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Indicators of transfer pricing policy design risk (part 3)

Published 10 September 2024

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 

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.