BEPS Action 9: Risk and Capital

Action 9 of the Base Erosion and Profit Shifting (BEPS) 2015 Final Reports deals with transferring risks among, and allocating excessive capital to, group members, as part of the consolidated Actions 8 -10 on aligning transfer pricing (TP) outcomes with value creation. Action 9, together with Action 10 (Other high-risk transactions), revises Chapter I, Section D (Guidance for applying the arm’s length principle) of the Organization for Economic Cooperation and Development (OECD) TP Guidelines

Action 9 provides rules to ensure that inappropriate returns will not accrue to an entity solely because it has contractually assumed risks or has provided capital. In particular, the guidance considers the contractual allocation of risks and the corresponding allocation of profits, which may not correspond with the activities actually carried out. The guidance also addresses the level of returns to funding provided by a capital-rich multinational enterprise (MNE) group member, where those returns do not correspond to the level of activity undertaken by the funding company.
COMPARABILITY ANALYSIS
Most TP rules across the globe (including the Philippines) adhere to the arm’s length principle. This requires transactions between associated enterprises to be priced as if the enterprises were independent, operating at arm’s length, and engaging in comparable transactions under similar conditions and economic circumstances. At the heart of the application of the arm’s length principle is a “comparability analysis,” the key aspects of which are identified in Action 9 as:
1. Accurate delineation of controlled transactions (i.e., identification of commercial or financial relations between associated enterprises and the conditions and economically relevant circumstances attaching to those relations); and,
2. Comparison with comparable transactions between independent enterprises.
In this article, we will focus on the first aspect of a comparability analysis.
For purposes of conducting a comparability analysis, the OECD TP Guidelines identify five economically relevant characteristics or comparability factors, one of which is the functions performed by each of the parties to the transactions (taking into account assets used and risks assumed). Thus, when conducting a functional analysis, the material risks assumed by each party have to be identified and considered, since the actual assumption of risks could influence the prices and other conditions of the transaction.
ANALYSIS OF RISKS
In applying the arm’s length principle, there is general reliance on the economic notion that higher risks warrant higher anticipated returns. Unfortunately, as noted in Action 9, this has led MNE groups to pursue tax planning strategies based on contractual re-allocation of risks, sometimes without any change in the business operations. This practice has led to outcomes which do not correspond to the value created through the underlying economic activity carried out by the members of an MNE group.
In order to address this issue on misallocation of risk, the guidance prescribes the following steps to be used in analyzing risk in a controlled transaction, in order to accurately delineate the actual transaction in respect to that risk.
Step 1: Specifically identify economically significant risks
When used in the TP context, Action 9 defines “risk” as the effect of uncertainty on the objectives of the business. The guidance recognizes that risk is associated with opportunity, and does not have downside connotations alone; it is inherent in commercial activity, and companies choose which risks they wish to assume in order to have the opportunity to generate profits. Whether a risk is significant or not would depend on the likelihood and size of the potential profits or losses arising from said risk.
For TP purposes, several types of risks based on the sources of uncertainty giving rise to risk are identified in the guidance. These include risks such as strategic risks or marketplace risks, infrastructure or operational risks, financial risks, transactional risks, and hazard risks.
Step 2: Contractual assumption of risk
When it comes to contractual assumption of risk, Action 9 requires that such assumption must be done prior to the occurrence of risk outcomes. When risk outcomes are already certain (i.e., after-the-fact), the guidance clarifies that there can be no more assumption of risk as there is no longer any risk to assume. The same principle applies to a subsequent reallocation of risk by the tax authority during a tax audit, which typically occurs years after the decision on the risk is made and when outcomes are already known. Thus, such after-the-fact reallocation of risk by a tax authority may, unless based on other guidance, be inappropriate.
Moreover, the guidance provides that pricing arrangements (e.g., cost plus) adopted in contractual arrangements alone do not determine which party assumes risk. It is determining how the parties actually manage and control risks that will determine the assumption of risks by the parties, and consequently dictate the selection of the most appropriate transfer pricing method.
Step 3: Functional analysis in relation to risk
The functions in relation to risk of the associated enterprises that are parties to the transaction are analyzed to provide information on how they operate in relation to assuming and managing the specific, economically significant risks, and in particular on:
• Which enterprise(s) perform(s) control functions and risk mitigation functions;
• Which enterprise(s) encounter(s) upside or downside consequences of risk outcomes; and,
• Which enterprise(s) has (have) the financial capacity to assume the risk.
Action 9 defines “risk management” as the function of assessing and responding to risk associated with commercial activity. It comprises three elements, namely:
• The capability to make decisions to take on, lay off, or decline a risk-bearing opportunity, together with the actual performance of that decision making function;
• The capability to make decisions on whether and how to respond to the risks associated with the opportunity, together with the actual performance of that decision making function; and,
• The capability to mitigate risk, which is the capability to take measures that affect risk outcomes, together with the actual performance of such risk mitigation.
On the other hand, “risk assumption” is defined as taking on the upside and downside consequences of the risk with the result that the party assuming the risk will also bear the financial and other consequences if the risk materializes. Thus, risk management is not the same as risk assumption. A party performing part of the risk management functions may not assume the risk that is the subject of the management activity, but may be hired to perform risk mitigation functions under the direction of the risk-assuming party.
According to the guidance, “control over risk” involves the first two elements of risk management (i.e., the capability and authority to decide to take on risk, and to decide whether and how to respond to that risk); day-to-day mitigation is not necessary but, if outsourced, control over such outsourcing is necessary. “Risk mitigation,” on the other hand, refers to measures taken that are expected to affect risk outcomes, which may include measures that reduce the uncertainty or measures that reduce the consequences in the event that the downside impact of risk occurs.
“Financial capacity to assume risk” is defined as access to funding to take on the risk or to lay off the risk, to pay for risk mitigation functions and to bear the consequences of the risk if the risk materializes. Access to funding by the party assuming the risk takes into account the available assets and the options realistically available to access additional liquidity, if needed, to cover the anticipated costs should the risk materialize.