The new OECD Guidance is ambiguous. Paragraph 1.94 states that if the legal entity that contractually assumes the risk exercises control over the risk (and has the required financial capacity) then the contractual allocation should be respected even if other legal entities also exercise control. However, Paragraph 1.105 states that any party that controls risk should be “adequately” compensated, and that such adequate compensation generally includes sharing in both the upside and downside of the outcome of that risk. Paragraph 1.105 therefore seems to imply that all entities that control risks must share in those risks.
This has potentially important implications for multinationals. Almost from the outset, the evolution of transfer pricing guidance under the BEPS initiative made it clear that respect for the contractual allocation of risk would depend upon exercising some level of control over that risk by people employed by the legal entity that was bearing the risk. The reason for this was relatively clear – the OECD had concluded that having legal entities with little substance and presumably located in a tax haven bear the benefits of the successful assumption of risk is not good tax policy. Therefore, the fact that the new OECD Guidance prevents entities that lack substantive control from bearing risk is not surprising.
However, the treatment of risk is an important issue in transactions among legal entities with substantial existing substance operating in countries with conventional tax regimes. Moreover, having a clearly delineated business arrangement with a clear allocation of risk that will be respected by tax authorities is an important way of mitigating disputes — both between taxpayers and tax authorities and among different tax authorities – over who should benefit from the ex post realization of risk, regardless of whether that leads to higher than expected profits or to losses. However, the disparity in language between Paragraph 1.94 and 1.105 clearly allows for differences in interpretation when multiple legal entities share in the control of risk.
Dealing with this issue is likely to be difficult. As a practical matter, the realities of operating a multinational business may require that control over risk be shared by different legal entities. Nor can MNEs realistically expect that the OECD will clarify the Guidance that it has developed over the past several years, as that Guidance reflects genuine differences in views among different countries.
It may be tempting under such circumstances to disregard intercompany contracts as ineffectual, in that there is a high risk that they will be ignored by certain tax authorities. However, I believe that this is a mistake. It is much easier to determine which legal entities are entitled to the benefits of the successful assumption of risk – or to determine which entity should incur the losses associated with the unsuccessful assumption of risk – based on the terms of a written business arrangement than with an ex post analysis of the relative importance of the control functions/decisions of several different legal entities, or to determine which of several legal entities exercised the “more important” control functions. However, going forward it will be important to show why the risks allocations contained in written business arrangements are not only arm’s length, but why they adequately remunerate any control functions carried out be legal entities that were insulated from some or all such risks.
I don’t know of any magic bullets that are guaranteed to work in all cases or for all tax authorities – perhaps APAs in theory, but many tax authorities are reluctant to enter an APA until they know whether the assumption of risk was successful or not. Some of the factors that I think should go into an analysis include:
- A focus on the control functions of the legal entity this is bearing this risk, and showing that they are at least a necessary part of controlling risk even if they are not the only control functions or sufficient in and of themselves;
- Demonstrating that the expected profits of the other entities that exercise control functions are sufficient to provide them with adequate compensation. In doing this, it is likely to be important to address the presumption on the part of tax authorities that any legal entity that exercises control is also likely to own intangibles and/or have other non-routine attributes.
- Addressing the negative as well as positive outcomes that may arise with the assumption of risk – in many cases, the only forecasts that are used in documenting transactions are forecasts based on a successful outcome of risk. The economic results that obtain if the investment is unsuccessful may be implicit, but are rarely discussed.
- An examination of how control and risk are dealt with in third party arrangements – the terms of third party agreements can provide important support for the contractual terms contained in related party agreements even if the third party agreements cannot be used to determine specific transfer prices.