TP Back to Basics – Transfer Pricing Risk Assessment

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This article is accompanied by a slide presentation on YouTube. Feel free to use my material for your own in-house purposes, all I ask is that you acknowledge the source.


This article draws on the OECD publications “Draft Handbook on Transfer Pricing Risk Assessment” (April 2013) and “Country-by-Country Reporting Handbook on Effective Tax Risk Assessment” (September 2017) and on the section of HMRC’s International Manual that deals with TP risk assessment (INTM482000 – 482170).

These OECD and HMRC publications are freely available to view online and should be referred to if more detail is required. Some of the material from these sources is reproduced here in its original form for clarity and the avoidance of doubt.

The aim of this article is to inform readers of the TP risk assessment process from a tax authority’s viewpoint and concludes with my thoughts on some actions you can take to minimise the risk of a tax authority enquiry.

Even a basic understanding of the TP risk assessment process such as this should help business’s and their advisers anticipate potential tax authority scrutiny and ensure that their TP documentation can’t easily be used against them.

The Risk Assessment Process

Many taxpayers seek to comply with transfer pricing rules and regulations, making conscientious efforts to establish prices for their controlled transactions that are consistent with the arm’s length principle.

Evidence that transfer prices and the methods used to compute them are thoroughly analysed and recorded may indicate that transfer pricing risk is low. Often the very act of preparing contemporaneous transfer pricing documentation tends to reduce the risk.

However, not all taxpayers consistently exhibit this type of transparent compliance.

The challenge for tax authorities is to distinguish taxpayers and transactions that involve a high degree of transfer pricing risk from those which do not – this involves TP risk assessment.

The OECD Draft Handbook on Transfer Pricing Risk Assessment

The OECD Draft Handbook on Transfer Pricing Risk Assessment sets out a number of risk factors to consider, as follows:

Risk arising from recurring transactions 

Certain types of controlled transactions may create more cause for concern than others, e.g.  large interest payments or insurance premiums, large service and management fees, and ongoing royalty payments.

Risk arising from large or complex one-off transactions 

A business restructuring or a transfer of income generating assets like intangibles, are also likely to come under close scrutiny.

Risk arising from taxpayer behaviour in governance, tax strategies or ability to deliver compliance 

This risk factor stems from the group’s behaviour rather than the nature of its transactions. A group which gives insufficient attention to compliance or lacks fundamental documentation on its controlled transactions is likely to attract attention.

Risk indicators 

The following OECD table summarises the risk-indicator guidance set out in the Draft Handbook on Transfer Pricing Risk Assessment. It adds a summary of where a tax authority is likely to find information related to the issues in question.

Feature Brief Description Where to look
Significant transactions with related parties in low tax jurisdictions Where transactions take place with lowly taxed and related entities there is a risk that mis-pricing will incorrectly attribute excess profits to the lowly taxed jurisdiction. Information return (Form) Contemporaneous documentation
Transfers of intangibles to related parties Transactions of this nature raise difficult valuation questions, especially where the intangibles are unique and consequently there is a lack of comparables. Information return (Form) Contemporaneous documentation

Financial accounts
Patent office

Business restructurings The transfer pricing aspects of business restructuring were the subject of a specific OECD study published and incorporated as a new Chapter IX of the Transfer Pricing Guidelines in July 2010. Information return (Form) Contemporaneous documentation Taxpayer’s website
Financial accounts

Press reports / trade magazines Securities analysts’ reports

Specific types of payments Payments of interest, insurance premiums and royalties to related parties because the underlying rights are highly mobile and consequently there is a risk that the payments do not reflect the true value being added by the related party. Information return (Form) Contemporaneous documentation

Financial accounts

Loss making Year on year loss making where there is no attempt made to change business operations or financing. Sustained losses may be evidence that the reported results do not reflect the true value of the business. Information return (Form) Contemporaneous documentation

Financial accounts

Poor results Similarly results that are not consistent with industry norms or with the functions carried on by the enterprise in the country concerned may be evidence that related party transactions have not been correctly priced. Information return (Form) Contemporaneous documentation Financial accounts Commercial databases
Press reports / trade magazines Securities analysts’ reports
Effective Tax Rate Significant variations between the effective tax rate reported at group level and the nominal rates to which it is subject can be the result of transfer pricing that allocates too much profit to low tax jurisdictions. Contemporaneous documentation Consolidated financial accounts
Poor/Non-existent Documentation Evidence that transfer prices and the methods used to compute them are inadequately recorded casts doubt on the reliability of the prices themselves. Contemporaneous documentation
Excessive Debt Debt that appears to be in excess of the amount that an entity could borrow if it were a free standing entity, or interest rates that appear to be in excess of market rates. Information return (Form) Contemporaneous documentation Financial accounts

The CbCR Handbook on Effective Tax Risk Assessment

The CbCR Handbook on Effective Tax Risk Assessment identifies 19 tax risk indicators that may be identified using information in CbC Reports. A detailed summary of these potential tax risk indicators is included in Annex 2 of the Handbook.

These indicators are:

  1. A group with a small footprint in a particular jurisdiction may have less potential to pose significant tax risk.
  2. A group’s activities in a jurisdiction may be limited to those that pose less risk, e.g. they may be of a type that are subject to a lower level of tax, i.e. don’t assume mis-pricing when things don’t look right
  3. A high value or high proportion of related party revenues in a jurisdiction might mean that even a small pricing error could have a significant tax impact.
  4. Where the results in a jurisdiction deviate from comparables the difference could be due to mis-pricing
  5. Where the results in a jurisdiction do not reflect market trends, they are perhaps being distorted by mis-pricing
  6. Where there are jurisdictions with significant profits but little activity, profits may have been shifted from another jurisdiction where the underlying economic activity is occurring
  7. There are jurisdictions with significant profits but low levels of tax accrued
  8. Where there are jurisdictions with significant activities but low levels of profit, the profits are perhaps being shifted to another jurisdiction
  9. A group has activities in jurisdictions which pose a BEPS risk
  10. Where a group has mobile activities located in jurisdictions where it pays a lower level of tax it may have shifted them there to benefit from the favourable tax regime. This isn’t always a problem, but the controlled transactions will need careful checking.
  11. Changes in a group’s structure, including the location of assets, are an obvious opportunity for BEPS  activities
  12. Where intellectual property is separated from the related activities within the group, it may be being used to strip taxable profit from other jurisdictions
  13. Where a group has marketing entities located in jurisdictions outside its key markets they could be earning profits that are not attributable to their countries of residence.
  14. Similarly, where procurement entities are located outside its key manufacturing locations they could be earning profits that are not attributable to their countries of residence
  15. Where tax paid is consistently lower than tax accrued a group may be making accruals for uncertain tax positions, which could indicate mis-pricing or other BEPS-related behaviour
  16. A group includes dual resident entities
  17. A group includes entities with no tax residence
  18. A group discloses stateless revenues in Table 1 (of the CbCR)
  19. Where information in a group’s CbCR does not correspond with information previously provided this could cast doubt on the accuracy of both the CbC Report and the information previously provided

HMRC Internal Guidance on Transfer Pricing Risk Assessment

HMRC case teams are advised to consider the following questions at an early stage in their risk assessment:

  • Does the case have the scope for transfer pricing risks to be present?
  • Is there sufficient resource available to work any risks that may be identified?
  • Are there indications that the amount of tax at risk could be significant?

If these questions cannot be be answered positively then the HMRC TP Governance Panel is unlikely to authorise an enquiry. Therefore the case team will probably move on to their next case rather than waste any more time on this one.

On the other hand, where the case team decides that an enquiry is appropriate, they must present a business case to the TP Governance Panel for authority to proceed.

The Business Case document sets out the case background, the risk assessment work undertaken, the reasons for and against enquiry and any special features.

The following is a summary of possible risk indicators which HMRC case teams are advised that they may encounter.

  1. UK company’s profits or losses appear inconsistent either with its business activities or with worldwide group results over a cycle of, say, 5 years
  1. UK company provides intangibles but it receives no or low royalties and does not seem to be generating an entrepreneurial reward for its R & D. The other party to the transaction has a high net margin given what is known about its business activities
  1. Borrowing appears disproportionately high in relation to shareholders’ funds, bearing in mind the type of business involved
  1. Interest appears high in relation to the business’s ability to service the debt from its operating profits before tax and interest payable.
  1. Transactions do not appear to make commercial sense e.g. insertion, for no apparent commercial purpose, of a new UK group holding company with substantial debt, particularly in comparison to the previous position.
  1. Transactions with related parties in low tax territories.
  1. Acquisition of a UK group by a private equity firm, which will rely on heavy debt funding.
  1. Notes in UK accounts, or other forms of information such as press or internet articles, which mention restructuring, acquisition/merger activity, transfer of UK activities to related parties and/or changes to the way in which the company is rewarded.
  1. Disappearance of/significant decline in stock.

Case teams are also advised to review effective tax rates, transfer pricing rules in the other countries, group context, ongoing losses and significant payments of management/service fees.

An HMRC transfer pricing risk assessment will also recommend the next course of action. This is a narrative document which sets out the case background, the risk assessment work undertaken, the reasons for and against enquiry,  any special features and the case team’s recommendations. It will include the following as required:

  1. An overview of the business, including a review of the group’s internet site, identifying where the head office is located and the basic management structure
  1. A detailed examination of the consolidated accounts and the accounts of appropriate entities within the group, to understand the profitability of the business in the UK and globally
  1. A review of the group structure, listing what are likely to be the key intra-group transactions
  1. A summary of the principal markets in which the business operates, identifying the key profit drivers in the business and as far as possible determining their location
  1. Details of where research and development is carried out
  1. A summary of the valuable intellectual property owned by the group, together with details as to which companies own what property
  1. A summary of the manufacturing process for the goods being sold and where the goods are physically manufactured
  1. Identification of the goods or services the group offers, and what are its principal products and/or brands
  1. What the supply route is, covering the whole process from raw materials to the sale of finished goods. This should include any central distribution or warehousing subsidiaries and if possible who has title to the goods at various stages
  1. How the goods are sold (e.g. retail, wholesale, commission basis, internet, etc.)
  1. Who the main competitors are
  1. A review of the trade press and internet for industry trends and details of where the taxpayer is placed within the sector
  1. A search using a commercial database to examine trends and comparables in the particular business sector
  1. An analysis of recent developments within the group (such as new acquisitions, new markets, disposals, etc)
  1. A review of the CFC return to identify potential risk
  1. Liaison with employer compliance teams for details of highly-paid UK staff
  1. Liaison (in appropriate cases) with indirect tax colleagues
  1. Liaison with a Trade Sector Adviser for the relevant sector
  1. A review of any previous transfer pricing enquiry
  1. A review of any other relevant information, such as recent arbitrage clearance applications
  1. A general review of the company or group for other useful information, such as claims made under double taxation treaties, older risk assessments and enquiries, notes of site visits, details of employees, claims for research and development allowances – anything that will add to the picture of the business activities


So, what can we take from all of the above?

There’s certainly a lot of guidance material on how tax authorities should perform their TP risk assessments and most of it is common sense.

However, I suspect that it’s not always followed by hard-pressed HMRC case teams. So don’t expect them to be as knowledgeable about your group as the guidance suggests they should be. You may still have to spend time ensuring that they understand your business and your transfer pricing.

But forewarned is forearmed. Prior knowledge of what might trigger tax authority scrutiny will enable you to lessen that risk, for example through better documentation and clearer explanation. It will also give you a tactical advantage in the event of an enquiry.

Unfortunately, some groups will always be considered high risk by HMRC despite taking all reasonable steps to comply, for example because of their size, where they operate or the nature of their controlled transactions.

However, steps can be taken to reduce the risk of being selected for enquiry, there are no guarantees but here are some suggestions.

  • Follow the latest OECD Guidelines on the arm’s length principle, TP methods, comparability analyses, TP documentation, intangibles, services, restructurings and so on. These are freely available to view on the OECD website
  • Don’t lose sight of the overarching objective of your TP documentation, which is to educate tax authorities about your business and demonstrate that all aspects of your controlled transactions are on an arm’s length basis. Step back and ask 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 by tax administrations. Sometimes you have to mention “missing” transactions. For example, if intellectual property is important in your business 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 experience of the local tax authority to sense-check your documentation before releasing it. At the very least you’ll be forewarned and better prepared for any potential challenges. Do the job properly and thoroughly and you’ll have fulfilled your legal obligations. Unfortunately it doesn’t follow that tax authorities will agree with you, but the burden of proof will be transferred to the tax authority if it doesn’t agree.
  • Enquiry risks can be mitigated by reviewing and updating your TP documentation contemporaneously and annually. This doesn’t mean a complete re-write every year, a letter that updates financial and benchmark data annually may be enough between major changes. Also review and maintain your inter-company legal agreements regularly. Tax authorities will compare contract terms with the behaviour of the parties so keeping them up to date will add credibility and lessen enquiry risk.
  • Check your ratios against the OECD CbCR Handbook on Effective Tax Risk Assessment. This lists 19 risk indicators and is a useful reference, especially the case study. This will help you prepare for tax administration scrutiny.
  • Beware of using regional or global comparables for your local file, unless you can clearly demonstrate that these are more reliable than local comparables. The local tax authority is likely to view this as a cost-saving short-cut which casts doubt on the reliability of the entire report, and may lead to a lengthy and expensive enquiry. And select reasonable benchmarks, if you take an aggressive position then expect an enquiry
  • Another short-cut guaranteed to alert the tax authority is the absence of segmentation in your report when it’s clearly appropriate. Often the local entity is tested as if it only performed a single function whereas in reality it probably performs several. Some of these may be insignificant and can be ignored for the purposes of  the benchmarking exercise, but others may have a material impact on the outcome and need to be allowed for.
  • The OECD three-tier approach to TP documentation should ensure cross-border consistency but, where local files are prepared separately by local group companies there has to be some oversight to ensure that transactions are described consistently from both sides.
  • On 20 December 2017, the Court of Justice of the European Union issued its decision in the Hamamatsu case, deciding that a transfer price subject to retroactive price adjustments cannot be used as the basis for the “Transaction Value” method to determine the customs value. It’s not entirely clear how this decision should be interpreted, but the outcome for Hamamatsu was that they were unable to reclaim around €4m of overpaid customs duty. This decision is an example of the conflict between transfer pricing and customs rules and perhaps highlights the need to apply a comprehensive pricing policy in the first place, bearing in mind transfer pricing, VAT and customs.
  • Sometimes, despite your best efforts, a transfer pricing enquiry can’t be avoided. Here you must do your best to ensure that the tax authority is basing its analyses and conclusions on accurate facts and information. So early, regular and open communication between the group and the tax authority to confirm the underlying facts is essential and can prevent unnecessary confusion and conflict.
  • If a transfer pricing enquiry becomes hostile and confrontational it is likely to take longer than necessary and the risk of an upwards adjustment is increased. So confrontation should be avoided. For example, follow up a request for information by calling the case-worker to ensure that their request and underlying concerns are fully understood. You should then respond promptly and completely to address their concerns, hopefully enabling them close your enquiry and move on to their next.
  • If the enquiry ends with a transfer pricing adjustment and double taxation, use the competent authority process to resolve it. Don’t attempt a “do-it-yourself” solution as this will not be acceptable to your tax authority and may leave you with permanent double tax if deadlines for a competent authority request are missed.


I try to make the contents of this website as useful, reliable and factual as possible but 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.

No responsibility for loss occasioned by any person acting or refraining from action as a result of the contents of this Website can be accepted by the author.


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