Risk analysis is a fundamental component of functional analysis, which in turn is one of the key steps in the analysis of transfer pricing. In essence, the theory says that the more functions are performed, the more assets used and more risks assumed, the expected profitability of a company should increase. However, to understand better the application of this idea in transfer pricing analysis, it would be interesting to review how the concept of risk has evolved over time in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (“OECD Guidelines”).
The guidelines, in their 1995 version, began to develop the topic of risk as part of functional analysis by stating that in comparing the functions performed, the risks assumed by the parties should be considered and that in the open market, the assumption of increased risk will be compensated by an increase in the expected return. Therefore, functional analysis would be incomplete unless the material risks assumed by each party have been considered. In addition, they mention that the types of risks to consider include market risk, risk of loss associated with investment in and use of property, plant, and equipment, risks of success or failure in of investment in research and development, financial risk (foreign exchange and interest rate), among others. On the other hand, from the contractual point of view, the risk allocation must be consistent with the economic substance. Likewise, it makes sense that the bigger share of the risks be assigned on the party having relatively greater control over these risks.
The OECD Guidelines were updated in 2010, and although the risk treatment as part of functional analysis did not change significantly in itself, Chapter IX on business restructurings was added to these guidelines. Part I of this chapter called “Special considerations for risks” attach great importance to the contractual terms in the risk allocation or risk assignment. It considers three perspectives: i) Whether the conduct of the associated enterprises conforms to the contractual allocation of risks; ii) Determining whether the allocation of risks in the controlled transaction is arm’s length and iii) Consequences of the risk allocation.
With regard to the allocation of risk and the conduct of the parties, in accordance with the provisions of Section B.1. Part I, Chapter IX of the OECD Guidelines, when these elements diverge, further analysis is needed to determine the actual terms of the transaction, where precisely the conduct of the parties should be the best evidence for the allocation of actual risks.
Regarding the allocation of risk and compliance with the Arm’s Length principle, section B.2. Part I, Chapter IX of the OECD Guidelines mentions that the control of the risk and the financial capacity to assume the risk must be considered for each of the parties involved. The first challenge arising in this regard is the identification of appropriate comparable transactions or companies, with the provision that if comparable transactions are not identified, this is not a sufficient reason to infer that the transaction at issue does not comply with the arm’s length principle.
On the one hand, the control over risk involves the capaclity to make decisions to take on the risk, which involves that the company has people (employees or directors) who have the authority to, and effectively do, perform these control functions. On the other hand, when the risk is transferred, it is contractually assigned to one party. If this one has not the financial capacity to assume the risk and avoid taking appropriate actions, the one who, in practice, would be assuming the final risk is the entity that would face the consequences if the risk materializes (e.g. parent company, creditors or other party, depending on the facts and circumstances). It should be noted that having the financial capacity to take the risk does not necessarily mean having the financial capacity to bear the full consequences of the risk materializing.
With regard to the consequences of risk allocation, Section B.3. Part I of Chapter IX of the OECD Guidelines states that the party who assumes the risk should ensure: i) taking the risk to manage or mitigate the risk, ii) bear the consequences if the risk materializes, iii) be compensated with an expected increase in profitability. Another important aspect mentioned in this section is to assess whether, from the economic viewpoint, the risk is significant. We need to consider its size or volume and the likelihood and predictability of its realization, as well as the possibility to of mitigating it.
One of the initiatives included in the BEPS Action Plan (Base Erosion and Profit Shifting) corresponds to Action 9: “Risks and Capital” that considers risk analysis. Its results were incorporated in the report of Actions 8 through 10, “Aligning Transfer Pricing Outcomes with Value Creation”, and later, in the 2017 update of the OECD Guidelines. The results of said report and the updating the guidelines involves an expanded guidance regarding the risk, which the first chapter of the OECD guidelines, referring to the Arm’s Length principle, has extended by including and deepening the concepts previously developed in chapter IX in 2010.
The new aspects of this expanded guidelines highlights, among others, a suggested process for risk analysis process that includes the following steps:
In addition, the term risk management is added, which is defined as the function of assessing and responding to risk associated with the commercial activity. It also consists of three elements. (i) the capacity to make decisions to take on, lay off, or decline a risk-bearing opportunity, together with the actual performance of that decision-making function. (ii) the capacity 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 (iii) the capacity to mitigate risk, that is the capacity to take measures that affect risk outcomes, together with the actual performance of such risk mitigation.
Business models have become more complex and sophisticated; similarly, the same process has happened with the notion of risk and risk analysis, where taxpayers and tax administrations must consider these complexities in their transfer pricing analyses.