HMRC releases new Transfer Pricing operational guidance on risk allocation

On January 26, 2024, HMRC published new chapters within its International Manual: “INTM485023 Transfer Pricing operational guidance: Accurate delineation of the actual transaction: Risk allocation” and “INTM485025 Transfer Pricing operational guidance: Accurate delineation of the actual transaction: Risk”.

This guidance addresses HMRC's view on the application of the six-step process within Chapter I of the Transfer Pricing Guidelines (TPG) and its impact on Transfer Pricing outcomes. Whilst guidance is welcome since the UK includes the TPG in domestic legislation, HMRC’s public interpretation may create more uncertainty than it solves when determining transfer prices and preparing tax returns. Note – HMRC guidance is HMRC’s interpretation of the law, not law itself and therefore should be viewed in that context.

For many Transfer Pricing and Tax Controversy professionals who regularly deal with HMRC Transfer Pricing and Diverted Profits Tax enquiries, the guidance formalises much of what is seen on the frontlines. Set out below is a summary of the guidance, how it is impacting clients and what clients are doing to manage the challenges this guidance presents.

Introduction to HMRC's new guidance

HMRC has released guidance focusing on the role of senior decision-makers in risk management for Transfer Pricing. This guidance is instrumental for businesses in preparing Transfer Pricing documentation and for navigating potential audits. It highlights the importance of the forensic examination of decision-making processes related to risk assumption and management.

Overview of the six-step process for risk analysis

The guidance elaborates on HMRC’s view on the six-step process, as per the OECD guidelines, for analysing risks in Transfer Pricing arrangements. This includes identifying economically significant risks, understanding the contractual allocation of risks, conducting a functional analysis to determine who controls the risks, and ensuring that the contractual terms are consistent with the conduct of the parties involved; and that the party has the capability and capacity to control the risk.

Implications for Transfer Pricing arrangements

The guidance has implications for transactions that involve the provision of decision makers. It challenges the routine return approach for tested parties, advocating for a more nuanced examination of risk control contributions which may lead to considering the profit split method more frequently in situations where decision-making significantly impacts risk management.

1. Divergent interpretations of risk control and inconsistency across jurisdictions: Tax authorities globally interpret and apply the TPG on risk control differently. HMRC's detailed guidance on the role of senior decision-makers and the process of risk management does not align with the practical interpretations of other countries, leading to potential disputes in cross-jurisdictional transactions.
2. Documentation and evidence requirements (note that this is in addition to the UK TP Documentation requirements that have come into force here): The guidance places a significant burden on taxpayers to provide detailed documentation and evidence of decision-making processes and control over risks. This requirement could pose challenges when the business models or operational realities do not easily align with the evidentiary expectations of tax authorities in other jurisdictions, leading to increased compliance costs and complexities.
3. Discrepancies in functional and risk analysis: The emphasis on functional analysis to determine who controls the risks and contributes to risk management may lead to discrepancies in how different tax authorities view the allocation of functions, assets, and risks within multinational enterprises (MNEs). Such discrepancies could result in double taxation if authorities arrive at divergent conclusions regarding the entity that should bear the risks (and rewards).
4. Valuation of risk control functions: Quantifying the value of risk management and decision-making contributions poses a technical challenge. The subjective nature of such valuations often leads to conflicts between businesses and HMRC, and similarly, between HMRC and other tax authorities, over the appropriate Transfer Pricing methods and outcomes.
5. Application of the profit split method: The guidance's implication that the profit split method may be more appropriate in certain scenarios heightens the technical complexity of Transfer Pricing analyses. This method's application requires a level of granularity in operational data and a consensus on profit allocation that may be difficult to achieve across jurisdictions. In practice we often see that HMRC prefer headcount related profit splits, which inherently is more difficult for clients to operationally implement given the constant change of employee numbers, location, grading, etc. adding to the ever-growing compliance burden for taxpayers.
6. Risk of double taxation and dispute resolution
   • Double taxation: The potential for double taxation arises when HMRC and other tax authorities do not agree on the interpretation of risk control functions and their impact on Transfer Pricing arrangements. Resolving these disputes may require lengthy and complex mutual agreement procedures (MAPs) or arbitration under tax treaties.
   • Dispute resolution mechanisms: The reliance on dispute resolution mechanisms, such as MAPs, increases in the context of these technical issues. However, these processes can be time and resource consuming and do not always guarantee a resolution that avoids double taxation; all of which adds to the uncertainty.

How are we helping clients?

• Review of Transfer Pricing policies: We are helping review clients’ existing Transfer Pricing arrangements to ensure they align with the guidance's detailed expectations for documenting risk control and decision-making processes.
• Functional analysis: Conducting an accurate and timely functional analysis is crucial. This analysis should accurately delineate transactions, identifying and documenting economically significant risks, and assessing the actual conduct of the parties involved. Doing this on a regular basis under legal professional privilege ensures that contemporaneous evidence is documented and protected.
• Decision-making process evaluation: It's important to scrutinise and document the roles of senior decision-makers in risk management processes. This includes helping clients document via a risk control framework, how decisions impacting risk are made, who makes these decisions, and how these processes contribute to the enterprise's overall risk control.
• Pricing method re-evaluation: Given the emphasis on decision-making and risk control, in delineating intra-group transactions clients may need to reassess their pricing method and in cases where decision-making has a significant impact on risk management consider the use of the profit split method.
• Preparation for HMRC enquiries: The guidance suggests HMRC will adopt a forensic approach in audits, focusing on decision-making processes. We are helping clients prepare comprehensive and contemporaneous documentation that form part of defence files which can withstand detailed enquiries.
• Achieve certainty:Leveraging the use of our former tax authority network we are helping clients assess the use of Advance Pricing Agreements (APAs), to secure upfront agreement from tax authorities on Transfer Pricing arrangements. This is particularly valuable for complex and material transactions.
• Uncertain Tax Treatment (UTT): Under the UTT regime there is an obligation to notify HMRC of uncertain tax treatments that differ from HMRC's known position. HMRC’s guidance is HMRC’s known position. Therefore, if your filed company tax return is at odds with HMRC’s risk control guidance, you may have a notification obligation and failure to do so may result in penalties.

In summary

HMRC's guidance on risk control in Transfer Pricing marks a significant shift towards a more detailed and forensic analysis of how businesses manage and document risk in their intercompany transactions. To ensure compliance, clients must take a proactive approach in reviewing and updating their Transfer Pricing policies and documentation. This includes a thorough functional and risk analysis, re-evaluation of pricing methods, and preparation for detailed scrutiny by HMRC on decision-making processes related to risk control.

By adopting these measures under legal professional privilege clients can better defend their Transfer Pricing arrangements and mitigate the risks of non-compliance, whilst maintaining control over the evidence produced.