The OECD and the U.S. Regarding Risk Allocation

Practical Guide to U.S. Transfer Pricing, 3rd Edition (2018)

29 Pages Posted: 18 Dec 2018

Date Written: November 27, 2018

Abstract

This subchapter explores the difference of review of risk allocation by contract between the Organization of Economic Cooperation and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) Actions 8-10 revisions to the 2017 OECD Guidelines and the U.S. Tax Court in its decisions since 2010. The OECD and the U.S. Tax Court diverge in their adherence to the language of contracts as the basis for assessing and controlling risk allocation. On the one hand, the U.S. Tax Court following the prescription of the Internal Revenue Code has focused largely on contractual language and terms of agreement. On the other hand, the OECD analyzes actual economic behavior and reality, independent of the contractual language of the related parties.

One of the changes to the 2017 OECD Guidelines initiated by BEPS in the Action Plan 8-10 is the interpretation of conduct in relation to reviewing the allocation of risk via a contractual arrangement between related parties, in particular with regards to intangibles. The OECD at first glance indicates that for application of the arm’s length principle, contractual arrangements should still be followed, but only as long as they conform to actual economic reality. At a second glance, the OECD states that legal ownership and contractual relationships serve merely as ‘reference points’ for identifying and analyzing an intragroup transaction. The OECD proposes a substance over form analysis:
“… where the facts of the case, including the conduct of the parties, differ from the written terms of any agreement between them or supplement these written terms, the actual transaction must be deduced from the facts as established, including the conduct of the parties.”

The OECD approach is that a contract may be respected as long as the arrangements in the contract reflect what would be agreed between arm’s length actors in consideration of several factors that the OECD lists as relevant to a third party’s negotiating position. Such factors include, non-exclusively, the functions performed by each party, the assets employed by each party, the risks assumed by each party, and the contributions made by other group members.

The main difference in the U.S. Transfer Pricing approach for risk allocation is that the U.S. Tax Court examines to validate the contractual arrangement in the first instance and then determines if the contracts conform to economic reality. While on the other hand, the OECD through BEPS has stated in a disguised manner—and as uncovered by Rutger Hafkenscheid—that contracts will only be considered if they are what “should” have been contracted under the functional analysis whereby a party has the control to bear risk and remuneration accordingly. Given these differences, there are many implications, such as a prospect of a political battle over the different jurisdictions’ rights to tax certain revenue streams and bases and a tension between the importance of the OECD versus the U.S. approach.

Following BEPS Action 8-9, there is a new six-step approach for risk. In short, the two prongs of step 5 in the new risk allocation analysis provide: (1) “control over risk” and (2) “whether the party assuming risk … has the financial capacity to assume risk”. Each prong has its own definition. Either prong trump the language of a contract. This two-pronged analysis may lead to different results comparing an affiliate within a corporate group or as a stand-alone tested party. Thus, step 5 of the new risk allocation analysis may create uncertainty in the fiction of the arm’s length principle.

Giammarco Cottani9 defines risk as volatility meaning that “business outcomes of an enterprise are heavily dependent on how their strategic choices expose them to certain types of volatility, e.g. fluctuations in the upside or downside of any given entrepreneurial direction.” Contractual allocation of risk is key for BEPS 8-10; and, Cottani points out that this contractual allocation of risk is normally referred to as the neoclassical economic concept of moral hazard applied in an international tax treaty scenario. Moral hazard in the neoclassical sense is the idea whereby a party insures itself from the probability of failure by shifting the potential of losing—monetary or other—value to another party.

In order to manage risk, it appears key to (1) identify the source of volatility; and (2) assess the impact of risk on business activity. To reach an effective risk management, there must exist a uniform definition and categorization of risk. In other words, risk management does not eliminate risk, but provides analysis and advice with which to maximize returns while reducing losses—a “risk/return trade-off” scenario.

The 2017 OECD Guidelines define risks as “the effect of uncertainty on the objectives of the business.” Indeed, every action a business takes involves risk. Generally, the more risk involved the higher the expected return will be. Specifically, BEPS Actions 8-10 provides a six-step approach to analyzing risk: (1) “identification of economically significant risks in the transaction; (2) Contractual assumption of the risks; (3) Functional analysis with respect to risks; (4) Interpretation of Steps 1 through 3; (5) Allocation of risks; and, (6) Pricing of the controlled transaction.”

The 2017 OECD Guidelines indicate that a company would not take risk without expecting return. Risk’s connection with return on value can be demonstrated by the concept of weighted average cost of capital (WACC) formula. “WACC is the expected rate of return for a company on the basis of the average portion of debt and equity in the company’s capital structure, the current required return on equity (i.e., cost of equity), and the company’s cost of debt.”

Given this idea that identifying risk is key to a transfer pricing analysis, multinationals may abuse this strategy by contractually re-allocating risks without any change to business operations. When multinationals abuse the transfer pricing methods, they create distortions in the tax revenue of host countries. The 2017 OECD Guidelines seeks to tackle this contractual re-allocation of risk.

To combat artificial contractual re-allocation of risk, the 2017 OECD Guidelines determines when risks are contractually assumed by a party that cannot “exercise meaningful and specifically defined control over the risks, or does not have the financial capacity to assume the risks.” Then the tax authorities should re-allocate risks to the party that actually—in economic reality—“does exercise such control and does have the financial capacity to assume the risks.”

Suggested Citation

Lincoln IV, Charles Edward Andrew, The OECD and the U.S. Regarding Risk Allocation (November 27, 2018). Practical Guide to U.S. Transfer Pricing, 3rd Edition (2018), Available at SSRN: https://ssrn.com/abstract=3291678

Charles Edward Andrew Lincoln IV (Contact Author)

University of Groningen, Faculty of Law ( email )

Groningen
Netherlands

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