This guest article was kindly contributed by Oliver Treidler and Tom-Eric Kunz, from TP&C GmbH, transfer pricing specialists based in Berlin, Germany.
The OECD’s Base Erosion and Profit Shifting (BEPS) project has created uncertainty about various transfer pricing issues and has made an already complex issue even more complex. Now that the dust has settled and implementation of the modified regulation is largely complete, it is worth looking at the main systematic changes and thinking about the main practical implications. While other contemporary discussions, namely the taxation of the digital economy and the respective “Pillar 1” and “Pillar 2“ proposals made by the OECD, enjoy the spotlight of the transfer pricing world, engaging with the bread-and-butter tasks of compliance will likely yield more tangible results in regards to reducing your tax risks. While the future shape of regulatory framework is difficult to anticipate, you can be sure that tax auditors all over the world will request to be provided with transfer pricing documentation and intercompany agreements. Being prepared thus remains key.
In this article, we specifically want to address the following question: Do I need to update my intercompany agreements due to BEPS?
The short answer is obvious: Yes. You are looking at low hanging fruit and complacency or unwillingness to allocate the required resources will potentially hurt you.
The long answer follows below:
Fundamental aspects of transfer pricing
To successfully deal with transfer pricing issues, the arm’s length principle (ALP), which is still the globally accepted paradigm in transfer pricing, must be embraced as a guiding star by MNEs whenever determining prices for intercompany transactions. Pursuant to the ALP, MNEs are required to utilize prices that would be agreed between unrelated third parties in comparable circumstances. Hence, unsurprisingly, the issue of “comparability” is rather crucial in the realm of transfer pricing.
Having a holistic understanding of business relationships within an MNE and conducting an adequate aggregation (segmentation) of the intra-group transactions is, arguably, the most fundamental component of appropriately applying the ALP. If you want to understand a specific business relationship, you must, as a minimum, develop an understanding of the industry, the business model and key success factors of the MNE-group. After developing that understanding, the value contributions of individual entities should be delineated in a value chain analysis (functional and risk analysis), which will translate the business model into a tax viable transfer pricing system by identifying core and support functions within the MNE. A solid functional and risk analysis ensures that the choice of the “tested party” and thus the allocation of the residual profit cannot be effectively challenged by tax authorities – it is thus the heart and soul of any transfer pricing system.
While functions are obviously an integral part of that analysis, they sometimes distort the analysis if looked at in isolation. Appropriate attention should also be paid to risks – considering the expanded Section D 1.2.1 of the OECD-GL (see below). Although in day-to-day transfer pricing, functions and risks will often be appropriately (“naturally”) aligned, the economic analysis is incomplete unless risks are adequately identified and considered. Risks are an integral part of the functional analysis, because assuming increased risk would, ceteris paribus, be remunerated by an increase in expected return.
The focus of transfer pricing is increasingly on economic substance
First, it must be emphasized that the legal framework for transfer pricing was not changed in principle by the BEPS project. The outcome of BEPS can be summarised, in somewhat simplified terms, as a “modernisation of the ALP“. The characteristic feature of this modernization is that the issue of economic substance is moving to centre stage when applying the ALP. This increased focus on economic substance can perhaps be most clearly seen in the greatly expanded section on “risks” within the 2017 OECD Guidelines (Section D 1.2.1). In about 50 paragraphs (the largest single sub-section of the entire guidelines), the OECD emphasises the need to clearly identify the relevant risks when reviewing transfer pricing arrangements and to focus both on the contractual allocation and, in particular, on the actual management of economic risks.
In a first step, and most importantly, it needs to be ensured that inter-company agreements (ICAs) are aligned with actual allocation of risks of the underlying business model. An (ex-ante) contractual allocation of risks needs to clearly stipulate who bears the potential costs which may occur if negative outcomes come to fruition (ex-post). Consequently, in return, the party bearing that risk should also be rewarded with most (or all) of the potential benefit of the positive outcomes.
It is crucial that the ex-ante contractual allocation of risks provides clear evidence of a commitment to assume risk before the realisation of risk outcomes occurs. The reason is straightforward, as a tax audit is often conducted by the respective authorities several years after outcomes have been established. Therefore, an assumption of risks after the fact, when outcomes are known, is not an effective assumption of risk for transfer pricing purposes. If an unambiguous allocation of risks is lacking, tax authorities may challenge the structure of your transfer pricing system; e.g. if a local manufacturer realizes losses, the local tax authorities might challenge the arm’s length nature of such losses based on the argument that the entity merely performs contract manufacturing services on behalf of a principal without having authority to influence entrepreneurial decisions. Such a challenge, which is rather typical and “automatic” in tax audits, can be resisted (mitigated) by ensuring unambiguous ex-ante contractual allocation of risks, capturing sufficient evidence about control over the key financial and strategical risks.
Recommendation: An appropriate ICA will constitute a robust defense file that is available to prevent arguments against your transfer pricing structure. It is your first line of defence. As auditors will habitually request and check your ICAs, make sure your ICAs, at the very least pass the “smell test”.
ICAs are naturally an essential part of your transfer pricing documentation, as they are the legal implementation of the transfer pricing arrangements and have an important (preventive) support function. As mentioned above, ICAs must be concluded in advance – as you do not want to engage in backdating.
While the contractual allocation of risks is of great importance, it is only a first step. It is even more important, especially post-BEPS, that the ICAs are consistent with the actual conduct of the associated parties. ICAs should reflect economic realities not wishful thinking. Considering that allocation of risks often coincides with the claim to entrepreneurial profits (or a share of the residual profit), the OECD strongly emphasises that only a company which has the actual economic opportunity to influence these risks (‘risk management’ and ‘risk mitigation’) and which also has the financial capacity to bear these risks (‘financial capacity’) can be granted such a claim. Now, verifying that ICAs are aligned with “economic reality”, as understood by the OECD, requires careful analysis.
Conceptually, it can be harder to identify risks than functions or assets, because the challenge is to explore the unknown and identify invisible risks. But even if the risks are known as such, it is often not possible to estimate when they will occur and what their consequences will be. To identify the relevant risks, you should bear in mind that risks, functions and assets go hand in hand and in day-to-day transfer pricing practices you will often see that the performance of functions and the assumption of related risk are aligned (especially in SMEs without elaborate holding structures).
Recommendation: At this point you need to look at your functional and risk analysis. Does it convey an accurate summary of your business? Can you anticipate questions a tax auditor may raise? By identifying and delineating the value-added functions, you will also get a good idea of the allocation of the assumed risks. Risks must generally not be analysed separately, but rather complementary to a comprehensive analysis of the functions. In some cases, it might, however, add clarity to the summary of your business to separately describe risk management and risk mitigation.
Risk management refers to the functions of appraising and responding to risk associated with the transaction and consists in the capability of decision-making function in respect to take on or decline a risk-bearing opportunity as well as the response to that risk related with the opportunity and the actual performance.
Risk mitigation is a part of risk management i.e. the ability to take actions that mitigate the adverse impact of the related outcomes. There are risk management functions which can only be allocated to the party which is actually conducting the related functions for accomplishing the set goal, while other risk management functions not necessarily need to be allocated to that party and can be assumed by another party. Risk management itself should not be treated as a necessarily separate function which requires separate remuneration, apart from the performance of optimizing profits.
For instance, in a contract R&D transaction, remuneration for risk mitigation functions conducted through the development activity would be included into the arm’s length payment and the residual income would be allocated to the contractor who bears the entrepreneurial (intangible) risk. The OECD illustrates this by giving the following example:
Example 1 – Risk Management
Company A pursues a development activity and contracts Company B to perform the operative development functions on its behalf; i.e. a typical Contract R&D arrangement. Company A controls its development risk through executing its capability in making essential decisions about whether and how to take on the development risk, including: performing parts of the development itself, hiring a particular researcher, specifying objectives and milestones as well as determining the budget for Company B. In the case at hand, Company A mitigates its risk by outsourcing part of its development to Company B, which assumes the day-to-day responsibilities for its competent performance under the control of Company A. Also, Company B reports to Company A at predetermined milestones, where Company A then decides whether objectives are met and to continue with further investments or to stop the development project. In this case, Company A has the financial capacity to assume the risk. Company B neither makes any decisions about Company A’s activities, nor has it the capability to evaluate the development risk. The risk Company B takes is limited to decisions about its own processes and expertise, its competent performance, while Company A assumes the strategical (entrepreneurial) development risks based on the functional and risk analysis.
The example illustrates that risk management does not equal assuming the risk. Risk assumption refers to bearing the positive and negative outcomes if the risk occurs, consequently, the party assuming the risk will also bear the financial consequences (here Company A). In order to exercise control over risk it is not necessary to perform the day-to-day risk mitigation functions, as described above; it rather requires financial capability and strategical (entrepreneurial) functional performance (both clearly assumed by Company A in this example). Financial capability to take on the risk can be shown in the access to funding to pay for risk mitigation functions and to bear the costs of a negative outcome.
Many of the aggressive tax avoidance schemes against which BEPS was targeted were based on assigning risks to entities with insufficient economic substance – i.e. entities that could not actually perform the entrepreneurial function in a similar way as Company A in the above example. The tax policy objective of the OECD, which is broadly supported by all tax authorities, is clear: the shift from corporate profits to “letterbox companies” through the contractual allocation of risks is to be prevented.
Regarding the control of risks, the OECD has now clarified for the first time that while the operational execution of risk management can be outsourced, the entrepreneurial risks must always lie with the company bearing the contractual risks (see above). To this end, the employees of this company must have the necessary skills and (decision-making) authority, which must be proven upon request.
Description of economic substance in inter-company contracts
Despite the many discussions, BEPS should not give rise to blind activism. Transfer pricing systems that were commensurate with the ALP prior to BEPS remain compliant post-BEPS. Especially for taxpayers whose transfer prices are closely linked to business processes and for whom the question of substance never really arises, there is little cause for concern. They will face little difficulty in substantiating their functional and risk analysis. While even pre-BEPS a functional and risk analysis should have formed the core of any transfer pricing system, the importance of this analysis for the tax viability of any transfer pricing system has substantially increased with BEPS. As such, BEPS unfortunately also implies an increased need for documentation as well as additional discussions during tax audits. The corresponding effort (in terms of time and money) as well as the risks can, however, be minimized by proactively reviewing existing ICAs. Checking whether the existing contracts accurately reflect the operational assignment of functions and risks is a paramount first step – and shall be further illustrated by providing examples from day-to-day transfer pricing.
In the case of ICAs for contract manufacturing or limited risk distribution, for example, it is necessary to check whether the essential strategic decisions are actually – and demonstrably – made by the principal. In this context, consideration should also be given to how the necessary substance can be substantiated at principal level. It should also be checked whether the contractual agreements are properly implemented. If routine companies (e.g. contract manufacturers or limited risk distributors identified as tested parties) exhibit highly volatile net results or even (permanent) losses, this could be an indication that the ICA is not sufficiently aligned with the economic substance and that therefore potential tax risks arise. In such cases, targeted adjustments of ICAs can often be sufficient to reduce such tax risks. The following example illustrates the causal relationship of an appropriate alignment of ICAs with economic substance and the resulting arm’s length profit allocation:
Example 2 – Aligning economic substance with ICAs leads to arm’s length profit distribution
The example features a Swiss manufacturer and a German distributor, which are part of a MNE-Group. The principal intercompany transaction is selling goods from the Swiss manufacturer to the German distributor.
In 2016, the two parties conclude a Sales Agreement for the transaction, where it is stated that the Swiss manufacturer performs vital entrepreneurial functions (developing and producing the goods, determining price list, marketing strategy etc.) and also assumes all strategic risks (i.e. market risks, credit risks). The German distributor on the other hand only assumes operational risks in respect to its performed functions, specifically selling and distributing the right product to the right customer on time and performing first level support services. Hence, the German party exhibits distinct characteristics of a low-risk distributor; i.e. it essentially renders sales and distribution services on behalf of the Swiss principal. The German distributor can appropriately be classified as a routine-entity (be identified as “tested party”) and consequently be remunerated on arm’s length with rather small and stable profits. In the ICA this could possibly have been manifested by stipulating a rather narrow target net margin range for the German distributor ranging from 1% to 3%, with the median (2%) being the focus of the price-setting processes. Also, in such cases outcome-testing procedure (calculation of “true-up payments”) are a prominent feature of the respective ICAs.
However, as the business matures, the German distributor assumes additional functions and gains discretionary authority in respect to local distribution activities. By 2018 it has established a local marketing department for market research and hired highly skilled personnel for conducting marketing campaigns to increase the market share in Germany. The distributor further gains substantial competencies in respect to price-setting and negotiations (i.e. the price list issued by the Swiss principal only provide a rough idea for a starting position in respective negotiations at this point). In other words, the German distributor makes more valuable contributions to the success of the business in 2018, clearly exceeding the 2016 focus of rendering sales and distribution services on behalf of the Swiss principal.
Consequently, the contractual allocation of the related risks is no longer aligned with the actual performance (value contributions) of the German subsidiary, which by 2018 rather exhibits the characteristics of a fully-fledged distributor and must be compensated accordingly; i.e. the target range stipulated in the 2016 ICA does no longer ensure an arm’s length remuneration.
Tax authorities will likely challenge the classification as a routine-entity (low-risk distributor) and push it at least to a “hybrid” classification, which necessitates revisiting the choice of the transfer pricing method and ultimately the profit allocation. Especially in case that the local business is rather profitable, as illustrated by the Figure 1 below, the German tax authorities would mount a strong challenge and disregard the ICA, including the stipulated target range, for transfer pricing purposes.
Figure 1 illustrates and quantifies example 2, where the contractual agreement does not reflect the actual commercial relation between the associated parties anymore.
This simplified example illustrates the importance of (periodically) reviewing the consistency between ICAs and economic substance to prevent challenges by tax authorities. The applied transfer pricing method here is the resale price method (i.e. the resale (gross) margin allocated to the German subsidiary (tested party) is calibrated to result in an arm’s length net margin). While the 20% net margin is somewhat “dramatic” it is not too farfetched for an initial demand by the tax authority. Also, while this example focussed on the “gap” in the arm’s length net margin, you should also be mindful that the implied “shift” of profit potential (here from Switzerland to Germany) arising as an immediate consequence of the business restructuring could trigger exit taxation. This, again, constitutes an unwelcome source of tax risk and uncertainly and illustrates that periodically checking the alignment between ICA and economic substance is without doubt among the most important “homework” of transfer pricing professionals.
Last Warning: Do not forget about intangibles!
A particular focus of BEPS was the regulations on intangible assets. The above comments on the greater significance of economic substance apply analogously. In the context of intangibles, it should be explicitly noted that legal ownership alone will no longer be sufficient to allocate the (residual) profits arising from the commercialisation of intangibles to a company. Within the framework of audits, it will be necessary to explain which company assumes the economic functions (risks) with regard to development, enhancement, maintenance, protection, and exploitation (commercialization) and what significance the respective functions have for the intangible asset. The corresponding classifications should be appropriately reflected both in contract research agreements (strategic objectives, monitoring of milestones, non-results-related remuneration) and in license agreements (right to sublicense, specifications and participation in marketing measures, etc.).
The authors would like to thank Paul Sutton from LCN Legal for a review of the draft of this article. TP & C specializes in providing pragmatic transfer pricing support. If you are interested in taking a closer look at our consulting philosophy, feel free to check-out our publication “Transfer Pricing in One Lesson“
 Although developments under BEPS Pillar one “Tax Challenges of the Digitalization of the Economy” by the OECD suggest a shift to formulary apportionment in the draft of the “Unified Approach”, a general consensus in transfer pricing is reasonably the proven concept of the arm’s length principle (See Lorraine Eden, 2019, “The arm’s length standard is not the problem”, Tax Management International Journal, 48.10, October 11, 2019)
 As a general rule, the “tested party” is the one to which a (one-sided) transfer pricing method (e.g. cost-plus or TNMM) can be applied in the most reliable manner and for which the most reliable external comparables can be found, i.e. it will most often be the one that has the less complex functional profile. The most frequent approach to ascertain the arm’s length nature of transfer prices is to identify a tested party and subsequently ensure that the profitability (net margin) of that party falls within a range of margins realized by companies that perform comparable (rather simple of ‘routine’) functions. After thus remunerating the tested party, the remaining (residual) profits (losses) resulting from a transaction will subsequently be allocated to the other party.
 See OECD-GL Section D1.2.1 Paragraph 1.105
 See OECD-GL Section D1.2.1 Paragraph 1.57
 See OECD-GL Section D1.2.1. Paragraph 1.61
 See OECD-GL Section D1.2.1 Paragraph 1.62
 See OECD-GL Section D1.2.1 Paragraph 1.64
 For Germany, the resulting increased requirements for proof of economic substance manifest themselves in the (2017 revised) Ordinance on the Recording of Deferred Profits (GAufzV).
 See OECD-GL Ch.VI Section B Paragraph 6.32