or roll forward of comparables
2.3.4 Common risks in comparability analysis

The OECD TPG sets out the objectives of a comparability analysis. The expectation is that a detailed comparability analysis is performed for each documented category of controlled transactions. The price and conditions of the controlled transaction as accurately delineated should be compared with those of a comparable transaction between independent enterprises. HMRC INTM485021 — Comparability Analysis provides more commentary on the role of comparability analysis. This part on best practice approaches does not attempt to summarise that guidance and should not be used as a substitute.

2.3.1 General comparability analysis documentation observations

In HMRC’s experience, high quality examples observed of comparability analysis documentation to support the filed position which specialists may wish to consider in their approaches include a well documented:

process for identifying external comparables
search for potential internal comparables and conclusions
explanation of the profit measure selected
analysis of areas where comparability is less reliable

Process for identifying external comparables

A well documented process for identifying external comparables would be in a format capable of review and audit and feature:

clear audit trail of search criteria employed
clear steps showing how comparables were reviewed, accepted and rejected
clear explanations for judgements and positions taken
tables detailing the accept or reject criteria applied to each potentially comparable entity, rather than summary statements
accept reject criteria audit trail for comparables where a multi-territory benchmarking approach is used, comparing comparables with UK comparability factors specifically
references sources used to form judgements in arriving at the final set such as Bureau van Dijk business description or website review

HMRC INTM483120 — working a transfer pricing case — penalties — negligence or carelessness examples 1 and 2 provide useful illustrations for awareness purposes.

Search for potential internal comparables and conclusions

A well documented search for potential internal comparables and conclusions would contain searches that are reasonable given the nature, size and complexity of the intercompany transaction and clearly feature:

the process used to identify and select the most relevant workable sample of internal comparables
explanations as to why those reviewed were selected and where relevant, rejected

Examples might include:

a description of records maintained by the business that list and summarise third party business-to-business arrangements and the basis for selecting most relevant sample to the controlled transaction for further checks
documentation of discussions and conclusions regarding any new or previously unidentified third party business to business outsourcing in the period. For example, supply, contract service or collaboration arrangements that are potentially comparable in areas such as sales, marketing, supply, technology, product, infrastructure and research

HMRC INTM483120 — working a transfer pricing case — penalties — negligence or carelessness example 7 provides a useful illustration for awareness purposes.

HMRC recognises that in some cases it is impractical to consider all third party arrangements. In these circumstances clear criteria focused on identifying the most reliable sample should be used and described.

Explanation of the profit measure selected

A well documented explanation of the profit measure selected (return on cost, income, or assets) would feature:

why this measure was selected over others, for example, return on cost, income or assets
for net margin measures justification for the level at which the margin is calculated, for example, earnings before interest and tax (EBIT), operating profit post trading foreign exchange (forex)

Analysis of areas where comparability is less reliable

A well documented analysis of areas where comparability is less reliable in the context of comparability factors identified would include:

how range refinements applied have resulted in the most reliable comparables set in the context of comparability factors
how any appropriate comparability adjustments have improved comparability
how any statistical methods have increased comparability and increased reliability

2.3.2 Centralised comparability analysis

Transfer pricing comparability analysis is sometimes performed centrally to cover multiple regional or global territories. This approach uses functional analysis performed for a typical reference entity and usually relies on a single benchmarking study. Centralised analysis might be performed in-house at a head office location or by a centralised third party provider.

This approach is reasonable if the analysis includes enough UK entity ‘localisation’ to reflect the functional analysis for the UK business. The degree of localisation required will vary. The facts and circumstances of the UK entity relative to the content of the ‘typical’ entity functional analysis will affect the degree of localisation needed.

Where a centralised analysis approach is taken, HMRC considers best practice to include these approaches to support the UK position:

checks that UK-specific comparability factors are reflected in the comparability analysis and pricing
checks to make sure comparables in the single regional or global benchmarking study are sufficiently comparable to the functional and comparability analysis of the UK entity
a review of the comparability of non-domestic comparables included within multi-territory comparables sets, particularly regarding economic circumstances including market differences and differences in accounting standards

HMRC INTM483120 — working a transfer pricing case — penalties — negligence or carelessness example 5 provides a useful illustration for awareness purposes.

2.3.3 Reuse or roll forward of comparables

Transfer pricing analysis of a current period sometimes reuses comparability analysis prepared for a prior financial period. This approach is often referred to as a ‘roll-forward’ exercise in which comparables data is updated for comparable entities identified in the earlier period, but a fresh search for comparable entities is not performed.

In seeking to reuse and roll forward comparables from a prior period, HMRC considers best practice to support the filed position to include:

establishing that there have been no changes to UK functional analysis that might impact comparables selected
updating financial data for comparables to sufficiently cover the current period (or relevant multi-period average) results of rolled forward comparables
checking comparables identified in prior periods remain appropriate, rather than rolling forward prior year comparables by default, by confirming the economically significant factors of the UK entity and comparable entities have not changed, for example, independence criteria or nature of activities
performing new comparability searches every three years as a minimum

A roll-forward exercise is only likely to be a reasonable approach where the transactions of the UK entity have been properly delineated in an earlier period as a result of a detailed functional and comparability analysis, and where the business activities of the tested party and the comparables are unchanged. HMRC’s expectations are that this continuity should be properly established and documented and should not be assumed. This includes contemporaneous evidence that no update to the functional analysis and delineation conclusions is required.

2.3.4 Common risks in comparability analysis

These examples represent approaches to comparability analysis encountered by HMRC that resulted in comparables being rejected, or which HMRC requested to be reperformed or supplemented with further work. Such approaches can create compliance risk due to the fact that the arm’s length return may not have been achieved.

This part covers some of the most common approaches HMRC encounters which can create compliance risk in the areas of:

comparables search design
comparability and reliability of comparables

Comparables search design

Compliance risk can be created where the design of comparables searches features any of these approaches:

reasonable searches for internal comparables have not been included, for example:
- the report states that ‘the tested party did not purchase similar goods from an unrelated party, therefore the internal comparable uncontrolled price (CUP) method is rejected’
- on further investigation, such a search was not performed and potential comparables were either not considered at the time or were passed over in preference for the transactional net margin method (TNMM) (a method often selected by default or design)
criteria used to design search parameters are not based on the economically significant activities, or comparability factors arising from the functional analysis
use of search criteria that cannot reliably cover all the functions and services to be priced
search design that is set to cover a wide range of industries with differing activities resulting in a broad comparables range that includes highly differentiated enterprises without:
- further refinement of the range to identify the most reliable comparables
- evidence as to the scarcity of same sector comparables
the basis for any accept or reject criteria used has been automatically applied at all stages of the search without sufficient manual review to remove the less reliable potential comparables before statistical analysis is applied
a single set of comparables is used for multiple territories including the UK without checking whether UK search parameters would be the same
lack of focus on the UK entity, and economically significant factors identified in the accurate delineation, when searching for and refining potential comparables

Comparability and reliability of comparables

Compliance risk can be created where work to determine the most reliable comparables features any of these approaches:

broad ranges of comparables used which are unlikely to be equally reliable or comparable, but analysis of their comparability as against reasonable comparability factors has not been assessed or conclusions drawn
comparables identified for a specific transaction that are subsequently applied to a different transaction without proper consideration as to whether the comparables are sufficiently similar to be reliable
reliance on a single comparables search to cover multiple functions (blended comparables), without support for or explanation as to how the functions meet bundling criteria or whether if separated into distinct sets the arm’s length return would be different
absence of checks for material differences in profit and loss line item comparability of the UK entity and comparables — discerned where accounts are available for example from:
- different treatment of pass-through costs, reimbursed expense or income as agent or intermediary
- different accounting presentation of costs between cost of goods and operating expenditure
application of the inter-quartile range to comparables by default rather than when application satisfies the criteria as set out in OECD TPG or before attempts to refine the range using comparability factors
low value adding functions priced under a separate transfer pricing policy within the UK entity are not removed from the cost base of comparables for higher value functions, depressing the effective mark up on costs
comparability adjustments under OECD TPG not considered

Question 6

2.4  Common risks in calculations and adjustments

Accepted Answer

HMRC commonly observe errors in the calculation of the arm’s length result. This is used in an accounting period to compare with the arm’s length price or range based on the group policy. These calculation errors can result in:

comparison of incorrect profits or losses achieved with the arm’s length price or range
necessary transfer pricing changes or adjustments being overlooked or mispriced
UK businesses filing a return on a non-arm’s length basis despite undertaking compliant analysis and documentation
sizeable unforeseen adjustments unprovided for in the accounts or double taxation

This part includes common examples designed to assist specialists in helping UK businesses minimise the likelihood of such errors occurring in the areas of:

2.4.1 Errors of allocation, apportionment and categorisation
2.4.2 Common risks in giving effect to transfer pricing changes and adjustments

2.4.1 Errors of allocation, apportionment and categorisation

Compliance risk can be created where calculation of the profit or loss achieved under a transfer pricing policy for the period contains these errors or approaches:

errors in calculating the allocation of costs or revenues to the UK entity under the allocation key defined in the group transfer pricing policy, for example, use of incorrect numerator or denominator for allocating shared service centre costs or share based payments
errors in allocating costs or revenues between different transfer pricing policies within a UK entity, for example, due to lack of analysis between ‘direct’ costs (specific to a single product, service, or asset) versus ‘indirect costs’ (specific to a more than one product, service or asset requiring a just and reasonable basis of allocation)
cost, revenue or asset bases used in TNMM calculations that cannot be reconciled to the UK entity’s statutory accounts, and there is no analysis and explanation of any differences
including all costs and revenues not covered by other function or service specific transfer pricing policies within a ‘residual’ profit and loss, for example, inclusion of all costs outside of a cost-based contract R&D policy within a residual profit and loss for inbound marketing and distribution, regardless of whether such costs relate to the residual function or are reflected in comparability analysis
allocating IP costs not in line with the IP ownership model or cost share or similar arrangement, for example, R&D or marketing intangibles spend
incorrectly blending operating margins for related party and third-party transactions, for example, not separately calculating operating margins when the tested party has both sales or services to third parties and related parties resulting in one margin subsidising the other
calculations based on management account-based transfer pricing that do not reflect key differences between management accounts and the audited statutory accounts such as:
- material generally accepted accounting practice (GAAP) and accounting standard differences
- central cost allocations excluded from entity level management accounts
- year end audit adjustments

In addition, issues can arise where calculations of the profit or loss achieved under transfer pricing policies are based on a different GAAP to the UK statutory accounts and there are material differences in how certain items will be treated in the UK entity’s statutory accounts. For example, how the treatment of stock-based compensation and amortisation of intangible assets affects TNMM returns achieved for service fees.

Ultimately, the profit or loss under a transfer pricing policy will need to reconcile to the UK entity’s GAAP statutory accounts. HMRC recommended maintaining information and allocation schedules showing how the financial data used in applying the transfer pricing method may be reconciled to the annual statutory accounts.

2.4.2 Common risks in giving effect to transfer pricing changes and adjustments

Compliance risk may also be created in giving effect to in year changes to transfer prices (including year end ‘true ups’), or adjustments through the tax return. This sub-section contains our observations of where risk commonly occurs in giving effect to transfer pricing changes and adjustments. The observations are non-exhaustive.

Common risks in giving effect to transfer pricing changes during the accounting period

Where UK businesses seek to amend transfer prices either prospectively during the accounting period or retrospectively at year end before the accounts are finalised, specialists may wish to monitor for these risks:

not taking into the account the extent to which price changes will flow through to the balance sheet (for example, stock and work in progress) as opposed to the profit and loss
failure to consider any indirect tax consequences in the UK or other tax jurisdictions of any transfer price changes effected through additional invoices or credit notes, for example customs duties

In addition, ‘loading’ or ‘grouping’ of transfer price changes relating to a wide range of transactions with multiple entities or territories onto one or more major product, service, or supply, from a single or reduced number of territories can create risk.

Such adjustments can leave the UK exposed to a less than arm’s length return for one or more counterparties in non-UK jurisdictions. Risk is increased where such loading is unduly weighted toward increasing prices from low tax supply or service points, or reducing prices from high tax equivalents.

Common risks in giving effect to transfer pricing adjustments through the relevant tax return

Where UK businesses seek to amend transfer prices solely through the relevant tax return after the accounts have been finalised and where time limits permit, specialists may wish to monitor for these risks:

netting off transfer pricing adjustments for separate transactions which increase or decrease UK entity profits or losses where the one-way street principle would apply if treated separately — in this context netting off does not include intentional set-offs discussed in paragraphs 3.13 to 3.17 of the OECD TPG
transfer pricing adjustments relating to a non-UK tax audit or equivalent which have the effect of giving double tax relief, for which relief is only available under the Mutual Agreement Procedure process

Specialists should make sure that in giving effect to transfer pricing adjustments, the UK entity’s profits for each chargeable period are arm’s length. The arm’s length return of the UK entity cannot be calculated or tested based upon averaging the UK entity’s results over multiple accounting periods. Adjustments if required should be calculated separately for each period and applied to the individual tax returns affected whilst respecting the one-way street principle. Relief against double taxation can be requested under MAP where available.

Question 7

2.5  Documenting the functional analysis

Accepted Answer

HMRC frequently encounters transfer pricing documentation which is too high level and insufficiently evidenced. In these circumstances HMRC are unable to assess from the documentation whether an arm’s length return has been filed. This can lead to additional compliance costs for businesses.

HMRC recognise that compliance budgets and other factors can impact the scope and depth of analysis and sufficiency of documentation. Where appropriate underlying work has been performed, it is important that the documentation fully reflects this, as this can result in additional compliance burdens for businesses that could be avoided.

Previous parts have focused on best practice approaches to transfer pricing analysis. This part highlights both best practice and unhelpful approaches to functional analysis documentation:

2.5.1 Best practice documentation approaches
2.5.2 Common quality issues with documentation of the functional analysis
2.5.3 Documenting functional analysis conclusions
2.5.4 Documenting the arm’s length result

Contents of this part are relevant for:

formalised transfer pricing documentation comprised of transfer pricing reports including OECD analysis and benchmarking studies, or for local and master files where applicable
UK businesses exempt from preparing the master and local file but who are obliged to retain sufficient documentation to evidence the tax return is correct and complete, and evidence the arm’s length return in the event of an enquiry

For many businesses subject to corporation tax, adoption of the OECD master and local file requirements (read INTM450000 — Transfer pricing records) introduced a formal requirement to produce local and master files for accounting periods commencing on or after 1 April 2023 within 30 days of request. HMRC already requires all groups subject to transfer pricing rules to maintain evidence to demonstrate an arm’s length result. OECD TPG Chapter 5 sets out transfer pricing documentation guidance.

Content of this part supplements HMRC guidance on keeping records and ‘evidence to demonstrate an arm’s length result’ — read INTM483030 — working a transfer pricing case — transfer pricing documentation. It does not attempt to summarise that guidance and should not be used as a substitute.

2.5.1 Best practice documentation approaches

In documenting functional analysis and resulting conclusions, there are a number of general best practice approaches which can allow HMRC to place greater reliance upon the contents. These include:

documentation of transfer pricing analysis performed immediately after the analysis has been performed and conclusions drawn. Documentation delayed until after the tax return has been filed, even where the analysis is complete, can carry penalty risks where the requirement to provide a local file applies, and carries a 30-day notice period — read INTM483030 — working a transfer pricing case — transfer pricing documentation
transfer pricing documentation that clearly distinguishes between facts obtained and the technical transfer pricing analysis, and conclusions formed by the specialist, with facts organised separately allowing them to be viewed objectively without overlay of opinion or technical interpretation
statements of facts that are cross referenced to the underlying source of evidence that established or tested those facts
functional analysis documenting the work in detail, for each category of controlled transactions, highlighting any changes compared to prior years

Regardless of whether local file requirements apply, HMRC recommends documentation be prepared unless exempt in line with the OECD’s recommended approach. Businesses should be in a position to evidence the functional analysis that was performed at the time and the facts that it was based upon to support the tax return.

2.5.2 Common quality issues with documentation of the functional analysis

HMRC wishes to promote awareness of approaches to documenting function, asset and risk analysis that specialists should seek to minimise. Such approaches can create a perception of risk, as they are unable to provide HMRC with confidence that the functional analysis is accurate and reliable. They include:

It is recommended that the facts that proved determinative to analysis are documented — those that identified the economically relevant characteristics or comparability factors identified in the commercial or financial relations between the associated enterprises (OECD TPG 1.36).

2.5.3 Documenting functional analysis conclusions

HMRC often observe insufficient explanation of how conclusions were arrived at within documentation.

When under enquiry it can be particularly challenging to evidence how conclusions were reached if all that is recorded is some of the base facts considered. It is important to also highlight the key facts that were drawn upon at the time in reaching the conclusions under the steps set out in OECD TPG.

Best practice examples of documenting conclusions feature these attributes:

documentation of risk analysis conclusions covers identification of the relevant economically significant risks of the group, and for each risk separately the extent UK parties assume or contribute to the control of them, and the structure, role and composition of committees and decision bodies managing economically significant risks
intangible asset DEMPE functional analysis conclusions distinguish between UK entity and counterparty controlling versus performance functions, with any conclusions also incorporated into documenting the risk management analysis for intangible asset risks
UK entity transaction ‘characterisation’ conclusions:
- document the facts drawn upon across the functions performed, assets used, and risks assumed by the UK entity reflecting actual conduct
- sets out and reconciles any differences in the role of the UK entity per intra-group contracts or transfer pricing policies and actual conduct
- for example, characterisation is based upon a documented analysis of UK based employees’ headcount (functions, roles, payroll or pay band) or facts established through objective interview of non-tax function employees such as function or department heads
options realistically available conclusions set out the alternatives from the perspective of both sides of the transaction, and outline which options have been considered and any reasons for rejection, for example:
- whether the entity needed to enter that transaction or had better prospects going it alone
- whether more commercially attractive alternatives existed
- whether they accepted terms unlikely to be acceptable in independent circumstances between two third parties
conclusions relating to business restructurings set out the transfer pricing analysis in support of valuations used and the commercial rational from an entity and group perspective, together with any impact on other transactions in scope — valuations prepared for another purpose such as fair value for financial reporting are not a substitute for analysis

2.5.4 Documenting the arm’s length result

When documenting the profit or loss of the UK entity under its transfer pricing policies, it is important that HMRC can clearly understand how the profit or loss has been determined under each policy. This helps limit the need for further information to understand the basis of the profit or loss calculations and how they relate to the signed accounts. Best practice documentation approaches include:

a reconciliation of the returns under separate policies to the statutory profit and loss results and any revenue or costs not covered explained or adjustment proposed
clear documentation of demarcation of related and unrelated party profits or losses and the basis of allocation of any shared costs between them
details of numerators and denominators of allocation keys used to allocate costs or revenues between policies or between entities
where a UK entity splits its profits with a non-UK entity, an audit trail describing the process by which the profits of the parties were put onto a common basis as to accounting practice and currency and then combined and allocated

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