HMRC updates guidance on transfer pricing risk

While the new guidance is aimed primarily at HMRC officers conducting transfer enquiries, Pinsent Masons tax expert Steven Porter said, “it may be useful for multinational enterprises to consider the likely approach that HMRC will take when determining their transfer prices and preparing their returns.”

During a transfer pricing enquiry, HMRC identifies the price charged in a transaction between two ‘connected’ persons – for example, a parent company and its subsidiary – and test that price to see if it reflects the ‘arm’s length’ price which would have been paid between two unconnected persons.

When testing that price, HMRC must apply the principles set out in the Organisation for Economic Cooperation and Development (OECD) global transfer pricing guidelines. If HMRC does not consider that the price paid between the two connected persons was at arm’s length, it must find an alternative comparable transaction, which must then also be tested in accordance with the transfer pricing guidelines (TPG).

The first stage of an enquiry is to establish the facts and HMRC notes that it is important to review the actual transaction that took place, not focus on what is supposed to have happened by virtue of the contractual arrangements. This stage is referred to as “the delineation of the actual transaction” as it considers the transaction precisely. It is in the delineation stage that risk becomes important. HMRC must establish the economically relevant characteristics of the transaction which includes considering factors such as an analysis of the functions performed by parties including the assets used and the risks assumed.

Both HMRC and the OECD consider that the determination of which parties assume or exercise control over the economically significant risks involved to be a particularly difficult aspect of delineating the transaction. As a result, there is already a great deal of guidance in the TPG. Both are also clear that this is because risk allocation is more difficult, rather than more important, than the other elements of delineation of the transaction.

The new guidance provides detail on how HMRC will apply the six-step process for establishing the risk allocation in the functional analysis.

Steven Porter comments: “Much of the guidance refers to the OECD transfer pricing guidelines and extracts core principles and factors which HMRC consider to be important. However, there are a number of key elements of the new guidance where HMRC expresses it is considered view. It is particularly important for taxpayers to be aware of this stated position in light of the obligation on taxpayers to notify uncertain tax treatments which adopt a position contrary to HMRC's known position.”

One of the areas in which HMRC expresses its opinion is in relation to determining which entities control the risk. Any entity is considered to control a risk where it has the capability to, and actually does, make decisions on whether to take on or decline a risk. These parties also must consider how to respond to risks that are associated with a commercial opportunity. The TPG identifies that there are different levels of risk control within a multinational group. For example, board or executive committee group level where the control framework for identifying and reporting risk in operations is set. Another example is within specific management in operational entities which may identify and assess risk in each given transaction.

Previously, arguments have been raised claiming the TPG favours line management level control. However, HMRC’s view is that the TPG does not prefer one level of control over the other. Instead, HMRC’s view is this determination of risk is entirely fact specific and must follow a detailed understanding of the corporate group’s commercial practices. HMRC will, therefore, not accept an answer that simply states that control is set at line management level, based on an interpretation of the TPG.