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Indicators of transfer pricing policy design risk (part 3)

Updated 19 December 2025

Who should read this part

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 
• reviewing for risks in existing transfer pricing policy approaches

Why it is important 

In HMRC’s experience, compliance risk is often created by setting transfer pricing policies which appear high level and insufficiently supported by analysis, or which do not adequately reflect the facts and circumstances of the UK business. 

This part of these guidelines aims to allow specialists to identify common risk indicators of policy design which may feature in their arrangements. It sets out: 

• high risk indicators, which based upon our experience can result in enquiry compliance costs or transfer pricing adjustments for UK business
• best practice suggestions to reduce risk

This will enable specialists to check that the indicators are not evidence of underlying non-compliance risk, and either:

• where individual facts and circumstances indicate this is the case use the accompanying suggestions as to best practice to reduce the risk
• where the indicator has not resulted in risk, proactively document the conclusions as to how the policy design resulted in an arm’s length return, understanding this is likely to be an area of greater scrutiny by HMRC

This content highlights HMRC’s view of common indicators of high risk approaches to policy design in a number of relevant areas:

• 3.1 — General risks in policy setting approaches
• 3.2 — Intangible assets ownership and exploitation
• 3.3 — Above market intra-group services
• 3.4 — Transfer pricing target margin models
• 3.5 — Cost based reward for services
• 3.6 — Sales based reward for services
• 3.7 — Franchise fees and similar single fee arrangements
• 3.8 — Offshore procurement hubs

Financial transfer pricing is 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.

These guidelines do not represent the views of HMRC’s underlying policy positions. The risk areas included are not an exhaustive list and they are not presented in order of priority. No inference can be made of the risk profile of transactions not covered by these guidelines. 

Areas covered in this part may have interactions with other rules of taxation, for example, Part 8 of the Corporation Tax Act 2009, VAT and withholding tax. They are not within the remit of these guidelines and specialists should consider these separately. 

3.1 General risks in policy setting approaches 

A common driver of risk in transfer pricing policy setting or method selection is where there is significant divergence between: 

• transfer pricing group policy design goals or operational simplification aims
• how the UK business actually operates based on functional analysis and actual conduct 

General risk indicators

General indicators of such risk which can carry a high risk of transfer pricing error include: 

• reliance on contractual allocation of risk when this differs from the capacity or capability to bear risk as evidenced by underlying conduct 
• reliance on legal ownership of assets or rights as justification of entitlement to residual profits from those assets, without regard to the function and risk profile of others in contributing to asset value and the arm’s length return for those contributions 
• group policies based on effective tax rate goals divorced from operational reality 
• fragmentation of a multi-functional or complex entity into numerous separate ‘routine’ policies which result in a lower return than if viewed holistically — read INTM440130 — Types of transactions — intangibles — fragmentation 
• inclusion of, on first impression, commercially irrational terms, that do not feature in third party arrangements or that parties would be unlikely to enter into at arm’s length

Best practice approaches to reduce risk

General risks in policy setting are reduced when transfer pricing policy is based upon robust analysis as set out in part 2 (Common issues in transfer pricing documentation). Such analysis should reflect the actual conduct as opposed to solely contractual terms of the relevant parties. 

Policy design should be based on evidence of the commercial and financial relations for the 5 categories of economically relevant characteristics of the transactions, which are:

• the contractual terms 
• the functions performed by each of the parties to the transaction, considering assets used and risks assumed
• the characteristics of property transferred, or services provided 
• the economic circumstances of the parties and of the market in which the parties operate
• the business strategies pursued by the parties 

Risk is further reduced where those familiar with day-to-day business operations are involved in sense checking the outcomes.

3.2 Intangible assets ownership and exploitation 

Common risks in setting transfer pricing policies or intra-group contract terms that determine the owner’s share of proceeds from exploitation of intangible assets are set out in this part — read INTM440120 — Types of transactions — intangibles — how are intangibles exploited. HMRC best practice suggestions to reduce risk are also featured.

Where high risk indicators are present within the approach adopted by a UK business, specialists are encouraged to review the compliance approach and either recommend changes or evidence and document in their analysis how the approach featuring the risk indicator has resulted in an arm’s length return.

HMRC recognises that in multinational groups, centralised ownership of intangibles, including intellectual property can simplify business. However, we frequently observe compliance risk, where:

• the approach attributes income directly or indirectly to a company with legal ownership 
• the company in question lacks the capability or capacity to develop, enhance and exploit the intangible asset

This is particularly the case where development, enhancement, maintenance, protection and exploitation (DEMPE) functions are sub-contracted to an affiliate. 

If high risk indicators are present in the policy design, HMRC recommend specialists review the compliance approach. This is likely to result in either:

• recommended changes to the policy including our suggested best practice 
• evidenced analysis of how the policy resulted in an arm’s length return within documentation

High risk indicators — intangible assets ownership and exploitation

Compliance risk can be created where intangibles ownership and residual income are located in companies with either limited substance or little apparent management of risk relating to the intangible. Examples of risk indicators include:

• ownership located in manufacturing companies where manufacturing process development is not a key driver of value creation
• ownership located in ‘master distributor’ intermediaries where economically significant market risk driving profits is managed in local distribution affiliates
• ownership located in ‘intellectual property (IP) owning entities’ where important functions and control of economically significant risks relating to that IP are effectively ‘contracted out’ — this includes to affiliates who may have realistically available alternatives to retain ownership, form a cost contribution arrangement (CCA) or a similar shared intangible risk and return arrangement or receive royalties typical for the industry
• where ownership is centralised into ‘IP owning entities’, said to control the economically significant risks associated with exploitation, but legal ownership is only transferred for selective assets when the probability of success is high, and the legal owner must rely on affiliates to exploit the intangible commercially
• where intangibles are licensed to ‘IP owning entities’ where the development of replacement assets is not controlled by the legal owner, but allocation of the residual continues after the assets have been effectively refreshed or replaced — an example of this would be software development
• where UK entities are participants of loss-making intangible development CCAs (or similar arrangements) where documentation insufficiently evidences that the UK entity would have incurred those losses at arm’s length
• where there are material changes to the expected benefits of a CCA (or similar arrangements) including the UK and there does not appear to be any ongoing assessment of whether the CCA outcome remains arm’s length
• UK ‘IP owning entities’ incurring significant levels of amortisation charges on intangible assets acquired from affiliates, relating to any form of intangible asset arrangement
• where an affiliate pays a license fee to use intangibles in their business and there is a disparity between the payment and reward received by the affiliate for contributing assets, economically significant functions or risk management and control of the intangible assets
• new IP ‘owning entities’ licensing group intangibles who lack the capacity or capability to control risk without relying on exploitation of the assets to finance acquisition costs from licensees
• where UK entities are undertaking ‘Blue sky’ research, platform IP development, or other important functions (as listed in 6.56 of TPG) and are rewarded by a margin on cost without analysis and documentation as to whether a realistically available alternative to share in profit exists
• benchmarking exercises to identify comparable IP agreements have not been screened with reference to the most economically relevant characteristics so as to identify comparables reflecting key factors such as stage of development, exclusivity, useful economic life, attrition risk and the effective underlying profit split represented by the royalty
• risk management (control and mitigation) decisions relating to intangibles development, enhancement and maintenance are fragmented across multiple group decision making bodies and committees populated by employees of numerous group entities resident across the globe, with the residual return accruing to the legal owner by default
• reward is attributed to the legal owner for intangibles which represent the collective human capital assets of knowledge and know-how networks within affiliates harnessed within a central system or repository
• royalty waivers or contractual terms where royalties are varied due to non sales related factors

Best practice approaches to reduce risk — intangible assets ownership and exploitation

In HMRC’s experience risk can be reduced by adopting these best practice approaches:

• ensuring transfer pricing policies for intangibles align the return from the exploitation of the intangible with the control of the relevant economically significant risks and other important functions
• retaining appropriate contemporaneous forecasts supporting intangibles evaluation
• checking that allocation of income relating to intangibles development or commercialisation considers internal comparable uncontrolled transactions with appropriate comparability adjustments
• undertaking a periodic review of CCA (or similar arrangement such as a cost share agreement) participants relative shares of expected benefits and consideration of whether adjustments are necessary (8.22 OECD TPG)
• ensuring the analysis of the role of the UK in risk control does not ignore risk control or management roles for economically significantly risks below the top level of senior management, or exercised jointly in concert with other affiliates
• documenting options realistically available to both parties (including the UK) in group IP restructuring situations and assessing without hindsight whether there were any alternatives offering a greater opportunity for the parties to meet their commercial objectives
• undertaking proper comparability analysis — read part 2 (Common compliance risks), in selecting benchmarks for UK functions, assets, and risk in relation to intangibles using the DEMPE framework
• retaining evidence that potential internal comparable uncontrolled prices (CUPs) have been robustly reviewed and external CUPs fully explored including corroborative analysis where helpful
• reviewing instances of royalty waivers or royalties varied due to factors other than sales to ensure they are arm’s length

HMRC INTM483120 — working a transfer pricing case — penalties — negligence or carelessness examples 8 and 9 provide useful illustrations for awareness purposes.

Other considerations

Note that consideration should be given to Part 8 Corporation Tax Act (CTA) 2009 where there is either:

• a transfer between a UK company and a related party of an intangible asset
• a grant of licence or other right in respect of an intangible asset between a UK company and a related party

Such consideration includes the recognition and accounting of any intangible assets and associated amortisation. Market Value or Fair Value valuations may feature in these circumstances together with, or in place of the arm’s length price.

Guidance on intangible asset valuation issues can be found in CIRD10240 — Intangible assets — introduction — valuation issues.

3.3 Above market intra-group services

Compliance risk can be created where UK staff have global or regional roles which either: 

• control key DEMPE functions or economically significant risks 
• create the profit-earning activities and contribute to economically significant activities of the group 

These roles are often known as ‘above market’ activities. This is because the role benefits territories other than the UK. 

HMRC recognises that identifying uncontrolled entities under comparability analysis can be challenging. Above market functions are often of a nature kept ‘in-house’ by multinational businesses and rarely outsourced.

HMRC often observes reward for these activities either: 

• subsumed within policies for low value adding services 
• based on a mark-up of cost or UK only sales 

Functions are often fragmented across several affiliates, and not given sufficient focus in individual entities transfer pricing arrangements. 

Whether the above market service requires an arm’s length return beyond existing policies depends on the facts and circumstance of each case. In HMRC’s experience these activities can often: 

• fall outside the OECD TPG on low value adding intra-group services 
• impact revenues and profits beyond that of the UK

If high risk indicators are present in the policy design, HMRC recommend specialists review the compliance approach. This is likely to result in either:

• recommended changes to the policy including our suggested best practice 
• evidenced analysis of how the policy resulted in an arm’s length return within documentation

High risk indicators — above market intra-group services

Compliance risk can be created where multi-territory, regional or global functional heads, heads of department or senior leadership roles are based in the UK. Examples of risk indicators include where: 

• transfer pricing policy is based upon a contractual description of the service without analysis of the underlying conduct and reflection of any leadership of economically significant functions or management of economically significant risks
• transfer pricing policy does not address roles that benefit other territories or entities, or the extent of actual management and mitigation of economically significant risks compared to where risk is attributed
• the costs for global or regional functions are subsumed within calculations for other UK sales or cost-based transfer pricing policies applying to the entity ‘in territory’ functions for which comparability or bundling criteria for combined transactions would not be met
• an inappropriate profit level indicator is employed, for example return on UK sales where activities drive the sales line in non-UK territories
• activities are described as ‘routinely capable of outsourcing’ but for which credible outsourcing options or comparables do not appear to exist, which may indicate roles with risk management responsibilities
• transfer pricing policy is designed for service costs not to be charged to affiliates to avoid legal restrictions on remittance or to mitigate tax deductibility or withholding, when such costs would not be borne by the service provider at arm’s length

Best practice approaches to reduce risk — above market intra-group services

In HMRC’s experience risk can be reduced by adopting these best practice approaches: 

• performing a detailed functional analysis following the guidance in part 2 (Common compliance risks), paying particular attention to identifying above market roles and functions 
• determining whether any of the above market services typically represent low value adding services
• for high value adding services, analysing and documenting the extent to which the above market roles and functions are considered economically significant functions or contribute to the management of economically significant risks, either in whole or in part, and the role of other group entities in that context 
• considering whether internal comparable uncontrolled transactions exist for similar functions within comparable geographies that could inform policy and pricing of some or all of functions and roles
• identifying any industry comparables that include similar roles, or which can be reliably adjusted to aid comparability 
• considering the most appropriate transfer pricing methodology and particularly profit level indicator, based upon functional analysis 
• documenting a reasonable and principled approach to determine a transfer pricing policy and arm’s length price for any remaining roles, leveraging corroborative approaches to support a differentiated return for high value add services — an example of corroboration would be evidencing that a proposed margin on cost equates to an arm’s length commission or gain share on regional income or margin
• ensuring and documenting that individual transactions are priced at arm’s length if seeking to offset reciprocal arrangements instead of invoice and payment and considering any indirect tax consequences of offsetting

Approaches to analysis and documentation that make a serious attempt to separately identify and price above market functions can reduce the likelihood of a non-arm’s length result.

3.4 Transfer pricing target margin models

Compliance risk can be created when target margin transfer pricing policy approaches are used to deliver a fixed return to UK businesses and similar affiliates in other territories.

Introduction of target margin policies that have a material impact on the profit or loss of the UK entity without commensurate changes to the UK functions, assets and risks are a common cause of HMRC enquiries. 

Such policy changes often feature in these situations: 

• conversion of previously entrepreneurial or fully risked entities into managed margin entities such as ‘limited’ or ‘low risk’ distributors, ‘commissionaires’ or ‘contract service providers’
• change of profit level indicator, for example, from a cost to a revenue-based indicator or vice versa
• insertion of new intermediaries into a supply chain such as centralised licensing or service hubs, regional headquarters or master distributors
• centralisation of contractual assumption of economically significant risks
• centralisation of legal ownership of or rights over intangible assets — read part 3.2 (intangible assets ownership and exploitation)

HMRC acknowledges that target margin policies can be appropriate if they are:

• based on appropriate functional and comparability analysis 
• have been properly implemented and documented

However, in HMRC’s experience such policies are often applied to multiple group entities relying heavily on contractual terms and the use of language to characterise and delineate transactions. This is without regard to the specificity of UK functions and conduct to support the policy and method selection. HMRC INTM483120 — working a transfer pricing case — penalties — negligence or carelessness example 5 provides a useful illustration for awareness purposes.

If high risk indicators are present in the policy design, HMRC recommend specialists review the compliance approach. This is likely to result in either:

• recommended changes to the policy including our suggested best practice 
• evidenced analysis of how the policy resulted in an arm’s length return within documentation

High risk indicators — transfer pricing target margin models

Compliance risk can be created where a change to the characterisation of an entity or transaction is based on the policy aims and contractual arrangements as opposed to how the business actually operates in conduct, or commercial realism as evidenced by:

• a policy that changes the characterisation basis of reward for an entity where no significant change to the underlying functions, assets and risks of the entity has occurred
• a policy that purports to move functions and risk away from the UK but then requires intra-group agreements with the UK for contract services or risk management covering those functions and risks
• a risk profile based upon the pricing approach rather than functional analysis, for example citing a guaranteed return as evidence that the UK must be de-risked rather than an analysis of the UK’s actual role in managing and controlling risks
• characterisation based upon the contractual allocation of functions and risk to offshore intermediaries or principals instead of functional analysis of the parties including conduct — examples might include describing a marketing hub as ‘responsible’ for pricing parameters or strategy despite them being set elsewhere
• the UK as ‘bearing no risk of development’ where costs are recharged but the UK has a role in the control of development risks
• an HQ or hub as providing a range of assets and services when in fact these are provided through services contracts with affiliates

Risk can also be created where the implementation of the target margin model results in the loss of rights or revenue streams to the UK entity without considering:

• whether exit charges, notice periods or termination compensation would apply in comparable independent circumstances, for example, a 3 month termination notice following significant capital investment to service the contract
• options realistically available for the UK entity to the target operating model that would support commercial objectives, such as continuing as a full risk distributor manufacturing its own product

Best practice approaches to reduce risk — transfer pricing target margin models

In HMRC’s experience the risk that the characterisation of entities or transactions under a target margin model does not reflect how the business actually operates can be reduced by adopting these best practice approaches:

• following the guidance on appropriate functional and comparability analysis contained in part 2 (Common compliance risks)
• avoiding use of descriptions and broad risk statements regarding the entity that are unsupported by functional analysis
• performing a two-sided functional analysis of both parties on which to base a policy
• evaluating and documenting options realistically available to the re-characterised entity
• highlighting what has changed with regard to UK functions, assets and risks and how commercially the changed terms of transactions with the UK would be entered into at arm’s length

In HMRC’s experience risks relating to commercially unrealistic loss of UK rights or revenue can be reduced by adopting these best practice approaches: 

• checking that intra-group contracts or arrangements reflect commercially realistic exit charges, notice periods and termination compensation per industry norms
• where such terms are not explicitly covered, ensuring they are considered in determining whether a move to or significant variation in a target margin model is arm’s length
• avoiding scenarios where entities characterised as de-risked incur significant costs or exceptional costs relating to exiting an arrangement, such as redundancy costs
• considering options realistically available, and evaluating whether at arm’s length a business would accept the new terms when comparing the target margin offered to any potential exposure to risk or contract termination

3.5 Cost based reward for services 

Compliance risk can be created in the setting of transfer pricing policies providing a margin on cost to a principal under a contract for services. Risk can arise in areas including: 

• selection of methodology 
• the definition of cost base 
• allocation keys employed 
• net profit indicators used in assessing comparability 
• benchmarking of comparable transactions 

If high risk indicators are present in the policy design, HMRC recommend specialists review the compliance approach. This is likely to result in either:

• recommended changes to the policy including our suggested best practice 
• evidenced analysis of how the policy resulted in an arm’s length return within documentation

Summary of high risk indicators and best practice approaches to reduce risk

High risk indicators increasing risk of enquiry	Best practice approaches to reduce risk
Transfer pricing policy is based upon a contractual description of the service provided without examination of the underlying conduct through functional analysis to understand the services actually being performed and risks actually borne and managed. For example, leadership of economically significant functions or management of economically significant risks are generically labelled as ‘advisory’, ‘management’ or ‘support’ services under contract.	In HMRC’s experience risk can be reduced by: • performing a detailed functional analysis • following the guidelines in part 2 (Common issues in transfer pricing documentation)
A cost-based margin approach is applied to ‘above market’ services for which a sales or profit based reward may represent a more appropriate approach.	In HMRC’s experience risk can be reduced by following the guidelines in part 3.3 (transfer pricing target margin models).
Treatment of the defined cost base to which a mark-up is applied, is unsupported by comparability analysis or adjustments to improve comparability — read INTM421060 — OECD Guidelines — Cost plus.	In HMRC’s experience risk can be reduced by analysing the differences in the cost base composition of the entity and of the comparables to understand any differences. Differences may occur in the level (or complete absence) of cost categories as part of the comparability analysis (including functional analysis) which could impact the arm’s length return. Analysis should cover internal costs, external third-party costs and out of pocket or reimbursable expenses where relevant. Differences should be reflected in calculating the effective mark-up on costs, and the cost base to which they can be reliably applied.
Direct costs are excluded from the UK business cost case which feature in the cost base of comparable uncontrolled transactions. As a result, no mark-up has been applied, with costs often erroneously included in a separate sales based TNMM policy return.	In HMRC’s experience risk can be reduced by: • analysing the differences in the cost base composition of the entity and of the comparables to understand any differences • ensuring direct costs relating to the good or service are not included in other transfer pricing policies • adjusting the cost base or effective mark-up for the differences
Cost base definition does not include some or all of indirect costs attributable to the service provided compared to the cost base of uncontrolled entities or transaction used as comparables. This may be either by design or as a result of a separate policy for rewarding support or low value adding functions.	In HMRC’s experience risk can be reduced by: • analysing the differences in the cost base composition of the entity and of the comparables to understand any differences • adjusting the cost base or effective mark-up for the differences
Costs are recharged to other group entities at cost, where these were not incurred as intermediary or agent on behalf of those entities but as part of wider service that would attract a mark-up at arm’s length.	In HMRC’s experience risk can be reduced by ensuring that all costs incurred in the provision of services attract an appropriate mark-up.
Cost base definitions do not include comparable full cost of employment including pensions and share based payments or stock options compared to the cost base of uncontrolled entities or transaction used as comparables.	In HMRC’s experience risk can be reduced by: • analysing the differences in the cost base composition of the entity and of the comparables to understand any differences • adjusting the cost base or effective mark-up for the differences
Costs that are treated as ‘pass-through’ and are excluded from the cost base definition for applying a mark-up where: • they relate to activities that go beyond that of an agency and intermediary in conduct • costs are treated as pass-through purely because they are third party external costs in nature	In HMRC’s experience risk can be reduced by: • correctly identifying third party external costs that represent input costs of the tested party’s business and not treating those costs as automatically pass-through • establishing whether the external cost is to some extent transformed, or the tested party adds value to externally outsourced services An example would be where services are outsourced to a third party for which the tested party is the recipient and who may specify, control or supervise the service for quality and risk management purposes.
Costs are reasonably treated as pass-through costs in the tested transaction, but where there has been a failure to consider if the potential comparables also incur similar costs when testing the transaction.	In HMRC’s experience risk can be reduced by considering if comparable uncontrolled entities, especially within the sector might have similar pass-through costs impacting the effective mark-up such as reimbursement of clinical trial patient fees or influencer fees.
No consideration is given to the differences in Generally Accepted Accounting Principles (GAAP) and accounting standards between the entity and uncontrolled entities used to price the transaction that may materially impact the cost base to be included in any method based on the profit level indicator. For example, distribution costs, depreciation or amortisation appear in different parts of the profit and loss account, impacting the cost base.	In HMRC’s experience risk can be reduced by: • assessing whether any material differences in accounting figures arise from the use of different GAAP frameworks by comparables (for example, pension movements, share-based remuneration, whether costs appear above or below gross margin) — where they do, exploring reasonable adjustments to present accounting figures on a comparable basis for benchmarking purposes.
Cost base relates to functions which may be more appropriately rewarded by reference to a different profit level indicator to cost. For example, ‘marketing activities’ driving the sales line for which a third party would expect a reward linked to sales performance as opposed to cost.	In HMRC’s experience risk can be reduced by: • considering and documenting the appropriate profit indicator in line with OECD TPG • evidencing the typical commercial mechanism of reward at arm’s length under industry norms
Non-specific product or function costs (especially indirect costs and overheads) or group recharges benefiting more than one entity have been allocated to the cost base using an inappropriate allocation key that: • is not the most appropriate allocation key based upon operational drivers • applies to multiple cost categories that have different underlying drivers • allocates all the cost category to the entity without further analysis as to whether an allocation key is required	In HMRC’s experience risk can be reduced by: • sense checking the scope and fairness of the allocation key drivers selected • sensitivity analysis as to allocation key options where the impact is material, and the selection basis is not straight-forward
Where the policy allows for the non-recharge of costs from the UK which will wholly or partly be invoiced back to the UK under the same transaction to avoid what is commonly called ‘round tripping’ but: • analysis has not been performed to evidence whether the outbound or inbound recharges net to nil • customs valuation or VAT impact has not been considered, for example, through a shared service arrangement	In HMRC’s experience risk can be reduced by businesses wishing to rely on offset instead of payment or invoice conducting ex-ante analysis and documentation. This should demonstrate that the offset of value is not expected to impact the arm’s length return that would be achieved if the offset were not to take place. Establishing processes for review on an ongoing basis that the basis of offset remains valid is recommended.
A mark-up is not applied to costs recharged, or only applied to a net amount chargeable receivable to or from group entities on the basis that reciprocal services are provided, unsupported by proper analysis that this does not impact the arm’s length return that would be payable between independent parties.	In HMRC’s experience risk can be reduced by businesses wishing to rely on netting off or offset instead of payment or invoice conducting ex-ante analysis and documentation to demonstrate that the approach does not impact the arm’s length return. Establishing processes for review on an ongoing basis that the basis of offset remains valid is recommended.
Inbound management charges or recharges that are effectively costs of the recipient (as opposed to a charge for services) are unsupported by an appropriate cost breakdown to allow non-deductible costs to be identified such as: • recharges of costs purely capital in nature • recharges of costs borne in the wrong entity to the UK which have not been reviewed for deductibility by the UK recipient • recharges of pass-through costs ancillary to a service where deductibility has not been considered by the UK recipient, for example fines	In HMRC’s experience risk can be reduced by ensuring inbound recharges or pass through costs (which are effectively costs of the recipient) are supported by a cost breakdown which is reviewed by the UK entity for appropriate tax treatment.
Costs are classified as costs of ‘stewardship’ or managing investments without attempting to identify any activities within this cost that represent provision of services to other group members to which a transfer price should apply.	In HMRC’s experience risk can be reduced by analysing costs classified in this way, to identify shareholder costs or beneficial service costs included within the figure.

3.6 Sales based reward for services

Compliance risk can be created where the UK is performing functions or services for which the arm’s length reward is defined and measured with reference to sales. Reward is achieved and managed through the setting of intra-group charges and prices for transactions, for example, cost of goods, recharges, fees and commissions.

Risk can arise as a result of:

• transfer pricing policy, delineation and method selection based upon a contractual description of the service(s) provided without functional analysis of the underlying conduct and economic substance
• policy and benchmarks basing reward for UK activities upon turnover of only the UK entity where this may be insufficient
• comparables search and selection criteria impacting benchmarking reliability
• comparability issues exist relating to the functional margin (revenues less costs) of comparable entities compared to the UK entity

If high risk indicators are present in the policy design, HMRC recommend specialists review the compliance approach. This is likely to result in either:

• recommended changes to the policy including our suggested best practice 
• evidenced analysis of how the policy resulted in an arm’s length return within documentation

Summary of high risk indicators and best practice approaches to reduce risk

High risk indicators increasing risk of enquiry	Best practice approaches to reduce risk
UK manages or controls significant sales or market risks whilst described in the Transfer Pricing policy or documentation as ‘low risk’ or ‘de-risked’.	In HMRC’s experience risk can be reduced by following the guidance in part 2 (Common issues in transfer pricing documentation) for appropriate functional analysis, including: • risk analysis for economically significant risks • understanding the economic substance of services actually being performed
UK has intangibles, rights or unique economically relevant characteristics not appropriately captured in functional analysis or delineation on which the method is based.	In HMRC’s experience risk can be reduced by following the guidance in part 2 (Common risks in transfer pricing documentation), for appropriate functional analysis.
Above market functions are overlooked or unpriced.	In HMRC’s experience risk can be reduced by following the guidelines in part 3.3 (above market intra-group services).
UK ‘limited risk’ distributor paying a royalty or other license or usage fee to operate without functional analysis to determine the conduct of the parties in relation to the assets or services being provided or options realistically available.	In HMRC’s experience risk can be reduced by following the guidance in part 2 (Common risks in transfer pricing documentation) for appropriate functional analysis.
Sales attributable to sales and marketing activities performed by a UK group entity are booked in another non-UK group company, for example through direct invoicing for specific products or channels to market, or because of differences in revenue recognition under GAAP.	In HMRC’s experience risk can be reduced by robustly identifying all sales (UK and overseas) that are driven by the UK activities for which a sales based profit level indicator is appropriate.
UK staff performing value adding functions for customers on behalf of non-UK entities for which non-UK turnover or a different pricing method may be an appropriate basis for reward. Examples may include regional technical support, sales demonstration, promotion, support and training, or regional distribution.	In HMRC’s experience risk can be reduced by: • analysing the type of sales, and how those sales are generated and accounted for and including that analysis in the comparability analysis • following the guidance in part 3.3 (above market intra-group services)
UK staff perform above market functions or control economically significant risks beyond risks typically managed in comparable entities, and reward has been incorrectly subsumed within a UK sales-based return for the local sales, marketing and distribution function. Examples may include regional or global strategic functions or risk control decisions creating value offshore.	In HMRC’s experience risk can be reduced by: • following the guidelines in part 3.3 (above market intra-group services) • identifying roles, functions, and activities not typically capable of outsourcing or not typically present in external comparables
Potential comparables included that do not reflect higher margins on sales in the UK local market than other territories due to local market features or market premium.	In HMRC’s experience risk can be reduced by ensuring proper comparability analysis is undertaken following OECD TPG.
Inclusion of numbers of non-UK comparables in markets with material differences to the UK.	In HMRC’s experience risk can be reduced by ensuring proper comparability analysis is undertaken following OECD TPG.
Margin calculation is after costs attributable to other cost-based transfer pricing policies within the entity, or which do not represent the functional analysis for the activities to be rewarded based upon a margin on sales. This risk is particularly high where a sales based TNMM represents the balance of an entity’s results after cost based rewards (often cost plus) under other transfer policies have been carved out.	In HMRC’s experience risk can be reduced by critically assessing the revenue and cost base of the UK entity used in arriving at the sales-based margin to be priced including: • whether all appropriate costs, including indirect costs have been allocated to the other cost-based policies • whether any costs remaining in the P&L to be benchmarked to a sales-based margin relate to functions, assets and risks not covered by the comparable which may require separate pricing or comparability adjustments
Differences in the accounting definition of sales between the tested party and comparables not taken into account, impacting comparability. For example, whether sales are expressed gross or net of certain costs.	In HMRC’s experience risk can be reduced by ensuring that the same basis of sales is used in margin calculations.
Margins of comparables representing different stages of the supply chain applied to UK sales with no audit trail of searches for comparable stages of the supply chain and no attempt to make comparability adjustments. An example would be use of simple wholesale operations to price retail sales or selling, marketing and distribution operations.	In HMRC’s experience risk can be reduced by ensuring proper comparability analysis is undertaken following OECD TPG and best practice within part 2 (Common risks in transfer pricing documentation).
A single margin on sales based on comparables is applied to the commercial exploitation of aggregated products, services or assets by the UK entity that do not meet bundling criteria and warrant benchmarking by separate sets of comparables. Examples may include wholesale vs retail, or high margin vs low margin products.	In HMRC’s experience risk can be reduced by identifying margins derived from transactions that do not meet bundling criteria and require separate benchmarking.
Comparing a combined margin on sales which includes revenues and costs relating to third party transactions at arm’s length to the uncontrolled comparable entity margin. Examples may include combining resale of third-party vs in house manufactured product, or combining margins on leveraging own intangibles versus licensed.	In HMRC’s experience risk can be reduced by identifying whether margins of the UK entity need to be split out (‘segmented’) to separate third party from related party margins.
Differences in where the cost base is reported because of the impact of different GAAP approaches have not been adjusted for in calculating the margin on sales. For example where a cost category is included in the Cost of Goods Sold (COGS) under UK GAAP, but in operating expenditure for a resale price gross margin comparable.	In HMRC’s experience risk can be reduced by performing, as part of the comparability analysis, a critical analysis of differences in where costs appear in the P&L relative to sales margin as a result of GAAP differences which could impact comparability. Examples include key cost categories included and excluded, GAAP reporting differences, trading costs below the margin Profit Level Indicator (PLI).
Differences in the cost base in calculating the margin on sales because of where comparable costs appear relative to (above or below) the margin profit level indicator have not been considered. Examples may include one-off costs, exceptional costs, restructuring costs, amortisation, indirect overheads, trading forex or share based payments.	In HMRC’s experience risk can be reduced by performing, as part of the comparability analysis, a critical analysis of differences in the cost base composition. This would include identifying differences between the tested party and the comparables in scope of costs or where they appear in the P&L that could impact comparability. Examples include key cost categories included and excluded and trading costs below the margin PLI.
Group synergies as a result of deliberate concerted action by the UK entity and which do not feature in the comparable entity, have not been considered as part of comparability analysis.	In HMRC’s experience risk can be reduced by identifying group synergies beyond incidental benefits and factoring these into comparability analysis.

3.7 Franchise fees and similar single fee arrangements 

Compliance risk can be created where a transaction is priced under a single fee approach that involves a bundle of assets and services. Description often includes franchise fees, value-based fees and variable fees.

HMRC commonly experience issues with the design of transfer pricing policies applied to single fee arrangements that do not appropriately evidence that the transfer pricing method and benchmark reflects the constituent elements and are arm’s length. 

Risk can arise as a result of:

• incomplete analysis supporting the assets and services provided as a bundle via a franchise or single fee arrangement
• pricing approaches that do not align reward with functional analysis based upon conduct, including risk analysis
• similar fees paid by third parties to group entities relied upon as CUPs when group synergies and functional analysis do not support comparability
• the terms of the franchise fee or similar arrangement representing inconsistent or uncommercial arrangements

If high risk indicators are present in the policy design, HMRC recommend specialists review the compliance approach. This is likely to result in either:

• recommended changes to the policy including our suggested best practice 
• evidenced analysis of how the policy resulted in an arm’s length return within documentation

Summary of high risk indicators and best practice approaches to reduce risk

High risk indicators increasing risk of enquiry	Best practice approaches to reduce risk
Analysis of the commercial rationale, namely incremental value to the UK beyond invoicing simplification, and analysis of realistically available alternatives has not been performed.	In HMRC’s experience risk can be reduced by consideration of whether the structures are commercially rational, or occur within the industry between unconnected parties and evaluation of options realistically available to the parties. An example would be ex ante forecasts of the net benefits anticipated from the arrangement.
Evidence to support the single fee level has not been evidenced by two-sided functional and comparability analysis to establish if the arm’s length price of each component bundled into the single fee arrangement can be reliably priced separately, or should be charged for. This is particularly a risk where the overall single fee level is unsupported by internal comparable arrangements with third parties or external comparables and the bundle of assets and services includes: • assets or services sourced by the provider from third parties • assets or services contracted out to entities including the UK • assets or services that represent central hosting of group synergies or collective know how	In HMRC’s experience risk can be reduced by following the guidance on appropriate functional and comparability analysis contained in part 2 (Common issues in transfer pricing documentation) in setting fee levels. This should include: • identifying what represents group synergies or group wide know how • identifying assets or services capable of separate measurement • identifying assets or services contributed by the franchisees • critically evaluating any effective mark-up on assets or services outsourced to third party providers where what is provided is not transformed by the franchisor
Contemporaneous consideration of how the responsibilities, risks, and anticipated outcomes arising from entering the arrangement were intended to be divided at the time has not been performed. An example is where the transaction effectively represents the application of a non-traditional transfer pricing method such as profit split.	In HMRC’s experience risk can be reduced by ensuring contemporaneous documentation of the intentions between the parties and basis of valuation.
The bundle of services and assets is priced so as to attribute significant profit to the franchisor or principal on the basis it includes suggested valuable intangible or intellectual property without analysis as to: • whether these are key value drivers for the group • whether the remaining reward to the franchisee is arm’s length	In HMRC’s experience risk can be reduced by: • following the guidance on appropriate functional analysis in OECD TPG, part 2 (Common risks in transfer pricing documentation) and understanding the economically relevant characteristics • checking that the risks assumed by the franchisor are economically significant and not contracted out to, or managed and controlled to some extent by the franchisee
The fee level is such that the UK operating return is below industry norms for operators pursuing a similar business strategy or realistically available alternatives.	In HMRC’s experience risk can be reduced by critically assessing the UK’s options realistically available and associated benefits versus industry norms.
The fee level reduces the UK operating profit margin below the average levels the UK entity earned prior to entering into the arrangement without evidence of expected additional benefits attributable to the franchise model to compensate.	In HMRC’s experience risk can be reduced by robustly reviewing historical performance and profitability of the UK business if it previously operated as an independent business, or without a franchise fee charge and the impact of the change.
The fee level is the same for all group entities despite varying levels of ongoing contribution to the underlying assets and services.	In HMRC’s experience risk can be reduced by ensuring franchise or similar fees are tailored for group entities take into account their specific functionality and contributions.
The fee level represents a material disparity between the reward received by the UK for providing or refreshing the assets and services comprised within the bundle, and the fee charged to use them.	In HMRC’s experience risk can be reduced by: • ensuring through two-sided functional analysis, that the reward for UK specific assets or DEMPE contributions comprised within the bundle transferred and centralised within the franchisor or licensor is commensurate with the charge to use them • ensuring that the reward to the UK under the franchise model or single fee arrangement for refresh of those assets on an ongoing basis, is commensurate with the charge to use them
Similar fees paid by third parties to group entities are relied upon as CUPs which upon analysis do not reflect differences in the historic and ongoing contributions to the bundle of assets and service provided by the UK.	In HMRC’s experience risk can be reduced by: • undertaking a thorough comparability review of any potential CUPs, with specific attention to the bundle of specified assets and services and consideration of comparability adjustments to improve reliability • ensuring that if internal fee terms differ to comparables, conclusions as to the impact of comparability issues are documented and appropriate comparability adjustments considered
Similar fees paid by third parties to group entities are relied upon as CUPs which upon analysis do not reflect implicit benefits from group membership already available to the UK.	In HMRC’s experience risk can be reduced by undertaking a thorough comparability review of any potential CUPs, with specific attention to implicit benefits from group membership the UK would not need to pay to access.
Similar fees paid by third parties to group entities are relied upon as CUPs which upon analysis do not reflect differences in the rights to upside or downside returns between the UK and the related party.	In HMRC’s experience risk can be reduced by undertaking a thorough comparability review of any potential CUPs, with specific attention to the extent to which the transfer prices, or revisions to them, operate to limit upside and downside on returns in ways different to the proposed CUP.
Similar fees paid by third parties to group entities are relied upon as CUPs which upon analysis do not reflect options realistically available to the UK.	In HMRC’s experience risk can be reduced by undertaking a thorough comparability review of any potential CUPs, with specific attention to the extent to which the UK entity requires or has alternatives available to access the bundle of assets and services to achieve a better commercial outcome. An example might be where the UK and other operational affiliates could form a CCA to share assets, services and reward.
External franchising comparables are relied upon for pricing where commercially franchise models are not otherwise observed within the industry or sector.	In HMRC’s experience risk can be reduced by evidencing the existence of such arrangements in the sector, or between the group and third parties.
The terms of the arrangement are purported to allow the franchisee to benefit from upside in a commercial manner when in reality upside is capped or the fee increased to limit realisation of any upside.	In HMRC’s experience risk can be reduced by objectively assessing the terms in the light of realistically available alternatives and incentives for growth and profit potential.
Internal franchise or single fee arrangements either: • exclude ex-ante terms typically found in third party commercial arrangements relating to renegotiation or changes in fee level • are subject to fee increases under contractual or non-contractual terms that a third party would not agree to at arm’s length or which are not reflected in third party commercial arrangements	In HMRC’s experience risk can be reduced by ensuring any terms governing changes to the fee are commercial in nature and reflect industry practice.

3.8 Offshore procurement hubs

An offshore procurement hub is a centralised structure in which an offshore principal or agent in an MNE group provides procurement services to a UK resident and other group entities by sourcing goods and or services from third parties, without significant modification. The offshore principal or agent is referred to as the procurement hub.

Remuneration is only appropriate if an offshore principal or agent performs an economic function or assumes significant risk.

Transfer pricing methodologies commonly used in procurement hubs are:

• Cost-Plus or TNMM — suitable for benchmarkable activities
• CUP — internal or external
• Transactional profit split method — applied when hubs require significant skill and create substantial value

An entity performing central procurement should be rewarded for any active function in coordinating benefits, such as increased buying power or reduced unit costs. Savings as a result of group synergies should be shared among group entities based on their purchase volumes after any service of providing the synergy has been appropriately rewarded. Examples of synergies are:

• elimination of duplicate costs
• aggregation of buying power for larger purchases
• reduction of the number of active suppliers

The complexity of the procurement hub’s functions should determine its return. Services which amount to little more than the aggregation of buying functions typically result in a cost-plus mark-up. While more complex functions may warrant returns reflective of that complexity. In some multinationals, certain entities in the group may have bespoke procurement needs that require co-location with strategic leadership functions, making a fully centralised approach impractical. The reward from a given recipient of a procurement service should reflect the delivery of any such bespoke requirements. 

A procurement hub’s functionality can incorporate a number of activities. The complexity of the functions undertaken by the procurement hub relative to the overall business will determine the extent of the value it creates. Functions performed through a procurement hub may be indicative of strategic sourcing.

The following are common examples of strategic sourcing functions: 

• new product development — innovating and transforming products
• supplier capability — expertise and market know-how
• supply chain management — ensuring compliance and quality control
• spend data analysis — strategic sourcing to achieve savings
• IP utilisation — managing and exploiting IP to add value
• category management strategy — long-term sourcing strategies
• market intelligence — setting strategies across spend categories

Strategic sourcing functions should be included in a functional analysis and their value should be determined. A value chain analysis may assist with this. Read part 2.2.8 of Common compliance risks (part 2) — Value chain analysis in functional analysis. Any strategic functions and contributions of the procurement hub cannot be assessed in isolation from other activities within the wider business that also affect profitability.

A common driver of risk in transfer pricing policy setting or method selection is significant divergence between:

• group transfer pricing policy design goals or operational simplification aims
• the functional analysis of the hub’s activities (and potentially others in the wider value chain)
• how the hub actually operates in practice

Compliance risk can be mitigated where an MNE undertakes an accurate delineation of the transaction to inform appropriate pricing. This includes a functional analysis of the activities performed by the procurement hub and any other contributors. Read section 2.2.8 of ‘Common compliance risks (part 2)’.

3.8.1 Business restructurings involving procurement services

Business restructuring involving procurement services refers to the movement or centralisation of functions, assets (including intangibles) or risks to a procurement hub to replace the sourcing and buying operations of several associated enterprises. Read OECD TPG 9.1 on their website.

The movement of functions or the centralisation of operations may result in fewer local operational contributors in the supply chain. In our experience, the commercial drivers of restructuring to a centralised procurement hub most often relate to:

• potential for streamlined savings and benefits, such as combined synergistic benefits and economies of scale
• supply chain optimisation from centralised control
• administrative or location savings

While business restructurings can be motivated by a purpose of attaining some form of tax benefit to the MNE, this of itself does not necessarily mean that the restructure is non-arm’s length. Read OECD TPG 9.38 on their website. Reading part 2.2.4 Common compliance risk (part 2) — reflecting business change in functional analysis and delineation conclusions provides 7 helpful best practice suggestions for business restructurings.

Business restructuring involving procurement hubs requires accurate delineation to understand the new arrangements. The written contractual agreements stipulating activities and roles performed by the integrated procurement hub provide a starting point for delineation which may reflect the intention of the involved parties.

The terms outlined in contracts may not always reflect the activities that are actually being performed, and so it is important to also test the conduct and substance of the entities, both pre and post restructuring. Doing so clarifies that functions are actually being performed and that the contractual assumption of economically significant risks related to the controlled transaction properly aligns with the actual conduct of involved parties.

In our view, to accurately delineate a business restructuring that includes an offshore procurement hub requires a robust functional analysis which:

• provides an examination of the reallocation of functions performed, assets held, and economically significant risks assumed through a business restructuring
• outlines the entities that perform and control the economically significant activities and risks pre and post restructuring
• provides a detailed description of business restructuring and the impact on the UK business

This approach should result in a functional analysis which can support and evidence how entities should be remunerated for pre and post restructuring. 

For example

A UK business, prior to the business restructuring had responsibility for decision-making in the procurement of goods to input into its business model. The business restructures and moves the decision-making for the procurement of the same goods to a centralised procurement hub located offshore in Country A. The review, testing, functional analysis, and delineation of the business restructuring, as evidenced in the local file, should demonstrate whether and how the entity in Country A now carries on the same or similar decision-making capability that previously resided in the UK. Alternatively, there should be an analysis, post-restructuring of the impact of some, or all, of the decision-making functions remaining with the UK business. This is particularly relevant where the process of implementation proceeds more slowly than originally intended.

Subject to options realistically available, where contributions pre-restructure are projected to lead to economic profit for future years post-restructure, those contributors should be compensated for their ongoing contribution to the profit potential. The commercial reasons and anticipated benefits of the business restructuring, aligned with the decisions and reallocations of business risk, should delineate the transaction such that contributions pre-restructure are rewarded appropriately for efforts toward future profits. At arm’s length this may be reflected through compensation, such as an exit payment, or some form of reimbursement based on a gainshare.

Where a procurement hub is located in a low tax jurisdiction (a jurisdiction of interest) which offers opportunity and incentives to exploit tax benefits and exemptions, there may be an indication of tax risk.

HMRC accepts that tax incentives to operate in a location may be part of a wider commercial decision. We recognise the deliberation and selection of location can also be influenced by sourcing benefits such as:

• locality and proximity of other procurement hubs
• being closer to the end source of the required product or service
• proximity to key suppliers and vendors, to manage and maintain closer relationships

The question of whether an additional, genuine value-adding service is being provided to the UK business, that it would need to pay for at arm’s length, should be considered in the analysis.

Where after a business restructuring a number of operating companies can better leverage their combined purchasing power, this is a reflection, to an extent, of group synergy benefits. Such benefits may arise from the economies of scale that stem from the collective bargaining power and volume aggregation. The savings attributable to group synergies should be appropriately split between the entities which contributed toward the leverage created in proportion to their contribution.

For example

Where economies of scale result from high-volume, the benefits should typically be shared by the members of the group in proportion to their purchasing volumes after an appropriate reward has been provided to the party coordinating the purchasing activities.

Volume or supplier consolidation, which refers to reduced suppliers as part of procurement management, is distinct from volume aggregation. Although volume or supplier consolidation can be controlled by the procurement hub to create improvements in supply chain optimisation, its benefits over time tend to be limited.

In our view, volume or supplier consolidation savings resulting from a typical business restructuring should be treated as benefits arising from group synergies. However, if the consolidation savings are atypical due to the specific nature of the business restructuring, industry or goods or services being procured, then a robust analysis based on the unique facts and circumstances should be performed. The outcome should be contemporaneously recorded and included in the transfer pricing documentation that supports the transfer pricing outcome.

Where there has been a business restructuring, the volumes of goods and services sourced by the procurement hub are of importance when determining the most appropriate reward for functionality and contribution toward economic profit. We recommend consideration is given to:

• whether volume plays a part in the complexity of the functionality of the procurement hub
• the level of skill required to manage volumes
• whether the variation in goods (albeit increasing the volume) is more relevant than larger volumes of a set range of products

3.8.1.1 Business restructuring — high risk indicators for procurement hubs

The following risk indicators relate to where a business restructuring has taken place, but they can be applied in other circumstances. For example, the risks noted regarding ‘location’ can be relevant to the business model even if a restructuring has not taken place. Therefore, we recommend that the risk indicators be assessed irrespective of whether there has been a business change.

Compliance risk can be created where the business undergoes some form of restructuring resulting in actual or purported changes to function, asset and risk profiles of the UK and counterparties to the transaction. Indicators of higher risk for procurement hubs include where:

• functions, assets and risks (FAR) of the UK business are fragmented across multiple entities with no change in the underlying FAR, with the result of a significant reduction in a previously arm’s length reward
• the procurement hub operates a freight on board (FOB) ownership structure so does not take title for goods, nor does it have the financial capacity to bear the risk of having title for the goods, and does not control or manage any of the economically significant risks in the business model, but the reward it receives is more reflective of significant risk assumption
• the functional analysis and pricing are based on a restructuring plan made in advance of implementation which has either then not been implemented as planned or not implemented as quickly as envisaged resulting in the analysis not matching the actual facts

Location

Indicators of higher risk for procurement hubs involving restructuring location include where:

• the procurement hub is located in a jurisdiction offering low tax rates, tax incentives, tax benefits or tax exemptions — highlighted when the procurement and supply chain management functions that might benefit from local knowledge remain remote from the hub location

• significant rewards are assigned to the procurement hub based on the advantages its location provides, but there is limited functionality within the hub or the capability to exploit the practical benefits from this location

• there are no changes, or an insignificant change, in the number of employees following a relocation of functions — this could indicate that the functions were only shifted artificially and that the original jurisdiction is still performing the key functions even though the revenues are being reported in the jurisdiction of interest

Volumes

Indicators of higher risk for procurement hubs involving restructuring volumes include where:

• the procurement hub is receiving a significant reward for activities which are mostly limited to aggregation of group volumes
• incorrectly defining volume aggregation as a value adding activity rather than a group synergy
• the procurement services are such that remuneration for services is set at a flat rate commission on managed spend — for example, when a flat commission rate is applied to large spending volumes, the procurement hub’s remuneration is likely to far outstrip its costs

3.8.1.2 Business restructuring — best practice approaches for procurement hubs

In HMRC’s experience compliance risk can be reduced by adopting these recommendations of best practice:

• carrying out a value chain analysis — read part 2.2.8 Common compliance risks (part 2) — Value chain analysis in functional analysis
• documenting the decisions and intentions regarding the restructure including the commercial rational for the restructure from an entity and group perspective, together with any impact on other transactions in scope
• ensuring the value or consequence of any disposal, assignment or transfer of assets or risk through restructuring is properly remunerated
• reviewing the transfer or movement of functions from pre- to post-restructuring, paying attention to supporting evidence of the decision-making capacities
• providing accurate fact patterns of the change in functions, assets and risks, to the transfer pricing specialist, which have been checked by the UK risk leads and key personnel involved in the restructure
• comparing and testing legal contracts and forecasts versus actual conduct to ensure that remuneration is accurately determined by functionality
• ensuring that any contributions to economically significant functions or management of economically significant risks pre-restructure are compensated, to the relevant parties, for loss of profit potential where such compensation would take place at arm’s length 
• testing the actual roles and responsibilities of the procurement hub to substantiate the contractual or planned position
• performing an analysis of key employees that contribute to the procurement hub functions
• evidencing the conduct of the procurement hubs relative to the economically significant risks for control and management of inventory and the reward

Location

Indicators of best practice for procurement hubs involving restructuring location include where:

• contemporaneous documentation of the deliberation of and business reasons for the relocation to the location
• justifying that the nexus between the hub’s functionality and the rewards are strongly aligned and reflects the functions, risks and assets transferred to the procurement hub
• examining and detailing the substance and conduct of the procurement function in terms of functions performed, assets held, and risks assumed
• evidencing a decrease in the number of employees in the jurisdiction where the functions left and an increase in the number of employees in the jurisdiction where the functions are now being performed — alternatively, evidencing changes in function and or remuneration levels where the numbers of employees have remained the same
• aligning policy setting approaches with operational reality rather than effective tax rate goals

Volumes

Indicators of best practice for procurement hubs involving restructuring volumes include where:

• reviewing whether volume plays a part in the complexity of the functionality of the procurement hub
• demonstrating the level of skill required to manage volumes
• evidencing the variation in goods (albeit increasing the volume) being more relevant than larger volumes of a set range of products
• operating companies with limited functionality use engagement and leverage to create volume aggregation and buying discounts this leads to:
  • rewards for their contribution to these aggregation savings
  • a cost-plus reward reflective of benefits realised
• tiering the remuneration so that it reduces as volumes reach a certain level, reflective of operations between independent parties

Pricing involving procurement hubs

HMRC frequently observes inaccuracies arising from an excessive reward structure where there is limited functionality in the procurement hub. This leads to profit shifting out of the UK or other group entities. This part also examines cases where there appears to be significant reward for hub activities which are largely limited to aggregation of group volumes and therefore the functionality of the hub does not warrant the return received.

Pricing risk indicators may be identified during the delineation of the procurement service but are more likely to become apparent during the assessment and selection of a methodology and consideration of comparability, including economically relevant characteristics.

The two key drivers for procurement savings are the presence in the procurement hub of:

• buying volume
• skill and experience

Savings realised are often the result of supply chain optimisation that leads to a reduction in unit costs. Such savings can be connected to legitimate strategic functionality and streamlining of the supply chain that reduces unit costs which lead to savings for the group. It is not commercial to quantify hypothetical savings that would reasonably be assumed to have materialised in the absence of the procurement hub, such as through benefits realised through the bargaining power at group level.

It is important to distinguish and separate viable savings realised as opposed to possible preventable costs. In our view it is not sufficient to merely provide examples of how savings could be achieved as a proxy to quantify savings actually realised. We regard the adoption of such an approach as an indicator of a pricing risk.

In a commercial sense, one of the aims of a centralised or streamlined procurement function is to reduce the overall cost of goods and services and the expenses associated with procuring them. It would generally be unusual for a procurement function to impact profitability through means other than a reduction in costs. We would expect the impact on costs of the procurement to be considered in the assessment of the hub’s profitability.

3.8.2.1 Pricing — high risk indicators for procurement hubs

Pricing risk can be created where:

• the return on the procurement hub’s own costs is above the comparable level for the industry in a third-party commercial relationship
• the reward retained by the hub largely outstrips the results it has delivered as this arrangement is unlikely to be entered into in a third-party commercial arrangement
• the chosen transfer pricing methodology leaves the procurement hub with excessive windfall profits when measured by other criteria such as their return on own costs
• the UK business fails to track performance delivery of the offshore procurement hub
• procurement hubs are rewarded through a flat rate commission — there is potential to significantly over-reward the hub based on its functionality to volume
• absence of a financial analysis, such as a cost-based analysis, of the arrangement to identify if there is an excessive return on the procurement hub’s own costs
• a cost-plus reward based on sell-through margin of procured goods and services is used as a pricing model, rather than internal cost
• low staff numbers relative to the functions, assets and risks held by the procurement hub indicate an overstatement of activity in the procurement hub, which may be reflected in excessive profits per employee
• a return to the procurement hub is constructed on a savings-based reward without reliable savings measurement processes
• savings realised by the procurement hub are calculated without reference to an accurate and effective baseline
• cost bases are not habitually revisited and re-baselined such that the effect of procurement service is likely to become exaggerated — leading to an uncommercial reward unaligned with the benefits or savings achieved
• errors in savings calculations are exacerbated because savings are modelled to repeat year-on-year either without justification or from an inaccurate or ineffective baseline
• all supplier rebates and discounts are paid to and retained by the procurement hub
• the year-end analysis and review of the hub’s actual savings and distribution of savings to operating companies is either not performed or is not adequately documented in the transfer pricing report
• the return for procurement services significantly increases year on year with no corresponding increase in the level of functionality of the procurement hub
• a CUP is used, which is based on a low volume good or service that is an indirect or direct non-core spend and is priced as a flat fee reflective of the procurement being non-critical to profits

3.8.2.2 Pricing — best practice for procurement hubs

In HMRC’s experience risk can be reduced by adopting these best practices:

• measuring the savings procured and the benefit attained through the procurement service to demonstrate that the hub’s reward is commensurate to the cost base of the hub
• calculating the procurement hub’s return on own costs, by dividing the operating profit by operating costs — the cost base should be in relation to the direct operating costs incurred by the procurement hub:
  • these costs should be evidenced as being connected to the costs that are directly incurred by the procurement hub function
  • HMRC recognises that operating costs including wages, inventory cost and lease costs, can be determined by location, whereby location costs can support lower operating costs comparative to certain jurisdictions
  • this can influence the ratio of returns to the procurement hub and produce a significant return on own costs — nonetheless, the return should be benchmarked to support that the reward is appropriate
• including consideration of the return generated by comparable independent procurement companies in the market
• including consideration of options realistically available, specifically whether there were better alternatives available to meet the commercial objectives
• including consideration of the appropriateness of CUPs that are based on flat fees for low volume goods or services that relate to indirect or direct non-core spend — and the tested transactions volumes and nature of procurement service
• including consideration of any bespoke requirements, or the absence thereof, specific to the UK recipient of the services compared to the overall offering from the procurement hub — this would include UK-based functions assisting with the procurement

Performance delivery

In HMRC’s experience risk can be reduced by adopting these additional best practices for the assessment of performance delivery:

• tracking performance delivery of the offshore procurement hub based on results by:

  • evaluating the performance of procurement hub in line with the objectives of the business and targeted outcomes
  • adjusting the reward to the procurement hub if expected outcomes are not achieved in line with targeted outcomes or they have failed to deliver the agreed acceptable level of service
• testing the arrangement against a return on costs analysis
• ensuring that the reward appears reasonable by benchmarking the level of reward to demonstrate that the reward is attainable by a third-party procurement entity
• where purchase volumes going through the procurement entity significantly increase or reduce, re-testing the methodology to ensure it continues to produce a reasonable result
• ensuring there is evidence that any internal operating costs used in the remuneration methodology are incurred by the procurement hub and linked to its functions
• testing against a third-party sourcing agency with comparable functionality and commercial terms has a similar profitability per employee ratio
• in an arm’s length gain-share arrangement a certain level of savings over cost base is achieved before savings are shared

Procurement savings

In HMRC’s experience risk can be reduced by adopting these best practices for procurement savings:

• periodic re-baselining to savings appropriate to the goods and services being procured to prevent over-rewarding the procurement hub based on overstated savings
• ensuring savings due to the functions and operations of the procurement hub, such as through cost avoidance or cost reduction, are accurately quantified
• reviewing baselines to which savings are set periodically and re-baseline ensuring that savings declared are not double counted or inflated
• Key Performance Indicators (KPIs) can be referenced to savings realised as part of incentive programmes designed to incentivise benefits and specific efficiencies which are driven by the procurement hub can also support pricing outcomes
• ensuring that aggregation benefits, supplier rebates and discounts are returned pro rata to the operating companies whose contributions via volumes earn them
• contemporaneously documenting the year end compliance process to calculate the hub’s actual savings and the calculation of how the savings are allocated to the operating companies by reference to an allocation key, such as volumes
• where applicable, evidencing that functionality within the procurement hub can be shown to drive significant savings above those achieved by group synergies, the hub may be allocated a share of the savings that it generated by its activities

3.8.3 Other considerations

Areas covered in this section may have interactions with other rules of taxation, for example Part 8 CTA 2009, VAT, customs valuations and withholding tax. They are not within the remit of these guidelines and specialists should consider these separately.

It is worth considering the VAT treatment of a transfer price agreed for services provided by a procurement hub to a UK entity. For instance whether it is:

• an adjustment to consideration for goods and services already supplied to the UK entity
• consideration for a separate supply of services to the UK entity (which would often be subject to the reverse charge)
• something outside the scope of VAT