BEPS Action 9 – Transfer Pricing: Risk and Capital

​On the 5th of October 2015 the OECD/G20 released the final results of the project against BEPS (“Base Erosion and Profit Shifting”). The Final Report “Aligning Transfer Pricing Outcomes with Value Creation” embraces three different Actions, i.e.

• “Action 8 – Intangibles”,
• “Action 9 – Risk and Capital” and
• “Action 10 – Other High Risk Transactions”

The issuance of one common Report for all three Actions amongst others is due to the fact that the single issues treated follow the same rationale: “profits should be taxed where economic activities take place and value is created”, in other words: profits should be allocated between the jurisdictions depending on where functions are performed, risks are assumed and assets are employed.

Purpose and content of Action 9 

The stated purpose of Action 9 is to ensure that inappropriate returns will not accrue to an entity solely because it has contractually assumed risks or has provided capital. The OECD dedicated extensive work to this issue, also because free capital movement and freedom of contract allows multinational enterprises (“MNE’s”) to easily shift capital and risks between group companies.

• the identification of economically significant risks,
• the determination of contractual allocation of these risks and
• the functions relating to these risks.

In order to have a clear picture on the before mentioned points, an exact and detailed functional analysis has to be performed. From a transfer pricing point of view, the risk should then be allocated to the party which controls the risk and has the financial capacity to assume the risk. Thus, it is essential identifying which entities have the capability to manage these risks, i.e. the functional substance (in other words: key personnel) of a company is crucial.  A pure financing company, providing funding but not exercising control over the financial risks associated with the funding, is only entitled to a risk-free return.

Practical considerations

This means that contractual arrangements between affiliated entities will come under greater scrutiny. In line with the basic principle relevant when analyzing the ownership of intangible assets under Action 8, also with respect to Risk and Capital the contractual agreement might form the starting point of the transfer pricing analysis, will however not be the decisive factor.  Tax authorities are allowed to disregard the transaction for transfer pricing purposes if the contractual arrangement does not match the conduct of the parties.

As an example, affected arrangements could probably be Contract Research and Development (“R&D”) Agreements, where a pure Funding Company is rewarded for the risk taking and capital endowment with the residual profit while the Contract  R&D Company is remunerated on a cost-basis. If the Funding Company should not have the functional substance allowing to control the risk, tax authorities could reclassify the transaction as a pure finance transaction, granting a risk-free return to the Funding Company and allocating the residual profit to the Contract R&D Company. 
  
From a practical point of view, it might thus be recommendable to accurately review actual contractual relationships within multinational enterprises under the guidance provided by Action 9.