49. Shuyona is the parent company of an MNE group. Shuyona is organised in and operates exclusively in country X. The Shuyona group is involved in the production and sale of consumer goods. In order to maintain and, if possible, improve its market position, ongoing research is carried out by the Shuyona group to improve existing products and develop new products. The Shuyona group maintains two R&D centres, one operated by Shuyona in country X, and the other operated by Company S, a subsidiary of Shuyona, operating in country Y. 50. The Shuyona group sells two lines of products. All R&D with respect to product line A is conducted by Shuyona. All R&D with respect to product line B is conducted by the R&D centre operated by Company S. Company S also functions as the regional headquarters of the Shuyona group in North America and has global responsibility for the operation of the business relating to product line B. However, all patents developed through Company S research efforts are registered by Shuyona. Shuyona makes no or only a nominal payment to Company S in relation to the patentable inventions developed by the Company S R&D centre. 51. The Shuyona and Company S R&D centres operate autonomously. Each bears its own operating costs. Under the general policy direction of Shuyona senior management, the Company S R&D centre develops its own research programmes, establishes its own budgets, makes determinations as to when R&D projects should be terminated or modified, and hires its own R&D staff. The Company S R&D centre reports to the product line B management team in Company S, and does not report to the Shuyona R&D centre. Joint meetings between the Shuyona and Company S R&D teams are sometimes held to discuss research methods and common issues. 52. The transfer pricing analysis of this fact pattern would begin by recognising that Shuyona is the legal owner/registrant of intangibles developed by Company S. Unlike the situation in Example 14, however, Shuyona neither performs nor exercises control over the research functions carried out by Company S, including the important functions related to management, design, budgeting and funding that research. Accordingly, Shuyona’s legal ownership of the intangibles does not entitle it to retain or be attributed any income related to the product line B intangibles. Tax administrations could arrive at an appropriate transfer pricing outcome by recognising Shuyona’s legal ownership of the intangibles but by noting that, because of the contributions of Company S in the form of functions, assets, and risks, appropriate compensation to Company S for its contributions could be ensured by confirming that Company S should make no royalty or other payment to Shuyona for the right to use any successfully developed Company S intangibles, so that the future income derived from the exploitation of those intangibles by Company S would be allocated to Company S and not to Shuyona. 53. If Shuyona exploits the product line B intangibles by itself, Shuyona should provide appropriate compensation to Company S for its functions performed, assets used and risks assumed related to intangible development. In determining the appropriate level of compensation for Company S, the fact that Company S performs all of the important functions related to intangible development would likely make it inappropriate to treat Company S as the tested party in an R&D service arrangement ...

46. Shuyona is the parent company of an MNE group. Shuyona is organised in and operates in country X. The Shuyona group is involved in the production and sale of consumer goods. In order to maintain and, if possible, improve its market position, ongoing research is carried out by the Shuyona group to improve existing products and develop new products. The Shuyona group maintains two R&D centres, one operated by Shuyona in country X and the other operated by Company S, a subsidiary of Shuyona operating in country Y. The Shuyona R&D centre is responsible for the overall research programme of Shuyona group. The Shuyona R&D centre designs research programmes, develops and controls budgets, makes decisions as to where R&D activities will be conducted, monitors the progress on all R&D projects and, in general, controls the R&D function for the MNE group, operating under strategic direction of Shuyona group senior management. 47. The Company S R&D centre operates on a separate project by project basis to carry out specific projects assigned by the Shuyona R&D centre. Suggestions of Company S R&D personnel for modifications to the research programme are required to be formally approved by the Shuyona R&D centre. The Company S R&D centre reports on its progress on at least a monthly basis to supervisory personnel at the Shuyona R&D centre. If Company S exceeds budgets established by Shuyona for its work, approval of Shuyona R&D management must be sought for further expenditures. Contracts between the Shuyona R&D centre and the Company S R&D centre specify that Shuyona will bear all risks and costs related to R&D undertaken by Company S. All patents, designs and other intangibles developed by Company S research personnel are registered by Shuyona, pursuant to contracts between the two companies. Shuyona pays Company S a service fee for its research and development activities. 48. The transfer pricing analysis of these facts would begin by recognising that Shuyona is the legal owner of the intangibles. Shuyona controls and manages both its own R&D work and that of Company S. It performs the important functions related to that work such as budgeting, establishing research programmes, designing projects and funding and controlling expenditures. Under these circumstances, Shuyona is entitled to returns derived from the exploitation of the intangibles developed through the R&D efforts of Company S. Company S is entitled to compensation for its functions performed, assets used, and risks assumed. In determining the amount of compensation due Company S, the relative skill and efficiency of the Company S R&D personnel, the nature of the research being undertaken, and other factors contributing to value should be considered as comparability factors. To the extent transfer pricing adjustments are required to reflect the amount a comparable R&D service provider would be paid for its services, such adjustments would generally relate to the year the service is provided and would not affect the entitlement of Shuyona to future returns derived from exploiting intangibles derived from the Company S R&D activities ...

In many cases, outsourcing certain aspects of the underwriting function would be inconsistent with the minimum regulatory standards required to operate an insurance business. However, in those situations where the captive insurance is permitted to outsource some of the activities that constitute the underwriting function (for instance, a captive insurance may be allowed to outsource the acceptance of insurance risk to an associated enterprise that acts as a broker and receives an arm’s length remuneration), special consideration of the retention by the captive insurance of the control functions would be required in order to conclude whether the risk is allocated to the captive insurance. A captive insurance that outsources all aspects of the underwriting process without performing control functions would not assume the insurance risk under Chapter I analysis ...

There may in some circumstances be an important inter-relationship between the compensation for the restructuring and an arm’s length reward for operating the business post-restructuring. This can be the case where a taxpayer disposes of business operations to an associated enterprise with which it must then transact business as part of those operations. One example of such a relationship is found in paragraph 9.74 regarding outsourcing ...

Another example of a possible application of the CUP method would be the case where independent parties provide manufacturing, selling or service activities comparable to the ones provided by the restructured affiliate. Given the recent development of outsourcing activities, it may be possible in some cases to find independent outsourcing transactions that provide a basis for using the CUP method in order to determine the arm’s length remuneration of post-restructuring controlled transactions. This of course is subject to the condition that the outsourcing transactions qualify as uncontrolled transactions and that the review of the five economically relevant characteristics or comparability factors provides sufficient comfort that either no material difference exists between the conditions of the uncontrolled outsourcing transactions and the conditions of the post-restructuring controlled transactions, or that reliable enough adjustments can be made (and are effectively made) to eliminate such differences ...

In outsourcing cases, it may happen that a party voluntarily decides to undergo a restructuring and to bear the associated restructuring costs in exchange for anticipated savings. For instance, assume a taxpayer that is manufacturing and selling products in a high-cost jurisdiction decides to outsource the manufacturing activity to an associated enterprise situated in a low-cost jurisdiction. Further to the restructuring, the taxpayer will purchase from its associated enterprise the products manufactured and will continue to sell them to third party customers. The restructuring may entail restructuring costs for the taxpayer while at the same time making it possible for it to benefit from cost savings on future procurements compared to its own manufacturing costs. Independent parties implementing this type of outsourcing arrangement may not necessarily require explicit compensation from the transferee, for example, where the anticipated benefits for the transferor are greater than its restructuring costs ...

In cases where CCA activities are outsourced, an arm’s length charge would be appropriate to compensate the entity for services or other contributions being rendered to the CCA participants. Where the entity is an associated enterprise of one or more of the CCA participants, the arm’s length charge would be determined under the general principles of Chapters I – III, including inter alia consideration of functions performed, assets used, and risks assumed, as well as the special considerations affecting an arm’s length charge for services and/or in relation to any intangibles, as described in Chapter VII and Chapter VI (including the guidance on hard-to-value intangibles) ...

As described in the previous paragraphs, it is not necessary for the CCA participants to perform all of the CCA activities through their own personnel. In some cases, the participants in a CCA may decide to outsource certain functions related to the subject activity to a separate entity that is not a participant under the standard of paragraph 8.14 above. In such situations, the participants to the CCA should individually meet the requirements on exercising control over the specific risks they assume under the CCA. Such requirements include exercising control over the outsourced functions by at least one of the participants to the CCA. In circumstances in which the objective of the CCA is to develop an intangible, at least one of the participants to the CCA should also exercise control over the important development, enhancement, maintenance, protection and exploitation functions that are outsourced. When the contribution of a participant to the CCA consists of activities other than controlling the outsourced functions, the guidance in paragraph 8.15 is relevant for assessing whether this party has the functional capability to exercise control over the specific risks it assumes under the CCA, in particular if these risks are closely linked to the outsourced functions ...

Because the important functions described in paragraph 6.56 are often instrumental in managing the different functions performed, assets used, and risks assumed that are key to the successful development, enhancement, maintenance, protection, or exploitation of intangibles, and are therefore essential to the creation of intangible value, it is necessary to carefully evaluate transactions between parties performing these important functions and other associated enterprises. In particular, the reliability of a one-sided transfer pricing method will be substantially reduced if the party or parties performing significant portions of the important functions are treated as the tested party or parties. See Example 6 ...

Because it may be difficult to find comparable transactions involving the outsourcing of such important functions, it may be necessary to utilise transfer pricing methods not directly based on comparables, including transactional profit split methods and ex ante valuation techniques, to appropriately reward the performance of those important functions. Where the legal owner outsources most or all of such important functions to other group members, attribution to the legal owner of any material portion of the return derived from the exploitation of the intangibles after compensating other group members for their functions should be carefully considered taking into account the functions it actually performs, the assets it actually uses and the risks it actually assumes under the guidance in Section D. 1.2 of Chapter I. Examples 16 and 17 in the Annex I to Chapter VI illustrate the principles contained in this paragraph ...

If the legal owner neither controls nor performs the functions related to the development, enhancement, maintenance, protection or exploitation of the intangible, the legal owner would not be entitled to any ongoing benefit attributable to the outsourced functions. Depending on the facts, the arm’s length compensation required to be provided by the legal owner to other associated enterprises performing or controlling functions related to the development, enhancement, maintenance, protection, or exploitation of intangibles may comprise any share of the total return derived from exploitation of the intangibles. A legal owner not performing any relevant function relating to the development, enhancement, maintenance, protection or exploitation of the intangible will therefore not be entitled to any portion of such returns related to the performance or control of functions relating to the development, enhancement, maintenance, protection or exploitation of the intangible. It is entitled to an arm’s length compensation for any functions it actually performs, any assets it actually uses and risks it actually assumes. See Sections B.2.2 to B.2.3. In determining the functions it actually performs, assets it actually uses and the risks it actually assumes the guidance in Section D.1.2 of Chapter I is especially relevant ...

In outsourcing transactions between independent enterprises, it is usually the case that an entity performing functions on behalf of the legal owner of the intangible that relate to the development, enhancement, maintenance, protection, and exploitation of the intangible will operate under the control of such legal owner (as discussed in paragraph 1.65). Because of the nature of the relationships between associated enterprises that are members of an MNE group, however, it may be the case that outsourced functions performed by associated enterprises will be controlled by an entity other than the legal owner of the intangibles. In such cases, the legal owner of the intangible should also compensate the entity performing control functions related to the development, enhancement, maintenance, protection, and exploitation of intangibles on an arm’s length basis. In assessing what member of the MNE group in fact controls the performance of the relevant functions, principles apply analogous to those for determining control over risk in Section D. 1.2.1 of Chapter I. Assessing the capacity of a particular entity to exert control and the actual performance of such control functions will be an important part of the analysis ...

The need to ensure that all members of the MNE group are appropriately compensated for the functions they perform, the assets they contribute and the risks they assume implies that if the legal owner of intangibles is to be entitled ultimately to retain all of the returns derived from exploitation of the intangibles it must perform all of the functions, contribute all assets used and assume all risks related to the development, enhancement, maintenance, protection and exploitation of the intangible. This does not imply, however, that the associated enterprises constituting an MNE group must structure their operations regarding the development, enhancement, maintenance, protection or exploitation of intangibles in any particular way. It is not essential that the legal owner physically performs all of the functions related to the development, enhancement, maintenance, protection and exploitation of an intangible through its own personnel in order to be entitled ultimately to retain or be attributed a portion of the return derived by the MNE group from exploitation of the intangibles. In transactions between independent enterprises, certain functions are sometimes outsourced to other entities. A member of an MNE group that is the legal owner of intangibles could similarly outsource functions related to the development, enhancement, maintenance, protection or exploitation of intangibles to either independent enterprises or associated enterprises ...

Under the principles of Chapters I – III, each member of the MNE group should receive arm’s length compensation for the functions it performs. In cases involving intangibles, this includes functions related to the development, enhancement, maintenance, protection, and exploitation of intangibles. The identity of the member or members of the group performing functions related to the development, enhancement, maintenance, protection, and exploitation of intangibles, therefore, is one of the key considerations in determining arm’s length conditions for controlled transactions ...

Risks can be categorised in various ways, but a relevant framework in a transfer pricing analysis is to consider the sources of uncertainty which give rise to risk. The following non-exclusive list of sources of risk is not intended to suggest a hierarchy of risk. Neither is it intended to provide rigid categories of risk, since there is overlap between the categories. Instead, it is intended to provide a framework that may assist in ensuring that a transfer pricing analysis considers the range of risks likely to arise from the commercial or financial relations of the associated enterprises, and from the context in which those relations take place. Reference is made to risks that are externally driven and those that are internally driven in order to help clarify sources of uncertainty. However, there should be no inference that externally driven risks are less relevant because they are not generated directly by activities. On the contrary, the ability of a company to face, respond to and mitigate externally driven risks is likely to be a necessary condition for a business to remain competitive. Importantly, guidance on the possible range of risk should assist in identifying material risks with specificity. Risks which are vaguely described or undifferentiated will not serve the purposes of a transfer pricing analysis seeking to delineate the actual transaction and the actual allocation of risk between the parties. a) Strategic risks or marketplace risks. These are largely external risks caused by the economic environment, political and regulatory events, competition, technological advance, or social and environmental changes. The assessment of such uncertainties may define the products and markets the company decides to target, and the capabilities it requires, including investment in intangibles and tangible assets, as well as in the talent of its human capital. There is considerable potential downside, but the upside is also considerable if the company identifies correctly the impact of external risks, and differentiates its products and secures and continues to protect competitive advantage. Examples of such risks may include marketplace trends, new geographical markets, and concentration of development investment. b) Infrastructure or operational risks. These are likely to include the uncertainties associated with the company’s business execution and may include the effectiveness of processes and operations. The impact of such risks is highly dependent on the nature of the activities and the uncertainties the company chooses to assume. In some circumstances breakdowns can have a crippling effect on the company’s operations or reputation and threaten its existence; whereas successful management of such risks can enhance reputation. In other circumstances, the failure to bring a product to market on time, to meet demand, to meet specifications, or to produce to high standards, can affect competitive and reputational position, and give advantage to companies which bring competing products to market more quickly, better exploit periods of market protection provided by, for example, patents, better manage supply chain risks and quality control. Some infrastructure risks are externally driven and may involve transport links, political and social situations, laws and regulations, whereas others are internally driven and may involve capability and availability of assets, employee capability, process design and execution, outsourcing arrangements, and IT systems. c) Financial risks. All risks are likely to affect a company’s financial performance, but there are specific financial risks related to the company’s ability to manage liquidity and cash flow, financial capacity, and creditworthiness. The uncertainty can be externally driven, for example by economic shock or credit crisis, but can also be internally driven through controls, investment decisions, credit terms, and through outcomes of infrastructure or operational risks. d) Transactional risks. These are likely to include pricing and payment terms in a commercial transaction for the supply of goods, property, or services. e) Hazard risks. These are likely to include adverse external events that may cause damages or losses, including accidents and natural disasters. Such risks can often be mitigated through insurance, but insurance may not cover all the potential loss, particularly where there are significant impacts on operations or reputation ...

There may in some circumstances be an important inter-relationship between the compensation for the restructuring and an arm’s length reward for operating the business post-restructuring. This can be the case where a taxpayer disposes of business operations to an associated enterprise with which it must then transact business as part of those operations. One example of such a relationship is found in paragraph 9.74 regarding outsourcing ...

Another example of a possible application of the CUP method would be the case where independent parties provide manufacturing, selling or service activities comparable to the ones provided by the restructured affiliate. Given the recent development of outsourcing activities, it may be possible in some cases to find independent outsourcing transactions that provide a basis for using the CUP method in order to determine the arm’s length remuneration of post-restructuring controlled transactions. This of course is subject to the condition that the outsourcing transactions qualify as uncontrolled transactions and that the review of the five economically relevant characteristics or comparability factors provides sufficient comfort that either no material difference exists between the conditions of the uncontrolled outsourcing transactions and the conditions of the post-restructuring controlled transactions, or that reliable enough adjustments can be made (and are effectively made) to eliminate such differences ...

In outsourcing cases, it may happen that a party voluntarily decides to undergo a restructuring and to bear the associated restructuring costs in exchange for anticipated savings. For instance, assume a taxpayer that is manufacturing and selling products in a high-cost jurisdiction decides to outsource the manufacturing activity to an associated enterprise situated in a low-cost jurisdiction. Further to the restructuring, the taxpayer will purchase from its associated enterprise the products manufactured and will continue to sell them to third party customers. The restructuring may entail restructuring costs for the taxpayer while at the same time making it possible for it to benefit from cost savings on future procurements compared to its own manufacturing costs. Independent parties implementing this type of outsourcing arrangement may not necessarily require explicit compensation from the transferee, for example, where the anticipated benefits for the transferor are greater than its restructuring costs ...

In cases where CCA activities are outsourced, an arm’s length charge would be appropriate to compensate the entity for services or other contributions being rendered to the CCA participants. Where the entity is an associated enterprise of one or more of the CCA participants, the arm’s length charge would be determined under the general principles of Chapters I – III, including inter alia consideration of functions performed, assets used, and risks assumed, as well as the special considerations affecting an arm’s length charge for services and/or in relation to any intangibles, as described in Chapter VII and Chapter VI (including the guidance on hard-to-value intangibles) ...

As described in the previous paragraphs, it is not necessary for the CCA participants to perform all of the CCA activities through their own personnel. In some cases, the participants in a CCA may decide to outsource certain functions related to the subject activity to a separate entity that is not a participant under the standard of paragraph 8.14 above. In such situations, the participants to the CCA should individually meet the requirements on exercising control over the specific risks they assume under the CCA. Such requirements include exercising control over the outsourced functions by at least one of the participants to the CCA. In circumstances in which the objective of the CCA is to develop an intangible, at least one of the participants to the CCA should also exercise control over the important development, enhancement, maintenance, protection and exploitation functions that are outsourced. When the contribution of a participant to the CCA consists of activities other than controlling the outsourced functions, the guidance in paragraph 8.15 is relevant for assessing whether this party has the functional capability to exercise control over the specific risks it assumes under the CCA, in particular if these risks are closely linked to the outsourced functions ...

Because the important functions described in paragraph 6.56 are often instrumental in managing the different functions performed, assets used, and risks assumed that are key to the successful development, enhancement, maintenance, protection, or exploitation of intangibles, and are therefore essential to the creation of intangible value, it is necessary to carefully evaluate transactions between parties performing these important functions and other associated enterprises. In particular, the reliability of a one-sided transfer pricing method will be substantially reduced if the party or parties performing significant portions of the important functions are treated as the tested party or parties. See Example 6 ...

Because it may be difficult to find comparable transactions involving the outsourcing of such important functions, it may be necessary to utilise transfer pricing methods not directly based on comparables, including transactional profit split methods and ex ante valuation techniques, to appropriately reward the performance of those important functions. Where the legal owner outsources most or all of such important functions to other group members, attribution to the legal owner of any material portion of the return derived from the exploitation of the intangibles after compensating other group members for their functions should be carefully considered taking into account the functions it actually performs, the assets it actually uses and the risks it actually assumes under the guidance in Section D. 1.2 of Chapter I. Examples 16 and 17 in the Annex to Chapter VI illustrate the principles contained in this paragraph ...

If the legal owner neither controls nor performs the functions related to the development, enhancement, maintenance, protection or exploitation of the intangible, the legal owner would not be entitled to any ongoing benefit attributable to the outsourced functions. Depending on the facts, the arm’s length compensation required to be provided by the legal owner to other associated enterprises performing or controlling functions related to the development, enhancement, maintenance, protection, or exploitation of intangibles may comprise any share of the total return derived from exploitation of the intangibles. A legal owner not performing any relevant function relating to the development, enhancement, maintenance, protection or exploitation of the intangible will therefore not be entitled to any portion of such returns related to the performance or control of functions relating to the development, enhancement, maintenance, protection or exploitation of the intangible. It is entitled to an arm’s length compensation for any functions it actually performs, any assets it actually uses and risks it actually assumes. See Sections B.2.2 to B.2.3. In determining the functions it actually performs, assets it actually uses and the risks it actually assumes the guidance in Section D.1.2 of Chapter I is especially relevant ...

In outsourcing transactions between independent enterprises, it is usually the case that an entity performing functions on behalf of the legal owner of the intangible that relate to the development, enhancement, maintenance, protection, and exploitation of the intangible will operate under the control of such legal owner (as discussed in paragraph 1.65). Because of the nature of the relationships between associated enterprises that are members of an MNE group, however, it may be the case that outsourced functions performed by associated enterprises will be controlled by an entity other than the legal owner of the intangibles. In such cases, the legal owner of the intangible should also compensate the entity performing control functions related to the development, enhancement, maintenance, protection, and exploitation of intangibles on an arm’s length basis. In assessing what member of the MNE group in fact controls the performance of the relevant functions, principles apply analogous to those for determining control over risk in Section D. 1.2.1 of Chapter I. Assessing the capacity of a particular entity to exert control and the actual performance of such control functions will be an important part of the analysis ...

The need to ensure that all members of the MNE group are appropriately compensated for the functions they perform, the assets they contribute and the risks they assume implies that if the legal owner of intangibles is to be entitled ultimately to retain all of the returns derived from exploitation of the intangibles it must perform all of the functions, contribute all assets used and assume all risks related to the development, enhancement, maintenance, protection and exploitation of the intangible. This does not imply, however, that the associated enterprises constituting an MNE group must structure their operations regarding the development, enhancement, maintenance, protection or exploitation of intangibles in any particular way. It is not essential that the legal owner physically performs all of the functions related to the development, enhancement, maintenance, protection and exploitation of an intangible through its own personnel in order to be entitled ultimately to retain or be attributed a portion of the return derived by the MNE group from exploitation of the intangibles. In transactions between independent enterprises, certain functions are sometimes outsourced to other entities. A member of an MNE group that is the legal owner of intangibles could similarly outsource functions related to the development, enhancement, maintenance, protection or exploitation of intangibles to either independent enterprises or associated enterprises ...

Under the principles of Chapters I – III, each member of the MNE group should receive arm’s length compensation for the functions it performs. In cases involving intangibles, this includes functions related to the development, enhancement, maintenance, protection, and exploitation of intangibles. The identity of the member or members of the group performing functions related to the development, enhancement, maintenance, protection, and exploitation of intangibles, therefore, is one of the key considerations in determining arm’s length conditions for controlled transactions ...

Risks can be categorised in various ways, but a relevant framework in a transfer pricing analysis is to consider the sources of uncertainty which give rise to risk. The following non-exclusive list of sources of risk is not intended to suggest a hierarchy of risk. Neither is it intended to provide rigid categories of risk, since there is overlap between the categories. Instead, it is intended to provide a framework that may assist in ensuring that a transfer pricing analysis considers the range of risks likely to arise from the commercial or financial relations of the associated enterprises, and from the context in which those relations take place. Reference is made to risks that are externally driven and those that are internally driven in order to help clarify sources of uncertainty. However, there should be no inference that externally driven risks are less relevant because they are not generated directly by activities. On the contrary, the ability of a company to face, respond to and mitigate externally driven risks is likely to be a necessary condition for a business to remain competitive. Importantly, guidance on the possible range of risk should assist in identifying material risks with specificity. Risks which are vaguely described or undifferentiated will not serve the purposes of a transfer pricing analysis seeking to delineate the actual transaction and the actual allocation of risk between the parties. a) Strategic risks or marketplace risks. These are largely external risks caused by the economic environment, political and regulatory events, competition, technological advance, or social and environmental changes. The assessment of such uncertainties may define the products and markets the company decides to target, and the capabilities it requires, including investment in intangibles and tangible assets, as well as in the talent of its human capital. There is considerable potential downside, but the upside is also considerable if the company identifies correctly the impact of external risks, and differentiates its products and secures and continues to protect competitive advantage. Examples of such risks may include marketplace trends, new geographical markets, and concentration of development investment. b) Infrastructure or operational risks. These are likely to include the uncertainties associated with the company’s business execution and may include the effectiveness of processes and operations. The impact of such risks is highly dependent on the nature of the activities and the uncertainties the company chooses to assume. In some circumstances breakdowns can have a crippling effect on the company’s operations or reputation and threaten its existence; whereas successful management of such risks can enhance reputation. In other circumstances, the failure to bring a product to market on time, to meet demand, to meet specifications, or to produce to high standards, can affect competitive and reputational position, and give advantage to companies which bring competing products to market more quickly, better exploit periods of market protection provided by, for example, patents, better manage supply chain risks and quality control. Some infrastructure risks are externally driven and may involve transport links, political and social situations, laws and regulations, whereas others are internally driven and may involve capability and availability of assets, employee capability, process design and execution, outsourcing arrangements, and IT systems. c) Financial risks. All risks are likely to affect a company’s financial performance, but there are specific financial risks related to the company’s ability to manage liquidity and cash flow, financial capacity, and creditworthiness. The uncertainty can be externally driven, for example by economic shock or credit crisis, but can also be internally driven through controls, investment decisions, credit terms, and through outcomes of infrastructure or operational risks. d) Transactional risks. These are likely to include pricing and payment terms in a commercial transaction for the supply of goods, property, or services. e) Hazard risks. These are likely to include adverse external events that may cause damages or losses, including accidents and natural disasters. Such risks can often be mitigated through insurance, but insurance may not cover all the potential loss, particularly where there are significant impacts on operations or reputation ...

Wx-Distributor (a subsidiary of the Wx-group i.d.F. Bw.) is responsible for the distribution of household appliances in Austria. It is wholly owned by Z. Deliveries to Wx-Distributor are made by production companies of the Group located in Germany, Italy, France, Slovakia, Poland and Sweden with which it has concluded distribution agreements to determine transfer prices. On average Wx-Distributor had been loss-making in FY 2001-2005. Following an tax audit, the intra-group transfer prices were re-determined for the years 2001 to 2004 by the tax authorities. It was determined that the transfer prices in two years were not within the arm’s length range. The review of the tax authorities had revealed a median EBIT margin of 1.53% and on that basis the operating margin for 2001 were set at 1.5%. For the following years the margin was set at 0.9% due to changed functions (outsourcing of accounts receivable, closure of half the IT department). The resulting adjustments were treated as hidden distribution of profits to the parent company. An appeal was filed by Wx-Distributor. Judgement of the Court The Court decided predominantly in favour of the tax authorities. Excerpts “The functions and risks described above do not justify distribution agreements that do not ensure that the applicant, as a limited risk distributor, will not be able to achieve an overall (cumulative) positive operating result over a reasonable (foreseeable) period of time. This is also the case if this would be associated with higher losses for the independent production companies.” “In the view of the UFS, the use of the median in the event that the EBIT margin achieved is outside the range is to be applied in the present case because, according to the study, there is no ‘highly reliable’ range (cf. Loukota/Jirousek comments on the criticism of the Transfer Pricing Guidelines 2010 ÖStZ 2011) due to comparability deficiencies. Insofar as the applicant assumes that the correction of the EBIT margin to the median value constitutes an impermissible punitive taxation and possibly seeks an adjustment to the lower bandwidth value, whereby it recognisably refers to a decision of the BFH of 17 October 2001 I R 103/00, according to which an estimate is based on the upper or lower value of the bandwidth of arm’s length transfer prices, which is more favourable for the taxpayer. In addition to the existing comparability deficiencies, which in themselves justify an adjustment to the median, reference should also be made to the transfer pricing study by Baker&McKenzie from 2005, which was also submitted by the applicant. It may be true that transfer prices have to be fixed in advance, but in the case at hand no transfer prices were fixed per transaction carried out; instead, distribution agreements had been concluded in unchanged form since 1999 and the arm’s length nature of these agreements was justified by the results of comparative company studies. From the above point of view, it is permissible to use a study (Baker&McKenzie) for the further assessment of the arm’s length nature of the EBIT margin, which was prepared at a time (here 31 December 2005) that follows the period in which the net returns to be assessed were generated (2001 to 2005), but which refers to data material that originates from this period (2002 to 2004). This is because a comparison of the net returns achieved in the period under review (2001 to 2005) with comparable enterprises based on data from the years 1996 to 1999 can at best be used for planning purposes, but subsequent significant developments in the period under review (e.g. economic downturns…) are not (or cannot be) taken into account. According to Baker&McKenzie, the data material used in this process led to the result of comparable net yields with a median of 2.3% and a quartile range between 1.3% and 3.9%. An appendix to this study, which was prepared especially for the company and deals with the special features of inventory adjustment, accounts receivable and accounts payable, shows a comparable median EBIT return for the company of 2.6% with a quartile range of 1.5% to 4.1%. The values shown were achieved by comparable companies in the audit period and are consistently above the adapted median according to the transfer pricing study by Ernst & Young, which is why the adjustment to the lower range requested by the applicant is also unjustified for this reason. If the UFS bases its assessment of the arm’s length transfer price on the Ernst & Young study and uses the median achieved there, this is because it follows the applicant’s argumentation regarding the price determination required in advance and for this reason bases its considerations regarding comparable net returns on the modified Ernst & Young transfer price study. There are no other particular influencing factors that would make an adjustment of this study necessary. In view of the above considerations, the UFS assumes that the median net return of 1.49% determined in the modified comparative study by Ernst & Young submitted by the applicant is appropriate and should be applied for the audit period.” Click here for English translation Click here for other translation ...

There can also be cases where neither A nor C would be willing to bear the indemnification costs at arm’s length because neither of them expects to derive sufficient benefits from the change. It can be the case that such termination is part of a group-wide restructuring decided by the parent company P in order to derive group-wide synergies, and that the indemnification of B should be borne by P at arm’s length (unless, for example, B, notwithstanding that its contract has been terminated or renegotiated, derives benefits from group-wide synergies that outweigh the cost to it of termination or renegotiation) ...

There can be cases where at arm’s length A and C would be willing to share the indemnification costs ...

There can be situations where C would be willing to pay such an amount as an entrance fee to obtain the manufacturing contract from A, e.g. if the present value of the expected profits to be derived from its new manufacturing contract makes it worth the investment for C. In such situations, the payment by C might be organised in a variety of ways, for instance it might be that C would be paying B, or that C would be paying A, or that C would be constructively paying A by meeting A’s indemnification obligation to B ...

There can be situations where A would be willing to bear the indemnification costs at arm’s length, for instance because it expects that the termination of its agreement with B will make it possible for it to derive costs savings through its new manufacturing agreement with C, and that the present value of these expected costs savings is greater than the amount of the indemnification ...

As indicated in Section E.1, the starting point in the analysis would be a review of the contractual terms between A and B. In some cases, contractual terms involving C, P and/or another party might also be relevant. The response depends on whether at arm’s length these entities would be willing to pay such a termination indemnification ...

Assume a manufacturing contract between two associated enterprises, entity A and entity B, is terminated by A (B being the manufacturer). Assume A decides to use another associated manufacturer, entity C, to continue the manufacturing that was previously performed by B. As noted at paragraph 9.103, there should be no presumption that all contract terminations or substantial renegotiations should give a right to indemnification at arm’s length. Assume that it is determined, following the guidance at Sections E.1 to E.3 above, that in the circumstances of the case, should the transaction take place between independent parties, B would be in a position to claim an indemnification for the detriment suffered from the termination. The question arises of whether such an indemnification should be borne by A (i.e. the party terminating the contract), C (i.e. the party taking over the manufacturing activity previously performed by B), their parent company P, or any other party ...

The transfer pricing analysis of the conditions of the termination or substantial renegotiation of an agreement should take account of both the perspectives of the transferor and of the transferee. Taking account of the transferee’s perspective is important both to value the amount of an arm’s length indemnification, if any, and to determine what party should bear it. It is not possible to derive a single answer for all cases and the response should be based on an examination of the facts and circumstances of the case, and in particular of the rights and other assets of the parties, of the economic rationale for the termination, of the determination of what party(ies) is (are) expected to benefit from it, and of the options realistically available to the parties. This can be illustrated as follows ...

In the assessment of whether the conditions of the termination or non-renewal of an existing arrangement are arm’s length, the possible recourse that may be offered by the applicable commercial law might provide some helpful insights. The applicable commercial legislation or case law may provide useful information on indemnification rights and terms and conditions that could be expected in case of termination of specific types of agreements, e.g. of a distributorship agreement. Under such rules, it may be that the terminated party has the right to claim before the courts an indemnification irrespective of whether or not it was provided for in the contract. Where the parties belong to the same MNE group, however, the terminated party is unlikely in practice to litigate against its associated enterprise in order to seek such an indemnification, and the conditions of the termination may therefore differ from the conditions that would be made between independent enterprises in similar circumstances ...

In the case where the conditions made or imposed between associated enterprises with respect to the termination, non-renewal or substantial renegotiation of their existing arrangements differ from the conditions that would be made between independent enterprises, then any profits that would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly ...

A similar issue may arise in the case where a party has undertaken development efforts resulting in losses or low returns in the early period and above-normal returns are expected in periods following the termination of the contract ...

“In case such evidence is not found, the question would be whether independent parties would have agreed to a similar allocation of risk. This will depend on the facts and circumstances of the transaction and in particular on the rights and other assets of the parties.• At arm’s length the party making the investment might not be willing to assume with no guarantee a risk (termination risk) that is controlled by the other (see paragraphs 1.49 and 9.17-9.33). There can be a variety of ways in which such a risk might have been taken into account in contract negotiations, for instance by providing for an appropriate indemnification clause in case of early termination, or for an option for the party making the investment to transfer it at a given price to the other party in case the investment becomes useless to the former due to the early termination of the contract by the latter.• Another possible approach would have been to factor the risk linked with the possible termination of the contract into the determination of the remuneration of the activities covered by the contract (e.g. by factoring the risk into the determination of the remuneration of the manufacturing activities and using third party comparables that bear comparable risks). In such a case the party making the investment consciously accepts the risk and is rewarded for it; no separate indemnification for the termination of the contract seems necessary.• Finally, in some cases, the risks might be shared between the parties, e.g. the party terminating the contract might bear part of the termination costs incurred by the terminated one.” ...

The general guidance in Part I of this chapter on how to determine whether a risk allocation is arm’s length would be relevant in such a case. In case comparable uncontrolled transactions are found that evidence a similar allocation of risks in uncontrolled transactions (taking account in particular the conditions of the investment, the remuneration of the manufacturing activity and the conditions of the termination), then the risk allocation between the associated enterprises would be regarded as arm’s length ...

An example would be where a manufacturing contract between associated enterprises requires the manufacturer to invest in a new manufacturing unit. Assume an arm’s length return on the investment can reasonably be anticipated by the manufacturer at the time the contract is concluded, subject to the manufacturing contract lasting for at least five years, for the manufacturing activity to produce at least x units per year, and for the remuneration of the manufacturing activity to be calculated on a basis (e.g. y$/unit) that is expected to generate an arm’s length return on the total investment in the new manufacturing unit. Assume that after three years, the associated enterprise terminates the contract in accordance with its terms in the context of a group-wide restructuring of the manufacturing operations. Assume the manufacturing unit is highly specialised and the manufacturer further to the termination has no other choice than to write off the assets. The question arises of whether in comparable circumstances, an independent manufacturer in the first place would have sought to mitigate the financial risk linked to the investment in case of termination of its manufacturing contract before the end of the five-year period it needed to obtain an arm’s length return on its investment ...

One circumstance that deserves particular attention, because it could have influenced the terms of the contract had it been concluded between independent parties, is the situation where the now-terminated contract required one party to make a significant investment for which an arm’s length return might only be reasonably expected if the contract was maintained for an extended period of time. This created a financial risk for the party making the investment in case the contract was terminated before the end of such period of time. The degree of the risk would depend on whether the investment was highly specialised or could be used (possibly subject to some adaptations) for other clients. Where the risk was material, it would have been reasonable for independent parties in comparable circumstances to take it into account when negotiating the contract ...

In some situations, it may be the case that, in comparable circumstances, an independent party would not have had any option realistically available that would be clearly more attractive to it than to accept the conditions of the termination or substantial renegotiation of the contract. In some other cases, it may be that, on the basis of an examination of the substance of the arrangement and of the actual conduct of the associated enterprises, an implicit longer term contract should be implied whereby the terminated party would have been entitled to some indemnification in case of early termination ...

When examining whether the conditions of an arrangement are arm’s length, it may be necessary to examine both the remuneration of the transactions that are the object of the arrangement and the financial conditions of the termination thereof, as both can be inter-related. In effect, the terms of a termination clause (or the absence thereof) may be a significant element of the functional analysis of the transactions and specifically of the analysis of the risks of the parties, and may accordingly need to be taken into account in the determination of an arm’s length remuneration for the transactions. Similarly, the remuneration of the transactions will affect the determination of whether the conditions of the termination of the arrangement are at arm’s length ...

Between independent parties, there are cases of contracts that are terminated, non-renewed or substantially renegotiated with no indemnification. However, because the same divergence of interests that exists between independent parties may not exist in the case of associated enterprises, the question can arise whether the terms of a contract between associated enterprises are arm’s length, i.e. whether independent parties in comparable conditions would have concluded such a contract (for instance a contract that contains no indemnification clause or guarantee of any kind in case of termination, non-renewal or renegotiation). Where comparables data evidence a similar indemnification clause (or absence thereof) in comparable circumstances, the indemnification clause (or absence thereof) in a controlled transaction will be regarded as arm’s length. In those cases however where such comparables data are not found, the determination of whether independent parties would have agreed to such an indemnification clause (or absence thereof) should take into account the rights and other assets of the parties, at the time of entering into the arrangement and of its termination or renegotiation, and might be assisted by an examination of the options realistically available to the parties. (As noted at paragraph 1.52, the terms of a transaction may also be found in correspondence/communications between the parties other than a written contract. Where no written terms exist, the contractual relationships of the parties must be deduced from their conduct and the economic principles that generally govern relationships between independent enterprises.) ( See paragraphs 9.59-9.64 for a discussion of options realistically available.) ...

However, the examination of the terms of the contract between the associated enterprises may not suffice from a transfer pricing perspective as the mere fact that a given terminated, non-renewed or renegotiated contract did not provide an indemnification or guarantee clause does not necessarily mean that this is arm’s length, as discussed below ...

Where the terminated, non-renewed or re-negotiated arrangement is formalised in writing, the starting point of the analysis should be a review of whether the conditions for termination, non-renewal or renegotiation of the contract were respected (e.g. with regard to any required notice period) and of whether an indemnification clause or other kind of guarantee for termination, non-renewal or renegotiation is provided for. As noted at paragraph 1.53, in transactions between independent enterprises, the divergence of interests between the parties ensures that they will ordinarily seek to hold each other to the terms of the contract, and that contractual terms will be ignored or modified after the fact generally only if it is in the interests of both parties. (As noted at paragraph 1.52, the terms of a transaction may also be found in correspondence/communications between the parties other than a written contract. Where no written terms exist, the contractual relationships of the parties must be deduced from their conduct and the economic principles that generally govern relationships between independent enterprises. ) ...

“There should be no presumption that all contract terminations or substantial renegotiations should give a right to indemnification at arm’s length. In order to assess whether an indemnification would be warranted at arm’s length, it is important to examine the circumstances at the time of the restructuring, particularly the rights and other assets of the parties as well as, where relevant, the options realistically available to the parties. For this purpose, the following four conditions may be important:• Whether the arrangement that is terminated, non-renewed or substantially re-negotiated is formalised in writing and provides for an indemnification clause (see Section E.1 below);• Whether the terms of the arrangement and the existence or non- existence of an indemnification clause or other type of guarantee (as well as the terms of such a clause where it exists) are arm’s length (see Section E.2 below);• Whether indemnification rights are provided for by commercial legislation or case law (see Section E.3 below); and• Whether at arm’s length another party would have been willing to indemnify the one that suffers from the termination or re-negotiation of the agreement (see Section E.4 below).” ...

For the purpose of this chapter, indemnification means any type of compensation that may be paid for detriments suffered by the restructured entity, whether in the form of an up-front payment, of a sharing in restructuring costs, of lower (or higher) purchase (or sale) prices in the context of the post-restructuring operations, or of any other form ...

The renegotiation of existing arrangements is sometimes accompanied by a transfer of rights or other assets. For instance, the termination of a distribution contract is sometimes accompanied by a transfer of intangibles. In such cases, the guidance at Sections D and E of this part should be read together ...

Where an existing contractual relationship is terminated or substantially renegotiated in the context of a business restructuring, the restructured entity might suffer detriments such as restructuring costs (e.g. write-off of assets, termination of employment contracts), re-conversion costs (e.g. in order to adapt its existing operation to other customer needs), and/or a loss of profit potential. In business restructurings, existing arrangements are often renegotiated in such a way that the respective risk profiles of the parties are changed, with consequences on the allocation of profit potential among them. For instance, a full-fledged distribution arrangement is converted into a low-risk distribution or commissionnaire arrangement; a full-fledged manufacturing arrangement is converted into a contract-manufacturing or toll-manufacturing arrangement. In these situations, the question arises of whether independent parties in similar circumstances would have agreed for an indemnification to be paid to the restructured entity (and if so how to determine such an indemnification) ...