When settling transfer pricing enquiries, HMRC will expect any adjustments to be to a central point in the arm’s length range.
HMRC have issued new advice to their compliance teams and governance boards on settling transfer pricing (TP) enquiries where HMRC consider that a taxpayer’s filed position is outside the arm’s length range and relief from double taxation is available by treaty under the Mutual Agreement Procedure (MAP). In such cases, the default position will be for HMRC to adjust to a central point in the range (for example, the median in the set of comparables used to establish the arm’s length range). Taxpayer settlement proposals to adjust to a lower, or higher, point in the range are unlikely to be accepted without very strong technical arguments. The advice is reflected in HMRC’s updated International Manual at INTM485120.
Why adjust to a central point in the range? Often in practice, limitations on available information mean that a transactional profit method, such as the TNMM is selected. The available information may not be sufficient to establish very precise comparability but the TNMM tests Net Profit Indicators (ratios), which the OECD Transfer Pricing Guidelines (TPG) explain are less affected by transactional differences and may be more tolerant to some functional differences than direct price testing. Even after a careful analysis in this way, there are two possible situations: either the identified comparable companies are of relatively equal and high reliability, or some unidentified and/or unquantified comparability defects remain. The former is unusual in practice in our experience. By way of example, it is relatively common to see comparable sets of distributors exhibiting interquartile ranges with spreads of approximately five percentage points or more.
The TPG explain that limited information means that ‘determining a reliable estimate of an arm’s length outcome requires flexibility and the exercise of good judgement’. Further, ‘a substantial deviation among points in that range may indicate that the data used in establishing some of the points may not be as reliable [as others]’. Where the points are of relatively equal and high reliability, ‘it could be argued that any point in the range satisfies the arm’s
length principle.’
Where some comparability defects remain, paragraph 3.62 of the TPG suggests it may be appropriate for tax administrations to determine the adjustment point using measures of central tendency, such as the median (or perhaps the arithmetic mean or others), to minimise the risk of error due to these defects. Put simply, in cases where there are non-quantifiable comparability defects, adjusting to a central point is likely to minimise the likelihood of error.
HMRC’s policy change is now generally to expect adjustment to the central point and to be much clearer about this policy expectation. HMRC’s approach is not novel. Several of the UK’s major partners, including France, Germany, India and the US, will adjust to the median or mean as a matter of law or policy if the taxpayer’s results fall outside the arm’s length range.
Our view: We understand that HMRC do not want to be in the position of settling cases based on adjustments to (say) the lower quartile, and then find themselves agreeing MAP relief for adjustments by other countries to the median or mean. They are therefore effectively instructing their audit teams to now generally adjust to the median of the arm’s length range where the tested party has fallen outside unless there is very strong support for another point in the range.
Such clarity from HMRC is useful in our view, although the arm’s length position in each specific case should be determined on its specific facts (as HMRC continue to recognise). The practical point is that HMRC view the median as generally most appropriate to use when making a TP audit adjustment and they are now making their position clear. A secondary motive from HMRC for this clarity may be to provide an extra incentive for taxpayers to self-assess transfer pricing adjustments where they have fallen outside the arm’s length range in a period and consider an adjustment to a different point in the range would be more appropriate.
Although HMRC’s approach to settlements where MAP is not available has not been updated, in practice we would expect to see HMRC’s governance boards adopt similar principles in those cases too.
Home >Articles > Meet in the middle: HMRC’s transfer pricing settlement policy
Meet in the middle: HMRC’s transfer pricing settlement policy
When settling transfer pricing enquiries, HMRC will expect any adjustments to be to a central point in the arm’s length range.
HMRC have issued new advice to their compliance teams and governance boards on settling transfer pricing (TP) enquiries where HMRC consider that a taxpayer’s filed position is outside the arm’s length range and relief from double taxation is available by treaty under the Mutual Agreement Procedure (MAP). In such cases, the default position will be for HMRC to adjust to a central point in the range (for example, the median in the set of comparables used to establish the arm’s length range). Taxpayer settlement proposals to adjust to a lower, or higher, point in the range are unlikely to be accepted without very strong technical arguments. The advice is reflected in HMRC’s updated International Manual at INTM485120.
Why adjust to a central point in the range? Often in practice, limitations on available information mean that a transactional profit method, such as the TNMM is selected. The available information may not be sufficient to establish very precise comparability but the TNMM tests Net Profit Indicators (ratios), which the OECD Transfer Pricing Guidelines (TPG) explain are less affected by transactional differences and may be more tolerant to some functional differences than direct price testing. Even after a careful analysis in this way, there are two possible situations: either the identified comparable companies are of relatively equal and high reliability, or some unidentified and/or unquantified comparability defects remain. The former is unusual in practice in our experience. By way of example, it is relatively common to see comparable sets of distributors exhibiting interquartile ranges with spreads of approximately five percentage points or more.
The TPG explain that limited information means that ‘determining a reliable estimate of an arm’s length outcome requires flexibility and the exercise of good judgement’. Further, ‘a substantial deviation among points in that range may indicate that the data used in establishing some of the points may not be as reliable [as others]’. Where the points are of relatively equal and high reliability, ‘it could be argued that any point in the range satisfies the arm’s
length principle.’
Where some comparability defects remain, paragraph 3.62 of the TPG suggests it may be appropriate for tax administrations to determine the adjustment point using measures of central tendency, such as the median (or perhaps the arithmetic mean or others), to minimise the risk of error due to these defects. Put simply, in cases where there are non-quantifiable comparability defects, adjusting to a central point is likely to minimise the likelihood of error.
HMRC’s policy change is now generally to expect adjustment to the central point and to be much clearer about this policy expectation. HMRC’s approach is not novel. Several of the UK’s major partners, including France, Germany, India and the US, will adjust to the median or mean as a matter of law or policy if the taxpayer’s results fall outside the arm’s length range.
Our view: We understand that HMRC do not want to be in the position of settling cases based on adjustments to (say) the lower quartile, and then find themselves agreeing MAP relief for adjustments by other countries to the median or mean. They are therefore effectively instructing their audit teams to now generally adjust to the median of the arm’s length range where the tested party has fallen outside unless there is very strong support for another point in the range.
Such clarity from HMRC is useful in our view, although the arm’s length position in each specific case should be determined on its specific facts (as HMRC continue to recognise). The practical point is that HMRC view the median as generally most appropriate to use when making a TP audit adjustment and they are now making their position clear. A secondary motive from HMRC for this clarity may be to provide an extra incentive for taxpayers to self-assess transfer pricing adjustments where they have fallen outside the arm’s length range in a period and consider an adjustment to a different point in the range would be more appropriate.
Although HMRC’s approach to settlements where MAP is not available has not been updated, in practice we would expect to see HMRC’s governance boards adopt similar principles in those cases too.
