Preventing BEPS by assuring transfer pricing outcomes are in line with "value creation
September, 30th 2015
The OECD/ G20 Action Plan on Base Erosion and Profit Shifting (BEPS) published in July 2013, identifies 15 actions to address BEPS in a comprehensive manner. Actions 8-10 of the BEPS Action Plan relate to a number of closely related topics. These include the development of rules to prevent BEPS by transferring risks among, or allocating excessive capital to, group members. This will involve adopting transfer pricing (TP) rules or special measures to ensure that inappropriate returns will not accrue to an entity solely because it has contractually assumed risks or has provided capital as well as clarifying circumstances in which transactions can be re-characterized.
The discussion draft released in December 2014 which encompasses issues at the heart of the arm's length principle emphasizes the relevance and allocation of risk. Even prior to the release of the discussion draft, there were a few trends that have emphasized the importance of the allocation of risks for TP purposes. Firstly, the OECD reports on Attribution of Profits to PE and Chapter IX of the OECD guidelines on Business Restructuring echo this theme. The OECD's interim guidance on TP aspects of Intangibles released in September 2014 has a clear focus on substance and stresses the importance of functions performed, assets used and risks assumed in the development, enhancement, maintenance, protection and exploitation (DEMPE) of intangibles. The 2013 CBDT Circular for recognizing contract R&D arrangement requires the foreign principal to perform and control economically significant functions and bear and control risks and costs relating to R&D. The consequence of all these trends means that contractual allocation of risk is under scrutiny by the tax authorities by review of behaviour of parties.
The Discussion Draft contains a new section with detailed guidance on identifying risks in commercial or financial relations. The Draft defines risk as the effect of uncertainty on the objectives of the business. Identifying risks is a crucial part of a TP analysis, because the assumption of risks affects profit potential and the allocation of risks between the parties affects the allocation of profits or losses of the transaction between the parties. The Discussion Draft states that risk-related issues are at the heart of the application of the arm's length principle. A fundamental question which the draft raises is how risk is actually managed by the multinational group members and does the party contractually or assuming the risk - (a) perform the operational activities from which the risk arises, (b) manage the risks, or (c) assess, monitor and direct risk mitigation?
The Draft emphasizes that (contractual) assumption of risk by a party will not in itself determine that this party should be allocated the risk for TP purposes. It is important to question how the risks are controlled in the business and which party's functions allow it to face and mitigate the risks. In determining the appropriate allocation of risk among group members, it should be analysed which multinational group entities have the capability and functionality to manage the risks. A relevant - thought not decisive - factor in considering whether a controlled party should be allocated a risk-return regards the financial capacity to bear the risk.
A key message of the OECD is that an arm's-length risk allocation should be established in accordance with the function that has significant control over the risk (i.e. risk control function). The OECD is of the view that 'control' should be understood as the capacity to make decisions to take on the risk and decisions on whether and how to manage the risk, internally or using an external provider. This would require the company to have people who have the authority to, and effectively do, perform these control functions. It goes without saying that the identification of the risk control function may require a very detailed functional analysis, in particular if the various decisions rights are scattered around and assigned to various enterprises. The OECD risk control framework requires a TP analysis to produce much richer information than is typically achieved in practice to date. To collect this type of information may significantly increase the compliance costs for business.
Recent global developments have raised the profile of economic substance issues in taxation. The judicial doctrines that "substance" must prevail over "form" and transactions must have "business purpose" to be respected for tax purposes have not often played a direct role in TP cases in India. However, the Discussion Draft now appears to introduce this concept while determining risk allocation. It appears that references to economic substance in the context of transfer pricing most often relate to the question of whether the respective related persons in fact conduct their affairs in the manner described in the agreements they enter into. Thus, if an entity with no R&D capability contends that it retained a related party to conduct research services on its behalf on a limited risk basis, the tax authority may challenge the substance of the limited risk characterization.
Taxpayers are advised to develop and enhance their TP analysis and documentation in light of the discussion draft. This would help ensure that the analysis of the "risk control functions", having regard to the managerial or operational control exercised over the risks is current and thorough.