As a result of Covid-19, businesses are faced with significant supply chain disruptions, fluctuations in demand, and a number of other problems that were hardly imaginable a year ago. As a consequence, they are undertaking various measures with third parties - for example, seeking to renegotiate contracts, defer payments and renegotiate financing. Within groups there are restructurings taking place to adapt to market conditions. A consequence of the internal and external changes means that risk profiles are changing for and within groups. Risk is a key determinant of transfer pricing outcomes, and therefore a change in risk needs to be understood and the consequences of that change for transfer pricing needs to be determined.
No discussion on risk would be complete without reference to the OECD ‘Base Erosion and Profit Shifting’ (‘BEPS’) programme concluded in 2015. BEPS has been one of the biggest transformational events in international tax in decades. Against a backdrop of increasing, politicised scrutiny around the tax affairs of multinationals, BEPS, a high profile assignment for the OECD, was a two-year project designed to ‘reset’ the fundamentals of an international system that had been outpaced by business change, with an estimate of USD 100 billion to USD 240 billion of corporate tax ‘lost’ a year.
In October 2015, thirteen final reports were issued across three key themes of transparency, coherence and ‘substance’. That was just the beginning and the world ‘post-BEPS’ is now in the long period of implementation, when the theory becomes reality in the complex, interlocking framework of domestic laws and bi-laterally agreed treaties. New frameworks, such as Pillar 1 and 2 to tackle the challenges of the digital economy, build on the foundations laid down in BEPS.
Given its nature, transfer pricing has been centre stage in BEPS. The recommendations the OECD has delivered on the realignment of taxation and relevant substance permeates the updated chapters to the OECD Guidelines on Transfer Pricing, and how these deal with the question of risk.
Defining transfer pricing substance
The concept of a ‘limited risk’ entity or a ‘routine’ entity is common within the transfer pricing world, and such entities will often attract low, stable margins. A radically changed external risk environment is now casting the spotlight on these traditional characterisations, and global circumstances are requiring a reassessment of the underlying substance, particularly as it relates to risk. But what is substance?
Instead of trying to define substance, the OECD has created a set of more precise tools and guidance to apply to individual facts and circumstances, to get to the meaning of transfer pricing substance. One such framework relates to risk.
Risk is an important part of transfer pricing analysis. Its significance derives from the principle that risk and reward go together at arm’s length. The party bearing the risks relating to value creation tends to reap the rewards (or take the losses) at arm’s length.
It follows that profit expectations can be set by the degree of risk that a legal entity will bear. Risk can be moved contractually and this has led to planning where significant risk is attributed by agreement and used as a basis to argue for the character of the entity. In the current environment, the question might be less of planning and more of reacting i.e. who really does bear the risk in a transfer pricing arrangement?
The question of risk bearing versus the control of risk is critical, and the OECD framework helps determine who assumes, controls and has capacity to take the risk. It is grounded in the conduct of the parties and people, and how that compares with the contractual position.
In headline terms, the framework requires an assessment of:
- Who assumes the risk (contractually)
- Who manages and controls the risk
- Who bears and has the capacity to bear the risk.
The framework indicates that where there is mismatch between the contractual assumption of risk versus the control and capacity, those latter aspects must feature an effective reallocation of the risk in determining and setting transfer prices.
In a business it is common to see separation of the day-to-day performance of risk mitigation functions from control of the risk mitigation. A key challenge for taxpayers and administrations will be getting to the heart of who controls risk. Is it enough to have a board set a risk framework policy? Does risk control mean the actual performance of day-to-day functions directly relating to it?
‘Capability’ to take measures to effect risk mitigation outcomes is an important test. Capability, inter alia, involves an understanding of the risk, a decision maker with sufficient competence and experience, with access to the relevant information and actual performance of the decision making. This is contrasted with the ‘mere formalisation’ of the outcome of decision-making made elsewhere. A robust functional analysis should flush out ‘capability’, which can allow for testing against the contractual position, in light of the capacity to bear the risk.
In light of that, does the label really describe what’s in the tin? Is an entity really a limited risk one? It’s a question that will be asked many times over the coming months and years as the impact of Covid-19 is absorbed.
What does this mean for restructuring and changes the business?
Whether the risk profile is changing due to an external risk event, or an internal re-organisation of the business, the transfer pricing position needs to be assessed. This includes a view of what the economically significant risks are, who contractually bears them, and who has the capacity to assume them. It also needs a view of the ‘substance’ – the activities and the people making the key controlling decisions.
Without this, a business may find that some difficult positions are being stored up for the future because of the immediate actions to redistribute risks around groups. Looking past the label of an entity, and getting into the substance of the allocation of risk is not always an easy job, but it is always an important one. So, does the label really describe what is in the tin? As is so often said: the proof is in the pudding.