As the tenth anniversary of the publication of the OECD/G20’s BEPS final reports approaches, it is appropriate to consider the challenges that multinational enterprises (MNEs) face in light of changes to the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, 2022 (the OECD Transfer Pricing Guidelines) and corresponding local regulations.
This article analyses the approach that various tax authorities appear to be adopting, specifically regarding the risk allocation within the MNE’s value chain. Additionally, it will explore possible strategies for managing the tax risk arising from this emerging trend. Through this assessment, the authors seek to offer a critical perspective that contributes to a better understanding of the challenges arising in the transfer pricing landscape in an ever-changing global context.
Accurate delineation of the transaction
It is becoming increasingly common for tax authorities to apply transfer pricing adjustments without challenging the designation of the taxpayer as the tested party or the transfer pricing method used. Instead, they focus solely on identifying contributions that they believe should be remunerated beyond the implemented policy.
What is truly surprising is that these adjustments do not respond to one of the main developments of actions 8–10 of the BEPS Project – namely, the identification of risks in commercial or financial relations, which is also known as accurate delineation of transactions (see Section D.1 of Chapter I of the OECD Transfer Pricing Guidelines) – but are instead based on specific aspects of business dynamics that, when considered in isolation, can lead to attributing a greater contribution to the local entity (and, hence, a higher domestic taxable base).
It is argued that taxpayers are undertaking functions that are more significant than those corresponding to their transfer pricing functional characterisation. However, they are failing to adequately identify the party or parties that are effectively controlling the risks (see the example given in paragraph 1.69 of the OECD Transfer Pricing Guidelines with regard to the concept of control). Consequently, their adjustments do not correspond to what independent parties would agree upon in similar circumstances. In transfer pricing audits that use this approach, tax authorities mainly look at the cost structure of local entities to determine their ‘functional profile’ (sometimes relying solely on the percentage of expenses allocated to operating costs) and/or specific (isolated) contractual terms that may support their position.
In some cases, tax authorities consider the locally incurred expenses to be a reflection of the activities performed without studying the functions, assets, and risks of the entities involved in the related-party transaction. Thus, if a taxpayer incurs marketing and sponsorship expenses that are not covered by the group, it is assumed that these costs are derived from domestic functions performed and risks assumed, and the local taxpayer is considered to be making a significant contribution to the group, such as developing the global brand.
This is particularly alarming given that transfer pricing policies (or changes/adjustments to them) should be based on an understanding of the MNE’s business and how functions, assets, and risks (e.g., decision making and the performance of significant activities) are assumed by the parties involved in the transaction to create or add value across the value chain.
Risk framework
The risk framework analysis is the starting point for the correct delineation of related-party transactions and the correct parametrisation of the value chain. For the purposes of a comprehensive comparability analysis, the OECD Transfer Pricing Guidelines recommend an assessment of the exposure and management of the risks assumed by the entities as a result of the related-party transactions.
This section describes the application of the risk analysis framework, known as the ‘six-step process’:
Step 1 – identify the economically significant risks with precision.
Step 2 – ascertain how the specific, economically significant risks are contractually assumed by the associated enterprises in accordance with the terms of the transaction.
Step 3 – conduct a functional analysis to evaluate the operations of the associated enterprises involved in the transaction concerning the assumption and management of the specific, economically significant risks. It is particularly important to identify which enterprise or enterprises are responsible for control and risk mitigation functions, which enterprise or enterprises experience the positive or negative consequences arising from risk outcomes, and which enterprise or enterprises possess the financial capacity to assume such risks.
Step 4 – steps 2 and 3 will yield information pertinent to the assumption and management of risks within the controlled transaction. The subsequent step is to interpret this information, assessing whether the contractual assumption of risk aligns with the conduct of the associated enterprises and other pertinent facts of the case by examining (i) whether the associated enterprises comply with the contractual terms, and (ii) whether the party assuming the risk, as analysed in (i), exercises adequate control over the risk and possesses the requisite financial capacity to assume it.
Step 5 – in instances where the party assuming the risk as outlined in steps 1–4(i) neither exercises control over the risk nor possesses the financial capacity to assume it, one should apply the established guidance on risk allocation.
Step 6 – the actual transaction, delineated with precision through careful consideration of all the evidence regarding the economically relevant characteristics of the transaction, should subsequently be evaluated for pricing, taking into account the financial repercussions and other outcomes of risk assumption, along with the appropriate allocation and compensation for risk management functions.
Thus, determining the allocation of returns within an MNE requires applying the above-mentioned six-step risk process to determine the entity entitled to risk-related returns, transaction by transaction. Consequently, this analysis should clearly and concisely highlight the overall transfer pricing situation, emphasising the commercial substance underlying the related-party transactions, both from an individual and a general perspective.
To this end, it is important to emphasise that correctly identifying how the parties manage and control risks will determine how much risk they assume, and dictate the most appropriate transfer pricing approach/method. If an entity’s role in the group’s value chain is found to be remunerated as it would be between independent parties in comparable circumstances, adjusting the transfer pricing policy or profits of the local taxpayer would not be appropriate.
Recommendations
The international taxation paradigm derived from the BEPS initiative has made the design and maintenance of transfer pricing policies, as well as subsequent documentation of related-party transactions, a central requirement. These are now the starting point for any strategy aimed at proactively and comprehensively managing the current exposure of multinational groups to tax risk, particularly in light of potential valuation adjustments resulting from an increase in the number and complexity of audits in this area.
In the current scenario, the key point to focus on to mitigate tax risk related to transfer pricing is to identify the group entities that manage and control the risks related to the group’s business and the various intragroup flows.
It is highly advisable to take a proactive position in response to this new approach assumed by some tax authorities. In this regard, it would be prudent to conduct the six-step risk analysis process in following the recommendations of the OECD Transfer Pricing Guidelines (as it is expected that the transfer pricing policy will be aligned with its conclusions).
The line of defence for managing this tax risk will depend largely on the extent to which this study can be supplemented with a compendium of evidence supporting the functional characterisation and role of the local entity in the group’s value chain.
Additionally, it is recommended to adopt internal protocols regarding the approval of payments for certain types of items (including the review of intragroup agreements that regulate them), such as sponsorship/marketing and advertising expenses, to avoid unnecessary reinvoicing that could be misunderstood during a transfer pricing audit.
Conclusions on risk allocation within the value chain
This article highlights the growing importance of accurately identifying where strategic activities are performed within MNEs, as tax authorities worldwide are paying increasing attention to this issue. Even when such functions are not carried out locally, thorough risk analyses supported by robust evidence and internal protocols to mitigate transfer pricing disputes remain advisable.
Recent experience shows that costs incurred (or pass-through costs applied) by local entities, such as sponsorship or marketing expenses, may be misinterpreted during transfer pricing audits, and could lead to transfer pricing adjustments. Furthermore, certain (isolated) contractual clauses within intragroup agreements may be used to challenge the classification of routine contributions and the allocation of domestically assumed risks.
Consequently, it is essential to proactively review and align these agreements in conjunction with a comprehensive application of the OECD’s six-step risk framework to effectively manage the above-mentioned tax uncertainty. An approach such as the one discussed would, among others, limit the possibility of adhering to the principles established in paragraph 7.34 of the OECD Transfer Pricing Guidelines.
Ultimately, it is critical to ensure that transfer pricing policies accurately reflect the functions, assets, and risks controlled by each entity within the value chain. This not only enhances compliance with international standards but also strengthens the taxpayer’s position against adjustments resulting from increasingly complex transfer pricing audits.
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