What is 'substance' for transfer pricing purposes?

What is 'substance' for transfer pricing purposes?

Substance, transparency, intellectual property and risk.


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The key driver of a multinational group’s effective tax rate is usually the jurisdictions in which its profits are recognised and taxed. The Organisation for Economic Co-operation and Development (OECD) has published transfer-pricing guidelines on the allocation of business profits between different jurisdictions. The OECD approach is followed in most (but not all) countries. The guidelines focus on ensuring functions, risks, and assets are rewarded on an arm’s length basis.

The fact that most countries follow a common set of principles reduces the risk of economic double taxation. However, the nature of transfer pricing is such that differences often arise in practice. Double taxation treaties between countries generally require different jurisdictions to co-operate to avoid double taxation. Nonetheless, it is a common occurrence for tax authorities to challenge the allocation of profits between jurisdictions – particularly for groups with complex global supply chains. This can lead to significant unexpected tax liabilities and can directly impact shareholder value. For this reason, the governance of transfer-pricing risk is critical and often a matter for consideration at board level.

Substance and transparency

Traditionally, the emphasis in transfer pricing has been on transaction-focused identification and pricing of intra-group transactions. There has tended to be less focus on the substance of the various group companies making the supplies. This has meant that the retention of residual profits has gone largely unchallenged.

However, as part of the recent Base Erosion and Profit Shifting (BEPS) project, the OECD has revised its transfer pricing guidelines in a number of areas. This includes the introduction of increased reporting and documentation requirements such as the country-by-country reporting initiatives (which are designed to bring greater transparency to a multinational’s activities thereby allowing tax authorities to improve their audit focus). These reporting requirements will apply to most groups for their 2016 financial year. Many groups are assessing how their affairs will be reported and are considering whether changes to how they are organised should be made.

In addition, the OECD has stated that greater emphasis should be placed on demonstrating the economic basis for retaining residual profits with a particular focus on economic substance across a group’s entire value chain. This chimes with much of what has been recently said about the need for the recognition of profits to be aligned with economic substance. This is not a new principle. “Ireland Inc” has long understood this and for many years has offered a low, stable corporate tax regime to companies that locate economic substance here.

Follow the risk

The primary transfer-pricing objective from the BEPS project is to ensure that transfer-pricing outcomes are in line with value creation or ‘substance’. The OECD have given a clear road map as to how economic substance should be analysed in this regard.

The OECD now emphasises that profits should follow risk. Consequently, the location where the key risks for a business are controlled will have significant impact on where the associated profits should be recognised.

In the first instance, assumption and bearing of risk is captured by the contract relating supply of goods or services concerned. This should then be evidenced by the actual conduct of the parties.

The control of the relevant risk involves:

  • The capability to make decisions to accept, decline, or lay off a risk-bearing opportunity, together with actual performance of that decision making function; and 
  • The capability to make decisions on whether and how to respond to the risks associated with the opportunity, together with actual performance of that decision making function.

It is important to note that it is not necessary for a company to perform the day-to-day mitigation of its risks itself as this activity may be outsourced to another party. However, it does not necessarily follow that control of those risks has been transferred to that other party. If the company outsourcing the risk-mitigation activities has (and retains) the capability to determine the objectives of the outsourced activities, to control the appointment of the agent providing the risk-mitigation functions, to assess whether the objectives are being adequately met and to decide whether to adapt or terminate the contract with that provider, these activities would support the position that the company has retained control of the risks.

Critically, however, decision makers should possess competence and experience in the area of the particular risk for which the decision is being made, and possess an understanding of the impact of the decision on the business. In short, they need to be credible.

Intellectual property

Insofar as Intellectual Property (IP) is concerned, it is worth noting that it is not necessary that the entity assuming and controlling the risk related to a piece of IP also carries out the development, enhancement, maintenance, protection and exploitation (DEMPE functions) in respect of that IP.

The outsourcing of DEMPE functions is a common practice and where it occurs, it is still possible for the IP owner to retain the risk associated with that IP provided that control over the outsourced activities is exercised by the owner. It naturally follows that the more discretion the outsourced service provider has, the higher their arm’s length fee will be. Therefore, where DEMPE functions, and in particular the important functions that make a significant contribution to the value of the IP, are not carried out by the party contractually assuming risk (i.e. the IP owner), this will reduce the profits of the IP owner and may increase the difficulty in evidencing the control of risk by the owner.

However, so long as the IP owner meets the control requirement (as evidenced by its actual conduct) and has the financial capability to bear the risk, the allocation of risk to the owner is not necessarily affected. This may be the case even where another party also exercises control over some of the risks through, for instance, DEMPE functions.

A rigorous approach

Successfully managing the above issues requires taxpayers to take a rigorous approach to transfer pricing through a thorough analysis of the total value chain. Depending on facts and circumstances, formal board meetings alone may not be sufficient to fulfil the control requirements for transactional risks. Instead, the manner in which the multinational group evaluates risk-bearing opportunities in practice, the processes it puts in place, and the personnel it deploys to participate in such processes are likely to be relevant.

The key message is that there is a clear way to identify and respond to transfer pricing risk for those groups who proactively address the issue having regard to the principles provided.

Steps involved in the new risk analysis framework

As outlined in the updated OECD Guidelines

  • Step 1: Identify the Economically Significant Risks of the business
  • Step 2: Determine how the economically significant risks are contractually assumed
  • Step 3: Perform detailed functional analysis of economically significant risks to determine which entity controls the risk and has the financial capacity to bear the risk
  • Step 4: Consider whether the contractual assumption of risk identified in Step 2 is consistent with the entities’ conduct identified in Step 3
  • Step 5: Where the contractual assumption of risk is not consistent with the entities’ conduct, reallocate the risk to the party that assumes it based on conduct in Step 3
  • Step 6: Perform TP analysis based on the delineated transactions after re-allocating risk.

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