Part 2 of GfC7 covers Common Compliance Risks and HMRC have inserted a new subsection on value chain analysis within section 2.2: Common issues with functional analysis. This begins by acknowledging that whilst a VCA is not a prescribed requirement in the OECD Transfer Pricing Guidelines (TPG) or UK law, per paragraph 1.51 of the TPG, functional analysis necessarily entails understanding “how value is generated by the group as a whole, the interdependencies of the functions performed by the associated enterprises with the rest of the group, and the contribution that the associated enterprises make to that value creation”.
A VCA is a structured approach to addressing this requirement and HMRC recommend that, where a VCA is not conducted, businesses keep a record of how assurance was gained that the functional analysis was sufficiently robust to support the arm’s length nature of the transaction without the need to perform a VCA as this will be “helpful should a later enquiry need to consider penalties”.
The purpose of the new section is to set out HMRC’s view on why and how a VCA can enhance the quality and reliability of transfer pricing analysis, in what circumstances a VCA is most likely to add value and what HMRC consider best practice approaches and pitfalls when conducting a VCA.
HMRC have sensibly not attempted to define a VCA, but they have explained what steps should be involved in a best practice VCA. It is clear from this that HMRC view the VCA as being most useful when it is integrated with entity level functional analysis and used to inform accurate delineation of controlled transactions and transfer pricing method selection. This involves linking the key value driving activities to specific entities and assessing their relative importance in the context of the overall value chain, and using that analysis to inform which are the most economically significant risks, functions and assets.
Materiality and proportionality are a recurring theme in GfC7 and HMRC suggest that these factors should guide decisions on undertaking a VCA, and the extent and depth of any VCA. Examples are given of when a VCA is more likely to be appropriate, essentially situations where using a one-sided pricing method may be less reliable, including where the group is earning significant residual profits, where there are high value or hard to value contributions (e.g. strategic decision making) from a number of entities including the UK, and business restructurings where there is a change in functional profile of a UK entity.
Where a VCA is undertaken HMRC expect that it is: (i) applied rigorously and contemporaneously; (ii) considers the UK entity’s role in value creation; and (iii) has clear links to the transfer pricing outcomes. Specific VCA best practices identified in GfC7 include:
- Analysis of the competitive position of the group within its industry including any sources of competitive advantage that exist;
- Identifying and assessing synergies explicitly, and considering how they are being shared;
- Distinguishing those activities in the value chain which are higher value-adding (referred to as ‘non-routine’) and which entities perform those activities; and
- Clear referencing of supporting evidence and rationale for findings.
The additional guidelines on conducting VCAs provide helpful clarification on HMRC’s views in this area. Preparing a VCA at the outset when designing a transfer pricing model or reviewing an existing one is a great way to ensure the model is built on solid foundations. As well as improving the quality of transfer pricing documentation, it can provide a basis for identifying areas of complexity and engaging constructively with tax authorities in the context of audits and tax certainty programmes.
KPMG’s VCA methodology was developed to closely follow the post-BEPS OECD TPG Chapters one and six and incorporates the best practices identified in GfC7. We have made enhancements to the way in which value drivers are identified, validated and weighted, taking into account trends in tax controversy themes.
