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The Risky Side of Transfer Pricing: The OECD Base Erosion and Profit Shifting Reports Sharpen the Rules on Risk Allocation under the Arm’ s Length StandardThe OECD developed a detailed framework for risk (re-)allocation under the BEPS Action 9 report. This article provides an overview of risk identification, delineation and allocation under this framework and comments on certain issues pertaining to the interpretation thereof.

1. Background

One significant area of work of the OECD in its BEPS Action Plan was to ensure that transfer pricing outcomes are in line with “value creation”. This work was spread over several Actions. Particularly noteworthy is how this work is divided over three Actions, namely Action 8 focusing on intangibles, Action 9 on risk and capital and Action 10 on other high risk transactions. The deliverables under these actions were published by the OECD in the final reports released on 5 October 2015.

When it launched the BEPS Project in 2013, the OECD defined as one of the key pressure areas “transfer pricing, in particular in relation to the shifting of risks […]”.1 While in transfer pricing jargon, risk is typically “allocated”, the use of the word “shifting” in this document already alluded to the fact that the OECD realizes that it may be tempting to multinational enterprises (multinationals) to diversify risk over affiliates in a more or less opportunistic way. In the BEPS Action Plan, the OECD indicated that it wants to combat situations where an entity earns inappropriate returns “solely because it has contractually assumed risk or has provided capital”.2 With this statement, the OECD set the scene for its further Action 9 work: while risk is still considered a key element in transfer pricing analy-sis, it cannot be considered in isolation to attract profits.

The work performed under Action 9 resulted in a funda-mental redrafting of Chapter I, section D (“Guidance for applying the arm’ s length principle”) of the OECD Transfer Pricing Guidelines (OECD Guidelines). The idea behind Action 9 was to tackle contractual risk allocations that lack the commercial rationality of uncontrolled transac-tions. While this aim sounds plausible and hard work was

* Isabel Verlinden is Global Head of Transfer Pricing Services at PwC in Belgium. David Ledure is Transfer Pricing Director at PwC in Belgium. Maxime Dessy is Senior Consultant at PwC in Belgium.

1. OECD, Addressing Base Erosion and Profit Shifting (OECD 2013), at 48, International Organizations’ Documentation IBFD.

2. OECD, Action Plan on Base Erosion and Profit Shifting, at 20, International Organizations’ Documentation IBFD.

undoubtedly put in this track by OECD officials and other stakeholders, these new guidelines risk creating uncer-tainty and even appear to deviate from the arm’ s length principle (which they are supposed to safeguard on some points).

The OECD’ s increased emphasis on the significance of risk allocation in transfer pricing and its interrelation with “human interaction” (i.e. “functions”) did not simply fall from the sky. The OECD’ s 2008 Report on the Attribution of Profits to Permanent Establishments3 already empha-sized the importance of “significant people functions” and key-entrepreneurial-risk-taking (KERT) functions when hypothesizing a permanent establishment as a “separate and independent enterprise”. In the absence of legal rela-tions between a head office and its branches, the allocation of risk within a legal entity was driven by the functions.

Similarly, the 2010 update of Chapters I-III of the OECD Guidelines already integrated the notion of “control over risk” in paragraph 1.49, while further details were provided in its then brand new Chapter IX on business restructur-ings. This tightened the link between functions and risks under transfer pricing analysis under article 9 of the OECD Model Tax Convention on Income and on Capital (OECD Model). Finally, the 2013 revised discussion draft on the transfer pricing aspects of intangibles4 already stressed the significance of identifying those entities that perform and exercise control over risks related to the development, enhancement, maintenance and protection of intangibles.

2. BEPS Action 9

As once said by John Paul Jones, a hero of the American Revolutionary War: “It seems to be a law of nature, inflex-ible and inexorable, that those who will not risk cannot win”. The use of a military metaphor was unintended when dealing with BEPS. However, it is true that risk and return have always walked hand in hand. The OECD acknowl-edges that this empirical fact is reflected in transactions between related parties.

The OECD’ s work under Action 9 aims to tackle BEPS by requiring that transactions be appropriately delineated

3. OECD Ctr. for Tax Policy and Admin., Report on the Attribution of Profits to Permanent Establishments (OECD 2008), International Organizations’ Documentation IBFD.

4. OECD, Revised Discussion Draft on Transfer Pricing Aspects of Intangibles (OECD 2013).

Isabel Verlinden, David Ledure and Maxime Dessy*International

Exported / Printed on 19 May 2016 by IBFD.

110 INTERNATIONAL TRANSFER PRICING JOURNAL MARCH/APRIL 2016 © IBFD

Isabel Verlinden, David Ledure and Maxime Dessy

so that the ultimate transfer pricing outcome aligns with each entity’ s contribution to value creation. In common parlance, such delineation simply means that one needs to “find the real deal”. To this end, the risk allocation analy-sis is a key element. Without waffling or prevaricating, the OECD aims mainly to tackle “cash boxes” and other struc-tures lacking the relevant substance to control the risks borne in relation to the underlying transactions.

Section D.1.2.1. of the proposed updated OECD Guide-lines introduces a new detailed framework to assist tax-payers and authorities in allocating risk returns amongst group entities. The OECD six-step approach provides guidance on risk identification, delineation and alloca-tion under the arm’ s length principle, as shown in the fol-lowing flowchart:

2.1. Step 1: Identify economically significant risks with specificity

The first step advocated by the OECD is aimed at identi-fying the “risks” which should be considered in the course of a transfer pricing analysis. Under the revised OECD Guidelines, risk is broadly defined as “the effect of uncer-

tainty on the objectives of business”.5 In order to be relevant for a transfer pricing analysis, a risk must be:

– economically significant, i.e. the materialization of that risk should economically impact the return earned by a company in pursuing a commercial opportu-nity; and

– with specificity, i.e. from a transfer pricing perspective, a risk should not be vaguely defined nor undifferenti-ated, as such risk would not help in determining the accurate delineation of a controlled transaction with respect to risks.

This very first step could already be cumbersome to com-plete, as little guidance is provided regarding what should be considered “economically significant”. The significance of risk depends on the “likelihood and size of the poten-tial profits or losses arising from the risk”.6 A first issue arises when applying this principle to a “very low prob-ability/very high impact” risk situation. If such risk does not crystallize, it may be appealing to tax authorities to attempt to argue – with hindsight – that this risk is merely theoretical and therefore not economically significant. If, on the contrary, such risk was not considered as economi-cally significant by the taxpayer but nevertheless resulted in major losses, tax authorities could likely argue that the risk analysis was not appropriate.

The OECD suggests a list of five risk sources that should be looked at in the course of a functional analysis, namely (i) strategic risks or marketplace risks, (ii) infrastructure risks, (iii) financial risks, (iv) transactional risks and (v) hazard risks. Even though the OECD emphasizes that this list is non-exhaustive and not to be regarded as a hierarchy, it is likely to be used as a checklist by tax authorities. Conse-quently, these risks should therefore be considered at the very least when conducting a risk analysis going forward.

2.2. Step 2: Contractual assumption of risk

The second step consists in determining the group entities which contractually assume the risks identified under Step 1. According to the final report on Actions 8-10, contrac-tual allocation remains a starting point when conduct-ing a transfer pricing analysis. However, the conduct of parties will prevail where a misalignment is identified between such conduct and contractual agreement (see Step 4). Considering the primacy of parties’ conduct over their contractual will, a well-considered contractual agree-ment nevertheless remains paramount, as tax authorities will have to demonstrate that it does not accord with the conduct of the parties. Moreover, contracts enable groups to more clearly define the various risks and – subject to the parties’ conduct being in line with the contractual terms – limit the room for interpretation as regards risk allocation.

5. OECD, Aligning Transfer Pricing Outcomes with Value Creation – Actions 8-10 Final Reports, OECD/G20 Base Erosion and Profit Shifting Project (OECD 2015), sec. D.1.2.1.1., Step 1: Identify economically significant risks with specificity para. 1.71, International Organizations’ Documentation IBFD.

6. Id.


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2.3. Step 3: Functional analysis in relation to risk

The functional analysis remains at the very core of any transfer pricing analysis. Under such analysis, it is para-mount to determine which enterprise(s):– perform(s) “risk management functions”. These func-

tions cover two types of activities, namely control over risk functions and risk mitigation functions;

– bear(s) the upside or downside consequences of risk outcomes; and

– has/have the financial capacity to assume the risk.

2.3.1. Control over risk functions

The control over risk function is the function to which that risk should be allocated for transfer pricing purposes. This function is defined as (i) “the capability to make deci-sions to take on/lay off/decline a risk-bearing opportu-nity, together with the actual performance of that decision-making function” and (ii) “the capability to make decisions on whether and how to respond to the risks associated with an opportunity, together with the actual performance of that decision-making function”.7 In other words, these functions are executed by the persons who, in practice, decide whether or not to pursue an opportunity and decide on the risks to take on board. The OECD specifies in this respect that setting general policies on risk limits cannot be considered as control over risk.

At first glance, it seems rather straightforward to identify these persons within a group. In practice, there is often a blurry line between control over risk functions and mere oversight functions. In the financial services industry for example, providing funding requires a credit risk decision. Control over such risk is often scattered amongst different layers of decision makers and committees, depending on the potential economic impact of the risk: low-risk or lim-ited-impact decisions will often be made locally, whereas high-risk or high-impact decisions may need to be esca-lated up the chain to bodies such as credit committees. The composition of these committees can, moreover, be quite dynamic and often not linked to a specific entity. Finally, the mere fact that risk limits are defined in a policy in se also embeds some form of control over risk; the risk limits and related pricing grid may be so strictly defined that they create a thin line between actual local decision making and merely ticking the box.

The traditional functional analysis appears to be more function-centric. Such analysis had the benefit of linking a return to a type of activity which could cover several risk-bearing opportunities. The revised OECD Guidelines seem to promote a rather risk-centric functional analysis. Done by the book, such analysis would require identifying each opportunity, the underlying risks and subsequently the people controlling each of these risks. Thus, the new framework appears to be more complex, as it requires decomposing each risk-bearing opportunity into a ray of risks, and each risk identified into a ray of functions. Such exhaustive analysis of each risk-bearing opportunity may

7. Id., supra n. 5, sec. D.1.2.1.1., Step 1: Identify economically significant risks with specificity para. 1.65.

be challenging for some businesses in view of the large amount of risk-bearing opportunities and subsequent intercompany transactions that multinationals have to deal with in the course of their activities.

The revised OECD Guidelines also provide examples as to what suffices or what is required for an enterprise to remain in control of a risk. Unfortunately, some ambiguity glimmers through. Specifically, paragraph 1.70 of the Final Report on Actions 8-10 provides an example of an investor hiring a fund manager to invest funds on its account. This example concludes that the investor remains in control through decisions such as:

the decision about its risk preference and therefore about the required diversification of the risks attached to the different investments that are part of the portfolio, the decision to hire (or terminate the contract with) that particular fund manager, the decision of the extent of the authority it gives to the fund manager and objectives it assigns to the latter, and the decision of the amount of the investment that it asks this fund manager to manage.8

Numerous open-market structures have been set up under a fund management scheme. For example, private indi-viduals can acquire funds from well-known asset man-agers. Besides looking at the key terms of the prospectus, such investors will rarely be involved in any of the activi-ties described by the OECD in the above example. Inves-tors will often lack the capabilities of an asset manager. However, such investors will nevertheless be entitled to the profits or losses of the underlying investments. This example seems not fundamentally different from other OECD examples where the control-over-risk test is not met. This is the case for the “tangible asset investor”.9 Here, a group entity invests in a tangible asset, while another group entity makes the assessment as to whether it is com-mercially appropriate to invest in that tangible asset, and yet another group entity is taking care of the day-to-day activities with regard to that tangible asset. The authors see no fundamental differences between the fund investor and the tangible asset investor, as in both cases the inves-tor makes the decision to delegate part of the functions to another, more expert enterprise.

2.3.2. Risk mitigation functions

Risk mitigation functions are defined as (i) “the capabil-ity to mitigate risk, that is, the capability to take measures that affect risk outcomes” and (ii) “the actual performance of such risk mitigation”.10 Again, such risk mitigation func-tions are often scattered amongst different layers within the organization, with standardized group policies being developed centrally on the basis of experience from local operations. However, it is not required to do the day-to-day risk mitigation in order to assume the risk, as a party may decide to outsource such function to another party.

8. Id. para. 1.70.9. Id., supra n. 5, sec. D.1.2.1.1., Step 3: Functional analysis in relation to risk,

Example 3, para. 1.85.10. Id., supra n. 5, sec. D.1.2.1. Analysis of risks in commercial or financial rela-

tions para. 1.61.




2.3.3. Upside or downside consequences of risk outcomes and financial capacity to assume the risk

The revised OECD Guidelines require that multina-tionals identify which enterprise(s) bear(s) the upside or downside consequences of risk outcomes, i.e. which enterprise(s) assume(s) the economic consequences of the risk. Such analysis is already a prerequisite under the existing OECD framework. The principal novelty is that the analysis now also requires identifying the enterprise(s) with the financial capacity to assume the risk.

With this new requirement, the OECD seems to go beyond the arm’ s length principle. Bankruptcy figures sadly remind us that it is not so uncommon to see com-panies taking on certain risks that they would not be able to assume when such risks actually materialize. It does not necessarily reflect irrational commercial behaviour. Com-panies have to continuously manage decisions involving many options. A company may decide to choose an option that it would actually not be able to financially assume should some specific risk actually occur because:– although the risk is economically significant, the odds

that the risk will materialize are perceived to be very low (think of an unprecedented natural disaster);

– although the risk is economically significant, it has been characterized as not (very) significant by man-agement (think of risks linked to mortgage backed securities contracts having led to the bankruptcy of large banking firms); and/or

– although the risk is economically significant, it has not been detected by management (think of the arrival of Columbus on the new land from the Aztecs’ point of view).

2.4. Step 4: Interpreting Steps 1-3

While the first three steps aim to gather information on existing risks and their contractual allocation, Step 4 aims to interpret this information in order to determine whether risk is adequately allocated amongst the parties. Under Step 4, one must analyse first whether the contrac-tual assumption of risk actually aligns with the conduct of the parties. In the case of misalignment, the conduct of parties will prevail and will be considered as best evidence of the intentions of the parties.

In a second step (i.e. once the party assuming the risk has been identified), one must determine whether the party assuming the risk does exercise control over the risk and has the financial capacity to assume the risk. If so, the trans-fer pricing analysis can directly jump to Step 6 (pricing). If not, a further step is required.

The revised guidance also provides rules as to which entity a risk should be allocated to in cases where more than one entity is capable of exercising control over a risk. Such guidance can be illustrated as follows:

10

can be illustrated as follows:

2.5. Step 5: Allocation of risk

If the party assuming the risk under the previous steps “does not exercise control over the risk

or does not have the financial capacity to assume the risk, then the risk should be allocated to

the enterprise exercising control and having the financial capacity to assume the risk”.11

Should the control and financial capacity be in the hands of several other parties, the risk

should be allocated to the associated enterprise or group of associated enterprises “exercising

the most control”.12 The other parties should nevertheless be appropriately compensated

according to the significance of the control they exerted over the risk. If no enterprise is

identified that both exercises control over the risk and has the financial capacity to assume

the risk, the OECD recommends that an assessment of the commercial rationality of the

transaction be performed, as, according to its point of view, such set-up would be unlikely to

11 OECD, Actions 8-10 Final Reports, supra n. 5, sec. D.1.2.5., Step 5: Allocation of risk para. 1.98. 12 Id.

2.5. Step 5: Allocation of risk

If the party assuming the risk under the previous steps “does not exercise control over the risk or does not have the financial capacity to assume the risk, then the risk should be allocated to the enterprise exercising control and having the financial capacity to assume the risk”.11 Should the control and financial capacity be in the hands of several other parties, the risk should be allocated to the associ-ated enterprise or group of associated enterprises “exer-cising the most control”.12 The other parties should nev-ertheless be appropriately compensated according to the significance of the control they exerted over the risk. If no enterprise is identified that both exercises control over the risk and has the financial capacity to assume the risk, the OECD recommends that an assessment of the commercial rationality of the transaction be performed, as, according to its point of view, such set-up would be unlikely to occur between third parties.

11. Id., supra n. 5, sec. D.1.2.5., Step 5: Allocation of risk para. 1.98.12. Id.


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2.6. Step 6: Pricing of the transaction, taking account of the consequences of risk allocation

The last step of the OECD approach aims to provide guid-ance on the pricing of the accurately delineated trans-action. This section is very brief and consists mostly of interpretations of three previous examples.

One of them is the cash box example, i.e. a company which:does not perform functions to evaluate the financing opportunity, does not consider the appropriate risk premium and other issues to determine the appropriate pricing of the financing opportu-nity, and does not evaluate the appropriate protection of its finan-cial investment.13

In the circumstances of Example 3, the revised OECD Guidelines consider that such company “would not be en-titled to any more than a risk-free return as an appropriate measure of the profits it is entitled to retain”.14

Actually, this is the only part of the Final Report on Actions 8-10 where cash boxes are so explicitly covered. This seems somewhat surprising, as combating cash boxes was one of the main objectives of the BEPS Project and it was an important trigger for several countries to join the discus-sion on that matter. From that perspective, the treatment of cash boxes rather unexpectedly ended up as an example of the interpretation of the updated principles.

Consequences of the new guidance might go beyond the original objective. By way of example real estate inves-tors often invest in real estate properties through special purpose vehicles (SPVs) in order to isolate the risks of each investment. It may be questioned under the above guid-ance whether an SPV does control the risk that remains at the level of the group. Based on the authors’ interpre-tation of the revised OECD Guidelines, the SPV’ s return could be corrected downwards (a risk-free return) where the residual profits would flow to the enterprise(s) actually controlling and having the financial capacity to assume the risks with respect to the underlying asset. This can be illustrated as follows:

13. Id., supra n. 5, sec. D.1.2.1.6., Step 6: Pricing of the transaction, taking account of the consequences of risk allocation para. 1.103.

14. Id.

12

Actually, this is the only part of the Final Report on Actions 8-10 where cash boxes are so

explicitly covered. This seems somewhat surprising, as combating cash boxes was one of the

main objectives of the BEPS Project and it was an important trigger for several countries to

join the discussion on that matter. From that perspective, the treatment of cash boxes rather

unexpectedly ended up as an example of the interpretation of the updated principles.

Consequences of the new guidance might go beyond the original objective. By way of

example real estate investors often invest in real estate properties through special purpose

vehicles (SPVs) in order to isolate the risks of each investment. It may be questioned under

the above guidance whether an SPV does control the risk that remains at the level of the

group. Based on the authors’ interpretation of the revised OECD Guidelines, the SPV’s return

could be corrected downwards (a risk-free return) where the residual profits would flow to

the enterprise(s) actually controlling and having the financial capacity to assume the risks

with respect to the underlying asset. This can be illustrated as follows:

One may reasonably wonder how the new OECD Guidelines will interact with other existing

international standards. The investor (with the residual profit entitlement) might create a

taxable presence in the SPV’s country due to the profit-generating building based on article 6

or 7 of the OECD Model.

At the end of the day, the control-over-risk requirement might come across as inconsistent

with a strict reading of the arm’s length principle. The reason to introduce a rather

unprincipled notion probably lies in the political imperative to curb the use of structures

One may reasonably wonder how the new OECD Guide-lines will interact with other existing international stan-dards. The investor (with the residual profit entitlement) might create a taxable presence in the SPV’ s country due to the profit-generating building based on article 6 or 7 of the OECD Model.

At the end of the day, the control-over-risk requirement might come across as inconsistent with a strict reading of the arm’ s length principle. The reason to introduce a rather unprincipled notion probably lies in the political imperative to curb the use of structures where highly capi-talized companies with weak substance enjoyed premium profits.15

3. Non-Recognition

The revised OECD Guidelines now also include an updated section determining under which conditions tax authori-ties can disregard a transaction and potentially replace it by an alternative transaction. Under this new section D.2. where the same transaction can be seen between inde-pendent parties in comparable circumstances, non-rec-ognition would not apply. Even if the transaction cannot be seen between independent parties, it does not neces-sary mean that it should be disregarded; non-recognition should apply only when an arrangement deviates from what would have been agreed between unrelated parties behaving in a commercially rational manner under com-parable economic circumstances.

Similarly to the guidance on business restructurings under Chapter IX of the OECD Guidelines, the commercial rationality of a transaction should be established consid-ering the options realistically available to the parties at the time of the transaction. On the basis of the foregoing, it is key that a taxpayer be able to demonstrate that the set-up of its intercompany transactions aims to satisfy the eco-nomic objectives of the different associated enterprises participating in the transaction.

15. M.L. Schler, The Arm’ s-Length Standard After Altera and BEPS, Tax Notes (30 Nov. 2015), 1164.




4. Consequences and Way Forward

As there is no such thing as a “comparable uncontrolled risk” (or CUR) in mainstream transfer pricing practice, it did not come as a surprise that quite some energy was put into the “risk allocation” conundrum throughout the BEPS Project. The introduction of the Business Restructurings chapter in 2010 in the OECD Guidelines left some of the more difficult questions unresolved. At the end of the day, common sense dictated that one needs the people with the expertise and authority to credibly oversee entrepreneur-ial risk in the “right location” when dealing with interna-tional tax planning.

The revised guidance will require an extra layer of analysis for taxpayers. Given that the control-over-risk functions are often scattered and dynamic, this will likely result in

spirited discussions with tax authorities. In the absence of robust contemporaneous substantiation of the actual risk profile, it might be tempting for the latter to use hind-sight by applying intelligence available when a risk actu-ally crystallizes.

The message to taxpayers is simply to take a proactive stance by carefully considering and documenting any risk aspect in the value chain. Hereto, the functional link with risk will be a cornerstone. In the post-BEPS world, transfer pricing becomes more risky, and risk becomes more trans-fer pricing. When both parties adhere to the new rules of the game and apply them with mutual empathy, they will pave a solid path to an international tax world character-ized by balanced, equitable, principled and sustainable rules and practices.

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