INTM461020 - Transfer pricing: risk assessment and case selection - Risk assessment - general overview

This section explains the principles of how risk should be assessed in applying transfer pricing rules, including when HMRC consider initiating transfer pricing enquiries into tax returns made by businesses or exercising its the reserve power for adjusting the results of medium-sized enterprises.

Transfer pricing rules apply, broadly speaking, where a business has transactions with a business to which it is related. In some circumstances, the rules require the actual results of those transactions to be adjusted to “arm’s length” results for the purpose of calculating taxable profits or losses.

A transfer pricing enquiry can be complex and costly both for HMRC and for the business. It should not be undertaken lightly without due regard to the nature of this complexity or a fully considered assessment of the amount of tax that is likely to be at risk. The establishment of an appropriate “arm’s length” result requires judgement as well as knowledge on the part of a business when making its tax return. The same principle applies to HMRC when deciding whether to make an enquiry into that aspect of a return. That is one of the reasons why a detailed Business Case has to be submitted to the relevant Transfer Pricing Panel whenever a transfer pricing enquiry is considered appropriate - see INTM453030 et seq.

Where two businesses are related with each other, the amount of the taxable profit of each can be significantly affected by the results of the transactions between them. There is scope, either through manipulation or insufficient attention to the arm’s length principle, for the taxable profit of a business to be significantly depressed. The same applies where persons who collectively control a business act together (see INTM461260 for additional advice on risk assessment in relation to such “acting together”). A decision by HMRC whether to make an enquiry into a particular tax return needs to take account of this possibility.

As far as transfer pricing is concerned, it is generally more likely that the cases where significant amounts of tax are at stake are those that result from manipulation rather than insufficient attention to the arm’s length principle. In deciding whether to make a transfer pricing enquiry into the tax return of a business which has transactions with a business to which it is related, HMRC will pay particular attention to the potential opportunities for securing a tax advantage through manipulation. This opportunity will depend to a large extent, on the tax position of the related business. Where the marginal tax rate borne by that other business is the same as, or similar to, the rate borne by the business in question, that opportunity will, in most cases, be lower than when the marginal tax rate of the related business differs to a material extent.

For example, where a UK business has taxable profits on which it pays tax at 28 per cent, and has transactions with a related business (whether or not a UK business) which pays tax at 28 per cent or thereabouts, the tax at risk in relation to such transactions is less likely to be significant than in cases where the related business pays tax at a low rate (including cases where the marginal effective tax rate is zero because of losses).

Having said that, tax can still be at stake where the marginal tax rate is the same or similar and there can be justification in taking up a transfer pricing enquiry in such circumstances.

The amount of tax at risk in respect of transactions between businesses that are related to each other should be judged by reference to the tax to which the business whose tax return is being considered is liable. The tax to which the related business is liable is not directly relevant. It is, however, indirectly relevant in a very important sense since, as already explained, there is more opportunity to secure a tax advantage through manipulation where there is a significant difference between the marginal tax rates.

Where there is no, or minimal, opportunity to secure a tax advantage through manipulation, and the business has clearly taken some steps to apply transfer pricing rules, there is less likely to be a need for HMRC to initiate a transfer pricing enquiry.

Indicators of high risk

The following are possible indicators that a high level of risk might be present in a particular case:

• a taxpaying UK business has a commercial relationship with a related party with a low marginal tax rate and receives income from that other business that appears to be small by reference to that relationship, or makes payments to that business that appear to be large by reference to that relationship;
• a loss-making UK business has a commercial relationship with a related party with a higher marginal tax rate and the loss appears to be the result of payments to that business;
• a UK business, whether taxpaying or loss making, has a commercial relationship with a related party and there are non-tax factors that might provide an incentive for manipulation, such as regulatory requirements involving customs valuations, anti-dumping duties, currency exchange or price controls, or cash flow incentives within a group affecting where profit is reported or how dividends are financed;
• a UK company that is a member of a group enters into a cost-sharing arrangement with other group members with no clear expectation of a future income stream commensurate with its obligation to share costs;
• a UK company that is a member of a group has acquired, created or enhanced an asset that is used by other group members, perhaps by incurring expenditure on research and development leading to the creation or enhancement of intellectual property.

Indicators of low risk

The following are possible indicators that a low level of risk might be present in a particular case:

• a UK business has transactions with a related party with a marginal tax rate equivalent to, or more especially greater than, its own;
• a UK business has a low marginal tax rate and the disallowance of a cost, or the attribution of income, as the result of a transfer pricing adjustment would not be immediately effective for tax purposes;
• a UK business enters into transactions with unrelated parties on similar terms to those it enters into in equivalent transactions with related parties;
• a UK company is a member of a group within which there are significant minority shareholders whose interests would be prejudiced by the diversion of profits to a majority shareholder.

Medium-sized enterprises

Businesses that are small or medium-sized enterprises are exempt from transfer pricing rules for most transactions. In the case of medium-sized enterprises only, this is subject to a reserve power that can be exercised by HMRC. The need to exercise the power may emerge during an enquiry.

HMRC can exercise the reserve power in respect of an accounting period of a business. The effect of exercising the power is that the business has to adjust the results of transactions with related businesses to an arm’s length result where that would increase the amount of its income chargeable to UK tax. In exercising the power, HMRC has to specify the transactions to which the power relates. This might be all of the transactions which a business has with related businesses in the period, or might be a specified sub-set.

HMRC will only exercise the reserve power in a particular case where there has been blatant manipulation in the way in which transactions with related businesses have been accounted for involving a significant amount of tax. Approval to exercise the power will only be given centrally and will not be within the discretion of the particular office responsible for the enquiry.

Discussions between businesses and HMRC

Because of the degree of judgement involved in establishing appropriate “arm’s length” results, and the cost implications of a transfer pricing enquiry for both the business and HMRC, it may well be sensible for a business to have a discussion with its tax office about transfer pricing issues before a tax return is made, or even before the transactions take place. It may be possible to discuss an appropriate approach that would, after the tax return has been made, satisfy the concerns of both the business and HMRC. However, as is made clear at INTM468000, the only way that certainty could be given to the taxpayer would be under the formal Advance Pricing Agreements process. For this reason, discussions cannot go as far as agreeing a particular transfer pricing methodology and can amount to no more than HMRC giving an indication, expressed in terms of the level of risk, of how the transfer pricing is likely to be viewed once the tax return has been made.

Although discussions in the nature of risk assessment fall outside the governance procedures for transfer pricing enquiries, Customer Relationship Managers and Tax Specialists should ensure there is liaison with the Transfer Pricing Group as appropriate with the aim of improving consistency and knowledge management. If possible this should be before they engage with business, to allow the Transfer Pricing Group to attend any pre-return discussions.