Transfer Pricing: Risky Business (Part I)

Panelists

• Karine Uzan-Mercie, Vice President, Tax & Corporate Initiatives, Coca-Cola Enterprises

• Paul Morton, Head of Group Tax, RELX Group • Mike McDonald, Financial Economist, U.S.

Treasury • Andrew Hickman, Head of Transfer Pricing Unit,

OECD Centre for Tax Policy and Administration

Topic

• The risk control framework in revised Chapter I of the Guidelines

• Implications for current work on attribution of profits to PEs and financial transactions

5

Revisions to Guidelines.

I Delineation of the actual transaction, risk Recognition of the accurately delineated transactionLocal market characteristics, assembled workforce, group synergies

II Commodity pricingTransactional profit split method

V TP Documentation, including CbC reporting

VI Intangibles, including HTVI, Implementation of HTVI

VII Low value-adding services, Implementation of LVAS

VIII Cost Contribution Arrangements

Financial transactions

Attribution of profits to permanent establishments

Conforming changes (e.g. Ch IX)

Report on Actions 8-10

Clarifying the fundamentals

• In framing BEPS Transfer Pricing Actions, tax administrations concerned that changing pieces of paper changed allocation of profits without changing business reality

• Action Plan required consideration of how to deal with risk, capital, legal ownership, and arrangements not seen between independent parties

• In responding the Final BEPS Reports focused on fundamentals of any transfer pricing analysis:• rigorous determination of what is actually happening—accurately

delineating the actual transaction• analytical framework for determining where risk is assumed, provides

approach to determine substance of risk allocation

Risk

• Increased assumption of risk Increase in expected return• Now have an analytical framework to determine the substance

requirements for assuming risks• It is not based on numbers of people, or on organisational hierarchy,

but on qualitative, specific decision-making functions relating to a transaction

• Paper allocations of risk cannot override actual decision-making capability and performance

• Identifying SPECIFIC risks IN A TRANSACTION that are ECONOMICALLY SIGNIFICANT goes hand-in-hand with identifying functions and assets

TP location of risk

• The contract tells us how parties have allocated risk on paper

• Do the parties follow that allocation in reality?

• Does the party control its risk?• The Guidelines assert that a party does not

assume a risk it does not control

4(i) Does

conduct follow

contract?

4(ii) Control &

financial capacity?

Test 4(ii) based

on conduct

NO

YES 5. Allocate to party with

control & financial

capacity

6. PriceYES

NO

1. Identify risks

2. Contracts

3. Functional analysis

9

Risk analysis framework (1.60)

Exercising control over risk (1.65)

Capability and actual performance:i. Decisions to take on, lay off or decline a risk-bearing

opportunityii. Decisions on whether and how to respond to the risks

associated with the opportunity iii. Mitigate risk: to take measures that affect risk outcomes

or, if risk mitigation is outsourced,Set objectivesHire, asses and, if necessary, fire the provider

Financial capacity to assume the risk (1.64)

• Access to funding to take on the risk or lay off the risk, to pay for the risk mitigation functions and to bear the consequences of the risk if the risk materialises

• Takes into account the available assets and the options realistically available to access additional liquidity, if needed, to cover the costs anticipated to arise should the risk materialise

In most cases a simple test (1.94)

• Does the party assuming a risk under the contract exercise control?

• If it does, and has financial capacity, it assumes the risk

• If other parties also exercise control, then that function should be compensated appropriately, but those other parties do not take on the risk

Transactional risk-taking not policy setting (1.66, 1.76)

• Control over risk is NOT• Formal approval• Signing of documents• Policy setting

• The Board or committees may set policies, but this is not a decision to take on, lay off, decline, or mitigate the specific risk in the transaction. It is not control.

The assumption of risk dictates the appropriate pricing method (1.81)

• No inference should be drawn from the pricing adopted that risks are borne in a particular manner

• It is the determination of how the parties control risks that determines risk assumption, and consequently the selection of the most appropriate transfer pricing method.

Discussion

Digital publishing (illustration)

Business: Sweden

Business: Denmark

Publisher: UK Contracting entity: Netherlands

Customer: Italy

Sales office: France

Software coding: India

Platform development: Netherlands

Datacentre: US

Production: Philippines

Review board: Various countries

User on holiday: Hawaii

User on secondment: Japan

Contributors are third partiesSales support

Review board members are third parties

Contracts with all global customers

Normally uses publicationsIn Japan

Actually uses publicationsIn Hawaii but using the Japanese VPN but his Italiansubscription agreement

The publisher has unique knowledgeand is responsible for this database

The platform cost $500 millionand was cost shared by five publishingcompanies – UK, US, Australia, Netherlands and Japan

One of several publishing companies

Technology platform development

• Year 1: Operating companies in US, UK, France, Netherlands and Japan contract to jointly develop a new platform

• Year 2: Development begins – led by a team in the UK, on US servers, with coding undertaken in India

• Year 3 – 5: Development continues• Year 6: First roll out in US• Year 7: First roll out in UK• Year 8: First roll out in France• Year 9: Japan decides that the platform is no longer

required for the Japanese market

Discussion

Additional guidance on Attribution of Profits to PEs

• Does the transfer pricing work related to intangibles, risk and capital affect application of Article 7?

• For Dependent Agent PEs where the Dependent Agent Enterprise is an associated enterprise, the risk framework under Article 9 may allocate risk to the DAE, and therefore the resulting profits would no longer be profits of the non-resident to be attributed to the DAPE.

• The risk framework under Article 9 may determine that the functions performed by the DAE do not lead to the assumption of risk by the DAE under Article 9 (for example, the non-resident contractually assumes risk and exercises control), but which are significant people functions relevant to the attribution of risk to the DAPE.

• Any return to capital to fund an asset under Article 9 may be attributed to the DAPEif the asset is economically attributed to the DAPE under Article 7.

Financial Transactions

Does the transfer pricing work on synergistic benefits, risk and capital lay useful foundations for the guidance on transfer pricing aspects of financial transactions?

• Relationship between risk and capital in an unregulated MNEGroup

• Role of funding activities in an MNE Group, and control of risks• The relevance of the procurement model to certain funding

arrangements

Discussion