RKS, whose business consists of the manufacture of very large custom bearings for the civil and military industries, is controlled by the Swedish SKF group through (SAS) SKF Holding France. RKS was subject to a tax audit for FY 2009 and 2010, at the end of which the tax authorities took the view that the results reported by SAS RKS (losses since 2005) had not been determined in accordance with the arm’s length principle. It therefore increased SAS RKS’s results from 2006 to 2010 to the median net margin observed in a benchmark of eight comparable companies, equal to 4.17% in 2006, 4.32% in 2007, 3.38% in 2008, 2.33% in 2009 and 2.62% in 2010. SAS SKF France Holding applied to the Administrative Court for a discharge, and in judgment no. 1608939 of April 23, 2018, the Montreuil Administrative Court upheld the claim. In ruling no. 18VE02849 of June 22, 2020, the Versailles Administrative Court of Appeal upheld the appeal lodged by the the authorities against this ruling. By decision no. 443133 of October 4, 2021, the Conseil d’Etat, hearing an appeal lodged by SAS SKF France Holding, set aside the decision of the Versailles Administrative Court of Appeal and referred the case back to it. Judgement of the Administrative Court of Appeal In accordance with the guidance provided in the decision of the Conseil d’Etat, the Administrative Court of Appeal ruled in favor of SKF Holding and annulled the assessment of the additional taxable income. Excerpts in English “6. In addition, as mentioned above, the tax authorities have found that SAS RKS has had a negative net margin since 2005, with the exception of 2008. It then carried out a functional analysis of SAS RKS’s intra-group relations, taking the view that SAS RKS performed only limited production functions, and that it was therefore not likely to receive negative remuneration in view of the risks associated with this role. Lastly, it applied a “transactional net margin method” (MTMN), comparing SAS RKS’s ratio of net margin to sales for the operations in question with that of eight companies operating at arm’s length in similar fields. In doing so, it noted that the company’s net margin ratio was -19.32% in 2006, -6.44% in 2007, 1.41% in 2008, -10.46% in 2009 and -21.87% in 2010, compared with 4.17% in 2006, 4.32% in 2007, 3.38% in 2008, 2.33% in 2009 and 2.62% in 2010 for the median of the companies compared. In view of these factors, and as stated in the Conseil d’Etat’s decision of October 4, 2021, in the absence of any criticism of the comparables used by the tax authorities, the latter have established a presumption of profit transfer for the transactions in question, up to the difference between the amount of revenue recorded and that which would have resulted from the application of the average net margin rate of the panel of comparable companies. 7. However, SKF Holding France maintains that its subsidiary SAS RKS in fact assumes a more important functional role than that of a simple production unit within the SKF group, which meant that it had to assume higher development and commercial risks, which materialized in 2009 and 2010 and led to significant operating losses. 8. It is clear from the investigation that SAS RKS, founded in 1932 and acquired by the SKF group in 1965, has long-standing technical expertise and manufactures very specific products, often made-to-measure, for civil and military engineering, whose clientele, made up exclusively of professionals, is in fact limited to around fifteen companies, thus requiring no sales prospecting expenditure on the part of the distributing companies. In addition, SAS RKS owns all the tangible assets required for production, bears the risks associated with production, such as product quality defects, organizes the transport and logistics of its products at its own expense, and bears the inventory risk, as recognized by the French tax authorities when they accepted the principle of a provision for inventory depreciation during the audit. While it is common ground that the intangible assets, including patents, required for this production are held by AB SKF in Sweden, it is nevertheless clear from the investigation that SAS RKS carried out research and development work during the period under review, that it participated, through its parent company SKF Holding France, in an agreement to share research and development costs organized at group level, and that it therefore benefited free of charge from all the intangible assets thus held by the Swedish parent company. Furthermore, while it is common ground that the Swedish parent company periodically sends SAS RKS a schedule of margins to be applied to production costs, depending on the country of invoicing. This schedule is intended to guarantee a margin of 3% for the distribution companies, it is clear from the investigation that SAS RKS is free to determine its own production costs, known as “standard production costs”, which serve as the basis for negotiations with the end customer, carried out jointly with the distribution companies. It also emerges from the investigation, and in particular from the results of computer processing carried out by the tax authorities, that this scale, while applied in the majority of intra-group transactions, is not systematically applied. Furthermore, the company, which bears the exchange rate risk, maintains, without being contradicted, that it can freely refuse to contract with a customer if the final price negotiated does not suit it. On the other hand, it appears from the investigation that the distributing companies are limited to managing sales in practical terms, for example by drawing up contracts and invoices, and to assisting end customers in their negotiations with SAS RKS. As a result, SAS RKS enjoys relative autonomy within the Group, and assumes a high level of risk due to its production activities. Furthermore, it is clear from the investigation that the standard production cost defined by SAS RKS, which serves as the basis for the final price agreed with the customer, is determined at a very early ...

In conducting a comparability analysis involving the transfer of intangibles or rights in intangibles, the existence of risks related to the likelihood of obtaining future economic benefits from the transferred intangibles must be considered, including the allocation of risk between the parties which should be analysed within the framework set out in Section D. 1.2 of Chapter I. The following types of risks, among others, should be considered in evaluating whether transfers of intangibles or combinations of intangibles are comparable, and in evaluating whether the intangibles themselves are comparable. Risks related to the future development of the intangibles. This includes an evaluation of whether the intangibles relate to commercially viable products, whether the intangibles may support commercially viable products in the future, the expected cost of required future development and testing, the likelihood that such development and testing will prove successful and similar considerations. The consideration of development risk is particularly important in situations involving transfers of partially developed intangibles. Risks related to product obsolescence and depreciation in the value of the intangibles. This includes an evaluation of the likelihood that competitors will introduce products or services in the future that would materially erode the market for products dependent on the intangibles being analysed. Risks related to infringement of the intangible rights. This includes an evaluation of the likelihood that others might successfully claim that products based on the intangibles infringe their own intangible rights and an evaluation of the likely costs of defending against such claims. It also includes an evaluation of the likelihood that the holder of intangible rights could successfully prevent others from infringing the intangibles, the risk that counterfeit products could erode the profitability of relevant markets, and the likelihood that substantial damages could be collected in the event of infringement. Product liability and similar risks related to the future use of the intangibles ...

In determining which member or members of the group assume risks related to intangibles, the principles of Section D. 1.2 of Chapter I apply. In particular, steps 1 to 5 of the process to analyse risk in a controlled transaction as laid out in paragraph 1.60 should be followed in determining which party assumes risks related to the development, enhancement, maintenance, protection, and exploitation of intangibles ...

RKS, whose business consists of the manufacture of very large custom bearings for the civil and military industries, is controlled by the Swedish group SKF through  (SAS) SKF Holding France. RKS was subject to a tax audit for FY 2009 and 2010, at the end of which the tax authorities adjusted the prices at which it had invoiced its products to the SKF group’s distribution companies abroad. According to the tax authorities, RKS was a simple manufacturing company that did not have control over strategic and operational risks, at therefore should not have losses resulting from such risks. As a result of the adjustment, SKF Holding France (the immediate parent of RKS) was subject to additional corporate income taxes amounting to EUR 5,385,325, including penalties. In a 2018 judgment the Montreuil Administrative Court discharged the additional taxes. However, this decision was set aside by the Versailles Administrative Court of Appeal in a judgment of 22 June 2020 in which the appeal of the tax authorities was granted. This judgement was then appealed by SKF to the Supreme Court. Judgement of the Supreme Court The Supreme Court decided in favor of SKF Holding and annulled the decision of the Versailles Administrative Court of Appeal. Excerpts from the Judgement “It is clear from the documents in the file submitted to the court that the administration applied a “transactional net margin method” (TNMM) during the audit of RKS, which consisted of comparing the ratio of net margin to turnover of this company for the transactions in question with that of eight companies operating at arm’s length and in similar fields of activity. In doing so, it found that the company’s net margin ratio was -10.46% in 2009 and -21.87% in 2010, whereas it was 2.33% in 2009 and 2.62% in 2010 for the average of the companies compared. Consequently, the administrative court of appeal was able to hold, without any error of law, that the service, at the end of this comparison, of which it noted that no criticism was addressed to it, had established a presumption of transfer of profits for the transactions in question, up to the difference between the amount of revenue recorded and that which would have resulted from the application of the average net margin rate of the panel of comparable companies. However, SKF Holding France argued before the court, in order to justify this difference, that RKS had a more important functional role than that of a simple production unit within the SKF group, which meant that it had to assume a development risk and a commercial risk and that this risk had affected its operating profit for the years in dispute. Firstly, as recommended by the OECD Transfer Pricing Guidelines, in order for it to be considered established that a company belonging to a group is in fact intended to assume an economic risk which the group’s transfer pricing policy leads it to bear, and that this policy is therefore consistent with the arm’s length principle, it is necessary for that company to have effective control and mitigation functions over that risk, as well as the financial capacity to assume it. In holding that RKS was not liable for economic losses related to the operation of its business on the sole ground that it did not have the status of ‘main contractor’ within the SKF group, without investigating whether its functional position within the SKF group was such that it could not be held liable, without investigating whether its functional position within the group gave it the right to bear the specific risks it invoked, namely, on the one hand, strategic risks linked to the choice to develop new products, and, on the other hand, operational risks linked to the efficiency of the production processes, the court vitiated its judgment with an error of law. Secondly, in holding that the negative margin rate of the company RKS was not the result of the realisation of a risk that it was intended to assume, the Administrative Court of Appeal noted that the consolidated result of the SKF group, all activities taken together, was at the same time between 6 and 14%, that the company’s purchases of raw materials had been stable and that its sales had not suffered any decrease in volume except for wind turbines. In so doing, it did not respond to the argument that SKF Holding France raised to justify the drop in RKS’s margin over the two financial years in question, according to which this company had suffered the consequences of a strategic risk linked to its choice to reorient its sole activity towards the wind power sector. It therefore vitiated its judgment by failing to state adequate reasons.” Click here for English translation Click here for other translation ...

RKS, whose business consists of the manufacture of very large custom bearings for the civil and military industries, is controlled by the Swedish group SKF through (SAS) SKF Holding France. RKS was subject to a tax audit for FY 2009 and 2010, at the end of which the tax authorities adjusted the prices at which it had invoiced its products to the SKF group’s distribution companies abroad. According to the tax authorities, RKS was a simple manufacturing company that did not have control over strategic and operational risks, at therefore should not have losses resulting from such risks. In a 2018 judgment the Montreuil Administrative Court discharged the additional taxes. However, this decision was set aside by the Versailles Administrative Court of Appeal in a judgment of 22 June 2020 in which the appeal of the tax authorities was granted. This judgement was then appealed by SKF to the Supreme Court. Judgement of the Supreme Administrative Court The court decided in favor of SKF Holding and annulled the decision of the Versailles Administrative Court of Appeal. Excerpt “It is clear from the documents in the file submitted to the court that the administration applied a “transactional net margin method” (TNMM) during the audit of RKS, which consisted of comparing the ratio of net margin to turnover of this company for the transactions in question with that of eight companies operating at arm’s length and in similar fields of activity. In doing so, it found that the company’s net margin ratio was -10.46% in 2009 and -21.87% in 2010, whereas it was 2.33% in 2009 and 2.62% in 2010 for the average of the companies compared. Consequently, the administrative court of appeal was able to hold, without any error of law, that the service, at the end of this comparison, of which it noted that no criticism was addressed to it, had established a presumption of transfer of profits for the transactions in question, up to the difference between the amount of revenue recorded and that which would have resulted from the application of the average net margin rate of the panel of comparable companies. However, RKS argued before the court, in order to justify this difference, that it had a more important functional role than that of a simple production unit within the SKF group, which meant that it had to assume a development and commercial risk and that this risk had affected its operating profit for the years in dispute. Firstly, as recommended by the OECD Transfer Pricing Guidelines, in order for it to be considered established that a company belonging to a group is in fact intended to assume an economic risk which the group’s transfer pricing policy leads it to bear, and that this policy is therefore in accordance with the arm’s length principle, it is necessary for that company to have effective control and mitigation functions over that risk, as well as the financial capacity to assume it. In holding that RKS was not liable for economic losses related to the operation of its business on the sole ground that it did not have the status of ‘main contractor’ within the SKF group, without investigating whether its functional position within the SKF group was such that it could not be held liable, without investigating whether its functional position within the group gave it the right to bear the specific risks it invoked, namely, on the one hand, strategic risks linked to the choice to develop new products, and, on the other hand, operational risks linked to the efficiency of the production processes, the court vitiated its judgment with an error of law. Secondly, in holding that the negative margin rate of the company RKS was not the result of the realisation of a risk that it was intended to assume, the Administrative Court of Appeal noted that the consolidated result of the SKF group, all activities taken together, was at the same time between 6 and 14%, that the company’s purchases of raw materials had been stable and that its sales had not suffered a drop in volume except for wind turbines. In so doing, it did not respond to the argument that the company raised to justify the drop in margin over the two financial years in question, according to which it had suffered the consequences of a strategic risk linked to its choice to reorient its sole activity towards the wind power sector. It therefore vitiated its judgment by failing to state adequate reasons.” Click here for English translation Click here for other translation ...

In determining whether or not a “limited-risk” entity may incur losses, the risks assumed by an entity will be particularly important. This reflects the fact that at arm’s length, the allocation of risks between the parties to an arrangement affects how profits or losses resulting from the transaction are allocated.23 For example, where there is a significant decline in demand due to COVID-19, a “limited-risk” distributor (classified as such, for example, based on limited inventory ownership – such as through the use of “flash title” and drop-shipping – and therefore limited risk of inventory obsolescence) that assumes some marketplace risk (based on the accurate delineation of the transaction) may at arm’s length earn a loss associated with the playing out of this risk. The extent of the loss that may be earned at arm’s length will be determined by the conditions and the economically relevant characteristics of the accurately delineated transaction compared to those of comparable uncontrolled transactions, including application of the most appropriate transfer pricing method and following the guidance in Chapter II of this note and Chapters II and III of the OECD TPG. In the example provided in this paragraph, the TNMM or potentially the resale- minus method depending on the more detailed facts and circumstances, might be used as the most appropriate method to test the arm’s length nature of the return, and third party comparable distributors might in these circumstances earn a loss, which may, for example, arise if the decline in demand means that the value of sales is insufficient to cover local fixed costs. It should be noted that the comparables chosen should be suitable in light of the accurate delineation of the transaction, in particular with reference to the risks assumed by each of the counterparties to the transaction. However, it will not be appropriate for a “limited-risk” distributor that does not assume any marketplace risk or another specific risk to bear a portion of the loss associated with the playing out of that risk. For instance, a “limited risk” distributor that does not assume credit risk should not bear losses derived from the playing out of the credit risk. For this reason, when determining whether an entity operating under limited risk arrangements can sustain losses the guidance in Chapter I of the OECD TPG, particularly as it relates to the analysis of risks in commercial or financial relations,24 will be particularly relevant. 23 Paragraph 1.58 of Chapter I of the OECD TPG. 24  Paragraphs 1.56 -1.106 of Chapter I of the OECD TPG ...

First, it is important to emphasise that the allocation of risks between the parties to an arrangement affects how profits or losses resulting from the transaction are allocated at arm’s length through the pricing of the transaction.18 Hence, the existing guidance on the analysis of risks in commercial or financial relations will be particularly relevant for determining how losses are allocated between associated parties. 18 Paragraph 1.58 of Chapter I of the OECD TPG ...

Against this background, taxpayers and tax administrations should carefully follow the guidance on the accurate delineation of controlled transactions in Chapter I of the OECD TPG to identify with specificity the economically significant risks and to determine the specific economically significant risks that each party to a controlled transaction assumes.5 Therefore, the interplay between the COVID-19 hazard risk and other economically significant risks should be evaluated when considering risk assumption in a particular controlled transaction. In undertaking this analysis, it may be determined that a party to a controlled transaction cannot influence the hazard risk associated with a pandemic, but nevertheless assumes other risks that have materialised as a result of COVID-19. Care must also be taken to determine how the associated enterprises and the group as a whole respond to the manifestation of hazard risks and its subsequent effects on the other economically significant risks identified in the controlled transaction. (See paragraphs 1.34 and 1.35 of Chapter I of the OECD TPG). In particular, the widespread effects of the COVID-19 pandemic in an industry or within an MNE group do not suffice to claim that a member of an MNE group has to bear the consequences of risks materialising as a result of the COVID-19 pandemic without an analysis of how the outcome of the economically significant risks controlled by the member of the group has been affected by the pandemic. 5 Paragraphs 1.59-1.60 of Chapter I of the OECD TPG ...

The significance of risk is particularly relevant in the current economic climate for the four issues discussed in this note. The COVID-19 pandemic, which constitutes a hazard risk, has led to unusual outcomes of other risks for some taxpayers, including: (i) marketplace risk, as demand for some products and services has collapsed; (ii) operational risk, as the pandemic has disrupted supply chains and inhibited production; and (iii) financial risks, as borrowing costs for some industries have spiked and customers have delayed or defaulted on payments.4 4 Paragraph 1.72 of Chapter I of the OECD TPG ...

The report on Transfer Pricing Examination Process (TPEP) provides a framework and guide for transfer pricing examinations. The guide will be updated regularly by the IRS based on feedback from examiners, taxpayers, practitioners and others ...

Acer Computer Ibérica S.A. (ACI) is part of the multinational ACER group, which manufactures and distributes personal computers and other electronic devices. Acer Europe AG (AEAG), a group entity in Switzerland, centralises the procurement of the subsidiaries established in Europe, the Middle East and Africa, and acts as the regional management centre for that geographical area. ACI is responsible for the wholesale marketing of electronic equipment and material, as well as in the provision of technical service related to these products in Spain and Portugal. ACI is characterized as a limited risk distributor by the group. At issue was deductibility of payments resulting from factoring agreements undertaken ACI with unrelated banks, adopted to manage liquidity risks arising from timing mismatches between its accounts payable and accounts receivable. Based on an interpretation of the limited risk agreement signed between ACI and its principal AEAG, the tax authorities disregarded the allocation of the risk – and hence allocation of the relevant costs – to ACI. The tax authorities considered that the financial costs arising from the relocation of cancelled orders, those arising from differences in the criteria for calculating collection and payment deadlines and those arising from delays in shipments are due to the application of incorrect criteria for the accounting and invoicing of certain transactions. It also considers that the assumption of those costs by ACI is in contradiction with its classification as a low-risk distributor and does not comply with the distribution of functions and risks between ACI and AEAG, which results from the distribution contract and the transfer pricing report. An assessment for FY 2006 – 2008 where the costs were added back to the taxable income of Acer Computer Ibérica S.A. was issued. Judgement of the Federal Court The court dismissed the appeal of Acer and upheld the tax assessment in which deductions for the costs in question had been disallowed. Excerpts “The interpretation of the contract terms which we uphold follows the above mentioned OECD Guidelines: In arm’s length transactions, the contract terms generally define, expressly or implicitly, how responsibilities, risks and results are allocated between the parties.” “However, it is irrelevant, in view of the foregoing on the assumption of risk, that ACI’s financing costs are higher than those of comparable undertakings (as the tax authorities maintain), since the refusal of deductibility is based on the fact that the costs claimed to be deductible are not borne by the appellant in accordance with the terms of the contract.” Click here for English Translation Click here for other translation ...

In conducting a comparability analysis involving the transfer of intangibles or rights in intangibles, the existence of risks related to the likelihood of obtaining future economic benefits from the transferred intangibles must be considered, including the allocation of risk between the parties which should be analysed within the framework set out in Section D. 1.2 of Chapter I. The following types of risks, among others, should be considered in evaluating whether transfers of intangibles or combinations of intangibles are comparable, and in evaluating whether the intangibles themselves are comparable. Risks related to the future development of the intangibles. This includes an evaluation of whether the intangibles relate to commercially viable products, whether the intangibles may support commercially viable products in the future, the expected cost of required future development and testing, the likelihood that such development and testing will prove successful and similar considerations. The consideration of development risk is particularly important in situations involving transfers of partially developed intangibles. Risks related to product obsolescence and depreciation in the value of the intangibles. This includes an evaluation of the likelihood that competitors will introduce products or services in the future that would materially erode the market for products dependent on the intangibles being analysed. Risks related to infringement of the intangible rights. This includes an evaluation of the likelihood that others might successfully claim that products based on the intangibles infringe their own intangible rights and an evaluation of the likely costs of defending against such claims. It also includes an evaluation of the likelihood that the holder of intangible rights could successfully prevent others from infringing the intangibles, the risk that counterfeit products could erode the profitability of relevant markets, and the likelihood that substantial damages could be collected in the event of infringement. Product liability and similar risks related to the future use of the intangibles ...

Concerning the transfer pricing method used to test the prices, margins or profits from the transaction, it should be the most appropriate transfer pricing method to the circumstances of the case (see paragraph 2.2). In particular, it should be consistent with the allocation of risk between the parties (provided such allocation of risk is arm’s length), as the risk allocation is an important part of the functional analysis of the transaction. Thus, it is the low (or high) risk nature of a business that will dictate the selection of the most appropriate transfer pricing method, and not the contrary. See Part III of this chapter for a discussion of the arm’s length remuneration of the post-restructuring arrangements ...

With respect to the former, the terms on which a party to a transaction is compensated cannot be ignored in evaluating the risk borne by that party. In effect, the pricing arrangement can directly affect the allocation of certain risks between the parties and can in some cases create a low risk environment. For instance, a manufacturer may be protected from the risk of price fluctuation of raw material as a consequence of its being remunerated on a cost plus basis that takes account of its actual costs. On the other hand, there can also be some risks the allocation of which does not derive from the pricing arrangement. For instance, remunerating a manufacturing activity on a cost plus basis may not as such affect the allocation of the risk of termination of the manufacturing agreement between the parties ...

The question of the relationship between the choice of a particular transfer pricing method and the level of risk left with the entity that is remunerated using that method is an important one in the context of business restructuring. It is quite commonly argued that because an arrangement is remunerated using a cost plus or TNMM that guarantees a certain level of gross or net profit to one of the parties, that party operates in a low risk environment. In this regard, one should distinguish between, on the one hand, the pricing arrangement according to which prices and other financial conditions of a transaction are contractually set and, on the other hand, the transfer pricing method that is used to test whether the price, margin or profits from a transaction are arm’s length ...

Accounting statements may provide useful information on the probability and quantum of certain risks (e.g. bad debt risks, inventory risks), but there are also economically significant risks that may not be recorded as such in the financial accounts (e.g. market risks) ...

“For instance, where a buy-sell distributor which is converted into a commissionnaire transfers the ownership of inventory to an overseas principal and where this transfer leads to a transfer of inventory risk, the tax administration would want to assess whether the inventory risk that is transferred is economically significant. It may want to ask:• What the level of investment in inventory is,• What the history of stock obsolescence is,• What the cost of insuring it is, and• What the history of loss in transit (if uninsured) is.” ...

One important issue is to assess whether a risk is economically significant, i.e. it carries significant profit potential, and, as a consequence, whether the reallocation of that risk may explain a significant reallocation of profit potential. The significance of a risk will depend on its size, the likelihood of its realisation and its predictability, as well as on the possibility to mitigate it. If a risk is assessed to be economically insignificant, then the bearing or reallocation of that risk would not ordinarily explain a substantial amount of or decrease in the entity’s profit potential. At arm’s length a party would not be expected to transfer a risk that is perceived as economically insignificant in exchange for a substantial decrease in its profit potential ...

The reallocation of risks amongst associated enterprises can lead to both positive and negative effects for the transferor and for the transferee: on the one hand, potential losses and possible liabilities may, as a result of the transfer, shift to the transferee; on the other hand, the expected return attached to the risk transferred may be realised by the transferee rather than the transferor ...

“In general, the consequence for one party of being allocated the risk associated with a controlled transaction, where such a risk allocation is found to be consistent with the arm’s length principle, is that such party should:a) Bear the costs, if any, of managing (whether internally or by using associated or independent service providers) or mitigating the risk (e.g. costs of hedging, or insurance premium),b) Bear the costs that may arise from the realisation of the risk. This also includes, where relevant, the anticipated effects on asset valuation (e.g. inventory valuation) and / or the booking of provisions, subject to the application of the relevant domestic accounting and tax rules; andc) Generally be compensated by an increase in the expected return (see paragraph 1.45).” ...

Assume now that the tax administration finds that the taxpayer’s arrangements made in relation to its controlled transactions, and in particular the allocation of excess inventory risk to the manufacturer, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner and that in comparable circumstances, a manufacturer would not agree at arm’s length to take on substantial excess inventory risk by, for example, agreeing to repurchase from the distributors at full price any unsold inventory. In such a case, the tax administration would seek to arrive at a reasonable solution through a pricing adjustment. In the exceptional circumstances however where a reasonable solution cannot be arrived at through a pricing adjustment, the tax administration may re-assign the consequences from the risk allocation to the associated distributors following the guidance at paragraphs 1.47-1.50 (e.g. by challenging the manufacturer’s obligation to repurchase unsold inventory at full price) if the allocation of that risk is one of the comparability factors affecting the controlled transaction under examination ...

It may be the case that, despite the lack of comparable uncontrolled transactions supporting the same risk allocation as the one in the taxpayer’s controlled transaction, such risk allocation is found to have economic substance and to be commercially rational, e.g. because the manufacturer has relatively more control over the excess inventory risk as it makes the decisions on the quantities of products purchased by the distributors. In such a case, the risk allocation would be respected and a comparability adjustment might be needed in order to eliminate the effects of any material difference between the controlled and uncontrolled transactions being compared ...

Assume now that there is no evidence from internal or external comparable uncontrolled transactions supporting the risk allocation in the manufacturer’s controlled transactions. As noted at paragraph 1.69, the fact that independent enterprises do not allocate risks in the same way as the taxpayer in its controlled transactions is not sufficient for not recognising the risk allocation in the controlled transactions, but it might be a reason to examine the economic logic of the controlled distribution arrangement more closely. In that case, it would be necessary to determine whether the contractual risk allocation in the controlled transactions would have been agreed at arm’s length. One factor that can assist in this determination is an examination of which party(ies) has(ve) greater control over the excess inventory risk (see paragraphs 1.49 and 9.22-9.28 above). As noted at paragraph 9.20, in arm’s length transactions, another factor that may influence the allocation of risk to an independent party is its financial capacity, at the time of the risk allocation, to assume that risk ...

In determining whether the contractual risk allocation is arm’s length, the tax administration would examine whether there is evidence from comparable uncontrolled transactions supporting the risk allocation in the manufacturer’s controlled transactions. If such evidence exists, whether from internal or external comparables, there would be no reason to challenge the risk allocation in the taxpayer’s controlled transactions ...

The difference between making a comparability adjustment and not recognising the risk allocation in a controlled transaction can be illustrated with the following example which is consistent with the example at paragraph 1.69. Suppose a manufacturer in Country A has associated distributors in Country B. Suppose that the tax administration of Country A is examining the manufacturer’s controlled transactions and in particular the allocation of excess inventory risk between the manufacturer and its associated distributors in Country B. It is assumed that in the particular case, the excess inventory risk is significant and warrants a detailed transfer pricing analysis. As a starting point, the tax administration would examine the contractual terms between the parties and whether they have economic substance, determined by reference to the conduct of the parties, and are arm’s length. Assume that in the particular case there is no doubt that the actual conduct of the parties is consistent with the contractual terms, i.e. that the manufacturer actually bears the excess inventory risk in its controlled transactions with associated distributors ...

The overall process of determining whether the allocation of risks in a controlled transaction is arm’s length can be illustrated as shown in the diagram below ...

The financial capacity to assume the risk is not necessarily the financial capacity to bear the full consequences of the risk materialising, as it can be the capacity for the risk-bearer to protect itself from the consequences of the risk materialising. Furthermore, a high level of capitalisation by itself does not mean that the highly capitalised party carries risk ...

This can be illustrated as follows. Assume that Company A bears product liability towards customers and enters into a contract with Company B according to which the latter will reimburse A for any claim that A may suffer in relation to such liability. The risk is contractually transferred from A to B. Assume now that, at the time when the contract is entered into, Company B does not have the financial capacity to assume the risk, i.e. it is anticipated that B will not have the capacity to reimburse A, should a claim arise, and also does not put in place a mechanism to cover the risk in case it materialises. Depending on the facts and circumstances of the case, this may cause A to effectively bear the costs of the product liability risk materialising, in which case the transfer of risk from A to B would not be effective. Alternatively, it may be that the parent company of B or another party will cover the claim that A has on B, in which case the transfer of risk away from A would be effective (although the claim would not be reimbursed by B) ...

Where risk is contractually assigned to a party (hereafter “the transferee”) that does not have, at the time when the contract is entered into, the financial capacity to assume it, e.g. because it is anticipated that it will not have the capacity to bear the consequences of the risk should it materialise and that it also does not put in place a mechanism to cover it, doubts may arise as to whether the risk would be assigned to this party at arm’s length. In effect, in such a situation, the risk may have to be effectively borne by the transferor, the parent company, creditors, or another party, depending on the facts and circumstances of the case, irrespective of the contractual terms that purportedly assigned it to the transferee ...

Another relevant, although not determinative factor that can assist in the determination of whether a risk allocation in a controlled transaction is one which would have been agreed between independent parties in comparable circumstances is whether the risk-bearer has, at the time when risk is allocated to it, the financial capacity to assume (i.e. to take on) the risk ...

It should be borne in mind that there are also, as acknowledged at paragraph 1.49, risks over which neither party has significant control. There are risks which are typically beyond the scope of either party to influence (e.g. economic conditions, money and stock market conditions, political environment, social patterns and trends, competition and availability of raw materials and labour), although the parties can make a decision whether or not to expose themselves to those risks and whether and if so how to mitigate those risks. As far as risks over which neither party has significant control are concerned, control would not be a helpful factor in the determination of whether their allocation between the parties is arm’s length ...

As a third example, suppose now that a principal hires a contract manufacturer to manufacture products on its behalf, using technology that belongs to the principal. Assume that the arrangement between the parties is that the principal guarantees to the contract manufacturer that it will purchase 100% of the products that the latter will manufacture according to technical specifications and designs provided by the principal and following a production plan that sets the volumes and timing of product delivery, while the contract manufacturer is allocated a guaranteed remuneration irrespective of whether and if so at what price the principal is able to re-sell the products on the market. Although the day-to-day manufacturing would be carried on by the personnel of the contract manufacturer, the principal would be expected to make a number of relevant decisions in order to control its market and inventory risk, such as: the decision to hire (or terminate the contract with) that particular contract manufacturer, the decision of the type of products that should be manufactured, including their technical specifications, and the decision of the volumes to be manufactured by the contract manufacturer and of the timing of delivery. The principal would be expected to be able to assess the outcome of the manufacturing activities, including quality control of the manufacturing process and of the manufactured products. The contract manufacturer’s own operational risk, e.g. the risk of losing a client or of suffering a penalty in case of negligence or failure to comply with the quality and other requirements set by the principal, is distinct from the market and inventory risks borne by the principal ...

As another example, assume that a principal hires a contract researcher to perform research on its behalf. Assume the arrangement between the parties is that the principal bears the risk of failure of the research and will be the owner of the outcome of the research in case of success, while the contract researcher is allocated a guaranteed remuneration irrespective of whether the research is a success or a failure, and no right to ownership on the outcome of the research. Although the day-to-day research would be carried on by the scientific personnel of the contract researcher, the principal would be expected to make a number of relevant decisions in order to control its risk, such as: the decision to hire (or terminate the contract with) that particular contract researcher, the decision of the type of research that should be carried out and objectives assigned to it, and the decision of the budget allocated to the contract researcher. Moreover, the contract researcher would generally be required to report back to the principal on a regular basis, e.g. at predetermined milestones. The principal would be expected to be able to assess the outcome of the research activities. The contract researcher’s own operational risk, e.g. the risk of losing a client or of suffering a penalty in case of negligence, is distinct from the failure risk borne by the principal ...

Assume that an investor hires a fund manager to invest funds on its account. Depending on the agreement between the investor and the fund manager, the latter may be given the authority to make all the investment decisions on behalf of the investor on a day-to-day basis, although the risk of loss in value of the investment would be borne by the investor. In such an example, the investor is controlling its risks through three relevant decisions: the decision to hire (or terminate the contract with) that particular fund manager, the decision of the extent of the authority it gives to the fund manager and objectives it assigns to the latter, and the decision of the amount of the investment that it asks this fund manager to manage. Moreover, the fund manager would generally be required to report back to the investor on a regular basis as the investor would want to assess the outcome of the fund manager’s activities. In such a case, the fund manager is providing a service and managing his business risk from his own perspective (e.g. to protect his credibility). The fund manager’s operational risk, including the possibility of losing a client, is distinct from his client’s investment risk. This illustrates the fact that an investor who gives to another person the authority to make all the day-to-day investment decisions does not necessarily transfer the investment risk to the person making these day-to-day decisions ...

While it is not necessary to perform the day-to-day monitoring and administration functions in order to control a risk (as it is possible to outsource these functions), in order to control a risk one has to be able to assess the outcome of the day-to-day monitoring and administration functions by the service provider (the level of control needed and the type of performance assessment would depend on the nature of the risk). This can be illustrated as follows ...

In the context of paragraph 1.49, “control” should be understood as the capacity to make decisions to take on the risk (decision to put the capital at risk) and decisions on whether and how to manage the risk, internally or using an external provider. This would require the company to have people – employees or directors – who have the authority to, and effectively do, perform these control functions. Thus, when one party bears a risk, the fact that it hires another party to administer and monitor the risk on a day-to-day basis is not sufficient to transfer the risk to that other party ...

The question of the relationship between risk allocation and control as a factor relevant to economic substance is addressed at paragraph 1.49. The statement in that paragraph is based on experience. In the absence of comparables evidencing the consistency with the arm’s length principle of the risk allocation in a controlled transaction, the examination of which party has greater control over the risk can be a relevant factor to assist in the determination of whether a similar risk allocation would have been agreed between independent parties in comparable circumstances. In such situations, if risks are allocated to the party to the controlled transaction that has relatively less control over them, the tax administration may decide to challenge the arm’s length nature of such risk allocation ...

The reference to the notions of “control over risk” and of “financial capacity to assume the risk” is not intended to set a standard under Article 9 of the OECD Model Tax Convention whereby risks would always follow capital or people functions. The analytical framework under Article 9 is different from the AOA that was developed under Article 7 of the OECD Model Tax Convention ...

This determination is by nature subjective, and it is desirable to provide some guidance on how to make such a determination in order to limit to the extent possible the uncertainties and risks of double taxation it can create. One relevant, although not determinative factor that can assist in this determination is the examination of which party(ies) has (have) relatively more control over the risk, as discussed in paragraphs 9.22-9.28 below. In arm’s length transactions, another factor that may influence an independent party’s willingness to take on a risk is its financial capacity to assume that risk, as discussed in paragraphs 9.29-9.32. Beyond the identification of these two relevant factors, it is not possible to provide prescriptive criteria that would provide certainty in all situations. The determination that the risk allocation in a controlled transaction is not one that would have been agreed between independent parties should therefore be made with great caution considering the facts and circumstances of each case ...

Of greater difficulty and contentiousness is the situation where no comparable is found to evidence the consistency with the arm’s length principle of the risk allocation in a controlled transaction. Just because an arrangement between associated enterprises is one not seen between independent parties should not of itself mean the arrangement is non-arm’s length. However, where no comparables are found to support a contractual allocation of risk between associated enterprises, it becomes necessary to determine whether that allocation of risk is one that might be expected to have been agreed between independent parties in similar circumstances ...

“Where data evidence a similar allocation of risk in comparable uncontrolled transactions, then the contractual risk allocation between the associated enterprises is regarded as arm’s length. In this respect, comparables data may be found either in a transaction between one party to the controlled transaction and an independent party (“internal comparable”) or in a transaction between two independent enterprises, neither of which is a party to the controlled transaction (“external comparable”). Generally, the search for comparables to assess the consistency with the arm’s length principle of a risk allocation will not be done in isolation from the general comparability analysis of the transactions with which the risk is associated.The comparables data will be used to assess the consistency with the arm’s length principle of the controlled transaction, including the allocation of significant risks in said transaction.” ...

Relevant guidance on the examination of risks in the context of the functional analysis is found at paragraphs 1.47-1.51 ...

A third example relates to the determination of which party bears credit risk in a distribution arrangement. In full-fledged distribution agreements, the bad debt risk is generally borne by the distributor who books the sales revenue (notwithstanding any risk mitigation or risk transfer mechanism that may be put in place). This risk would generally be reflected in the balance sheet at year end. However, the extent of the risk borne by the distributor at arm’s length may be different if the distributor receives indemnification from another party (e.g. from the supplier) for irrecoverable claims, and/or if its purchase price is determined on a resale price or commission basis that is proportionate to the cash (rather than invoiced) revenue. The examination of the actual conditions of the transactions between the parties, including the pricing of the transactions and the extent, if any, to which it is affected by credit risk, can provide evidence of whether in actual fact it is the supplier or the distributor (or both) who bear(s) the bad debt risk ...

Another example that is relevant to business restructurings is where a foreign associated enterprise assumes all the inventory risks by contract. When examining such a risk allocation, it may be relevant to examine for instance where the inventory write-downs are taken (i.e. whether the domestic taxpayer is in fact claiming the write-downs as deductions) and evidence may be sought to confirm that the parties’ conduct supports the allocation of these risks as per the contract ...

The parties’ conduct should generally be taken as the best evidence concerning the true allocation of risk. Paragraph 1.48 provides an example in which a manufacturer sells property to an associated distributor in another country and the distributor is claimed to assume all exchange rate risks, but the transfer price appears in fact to be adjusted so as to insulate the distributor from the effects of exchange rate movements. In such a case, the tax administrations may wish to challenge the purported allocation of exchange rate risk ...

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. The same divergence of interests may not exist in the case of associated enterprises, and it is therefore important to examine whether the conduct of the parties conforms to the terms of the contract or whether the parties’ conduct indicates that the contractual terms have not been followed or are a sham. In such cases, further analysis is required to determine the true terms of the transaction ...

“However, as noted at paragraphs 1.47 to 1.53, a tax administration is entitled to challenge the purported contractual allocation of risk between associated enterprises if it is not consistent with the economic substance of the transaction. Therefore, in examining the risk allocation between associated enterprises and its transfer pricing consequences, it is important to review not only the contractual terms but also the following additional questions: • Whether the conduct of the associated enterprises conforms to the contractual allocation of risks (see Section B.1 below), • Whether the allocation of risks in the controlled transaction is arm’s length (see Section B.2 below), and • What the consequences of the risk allocation are (see Section B.3 below).” ...

Unlike in the AOA that was developed for Article 7, the examination of risks in an Article 9 context starts from an examination of the contractual terms between the parties, as those generally define how risks are to be divided between the parties. Contractual arrangements are the starting point for determining which party to a transaction bears the risk associated with it. Accordingly, it would be a good practice for associated enterprises to document in writing their decisions to allocate or transfer significant risks before the transactions with respect to which the risks will be borne or transferred occur, and to document the evaluation of the consequences on profit potential of significant risk reallocations. As noted at paragraph 1.52, the terms of a transaction may be found in written contracts or in correspondence and/or other communications between the parties. 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 ...

Risks are of critical importance in the context of business restructurings. An examination of the allocation of risks between associated enterprises is an essential part of the functional analysis. Usually, in the open market, the assumption of increased risk would also be compensated by an increase in the expected return, although the actual return may or may not increase depending on the degree to which the risks are actually realised (see paragraph 1.45). Business restructurings often result in local operations being converted into low risk operations (e.g. “low risk distributors”, or “low risk contract manufacturers”) and being allocated relatively low (but generally stable) returns on the grounds that the entrepreneurial risks are borne by another party to which the residual profit is allocated. It is therefore important for tax administrations to assess the reallocation of the significant risks of the business that is restructured and the consequences of that reallocation on the application of the arm’s length principle to the restructuring itself and to the post-restructuring transactions. This part covers the allocation of risks between associated enterprises in an Article 9 context and in particular the interpretation and application of paragraphs 1.47 to 1.53. It is intended to provide general guidance on risks which will be of relevance to specific issues addressed elsewhere in this chapter, including Part II’s analysis of the arm’s length compensation for the restructuring itself, Part III’s analysis of the remuneration of the post-restructuring controlled transactions, and Part IV’s analysis of the recognition or non-recognition of transactions presented by a taxpayer ...