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The UK’s corporation tax self-assessment regime requires the taxpayer to ensure that their transfer pricing reflects arm’s length conditions for all their controlled transactions, including UK-UK.
Chapter 1 of the “OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” (“TP Guidelines”) provides guidance on the application of the arm’s length principle, the international transfer pricing standard agreed by OECD member countries for the valuation, for tax purposes, of transactions between associated enterprises (“controlled transactions”). The UK’s TP legislation must be interpreted in such a way as to best secure consistency with the TP Guidelines.
This article looks at chapter 1 of the TP Guidelines. It follows the structure of the Guidelines and original wording has been retained in places for clarity and the avoidance of doubt.
As the TP Guidelines are freely available online, they can give groups and their advisors an insight into HMRC processes and policies and into how HMRC specialists are trained to deal with transfer pricing and thin cap cases.
This is an extremely useful insight to have as it should enable you to better manage your relationship with HMRC and tailor your ATCA application to suit HMRC’s preferences.
Statement of the Arm’s Length Principle
The authoritative statement of the arm’s length principle is found in paragraph 1 of Article 9 of the OECD Model Tax Convention:
“[Where] conditions are made or imposed between the two [associated] enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.”
Members of a MNE group are therefore treated as if they were independent entities in an arm’s length relationship for transfer pricing purposes and so the arm’s length principle provides broad parity of treatment for members of MNE groups and independent enterprises.
Guidance for applying the Arm’s Length Principle
A. Identifying the commercial or financial relations
A comparability analysis is at the heart of the application of the arm’s length principle. There are two key aspects to this: identification and comparison.
You first have to identify the commercial or financial relations between the associated enterprises and analyse the conditions of the transaction and the economically relevant circumstances in which it takes place to accurately delineate the controlled transaction.
Then you must compare these conditions and circumstances with those of comparable arm’s length transactions between independent enterprises (“uncontrolled transactions”) to establish the arm’s length price for the controlled transaction.
Chapter I of the TP Guidelines provides guidance on identifying the commercial or financial relations between the associated enterprises and on accurately delineating the controlled transaction. Chapters II and III provide guidance on the second step, covering transfer pricing methods and the comparability analysis itself. This article focuses on Chapter 1. I’ll cover the comparison process in separate articles.
The five economically relevant characteristics (or comparability factors) that need to be identified in the commercial or financial relations between the associated enterprises in order to accurately delineate the actual transaction are as follows:
1. The contractual terms of the transaction
Where a controlled transaction has been formalised by a written contract this, with related communications between the parties, should form the starting point for accurately delineating the transaction and establishing how the responsibilities, risks, and anticipated outcomes were intended to be divided.
However, the analysis of all five comparability factors will provide evidence of the actual conduct of the parties and if this is inconsistent with the written contract then the functions they actually perform, the assets they actually use and the risks they actually assume, considered in the context of the contractual terms, should determine the facts and accurately delineate the actual transaction.
2. Functional analysis
Uncontrolled transaction prices will reflect the functions each independent party performs, taking into account assets used and risks assumed. Therefore, in accurately delineating the controlled transaction and determining comparability between controlled and uncontrolled transactions, a functional analysis is necessary. This focuses on what the parties actually do and the capabilities they provide.
It is particularly important to understand how value is generated by the group as a whole, the interdependencies of the functions performed by the associated enterprises with the rest of the group, and the contribution that the associated enterprises make to that value creation.
While one party may provide a large number of functions relative to that of the other party to the transaction, it is the economic significance of those functions in terms of their frequency, nature, and value to the respective parties to the transactions that is important.
2.1. Analysis of risks in commercial or financial relations
The 2017 TP Guidelines concentrate particularly on the assumption and allocation of risk. This does not mean that risk is considered more important than functions or assets but reflects the practical difficulties presented by risks, which can be harder to identify than functions or assets.
The level and assumption of risk are economically relevant characteristics that can be significant in determining the outcome of a transfer pricing analysis. Identifying risks goes hand in hand with identifying functions and assets and is integral to the process of identifying the commercial or financial relations between the associated enterprises and of accurately delineating the transaction or transactions.
The Executive Summary in the BEPS 8-10 Final Report states:
“Risks are defined as the effect of uncertainty on the objectives of the business. In all of a company’s operations, every step taken to exploit opportunities, every time a company spends money or generates income, uncertainty exists, and risk is assumed. No profit-seeking business takes on risk associated with commercial opportunities without expecting a positive return. This economic notion that higher risks warrant higher anticipated returns made MNE groups pursue tax planning strategies based on contractual re-allocations of risks, sometimes without any change in the business operations. In order to address this, the Report determines that risks contractually assumed by a party that cannot in fact exercise meaningful and specifically defined control over the risks, or does not have the financial capacity to assume the risks, will be allocated to the party that does exercise such control and does have the financial capacity to assume the risks.”
Basically, what they’re saying is that enterprises and their advisors were using the artificial re-allocation of risk to justify the shifting of profits to low tax jurisdictions. The new focus on risk in the Guidelines is to help counter this BEPS activity.
The steps for analysing risk in a controlled transaction are summarised in the TP Guidelines as follows:
- Identify economically significant risks with specificity.
- Determine how the specific, economically significant risks are contractually assumed by the associated enterprises under the terms of the transaction.
- Determine through a functional analysis how the associated enterprises that are parties to the transaction operate in relation to assumption and management of the specific, economically significant risks, and in particular which enterprise or enterprises perform control functions and risk mitigation functions, which enterprise or enterprises encounter upside or downside consequences of risk outcomes, and which enterprise or enterprises have the financial capacity to assume the risk.
- Steps 2-3 will have identified information relating to the assumption and management of risks in the controlled transaction. The next step is to interpret the information and determine whether the contractual assumption of risk is consistent with the conduct of the associated enterprises and other facts of the case by analysing
- whether the associated enterprises follow the contractual terms, and
- whether the party assuming risk, as analysed under (i), exercises control over the risk and has the financial capacity to assume the risk.
- Where the party assuming risk under steps 1-4(i) does not control the risk or does not have the financial capacity to assume the risk, apply the guidance on allocating risk.
- The actual transaction as accurately delineated by considering the evidence of all the economically relevant characteristics (i.e. comparability factors) of the transaction should then be priced taking into account the financial and other consequences of risk assumption, as appropriately allocated, and appropriately compensating risk management functions.
Note that general policy-setting with regard to risk is not control of risk.
3. Characteristics of property or services
Differences in the specific characteristics of property or services can account for differences in their value in the open market. Therefore, comparisons of these features may be useful in delineating the transaction and in determining the comparability of controlled and uncontrolled transactions.
Comparability analyses for methods based on gross or net profit indicators often put more emphasis on functional similarities than on product similarities. However, the acceptance of such an approach depends on the effects that the product differences have on the reliability of the comparison and on whether or not more reliable data are available.
4. Economic circumstances
Arm’s length prices may vary across different markets even for transactions involving the same property or services. Therefore, to achieve comparability requires that the markets in which the independent and associated enterprises operate do not have differences that have a material effect on price or that appropriate adjustments can be made.
The existence of a cycle (e.g. economic, business, or product cycle) is one of the economic circumstances that should be identified. Multiple year data can be helpful where there are cycles.
5. Business strategies
Business strategies, e.g. market penetration, innovation and new products, diversification, risk aversion, etc. may affect the comparability of controlled and uncontrolled transactions and enterprises.
When evaluating whether a business was following a strategy that temporarily decreased profits in return for higher long-term profits, the most important consideration is whether the strategy could plausibly be expected to prove profitable within the foreseeable future (while recognising that the strategy might fail), and that a party operating at arm’s length would have been prepared to sacrifice profitability for a similar period under such economic circumstances and competitive conditions.
B. Recognition of the accurately delineated transaction
After following the above guidance your transfer pricing analysis will have identified the factual substance of the commercial or financial relations between the parties and accurately delineated the actual transaction.
A tax administration should not disregard the actual transaction or substitute other transactions for it unless the transaction is commercially irrational. The mere fact that a transaction may not be seen between independent parties does not mean that it should not be recognised.
The key question in the analysis is whether the actual transaction possesses the commercial rationality of arrangements that would be agreed between unrelated parties under comparable economic circumstances, not whether the same transaction can be observed between independent parties.
If the actual transaction is replaced with an alternative transaction, the alternative should comport as closely as possible with the actual transaction whilst achieving a commercially rational result.
Associated enterprises, like independent enterprises, can sustain genuine losses for legitimate business reasons. However, an independent enterprise would not be prepared to tolerate losses indefinitely.
Recurring losses for a reasonable period may be justified in some cases, but where a loss-making pricing strategy continues beyond this, a transfer pricing adjustment may be appropriate.
D. The effect of government policies
There are some circumstances in which a taxpayer will consider that an arm’s length price must be adjusted to account for government interventions. The question is whether in light of these conditions the transactions undertaken by the controlled parties are consistent with transactions between independent enterprises.
E. Use of customs valuations
Customs valuation methods may not be aligned with the OECD’s transfer pricing methods, but may be useful to tax administrations in evaluating the arm’s length character of a controlled transaction transfer price.
F. Location savings and other local market features
Features of the geographic market in which business operations occur can affect comparability and arm’s length prices. Such issues may arise in connection with the cost savings from operating in a particular market, sometimes referred to as location savings. In other situations comparability issues can arise in connection with the consideration of local market advantages or disadvantages that may not be directly related to location savings.
1) Location savings
Location savings can arise through lower wage or property costs etc. In determining how location savings are to be shared between two or more associated enterprises, it is necessary to consider
- whether location savings exist;
- the amount of any location savings;
- the extent to which location savings are either retained by a member or members of the group or are passed on to independent customers or suppliers; and
- (iv)where location savings are not fully passed on to independent customers or suppliers, the manner in which independent enterprises operating under similar circumstances would allocate any retained net location savings.
Where reliable local market comparables are available and can be used to identify arm’s length prices, specific comparability adjustments for location savings should not be required.
2) Other local market features
In assessing whether comparability adjustments for other local market features are required, the most reliable approach will be to refer to data regarding comparable uncontrolled transactions in that geographic market. Where comparable transactions in the local market can be identified, specific adjustments for features of the local market should not be required.
G. Assembled workforce
Some businesses are successful in assembling a uniquely qualified or experienced workforce. The existence of such an employee group may affect the arm’s length price for services it provides or the efficiency with which services are provided or goods produced by the enterprise. Such factors should ordinarily be taken into account in a transfer pricing comparability analysis.
Where it is possible to determine the benefits or detriments of a unique assembled workforce in relation to potential comparables, comparability adjustments may be made to reflect the impact of the assembled workforce on arm’s length prices for goods or services.
H. MNE group synergies
The TP Guidelines suggest that an associated enterprise should not be considered to receive an intra-group service or be required to make any payment when it obtains incidental benefits attributable solely to its being part of a larger MNE group. In this context, the term incidental refers to benefits arising solely by virtue of group affiliation and in the absence of deliberate concerted actions or transactions leading to that benefit.
In some circumstances, however, synergistic benefits and burdens of group membership may arise because of deliberate concerted group actions and may give an MNE group a material, clearly identifiable structural advantage or disadvantage in the marketplace over market participants that are not part of an MNE group and that are involved in comparable transactions.
If important group synergies exist and can be attributed to deliberate concerted group actions, the benefits of such synergies should generally be shared by members of the group in proportion to their contribution to the creation of the synergy.
So, what can we take from all of the above?
The arm’s length principle is the international transfer pricing standard agreed by OECD member countries for the valuation, for tax purposes, of transactions between associated enterprises.
There is comprehensive guidance on the arm’s length principle in chapter 1 of the OECD TP Guidelines. This article provides a summary of the first step of a comparability analysis; the accurate delineation of the controlled transaction. Chapter 1 of the TP Guidelines is your authoritative guidance. The TP Guidelines are freely available to view on the OECD website and should be referred to for more detailed explanations and examples.
The UK’s TP legislation is linked to the TP Guidelines
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.
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 HMRC case teams fully understand your business and the evidence underpinning your prices. There are no guarantees but here are my suggestions:
- Obvious perhaps, but as the UK’s TP legislation is tied to the OECD TP Guidelines, always follow the latest Guidelines when applying the arm’s length principle. These are freely available to view on the OECD website, so no excuse.
- Don’t lose sight of the principal objective of your TP documentation, which is to educate tax authorities 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 TP specialist with HMRC experience to sense-check your documentation so you can correct any anomalies or discrepancies 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 your TP 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, 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.
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