The role of risks in arm’s length pricing : Risk analysis as a part of functional analysis

Abstract

The taxation of multinational enterprise (MNE) groups is based on the separate entity approach and governed by the arm’s length principle. This thesis examines the role of risks in the application of the arm’s length principle, focusing on risk analysis under the OECD Transfer Pricing Guidelines (TPG). Following the incorporation of BEPS Actions 8–10 into the TPG, transfer pricing outcomes are expected to be aligned with value creation, i.e., the value-adding functions performed and the economically significant risks assumed. Within the resulting six-step risk analysis framework, the contractual allocation of risk is respected only where it is consistent with the actual conduct of the parties to a transaction. The actual conduct takes into consideration control over risk and financial capacity to assume risk, which constitute the key focus area of this thesis. Control over risk and financial capacity to assume risk form the actual conduct principle, which together with the notion of value creation (e.g., the DEMPE functions) works towards aligning international corporate taxation outcomes with the objectives of BEPS Actions 8–10.

This thesis argues that control over risk is the primary component of the actual conduct principle, which can be implicitly observed from the TPG’s wording as well as from case law. It revolves around the decision-making function and the actual performance of that function to take on, lay off, or decline a risk-bearing opportunity, and on how to respond to risk entailed in the opportunity. Emphasis is given to key personnel responsible for operational decision-making, and to the location of this executive-level authority within the MNE group’s value chain. The thesis also argues that the interpretation and scope of financial capacity to assume risk is expansive. Financial capacity emphasises a company’s access to funding to control the risk and to sustain the economic ramifications should the risk materialise. To be aligned with value creation, access to funding should prioritise a company’s ability to generate cash flow. Strong cash flow serves as the basis for funding the company’s operations and risks on an ongoing basis, as well as constituting a critical factor, which unrelated lenders would take into consideration when granting debt financing.

Control over risk and financial capacity to assume risk reinforce the substance-over-form development in international corporate taxation. Tax structuring must be based on economic substance and the actual conduct of the parties, diminishing the effectiveness of artificial legal structures designed to segregate taxable profits from economic substance. This realises the objective of BEPS Actions 8–10 to minimise the role of capital-rich and low-functioning entities in tax planning driven by base erosion and profit shifting. Cross-border tax planning will continue under the separate entity fiction. However, structuring must be in line with the TPG, as transfer pricing models that clearly contradict the objectives of BEPS Actions 8–10 can be effectively challenged by local tax authorities.

The role of risks in arm’s length pricing is significant because the level of risk assumed is positively correlated with the expected return, i.e., the allocation of taxable profits. Risks assumed are a pivotal factor in the accurate delineation process, which can determine how a transaction is viewed when applying the arm’s length principle. The predominant role of the actual conduct principle in the allocation of economically significant risks may provide a focus area for cross-border tax planning through the relocation of control-over-risk functions and, therefore, the assumption of economically significant risks.