Transfer pricing disputes

Selecting taxpayers for transfer pricing audits

1. In your jurisdiction, how do the tax authorities select taxpayers for audits for transfer pricing cases and what are their focus areas that could lead to transfer pricing audits? And what measures and technology do the tax authorities have available to capture the essential information? 

When assessing a taxpayer for audit selection, HM Revenue and Customs’ (HMRC) main sources of information include transfer pricing reports, legal agreements, and other business records. From 1 April 2023, these can be requested by HMRC without the need for an official audit to be opened.

HMRC also uses data profiling and intelligence gathered from multiple sources (business websites, commercial databases, press reports, trade magazines and articles, internet searches, and overseas financial statements) to supplement its assessment, identifying taxpayers with specific features who might be appropriate to audit. For instance, HMRC works closely with other tax administrations to exchange information under the terms of tax treaties, including its partners in the expanding Joint International Taskforce on Shared Intelligence and Collaboration (JITSIC) network. 

When selecting a taxpayer for audit, HMRC will consider the scope for significant transfer pricing risks and the tax position of related businesses before any transactions are examined in detail. The size of tax at risk will also feature in their assessment since audit case teams need to consider where best to target their resources. 

HMRC has published their key focus areas in their International Tax Manual and are due to release a Guidelines for Compliance (GfC) product focused on transfer pricing this year. The GfCs are a series of products being released by HMRC with the intention of providing taxpayers with practical information about tax risks. They are viewed as an extra tool to help taxpayers manage their taxes and guide the behavior of those that wish to operate in a low tax-risk environment. The focus areas considered by HMRC are:

• UK taxpayers’ profits or losses appearing inconsistent either with its business activities or with worldwide group results over a cycle of, say, five years 
• UK taxpayer providing intangibles but receiving no or low royalties and does not seem to be generating an entrepreneurial reward for its R&D. For instance, if UK R&D functions are described as managing, controlling, and performing the development of valuable intangibles in the UK for the purpose of R&D expenditure credit or patent box claims but then described as low value for TP purposes and being rewarded by reference to a modest return on costs 
• Borrowing appears disproportionately high in relation to shareholders’ funds, bearing in mind the type of business involved 
• Interest appears high in relation to the business’s ability to service the debt from its operating profits before tax and interest payable. What constitutes 'high' is a complex issue, but the key question is whether the debt burden appears sustainable, alongside the company’s other requirements and obligations 
• Transactions do not appear to make commercial sense (e.g., insertion, for no apparent commercial purpose, of a new UK group holding company with substantial debt), particularly in comparison to the previous position
• Transactions with related parties in low tax territories
• Payments by UK entities to overseas procurement or sourcing entities or 'hubs' in low tax countries with limited functionality relative to the UK procurement function, or which relate to incidental benefits derived solely due to it being part of a larger MNE group (for example, group synergies or economies of scale)
• Sales and marketing entities in the UK performing key account management functions
• Acquisition of a UK group by a private equity firm, which will rely on heavy debt funding
• Notes in UK accounts, or other forms of information such as press or internet articles, which mention restructuring, acquisition/merger activity, transfer of UK activities to related parties and/or changes to the way in which the company is rewarded
• Disappearance of/significant decline in stock.

HMRC also highlights further areas as risk indicators, such as an over reliance on transfer pricing policies predicated on contractual assumption of risk and legal ownership of assets, giving insufficient weight to the location of the control functions and/or the contributions to those control functions in relation to the risk and/or the important functions in relation to the assets.

In particular, HMRC focuses on legal contracts between a UK entity and an overseas entity (or entities) which allocate key risks to the overseas entity which are then purported to support a limited or reduced reward for the UK, notwithstanding that functions related to the control of those key risks are performed by the UK. HMRC states where it has observed instances where the contractual allocation of key risks may not be consistent with the control of such key risks:

• commissionaire structures 
• limited risk distributors 
• toll or contract manufacturing arrangements 
• contract research and development arrangements. 

In the UK HMRC uses a broad range of material and technology to assess taxpayers’ potential for audit, but at the same time provides clear indications of what constitutes a higher tax-risk environment.

Approaches followed by tax authorities during transfer pricing audits

2. Which approaches are followed by the tax authorities during transfer pricing audits and what are the key elements considered by courts when deciding on transfer pricing related disputes? Please describe a few recent cases or rulings as examples to help illustrate your explanation. 

Transfer pricing inquiries are subject to a mandatory governance process. The three stages of transfer pricing governance are:

1. Making sure the selection of a case is appropriate; 
2. ensuring there is effective progress in a case; and 
3. reaching the appropriate conclusion in a case. 

When the second phase of a transfer pricing audit has been completed, a written review of the case by the case team has to be sent to the appropriate review body. The intention is for every case to proceed to resolution within the overall 18/36 month time limit.

The review body will then determine whether to close the case without adjustment, settle by negotiation, or proceed to litigation. Where the decision is to negotiate, the review body will authorise the case team to settle according to clearly defined parameters. If settlement proves elusive, the case must be referred back to the appropriate review body with further recommendations. 

Transfer pricing litigation in the UK is rare, but a recent case was HMRC v. BlackRock Holdco 5 LLC. This was also the first Upper Tribunal case on how to apply the just and reasonable apportionment provision in the loan relationship unallowable purpose rule.

The key transfer pricing element considered by the court was whether the transaction was something that third parties would have agreed to. Interestingly it was the lack of defense that the transaction was commercial which meant that the tax avoidance alleged by HMRC was upheld. This serves to emphasize the importance of robust, clear, and detailed transfer pricing documentation. 

How best to prepare for potential dispute

3. How can Multinational enterprises (MNEs) best prepare for potential disputes in light of the factors described in Questions 1 and 2, and what can they do to mitigate the risks of future disputes? 

In light of the factors above, taxpayers can best prepare for potential disputes by ensuring that not only their transfer pricing compliance documentation is robust and complete but also that they can demonstrate that they have clear, consistent, and commercially accurate policies and processes to support the documentation. Evidence is key; for example, is there any internal correspondence to support statements made in the documentation? Can this be archived separately in preparation of a potential audit? 

Process is often overlooked, both in preparing for and mitigating the risks of future disputes. A process which outlines the planning and thought put into designing the transfer pricing policies, combined with an implementation manual that has been agreed with internal finance teams, can help tremendously. It is also advisable to ensure that there is an annual review of the policies against the commercial reality of the business. If this is not undertaken and documented by the business, then the taxpayer needs to ensure that there is evidence that the business has validated the review.

For more insight and guidance, get in touch with Kirsty Rockall.

____________________________

This article first appeared in the October issue of the Transfer Pricing Forum. Reproduced with permission from Transfer Pricing Forum, 13 TPTPFU 1, 10/19/23. Copyright © 2023 by Bloomberg Industry Group, Inc. (800-372-1033) http://www.bloombergindustry.com