Transfer Pricing After BEPS: Where Are We and Where Should We Be Going By Joe Andrus and Paul Oosterhuis Joe Andrus and Paul Oosterhuis analyze transfer pricing developments, their impact on multinational tax planning and the likelihood for increased tax disputes. Included in the article is a review of fundamental alternatives to the arm's-length standard, including various proposals that allocate income to the jurisdiction where a product is sold or a service provided. n October 2015, the G20 and the OECD approved and issued a series of reports in their project on Base Erosion and Profit Shifting.1 Transfer pricing issues formed a significant portion of the subject matter of those reports. The Ifinal report on BEPS Actions 8–10: Aligning Transfer Pricing Outcomes and Value Creation2 contained nearly 200 pages of revisions to the OECD Transfer Pricing Guidelines.3 The final report on BEPS Action 13:Transfer Pricing Documentation and Country-by-Country Reporting4 rewrote Chapter V of the OECD Guidelines, setting out a new coordinated approach to transfer pricing documentation and reporting, including a requirement that large multinational enterprises prepare and submit annually a country-by-country report of their income, taxes paid and certain indicators of economic activity. The BEPS transfer pricing reports address a number of topics. However, they are directed toward one overarching objective: the alignment of the place where JOE ANDRUS is the Head of Transfer income is reported for tax purposes with the place of value creation. The first Pricing Unit, OECD’s CTPA. paragraph of the explanatory statement to the October 2015 BEPS reports sug- PAUL OOSTERHUIS is a Partner at Skad- gests that the collective BEPS outputs constitute “a bold move by policy makers den, Arps, Slate, Meagher & Flom LLP. to … ensure that profits are taxed where economic activities take place and value MARCH 2017 © 2017 J. ANDRUS AND P. OOSTERHUIS 89 TRANSFER PRICING AFTER BEPS: WHERE ARE WE AND WHERE SHOULD WE BE GOING is created.”5 The transfer pricing elements of the project risk.13 This means that in transactions between associated are especially important parts of the G20/OECD effort enterprises, a member of an MNE group that assumes risk to meet this objective. can expect a return that correlates with the level of risk In the 2013 Action Plan that initiated the BEPS Proj- it assumes, unless the risk factor plays out in a way that ect,6 the G20 and OECD countries committed to focus reduces or eliminates the return anticipated. While this attention on three transfer pricing problems that country correlation between risk and reward is a well-established representatives believed allow a separation of income from transfer pricing principle, there was little general guid- relevant economic activity under pre-BEPS interpretations ance in the pre-BEPS OECD Guidelines on how one of the arm’s-length principle. These are: (i) the transfer of determines which entities in an MNE group in fact bear intangibles and other mobile assets for less than full value; specific risks. 2010 changes to the OECD Guidelines had (ii) the over-capitalization of low-taxed group companies; provided some guidance on the allocation and transfer of and (iii) contractual allocations of risk to low tax environ- risk in business restructuring transactions,14 but there was ments in transactions that would be unlikely to occur little comprehensive treatment of risk in the general provi- between unrelated parties. To address these problems, the sions of the OECD Guidelines. The BEPS work sought G20 and OECD countries committed themselves in the to rectify this perceived lack of clear guidance. Action Plan to the following work: The Final BEPS Transfer Pricing Report begins by Developing rules to prevent profit shifting by ensuring discussing how, as a general matter, one determines the that inappropriate returns do not accrue to an entity actual terms and conditions of a related party transaction solely because of its contractual assumption of risk.7 to be analyzed under the transfer pricing rules. The report Developing rules ensuring that inappropriate returns suggests that one should begin with the terms, conditions do not accrue to an entity merely because it has pro- and allocations of risk contained in contracts and other vided capital.8 written terms of the transaction in question.15 However, Developing rules ensuring that profits associated with if written terms are ambiguous or missing, or if the con- the transfer and use of intangibles are appropriately duct of the parties differs from the transactional terms allocated in accordance with value creation. This contained in the contracts, one must “accurately delineate” work was to include updates to the provisions of the the transaction based on the conduct of the parties.16 This OECD Guidelines on hard to value intangibles and delineation of the transaction requires a careful, detailed, cost contribution arrangements.9 facts and circumstances-based functional analysis.17 Clarifying the circumstances under which transac- One of the important factual circumstances to be tions can be recharacterized or disregarded by tax considered in delineating the transaction relates to risk. administrations.10 The Final BEPS Transfer Pricing Report suggests that the Clarifying transfer pricing rules related to profit splits allocation of risk follows the general conduct related rule and other transfer pricing methods in the context of on delineation of transactions. That is, a particular risk global value chains.11 will be allocated to the party or parties in the MNE group The Action Plan underscored the OECD’s strong desire that contractually assumes the risk, provided the relevant to find solutions to the perceived transfer pricing problems parties also conduct their affairs in a manner consistent by inviting delegates to address those issues either under with what the contracts say about the allocation of risk. the arm’s-length principle or through special measures At the heart of the factual investigation of how the parties’ going beyond the arm’s-length principle.12 While the conduct affects the determination of which entity or enti- various workstreams listed in the Action Plan were obvi- ties in the MNE group actually bear risk are two questions: ously interrelated, the work on risk, provision of capital or (i) which party or parties control the risk, and (ii) which funding and transfers of intangibles were the foundational party or parties have the financial wherewithal to assume elements of the BEPS transfer pricing work. the risk.18 The report suggests that unless a party controls the risk in question, and has the financial wherewithal to Separation of Risk from assume the risk, its conduct will not support an allocation of the risk to that party, even if contracts clearly assign the Business Functions risk to that party. If these requirements are not satisfied, the risk will be deemed to be borne for transfer pricing The OECD Guidelines have long recognized that a party purposes by entities within the MNE group which do assuming a greater risk in its business dealings will tend to control the risk and which have financial wherewithal to expect a higher return as compensation for assuming the assume the risk.19 90 Taxes The Tax Magazine® MARCH 2017 The Final BEPS Transfer Pricing Report defines what where the decision making responsibility is shared, as it means to control risk for this purpose. It suggests that long as some decisions are taken by the entity contractu- there are three elements critical to the efforts of an in- ally assigned the risk, no further inquiry is required to dependent business to manage its risks. These elements confirm that that party will be treated as bearing risk are: (i) making decisions to take on risk, lay off risk or for transfer pricing purposes. to decline to undertake a risk bearing opportunity; (ii) making decisions regarding how to respond to the risks arising in connection with a business opportunity, and While in the past some have thought (iii) making decisions regarding the mitigation of risk by taking actions that affect risk outcomes. The first two of that such allocations of risk could these the BEPS report defines as being the functions that be achieved merely by adopting control risk. Risk mitigation, however, is not a required contracts specifying where the risk is element of control according to the BEPS Report.20 This categorization of risk-related functions and the allocated, following BEPS the critical definition of control is quite arbitrary and is not always question will be how much and what clear. Under these rules, however, a party must have the capacity to make, and must actually make, some of the type of decision making capacity risk controlling decisions of the MNE group in order to must be present in a particular entity claim that it bears that risk in the accurately delineated in order to support the contractual transaction. If there is no capacity to control risk, that is if all decisions related to risk are made elsewhere in the risk allocation and establish that the group, the entity will not be treated as having assumed entity controls its risks. the risk and will not be entitled to any risk-related pre- mium return from the business transactions that are the subject of the transfer pricing analysis. Thus, consistent Thus, to assign risk to a tax-advantaged jurisdiction, with the income alignment objectives of BEPS, risk there must be some decision making in that jurisdiction. and risk premiums will go to the entities performing However, not all risk control decisions must be allocated the income producing activity of controlling risk; a to the party contractually assigned the risk.22 Other enti- low-function entity, with no capacity to control risk or ties may assist in controlling risk by performing even make risk-related decisions, will not be treated as bearing important control functions.