When it Comes to Transfer Pricing Compliance, HMRC Says Get the Functional Analysis Right

The transfer pricing of multinational companies has always been a priority for HMRC. The British tax authority was among the first to develop a diverted profits tax and it’s constantly suspicious that multinational companies are parking tax dollars outside the jurisdiction via base erosion and profit shifting—in 2022, the latest statistic, HMRC claimed that U.S. multinationals underpaid the UK in tax by 5.6 billion pounds.  

Suffice it to say, HMRC is always on the lookout for suspicious transfer pricing—but at least the agency is transparent about its expectations. Last fall, it published Guidelines for Compliance to help multinational companies overcome transfer pricing risks. One area of particular interest? The functional analysis.  

According to HMRC, taxpayers often make mistakes on the functional analysis, which leads to errors in other parts of the documentation. Where are taxpayers going wrong? Here are some common issues along with HMRC’s advice on avoiding them: 

Your timing is off: Taxpayers conduct too many analyses after tax returns are filed, which puts them in the undesirable position of having to justify what they’ve filed because it’s too late to make adjustments. This increases the risk of double taxation or penalties for pricing that isn’t arm’s length.  

You’re not localizing your documentation: It may be more efficient—and certainly more convenient—to perform a central analysis and then standardize content for documentation throughout the group, but that won’t pass in the UK. HMRC wants localized information specific to your UK entities.  

You fail to update a functional analysis roll-forward: There are only a few circumstances where a role-forward analysis makes sense: 1.) you’ve completed a robust functional analysis of both parties in a prior period and 2.) the business activities of the parties and comparables haven’t changed. If you fail to meet either of those criteria, you’re better off starting from scratch. Even if you are going to reuse and roll forward a functional analysis, you should at least update entity data relevant to the transaction (head count, organizational structure, financial data, foundational facts, and so on).  

Your business has changed, but your functional analysis hasn’t: Businesses evolve and circumstances change—and your analyses need to reflect those changes and explain how they specifically impacted UK entities. HMRC advises that you identify and analyze business changes before the financial close, so transfer prices can be set or modified in real time.  

You view your risk analysis separate from the functional analysis: Part of your functional analysis should entail assessing the economically significant risks in your transaction, and you’ll need to explain how to you determined those risks. What facts did you rely on? Which key decisions or processes played a role? Use fact-based analysis instead of narrative labels (like “responsible for risk,” or “bearing risk”) to describe risk and present the financial capacity of entities that assume risks.  

You don’t say enough about intangibles in your functional analysis: HMRC wants to know about intangible assets owned, exploited, and/or developed by each UK entity. The problem is HMRC often finds that analyses lack detail. So, be sure to include robust descriptions of R&D functions that create value intangible assets; how UK entities contribute to DEMPE functions; historic facts related to the intangible; and other specific facts related to the intangible.  

You forget your staff: If your functional analysis doesn’t align with the reality of your UK entity staff’s functions, then HMRC is sure to have questions. Make sure you include details about individuals who manage reports, details about the number of employees below the c-suite, job titles for senior staff in the UK, and project operating models and bonus schemes by departments, among other relevant details.  

The functional analysis is the anchor of your transfer pricing documentation, so sufficient information is critical. In the UK—as in many jurisdictions around the world—anything less will be cause for a formal inquiry.