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Large multinational groups often voluntarily provide HMRC with copies of their transfer pricing reports to help the HMRC case team understand their business and its policies. However, in most cases reports are provided following an information request from HMRC at the start of an enquiry.
Case teams will carefully scrutinise your report to determine whether the business’s transfer pricing is actually on an arm’s length basis. They will not be fooled by the bulk or apparent sophistication of a report, but will drill down to the substance to determine whether its assertions are supported by credible evidence.
This article examines HMRC’s operational guidelines for staff on “Examining Transfer Pricing Reports”. It uses the same section headings as the HMRC guidance and original wording has been retained in places for clarity and the avoidance of doubt.
A transfer pricing report normally includes a review of transfer pricing legislation (for the client’s benefit). If the report was originally prepared for another tax jurisdiction it will state something like “the UK legislation works along similar lines”. Case teams will not accept this without careful scrutiny because the scope of Part 4 TIOPA2010 may be significantly broader than the other country’s legislation.
The case team needs to understand how each group company contributes to the overall trading activities of the group, so they can determine where transfer pricing risks may lie. This functional information should be available in the transfer pricing report.
The functional analysis is a vital element of the report and should have been prepared with substantial input from the people in the business who have day to day experience of operating the relevant functions.
Case teams are advised that where a functional analysis lacks detail about the UK business and its controlled transactions, or has omitted transactions, or was carried out at a high level rather than being built up from the front line, or contains unverified assumptions and facts, it is likely to be of little value.
What transactions are covered
It should be clear from the transfer pricing report what transactions are covered and what have been omitted and, for those covered, how they were carried out, how they were priced and what other parties were involved. Depending on the complexity of the business, HMRC may decide not to review all transactions but will agree with the business which to scrutinise.
Case teams are advised to watch out for “missing” transactions, i.e. transactions that you would expect to see but which are not mentioned.
Case teams will also consider the business’s activities as a whole, in addition to reviewing specific transactions because, at arm’s length, a business may look for an integrated return for all of its activities, potentially exceeding the sum of the individual returns viewed in isolation.
A transfer pricing report will normally include a lengthy review of the various OECD methodologies, explaining how they have been rejected or selected and applied to the business’s controlled transactions. The case team will carefully check this to determine whether the assumptions and conclusions are reasonable.
A comparable uncontrolled price (CUP) is the most appropriate and effective way of assessing an arm’s length price and so the case team will want to consider whether sufficient efforts have been made by the business to identify a CUP, particularly where there are potential internal CUPs.
HMRC guidance looks at all the OECD methods and states that the transactional net margin method (TNMM) is probably the most popular. However, case teams are reminded that it still requires “a rigid dependence on comparability”.
Using other methods
HMRC accepts that businesses may use a mix of methods, or one method to support another, or bespoke non-OECD methods to establish their arm’s length pricing or more accurately define the range. The main consideration for case teams is that the chosen method is the most appropriate given the facts and circumstances of the case and that it satisfies the arm’s length principle.
Arm’s length range
Transfer pricing isn’t an exact science and so a normal feature of a transfer pricing report is an arm’s length range rather than a specific value.
However, the case team will expect to see evidence that the final range presented by the business has been manually narrowed by careful analysis, adjustment for comparability differences and/or the filtering out of inappropriate or anomalous companies. In the absence of such an analysis the case team may conclude that range was invalid in the first place and any subsequent “narrowing” by statistical tools is meaningless.
So, benchmarking studies that return a wide range of results are treated with considerable caution by case teams.
Note that where you have a wide range it would be wrong to assume that the closest comparables to the tested party are those that cluster around the centre of the range. The correct approach would first be to carefully analyse the companies in the range and adjust or filter out as described above, after which statistical narrowing may be appropriate – a small number of strong comparables will give a more accurate result than a large number of weak ones.
Dealing with global transfer pricing
Often comparables from outside the UK are used. These should not be rejected simply because they are non-UK. They may be reliable and the best available, therefore their use must be considered on a case-by-case basis. However, generally speaking, local comparables will give the best available information.
So, what can we take from all of the above?
There is comprehensive guidance for HMRC transfer pricing case teams on the examination of transfer pricing reports. This article provides a review of that guidance. HMRC’s guidance for staff is freely available to view online and should be referred to for more detailed explanations and examples.
Transfer pricing is not an exact science but requires the exercise of reasonable judgement.
Therefore it is important not to lose sight of your objective when applying the arm’s length principle, which is to find a reasonable estimate of the arm’s length price of your controlled transactions, based on the most reliable information available. Your transfer pricing documentation must clearly and comprehensively demonstrate the arm’s length nature of your controlled transactions.
There are steps you can take to reduce the risk of a challenge from HMRC which, apart from following the rules, mostly involve ensuring that case teams fully understand your business and the evidence underpinning your prices. There are no guarantees but here are some suggestions.
- Don’t lose sight of the overarching objective of your transfer pricing documentation, which is to educate HMRC about your business and demonstrate to them that all aspects of your controlled transactions are on an arm’s length basis. Step back and ask yourself what the documentation says about your business and its transfer pricing. Ensure that it supports your position and can’t easily be used against you. Sometimes you may have to mention “missing” transactions. For example, if intellectual property is important in your sector but you don’t have any connected-party royalties or license fees, then your documentation should explain why not. Consider hiring an independent transfer pricing specialist with HMRC experience to sense-check your documentation before releasing it.
- Present your evidence clearly and concisely. Unfortunately, in my experience, many transfer pricing reports are padded out with lengthy but vague and distracting material of little value so, even where the pricing is perfectly reasonable, HMRC can’t easily tell that from the report, resulting in an unnecessary enquiry.
- Where a transfer pricing report was originally prepared for another tax jurisdiction it’s not sufficient to simply state that “the UK legislation works along similar lines”. Your transfer pricing must comply with UK legislation and you need to clearly demonstrate that.
- Enquiry risks can also be mitigated by reviewing and updating your transfer pricing documentation contemporaneously and annually. This doesn’t necessarily mean a complete re-write every year though, a letter that updates financial and benchmark data annually may be enough.
- The OECD three-tier approach to transfer pricing documentation should ensure cross-border consistency, but where local reports are prepared separately by local group companies for their own jurisdictions, there should be some oversight to ensure that the same transactions are described consistently from both sides.
- Beware of using regional or global comparables for your local report, unless you can clearly demonstrate that these are more reliable than local comparables. HMRC may view this as a cost-saving short-cut which casts doubt on the reliability of your entire report.
- Be reasonable but thorough in your selection of comparables and benchmarks, if you take an aggressive stance then expect an enquiry.
- Always follow up your electronic selection or deselection of potential comparables with a careful manual analysis of the remaining companies to adjust or deselect as required and narrow the range as far as reasonably possible.
- Often a group will benchmark local entities as if they performed only a single function, whereas they actually perform several. Some may be insignificant and can be ignored for the purposes of the benchmarking exercise, but others may have a material impact on its outcome so you should segment your P&L to allow for this.
- Finally, be open and cooperative with HMRC, talk to your case team. Do your best to ensure that they fully understand your business and the evidence you’ve gathered to demonstrate that your transfer pricing is on an arm’s length basis. It’s not unusual for HMRC enquiries to be opened or prolonged because case teams have reached erroneous conclusions due to a misunderstanding of the basic facts & circumstances. So, early, regular and open communication with HMRC will benefit you.
I try to make the contents of this website as useful, reliable and factual as possible and any opinions that slip through are solely my own.
The purpose of the site is to inform and educate readers with guidance and useful tips. It provides only an overview of the regulations and guidance in force at the date of publication and is not a substitute for professional advice. The contents are not designed to provide professional advice or financial advice and should not be relied on as such.
You should not base any action on the contents of this website without first obtaining specific professional advice, tailored to the facts and circumstances of your situation, from an appropriately qualified Transfer Pricing expert.
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