INTM485023 - Transfer pricing operational guidance: Accurate delineation of the actual transaction: Risk allocation
The following guidance provides a summary of the key aspects of the guidance on analysing risk in a controlled transaction within Chapter I of the Guidelines, including the six-step process set out at paragraph 1.60. This is an area which has been subject to much debate since the 2017, and subsequent, update to the Guidelines and as such a more comprehensive discussion of this area can be found in INTM485025.
Transfer pricing operational guidance: Accurate delineation of the actual transaction: Risk allocation
A particularly important aspect of the process of delineating the actual transaction is determination of which parties assume or exercise control over the economically significant risks involved.
The steps involved in the carrying out of this exercise are summarised at Paragraph 1.60 of the Transfer Pricing Guidelines as follows:
- Identify economically significant risks with specificity
- Determine how specific, economically significant risks are contractually assumed by the associated enterprises under the terms of the transaction
- Determine through a functional analysis how the associated enterprises that are parties to the transaction operate in relation to assumption and management of the specific, economically significant risks, and in particular which enterprise or enterprises perform control functions and risk mitigation functions, which enterprise or enterprises encounter upside or downside consequences of risk outcomes, and which enterprise or enterprises have the financial capacity to assume the risk.
- Steps 2-3 will have identified information relating to the assumption and management of risks in the controlled transaction. The next step is to interpret the information and determine whether the contractual assumption of risk is consistent with the conduct of the associated enterprises and other facts of the case by analysing (i) whether the associated enterprises follow the contractual terms; and (ii) whether the party assuming risk, as analysed under (i), exercises control over the risk and has the financial capacity to assume the risk.
- Where the party assuming risk under steps 1-4(i) does not control the risk or does not have the financial capacity to assume the risk, apply the guidance on allocating risk.
- The actual transaction as accurately delineated by considering the evidence of all the economically relevant characteristics of the transaction (see INTM480521), should then be priced taking into account the financial and other consequences of risk assumption, as appropriately allocated, and appropriately compensating risk management functions.
Control of Risk
The function of controlling risk is the most important factor in determining the allocation of risk and hence the reward in respect of that risk for transfer pricing purposes. It is defined in paragraph 1.65 of the Guidelines as including two elements:
- the capability to make decisions to take on, lay off, or decline a risk-bearing opportunity, together with the 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 the actual performance of that decision-making function.
Control of Risk: decision making
Both the capability to make decisions and the actual exercising of that capability is a significant factor in each element. Capability in this context means the possession of competence and experience in the area of the particular risk for which the decision is being made and of an understanding of the potential impact of their decision on the business (see paragraphs 1.66 and 1.76 of the Guidelines).
It is important to note that neither the setting of general policy regarding the level of risk the group is prepared to accept nor the establishment of the framework for managing and reporting risk by, for example, the board and executive committees of the group represent decision making for the purposes of establishing which party or parties within the group control a specific risk. Neither does the mere formalising of decisions made by others qualify as decision making for these purposes.
It is recognised that some risks such as those associated with general economic conditions and cycles cannot be directly influenced by MNE Group. With regard to such risks control should be understood as the capability and authority to decide to take on the risk and whether and how to respond to the risk (for example through development programmes or the design of marketing strategies).
Control of Risk vs Risk Management
‘Risk management’ is a wider concept than ‘control of risk’. In addition to the two elements of ‘control of risk’ described above it also encompasses the capability to mitigate risk, that is the capability to take measures that affect risk outcomes, together with the actual performance of such risk mitigation (that is, measures taken that are expected to affect risk outcomes in terms of either reducing or reducing the downside impact if the risk occurs. For example, where a party is engaged to perform day-to-day monitoring of quality control over a manufacturing process with the aim of reducing the risk of product recall, that party will be carrying out risk management activities but the “control” of the risk is being exercised by the party which engaged them to undertake that day-to-day monitoring.
“Control” does not require a party to ensure that risk mitigation measures are taken as it is an entirely valid business decision to decide, with respect to any particular risk, that the uncertainty associated with it should be taken on in order to create and maximise opportunities and/ or that the cost of risk mitigation measures with regard to that particular risk are disproportionate.
Where risk mitigation is outsourced to another party, however, control of the risk requires that the controlling party has the capability to and actually does make the decisions with regard to the objectives and specifications of the outsourced activities and monitors the performance of those activities by the party to whom they are outsourced.
Financial capacity to bear risk
Financial capacity to bear risk is another factor relevant to the allocation of specific risks between associated enterprises.
It is defined in paragraph 1.64 of the Guidelines as:
"access to funding to take on the risk or to lay off the risk, to pay for the risk mitigation functions and to bear the consequences of the risk if the risk materialises. Access to funding by the party assuming the risk takes into account the available assets and the options realistically available to access additional liquidity, if needed, to cover the costs anticipated to arise should the risk materialise.”
Allocation of risk
Where a comparable assumption of risk can be identified in a comparable uncontrolled transaction, the contractual allocation of risk in the controlled transaction should be respected. It is, however, important to ensure that the uncontrolled transaction is comparable in all respects including all economically relevant characteristics of the transaction – see INTM485022– and in particular that the enterprise assuming the risk in the uncontrolled transaction performed functions relevant to the control of that risk comparable to those performed by the associated enterprise in the tested transaction (see paragraph 1.97 of the Guidelines).
If a comparable assumption of risk cannot be identified in an uncontrolled transaction, the specific risk in question (and thus the financial consequences of the assumption of that risk) should be allocated to:
- The enterprise that is contractually allocated the risk IF that enterprise both:
- exercises some element of control over that risk and
- has the financial capacity to bear that risk
- If not, to the associated enterprise that both exercises control over the risk and has the financial capacity to bear it (where there is more than one such enterprise, the risk is allocated to that which exercises the most control over it)
- In the unlikely event that no associated enterprise can be identified which both exercises some element of control over the risk and has the financial capacity to assume it, the relevant adjustments should be determined following a rigorous consideration of the reasons actions and circumstances which gave rise to such an eventuality including an assessment of the commercial rationality of the transactions and the possibility of disregarding the accurately delineated actual transaction in accordance with the guidance on non-recognition (see INTM440200)
The process for allocation of risk is summarised in this diagram
Reward to parties who exercise some level of control over a risk but are not allocated that risk
The arm’s length principle requires that each associated enterprise within an MNE group is appropriately rewarded for its activities on the same basis as an independent enterprise would be in comparable circumstances.
Consequently, where an associated enterprise carries out functions which include some element of control of a specific risk but is not actually allocated that risk for transfer pricing purposes, it should nevertheless be appropriately remunerated for those functions and such remuneration will often consist of a share in the potential upside or downside of the materialisation of that risk. See paragraph 1.105 of the Guidelines.
Reward to parties who provide capital but do not exercise control
If a group member merely purchases assets or provides capital to an associated party without either having or exercising the capability to control the economically significant risks arising from the exploitation of the asset or the financial investment made, it will not be allocated those risks and consequently will be entitled to no more than a risk-free return on its investment (see paragraphs 1.85 and 1.103 of the Guidelines).
Additionally, where such situations arise, particularly careful consideration should be given to the commercial rationality of the transaction and whether it is appropriate to disregard it in accordance with the guidance at paragraph 1.119 to 1.128 of the guidelines (see INTM440200).