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HMRC internal manual

International Manual

HM Revenue & Customs
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Transfer Pricing: Transactions and Structures: business structures: transferring risk

Issues to consider

The profit-earning potential of a particular undertaking is linked to the functions carried out by that undertaking and the assets used. Risk is attached to functions and assets and risk gives rise to the potential for profit. At arm’s length, part of the reward tends to follow risk.


Hence a structure that is designed to minimise tax in a particular jurisdiction must minimise the profits that would arise there at arm’s length. One way of achieving this is to minimise the functions carried out and the associated risks consequently incurred by a connected party in that jurisdiction, since at arm’s length this would result in a lower profit. In reality, some functions are difficult to move away from a particular market or geographical market place for commercial reasons. These might be the functions that at arm’s length would attract high profits.


Evidence should be requested to substantiate any claims that risk or function has been moved. Teams should establish exactly what has changed and, in particular, look critically at claims that risk has been transferred when actual functions have not changed. A functional analysis should show how the business structures work in practice and the relative importance of each function in earning the profits. Teams should always consider where functions and the associated risk occur in reality.


Where parties are under common control, there is an opportunity to organise arrangements between them which would be unlikely to arise between independents. Always look critically at any such arrangements.


See in particular the guidance at INTM485023 on the allocation of risk in accurately delineating the actual transaction between associated parties.


Has risk been transferred?


The question of whether risk has been transferred is complex, and can affect other issues, such as whether an overseas company is trading in the UK. The facts may show that the risk holder is actually trading in the UK, in which case any profits accruing to the risk holder may be taxable here.


If it can be established that the principal is trading in the UK through a permanent establishment, working out the profits attributable to that PE can be complex (see INTM264000). The UK will no doubt have transferred risk (on paper) to the principal. For the purpose of attributing profit, is the transferred risk borne by the UK or the other territory? The contract to transfer the risk cannot be drawn up in such a way so it is said to be with a particular part of the principal. The principal is a single legal person and cannot be broken down into smaller constituent parts, for the purpose of entering into legally binding contracts.


Case teams should not accept arguments based on an internal agreement stating that the risks lie with the principal in the low tax state. The principal cannot contract with itself.


Where it can established that the principal is trading in the UK, the MNE cannot, by way of a legal contract alone, dictate who bears what risk. To establish who bears the risks, teams must consider what actually happens in fact:-

  • Risk tends to stick to the economic function and evidence must be produced to demonstrate that the risk has been transferred away from the UK.
  • Any risk tends to be incurred by the entity which carries out the relevant functions, including in particular control of that risk.


Scrutinise carefully any claims that a legal contract has resulted in the movement of risk particularly if any underlying economic function has not moved.


For example, where the business is the sale of goods and the principal owns the stock, there will be risks associated with ownership, such as insurance, and making sure that stock is ordered at the right time. These could be effectively be outsourced and managed away from the selling activity and the party carrying out those management activities would require appropriate compensation for that function.- However, the control of that risk as defined in the OECD Guidelines (see INTM485023) may well still be exercised by the principal by virtue of the decisions it makes to engage another party to carry out the management activities in question and its monitoring of those activities.


In the case of manufacture, it may be claimed that contract manufacturers exist, and that therefore risk can clearly be transferred. The type of contract manufacturers which exist commercially may be different from the connected party under review. Case teams should consider the type of risks that have actually been transferred. The principal may own the goods throughout the manufacturing process. Examine critically any claims that this means that the risk of the manufacturing function is no longer attached to that function.


Case teams should look critically at how the manufacturing business is run, which functions actually gives rise to material risks, how those risks are managed and controlled, and how the functions would be rewarded at arm’s length.


It is important to establish what the material risks are, as bearing an economically insignificant risk would not ordinarily justify a substantial amount of profit potential. Financial statements may provide information on the probability and quantum of certain risks (for example bad debt, inventory) but there may well be other economically significant risks, for example market risks.


In establishing where the risk is controlled, examine where the people who have and exercise the authority and capability to decide to take on the risk and whether and how to respond to that risk are located. Those people may not carry out the day-to-day functions of mitigation of that risk but they must have the capability to assess the outcome of any such day-to-day mitigation activities if outsourced to another party. So, a contract manufacturer may carry out manufacturing under the instructions of a principal who controls its market and inventory risk by:

  • Making the decision as to which contract manufacturer to hire/terminate the contract
  • Making the decisions as to what product to manufacture, including technical specifications, volumes to manufacture and timing of delivery
  • Assessing quality control of manufacturing process and products


The contract manufacturer’s risks are distinct from those of the principal and relate to its responsibilities to comply with the quality and other standards set by the principal.


The same arguments as have been discussed here in relation to selling and manufacturing will be valid for other structures involving the transfer of risks involved with research and development. Case teams must always bear in mind that the structure and, in particular, the risk allocation they are presented with may be one which would not exist between independent parties. In such cases, lack of a comparable risk allocation is not conclusive of a non-arm’s length pricing arrangement but may lead to an examination of the risk allocation in more detail.


There is a full discussion of the relevance of “control” of risks at paragraphs 1.56 to 1.106 of the OECD Guidelines. (see INTM485023).


As well as examining the relative abilities of the parties to the transaction to control significant risks, a factor that may be relevant when considering whether a risk would be transferred is whether the party assuming the risk has the financial capacity to take on that risk at the time the risk is allocated to it. Having the financial capacity to take on a risk does not necessarily mean that a risk-bearer has the financial capacity to bear the full cost of the risk materialising; it could be that the risk-bearer has the capacity to protect itself, eg by hedging, from the consequences of any risk materialising.