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Executive summary

On 26 January 2024 HMRC published new operational guidance (INTM485025) on the role of risk in the accurate delineation of the actual transaction as part of a transfer pricing analysis.

The guidance sets out HMRC's interpretation of the six-step process for analyzing risk contained within Chapter I of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (TPG) and its application to transfer pricing analyses.

The publication of this guidance makes it clear that HMRC considers the analysis of economically significant risks and their management to be an important component of a comprehensive transfer pricing analysis and will expect taxpayers to submit suitable documentation evidencing this. Taxpayers should expect this to be an area of focus for compliance and in any discussions with HMRC.

Importantly, HMRC's guidance emphasizes that a complete analysis of contributions to the control of economically significant risks should not be limited to parties that are contractually assuming or being allocated those risks in the controlled transaction that is being analyzed. The guidance provides extensive insight into HMRC's views on how contributions to the control of risk should be remunerated in a multinational enterprise (MNE) group, and in particular provides considerations for when the transactional profit split method may be the most appropriate method to reward contributions to risk control. This is a contentious area and, as the guidance notes, some commentators firmly disagree with HMRC's perspectives.

Nonetheless, the guidance is helpful in explaining HMRC's views. The publication of the guidance makes it clear that a well-reasoned analysis, identifying the contributions to risk control made by members of an MNE group and assessing the arm's-length reward for these contributions, will be an essential part of the documentation required to support the tax position of UK members of MNE groups.

Detailed discussion

Chapter I of the OECD TPG sets out the six-step process for analyzing risk as part of the accurate delineation of a controlled transaction. This process of accurate delineation considers the substance of the actual transaction, beyond its legal form.

The six-step process (outlined in full in paragraphs 1.60 to 1.106 of the OECD TPG) identifies economically significant risks relevant to a controlled transaction and determines whether the contractual assumption of those risks under the terms of the transaction aligns with the conduct of the parties by reference to their capability to exert control over the risks and their financial capacity to bear those risks. Where the party assuming risk does not control the risk or does not have the financial capacity to bear the risk, the risk may be reallocated. The final step in the six-step process is to determine arm's-length pricing for the transaction (after any reallocation of risk resulting from the preceding steps).

The guidance in INTM485025 presents HMRC's interpretation of this area of the OECD TPG for its case teams, for taxpayers and their advisors. Roughly half of the guidance deals with Steps 1-5 of the process, dealing with identifying risk and determining whether, for transfer pricing purposes, the contractual assumption of risk through a controlled transaction should be respected or whether risks should be reallocated. The remainder of the guidance addresses Step 6, on pricing, and includes extensive consideration of how arm's-length pricing may be determined for contributions to the control of risk by parties that are not (under Steps 1-5) allocated the risk for transfer pricing purposes. It also addresses situations in which entities other than the parties to the controlled transaction make contributions to the control of risk.

The guidance specifically notes that it must be considered in context, and that risk assumption is only one of several considerations that are relevant to accurate delineation of a controlled transaction, stating: "though this guidance focusses on risk and specifically the 6-step process, it should not be interpreted that HMRC view the delineation of risk as having more significance than functions or assets, or the other economically relevant characteristics or circumstances of the parties to transactions."

HMRC's guidance notes 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. Put simply, 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." What HMRC seems to be saying is that a full analysis requires consideration of all the contributions made to the control of an economically significant risk by entities in the group, to ensure that they are appropriately remunerated. HMRC accepts that, in most cases, it will be appropriate to price contributions to the control of a risk, without the assumption of that risk, using a "one-sided method" (e.g., cost plus, comparable uncontrolled price (CUP) or transactional net margin method (TNMM)).

However, the guidance further notes that Step 6 of the OECD TPG guidance states that arm's-length compensation for a party that contributes to the control of a risk, but does not assume the risk, may take the form of a sharing in the potential economic upside and downside commensurate with the contribution to that control. In some circumstances, HMRC considers that contribution to the control of risk may be appropriately rewarded by reference to the transactional profit split method (TPSM), and HMRC notes that it is important to consider the principles of Chapter II of the TPG to determine which method is appropriate in any specific case.

Having introduced the possibility that the TPSM may be the most appropriate method to reward contributions to the control of risk, the guidance goes on to provide HMRC's thinking on how such a profit split might be implemented. The guidance includes sections discussing (i) whether it should be based on anticipated profits ex ante or actual profits ex post, after the consequences of risk have played out; (ii) the relevant profits to be taken into account, considering the nature of the relevant risks, their links with other risks and the roles of different entities in the MNE group to the control of those risks; and (iii) practical matters, such as how to determine what share of profits is required to give a reward that is commensurate with an entity's contribution to the control of risks. These sections conclude with the possibility that in some cases, where there are many specific economically significant risks, a profit split based on the head count of a class of decision makers within the MNE group may be appropriate.

Finally, the guidance briefly discusses two specific classes of arrangement involving the contractual transfer of risk and associated profits between related parties: captive insurance, and total return swaps. The guidance sets out the factors that HMRC will take into account when assessing commercial rationale, which is critical to the transfer pricing position of captive insurance arrangements. The additional guidance further highlights HMRC's continued scrutiny in respect of captive arrangements and whether they should be delineated as insurance arrangements.

Implications

The detailed discussion in this guidance illustrates some of the key concerns around risk HMRC has raised in recent transfer pricing enquiries and other engagements with taxpayers. These concerns include that (i) entities in MNE groups may have contractually assumed risks, and are bearing the consequences of those risks, without having or exercising the capability to control those risks or having the financial capacity to assume them; (ii) contributions to risk control by members of an MNE group may not have been identified; or (iii) if they have been identified, the remuneration for those contributions might not be appropriate.

Businesses should therefore consider reviewing their economically significant risks to determine whether risk control activities, including contributions to risk control from other parties, are being adequately identified, analyzed and documented.

Businesses should also look to make sure that processes are in place to evidence risk control activities being performed on an ongoing basis, including who performs them, which entity they are employed by, and their capability and capacity to do so.