Transfer pricing risk assessment

26 October 2021

Over the last five years, HMRC has brought in approximately £6.9bn of additional tax from transfer pricing enquiries (including real time interventions), advance pricing agreements (APAs), advance thin capitalisation agreements (ATCAs) and transfer pricing mutual agreement procedure (MAP) cases.

HMRC is looking to increase the amount of additional tax to be raised with their release of a consultation dated 23 March 2021 on transfer pricing (TP) documentation. If the proposals within the consultation become law they will represent more onerous compliance regimes for many businesses in the UK and reflect HMRC’s data-led approach to risk assessing.

Existing legislation

The existing rules regarding the duty to keep and preserve records in the UK are set out in paragraph 21(1) of schedule 18 to the Finance Act 1998 which states that:

“A company which may be required to deliver a company tax return for any period must:
(a) keep such records as may be needed to enable it to deliver a correct and complete return for the period, and
(b) preserve those records until the end of the relevant day”.

It has been five years since the government adopted the country-by-country (CbC) minimum standard which came out of the OECD base erosion and profit shifting (BEPS) action plan, specifically Action 13 which requires multinational enterprises with a turnover of €750m or more to file the CbC report each year.

Unlike many other jurisdictions, the UK does not require businesses to keep a master file and local file under the recommendations of the OECD BEPS Action 13.

Transfer pricing documentation consultation

Since the OECD published the Action 13 Final Report in 2015, HMRC has become increasingly concerned that UK businesses are uncertain about their transfer pricing compliance obligations, and the lack of certainty is leading to inconsistent approaches.

The consultation released on 23 March 2021 considers the case for updating and strengthening current TP documentation requirements to:

  • provide greater certainty for UK businesses;
  • provide HMRC with better quality data to enable more efficient and targeted compliance interventions; and
  • align the UK’s practice more closely with the TP documentation requirements of comparable tax administrations and the Action 13 Final Report.

If the proposals become law it means that for the first time a transfer pricing master file and UK local file will be mandatory for the largest multinationals that meet the CbC filing threshold and be subject to a 30-day submission requirement if requested by HMRC.

If multinational enterprises (MNEs) do not meet the CbC filing threshold we recommend they include the same level of information as detailed in the consultation paper (see below) in their TP reports.

Evidence log

The local file includes details of transactions and demonstrates how an appropriate transfer pricing methodology has been selected and applied.

From HMRC’s experience a common difficulty in TP enquiries relates to distinguishing underlying facts and evidence from technical opinions. They believe that the presence of an evidence log as an annex to local files will allow HMRC to focus on technical issues rather than spending significant time on fact finding.

HMRC currently uses the evidence log approach in the profit diversion compliance facility (PDCF). The PDCF guidance provides an example of an evidence log and includes evidence such as financial data, agreements, notes from functional interviews and email reviews.

International dealings schedule (IDS)

In a move that emphasises HMRC’s intent to become more data-led in their transfer pricing compliance and risk assessment processes, the consultation paper has a dedicated section setting out proposals for requiring all taxpayers in scope of UK transfer pricing legislation to submit an IDS which will provide HMRC with details about cross-border intragroup transactions where the counterparty is in another territory.

Small and medium sized businesses are generally exempt from the requirement to apply transfer pricing and therefore would not be in scope of the IDS. In addition, UK to UK transactions would be excluded from having to file IDS forms. This would ensure that any requirement was focused on the areas of greatest tax risk and would align with OECD’s recommendations and the approach taken in other countries.

As detailed in the consultation, the types of data that could be requested include:

  • the nature and amount of specific types of transactions;
  • details of financial dealings;
  • compensation, receipts or payments of a non-financial nature;
  • information on restructuring activity;
  • information on the transfer pricing methodologies applied;
  • information on the level and type of supporting documentation for the transfer pricing methodology selected and applied;
  • counterparty details for transactions including identity and country location;
  • information on activities; and
  • corporate group information.

Risk mitigation - practical steps

We recommend that PE firms that sit outside the CbC filing threshold should include the level of information detailed above in their TP reports. Firms will need to prepare contemporaneous documentation that is backed up with an adequate audit trail.

PE firms will potentially have a significant new filing requirement with the introduction of the IDS due to the number of cross border transactions. Firms will need to consider how to mitigate the extra compliance burden.

A different approach to performing functional analyses will have to be considered including interviews being conducted at the point of documentation. Interview notes may be presented to tax authorities and interviewees may be named within the TP documentation.

Firms will have to consider their capabilities of extracting existing records to populate IDS forms and consider the availability of their personnel to assist in this process.

We offer a Macfarlanes TP health check to review pricing methodology, documentation and other compliance requirements, and can also provide bespoke accounting software for implementation of automated internal transfer pricing models with appropriate financial audit trails.

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