Tag: Risk mitigation

France vs (SAS) SKF Holding France, November 2023, CAA de Versailles, Case No. 21VE02781

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 ...

TPG2022 Chapter X paragraph 10.198

Captive insurances may be self-managed from within the MNE group, or managed by an unrelated service provider (often a division of a large insurance broker). Typically this management would include ensuring compliance with local law, issuing policy documents, collecting premiums, paying claims, preparing reports and providing local directors. If the captive insurance is managed from within the MNE group it is necessary to determine which entity manages it (if such management is not exercised by employees of the captive insurance) and to appropriately reward that management ...

TPG2022 Chapter X paragraph 10.197

The insurer is carrying out a risk mitigation function in respect of the insured party’s risk but not actually assuming that risk. It is assuming the risk of insuring (i.e. mitigating) the insured party’s risk. That risk will be controlled by either the insurer or (more likely in a captive insurance scenario) another entity within the MNE group that makes the decision that the risk should be assumed by the insurer. (See paragraph 10.223). The insurer (or other entity) can make decisions as to how to respond to this risk – in accordance with paragraph 1.61 (ii) – by, for example, further diversifying its portfolio of insured risks or by reinsuring ...

TPG2022 Chapter X paragraph 10.196

Although the quantum of the risk reward for the insured party and the insurer might be dependent upon exactly the same events in both cases, that quantum could be significantly different (for example, if the insured risk materialises and a claim is made, the insured party could potentially receive significant upside relative to the premium paid whereas the insurer’s income will be limited to the insurance premiums and investment income it has received regardless of the quantum of risk reward received by the insured party) ...

TPG2022 Chapter X paragraph 10.195

The principles of accurate delineation of the actual transactions and allocation of risk detailed in Chapter I of these Guidelines apply to captive insurance and reinsurance in the same manner that they apply to any other intra-group transactions. However, this section addresses mainly captive insurance (as well as captive reinsurance – fronting). In particular, it should be borne in mind that: the carrying on of risk mitigation functions falls within the wider concept of risk management but not within that of control of risk (see paragraphs 1.61 and 1.65); there is a difference between the specific risk being insured (the party taking the decision to insure – i.e. mitigate – or not, controls this risk; that party will usually be the insured but may be another entity within the MNE group) and the risk taken on by the insurer in providing insurance to the insured party ...

TPG2022 Chapter X paragraph 10.150

Often an MNE group will centralise treasury functions and implement risk mitigation strategies relating to interest rate and currency risks in order to improve efficiency and effectiveness with the result that individual entities may not contractually enter into hedging arrangements although their risk is hedged from the perspective of the MNE as a whole ...

TPG2022 Chapter VIII paragraph 8.15

A party would also not be a participant in a CCA if it does not exercise control over the specific risks it assumes under the CCA and does not have the financial capacity to assume these risks, as this party would not be entitled to a share in the output that is the objective of the CCA based on the functions it actually performs. The general principles set out in Chapter I of these guidelines on the assumption of risks apply to situations involving CCAs. Each participant makes particular contributions to the CCA objectives, and contractually assumes certain risks. Guidance under Section D. 1 of Chapter I on delineating the actual transaction will apply to the transfer pricing analysis in relation to these risks. This also means that a party assuming risks under a CCA based on an analysis under step 4(i) of the framework for analysing risks in paragraph 1.60 (“assumes the risk under the CCAâ€) must control the specific risks it assumes under the CCA and must have the financial capacity to assume these risks. In particular, this implies that a CCA participant must have (i) the capability to make decisions to take on, lay off, or decline the risk-bearing opportunity presented by participating in the CCA, and must actually perform that decision-making function and (ii) the capability to make decisions on whether and how to respond to the risks associated with the opportunity, and must actually perform that decision-making function. While it is not necessary for the party to perform day-to-day risk mitigation activities in relation to activities of the CCA, in such cases, it must have the capability to determine the objectives of those risk mitigation activities to be performed by another party, to decide to entrust that other party to provide the risk mitigation functions, to assess whether the objectives are being adequately met, and, where necessary, to decide to adapt or terminate the arrangement, and must actually perform such assessment and decision-making. In accordance with the principles of prudent business management, the extent of the risks involved in the arrangement will determine the extent of capability and control required. The guidance in paragraphs 6.60 to 6.64 is relevant for assessing whether a party providing funding has the functional capability to exercise control over the financial risk attached to its contributions to the CCA and whether it actually performs these functions. See Examples 4 and in the Annex to this chapter for an illustration of this principle ...

TPG2022 Chapter VI paragraph 6.63

The extent and form of the activities that will be necessary to exercise control over the financial risk attached to the provision of funding will depend on the riskiness of the investment for the funder, taking into account the amount of money at stake and the investment for which these funds are used. In accordance with the definition of control as reflected in paragraphs 1.65 and 1.66 of these Guidelines, exercising control over a specific financial risk requires the capability to make the relevant decisions related to the risk bearing opportunity, in this case the provision of the funding, together with the actual performance of these decision making functions. In addition, the party exercising control over the financial risk must perform the activities as indicated in paragraphs 1.65 and 1.66 in relation to the day-to-day risk mitigation activities related to these risks when these are outsourced and related to any preparatory work necessary to facilitate its decision making, if it does not perform these activities itself ...

TPG2022 Chapter I paragraph 1.69

The concept of control may be illustrated by the following examples. Company A appoints a specialist manufacturer, Company B to manufacture products on its behalf. The contractual arrangements indicate that Company B undertakes to perform manufacturing services, but that the product specifications and designs are provided by Company A, and that Company A determines production scheduling, including the volumes and timing of product delivery. The contractual relations imply that Company A bears the inventory risk and the product recall risk. Company A hires Company C to perform regular quality controls of the production process. Company A specifies the objectives of the quality control audits and the information that Company C should gather on its behalf. Company C reports directly to Company A. Analysis of the economically relevant characteristics shows that Company A controls its product recall and inventory risks by exercising its capability and authority to make a number of relevant decisions about whether and how to take on risk and how to respond to the risks. Besides that Company A has the capability to assess and take decisions relating to the risk mitigation functions and actually performs these functions. These include determining the objectives of the outsourced activities, the decision to hire the particular manufacturer and the party performing the quality checks, the assessment of whether the objectives are adequately met, and, where necessary, to decide to adapt or terminate the contracts ...

TPG2022 Chapter I paragraph 1.68

Risk mitigation refers to measures taken that are expected to affect risk outcomes. Such measures may include measures that reduce the uncertainty or measures that reduce the consequences in the event that the downside impact of risk occurs. Control should not be interpreted as requiring risk mitigation measures to be adopted, since in assessing risks businesses may decide that the uncertainty associated with some risks, including risks that may be fundamental to their core business operations, after being evaluated, should be taken on and faced in order to create and maximise opportunities ...

France vs (SAS) SKF Holding France, October 2021, Conseil d’Etat, Case No. 443133

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 France vs SKF 041021 Conseil d'Etat Case no 443133 ...

France vs (SAS) RKS, October 2021, Conseil d’Etat, Case No. 443130

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 France vs RKS October 2021 Conseil d'État, 8ème - 3ème chambres réunies, 04_10_2021, 443130 ...

TPG2020 Chapter X paragraph 10.198

Captive insurances may be self-managed from within the MNE group, or managed by an unrelated service provider (often a division of a large insurance broker). Typically this management would include ensuring compliance with local law, issuing policy documents, collecting premiums, paying claims, preparing reports and providing local directors. If the captive insurance is managed from within the MNE group it is necessary to determine which entity manages it (if such management is not exercised by employees of the captive insurance) and to appropriately reward that management ...

TPG2020 Chapter X paragraph 10.197

The insurer is carrying out a risk mitigation function in respect of the insured party’s risk but not actually assuming that risk. It is assuming the risk of insuring (i.e. mitigating) the insured party’s risk. That risk will be controlled by either the insurer or (more likely in a captive insurance scenario) another entity within the MNE group that makes the decision that the risk should be assumed by the insurer. (See paragraph 10.223). The insurer (or other entity) can make decisions as to how to respond to this risk – in accordance with paragraph 1.61 (ii) – by, for example, further diversifying its portfolio of insured risks or by reinsuring ...

TPG2020 Chapter X paragraph 10.196

Although the quantum of the risk reward for the insured party and the insurer might be dependent upon exactly the same events in both cases, that quantum could be significantly different (for example, if the insured risk materialises and a claim is made, the insured party could potentially receive significant upside relative to the premium paid whereas the insurer’s income will be limited to the insurance premiums and investment income it has received regardless of the quantum of risk reward received by the insured party) ...

TPG2020 Chapter X paragraph 10.195

The principles of accurate delineation of the actual transactions and allocation of risk detailed in Chapter I of these Guidelines apply to captive insurance and reinsurance in the same manner that they apply to any other intra-group transactions. However, this section addresses mainly captive insurance (as well as captive reinsurance – fronting). In particular, it should be borne in mind that: the carrying on of risk mitigation functions falls within the wider concept of risk management but not within that of control of risk (see paragraphs 1.61 and 1.65); there is a difference between the specific risk being insured (the party taking the decision to insure – i.e. mitigate – or not, controls this risk; that party will usually be the insured but may be another entity within the MNE group) and the risk taken on by the insurer in providing insurance to the insured party ...

TPG2017 Chapter VIII paragraph 8.15

A party would also not be a participant in a CCA if it does not exercise control over the specific risks it assumes under the CCA and does not have the financial capacity to assume these risks, as this party would not be entitled to a share in the output that is the objective of the CCA based on the functions it actually performs. The general principles set out in Chapter I of these guidelines on the assumption of risks apply to situations involving CCAs. Each participant makes particular contributions to the CCA objectives, and contractually assumes certain risks. Guidance under Section D. 1 of Chapter I on delineating the actual transaction will apply to the transfer pricing analysis in relation to these risks. This also means that a party assuming risks under a CCA based on an analysis under step 4(i) of the framework for analysing risks in paragraph 1.60 (“assumes the risk under the CCAâ€) must control the specific risks it assumes under the CCA and must have the financial capacity to assume these risks. In particular, this implies that a CCA participant must have (i) the capability to make decisions to take on, lay off, or decline the risk-bearing opportunity presented by participating in the CCA, and must actually perform that decision-making function and (ii) the capability to make decisions on whether and how to respond to the risks associated with the opportunity, and must actually perform that decision-making function. While it is not necessary for the party to perform day-to-day risk mitigation activities in relation to activities of the CCA, in such cases, it must have the capability to determine the objectives of those risk mitigation activities to be performed by another party, to decide to entrust that other party to provide the risk mitigation functions, to assess whether the objectives are being adequately met, and, where necessary, to decide to adapt or terminate the arrangement, and must actually perform such assessment and decision-making. In accordance with the principles of prudent business management, the extent of the risks involved in the arrangement will determine the extent of capability and control required. The guidance in paragraphs 6.60 to 6.64 is relevant for assessing whether a party providing funding has the functional capability to exercise control over the financial risk attached to its contributions to the CCA and whether it actually performs these functions. See Examples 4 and in the Annex to this chapter for an illustration of this principle ...

TPG2017 Chapter I paragraph 1.69

The concept of control may be illustrated by the following examples. Company A appoints a specialist manufacturer, Company B to manufacture products on its behalf. The contractual arrangements indicate that Company B undertakes to perform manufacturing services, but that the product specifications and designs are provided by Company A, and that Company A determines production scheduling, including the volumes and timing of product delivery. The contractual relations imply that Company A bears the inventory risk and the product recall risk. Company A hires Company C to perform regular quality controls of the production process. Company A specifies the objectives of the quality control audits and the information that Company C should gather on its behalf. Company C reports directly to Company A. Analysis of the economically relevant characteristics shows that Company A controls its product recall and inventory risks by exercising its capability and authority to make a number of relevant decisions about whether and how to take on risk and how to respond to the risks. Besides that Company A has the capability to assess and take decisions relating to the risk mitigation functions and actually performs these functions. These include determining the objectives of the outsourced activities, the decision to hire the particular manufacturer and the party performing the quality checks, the assessment of whether the objectives are adequately met, and, where necessary, to decide to adapt or terminate the contracts ...

TPG2017 Chapter I paragraph 1.68

Risk mitigation refers to measures taken that are expected to affect risk outcomes. Such measures may include measures that reduce the uncertainty or measures that reduce the consequences in the event that the downside impact of risk occurs. Control should not be interpreted as requiring risk mitigation measures to be adopted, since in assessing risks businesses may decide that the uncertainty associated with some risks, including risks that may be fundamental to their core business operations, after being evaluated, should be taken on and faced in order to create and maximise opportunities ...