HMRC increased focus on transfer pricing analysis of control of risk
New HMRC guidance highlights the importance of identifying key business risks and the entities that control them
New HMRC guidance on control of risk
HMRC have published new guidance setting out how they think the six-step process for analysing risk in Chapter I of the OECD Transfer Pricing Guidelines (TPG) applies. The guidance reinforces the importance of identifying key business risks and how they are controlled when designing and documenting transfer pricing policies. The guidance also sets out HMRC’s position on a significant area of uncertainty which emerged from the 2015 re-write of the TPG – how to reward contributions to the control of economically significant risks by entities which have neither contractually assumed nor been allocated the risks in question as part of the accurate delineation of the transaction. This guidance will be especially relevant for businesses with senior decision makers in the UK, where these decision makers are currently allocated a routine return. HMRC’s views are likely to stimulate further debate on this topic and may influence the approach of other tax administrations.
The risk control framework is an integral part of the process of accurately delineating a transaction, which was a new formulation introduced into the TPG as part of the BEPS Actions 8 – 10 Final Reports: Aligning Transfer Pricing Outcomes with Value Creation.
The risk control framework requires the reallocation of economically significant risks that have been contractually assumed by an enterprise within a multinational group that is not exercising control over those risks (based on capability and actual performance of decision making). Since its introduction the application of the risk control framework, and its close relative the DEMPE framework for intangible assets in Chapter VI of the TPG, have resulted in a growing number of transfer pricing disputes around the world. In the UK, transfer pricing and diverted profits enquiries, as well as cases handled under the Profit Diversion and Compliance Facility, have regularly focused on the control of risk framework – and specifically situations where UK employees are performing control functions which only attract routine returns.
In many multinationals the procedures for controlling high consequence risks involve contributions by a number of individuals who may not all be employed by the same group entity. Some commentators have expressed concern that the risk control framework is being extended beyond its intended purpose to accurately delineate transactions and is being used as a basis for assigning a share of residual profits to entities that contribute to the control of risks they have not contractually assumed, nor been allocated through the accurate delineation steps. Increasing mobility of senior management roles within globally run businesses has made this a critical issue for many multinational groups.
Against this backdrop, it is helpful that HMRC have been willing to set out their views on what is a difficult and contentious area in extensive published guidance in the International Manual at INTM485025.
Accurate delineation of risk
The guidance on steps 1-5 of the risk control framework, which determine risk allocation as a precursor to pricing a transaction, covers a number of areas including identifying which risks are economically significant, the level of specificity required in delineating individual risks and control over those risks and determining whether an entity has the financial capacity to assume a risk.
HMRC have stressed in the guidance that actual commercial practice including the control structures in a group will be informative for identifying the economic significance of risk(s) with specificity, and aggregation will only be appropriate where there is a commonality of the control structure.
In practice it can be difficult determining what constitutes ‘control’ and how much control is enough for the contract to be respected. The TPG provide limited assistance in answering these questions. HMRC’s view is that it is a question of fact in an individual case as the actual point a decision is made has to be identified to determine where actual control is exercised. HMRC accept that control over different economically significant risks will be exercised in different ways and frequency across different transactions and industries. They stress, however, that control is different from the question of value, since the control decision may be the result of a process involving many other parties, each making valuable contributions to the decision without exercising control.
On the subject of financial capacity, which has far less coverage in the TPG compared to control of risk, HMRC note that the TPG do not limit this capacity to the finances of the legal entity itself that assumes risk, but extend it to include “options realistically available” to access additional liquidity. HMRC state their view that where a legal entity has the capability to control the risks in an opportunity, “it is reasonable to suppose that capital could move to exploit that opportunity”. This indicates HMRC take the view that a lightly capitalised UK service company set up to employ senior managers undertaking risk control functions would not necessarily be regarded as lacking the financial capacity to assume risk. There are reasons to question this position, particularly in regulated sectors where specific capital requirements must be met by persons contractually assuming risk. It is recognised in the TPG, both in Chapter I when introducing the control of risk framework and in Chapter X ‘Financial Transactions’, that due regard should be given to the regulatory approach to risk allocation for regulated entities.
Pricing risk control contributions
A significant amount of the guidance relates to step 6 on pricing the transaction taking account of risk allocation, and how to approach contributions to the control of risk that do not lead to the risk being attributed to the party performing that function. This is a reflection that this is really the crux of the matter as far as HMRC and taxpayers are concerned.
HMRC cite a series of important paragraphs in the TPG as clearly indicating that “all risk management functions relevant to an economically significant risk must be identified, regardless of whether the contractual allocation of risk is respected as the pricing of all contributions to control is required.”
This has important ramifications for transfer pricing documentation as HMRC are saying that a contribution by one party to the control of a risk assumed by another is prima facie an economic relationship between the two which may be rewarded at arm’s length, and therefore it is necessary to consider what reward that contribution would earn.
Importantly, HMRC state that they accept that “in most cases, it will be appropriate to price contributions to control of risk, without the assumption of risk, using a ‘one sided method’”. There should not, therefore, be a default assumption that contributing to the control of risk leads to the application of a transactional profit split method (TPSM) – but HMRC go on to say that “where there is a high degree of integration of business operations, and specifically control functions, it is more likely that contributions to control of risk don’t result in a reallocation of risk but require pricing using the TPSM”.
Considerations for multinational groups
It is likely that the publication by HMRC of this guidance will bring further attention to this area of uncertainty and may help to move it up the OECD’s agenda as attention shifts from BEPS 2.0 to tackling global mobility issues.
Understanding this guidance will be important to multinational groups that are concerned about the distribution of various leadership roles and internal decision-making processes related to key risks and value drivers, including managing a distributed/remote workforce.
This guidance will be especially relevant for businesses with senior decision makers in the UK, where these decision makers are currently allocated a routine return as we expect this publication will result in these types of arrangements being subject to further scrutiny. However, the concepts may be applied by other tax authorities and therefore have relevance beyond the UK.
There are a number of approaches businesses can take including undertaking an initial risk assessment, proactively undertaking a detailed analysis of how economically significant risks are controlled, enhancement of existing transfer pricing documentation and risk mitigation through Advance Pricing Agreements, unprompted registration for the HMRC Profit Diversion Compliance Facility or the International Compliance Assurance Program (our earlier article on Preventing HMRC Transfer Pricing enquiries discusses this).
If you would like to discuss the impact of the HMRC guidance on your business please contact Phil Roper or you usual KPMG in the UK transfer pricing contact.
