Demonstrating Control Over Risk (Transfer Pricing)

The OECD's February 2020 publication with Transfer Pricing Guidance on Financial Transactions has equipped tax authorities with enhanced tools to scrutinize taxpayers' transfer pricing policies, which are increasingly being utilized in practice.

A crucial aspect of this OECD guidance is the further reiteration of the requirement for taxpayers to demonstrate sufficient financial capacity and effective risk control over their financial transactions, both when initiating new transactions and throughout their duration. Despite this, the guidance falls short on providing specific practical steps for taxpayers to substantiate their financial and functional capacity beyond the general six-step analysis for risk allocation (and some self-evident examples).

According to the guidance, if there is an absence or lack of financial capacity and/or control functions concerning significant risks, the remuneration for such transactions may be reallocated to the related party that possesses these capacities. The legal beneficiary, lacking financial capacity or risk control functions, would only qualify for a typically low risk-free return. This principle is adopted by the Dutch State Secretary of Finance in the 2022 Dutch Transfer Pricing Decree.

Practically, this can lead to double taxation, where income is taxed at both the legal beneficiary and the related party levels. The resolution mechanisms for resolving such double taxation are often suboptimal, with mutual agreement procedures (MAPs) potentially taking over two years to conclude, if at all. Consequently, it falls upon taxpayers and their advisors to persuade local authorities to make a one-sided correction. Therefore, robust defensive documentation is crucial to mitigate tax risks in these situations effectively.

For financial transactions structured through holding companies, it is imperative to document that the directors have the requisite functional capacity to control risk. Taxpayers should prove that their directors and/or staff can and do perform the following functions:

• Deciding to take on, lay off, or decline risk-bearing opportunities;
• Determining how to respond to associated risks and make related decisions; and
• Implementing measures to mitigate risk outcomes.

Taxpayers’ Transfer Pricing documentation should identify the individuals performing these functions, whilst also documenting the options realistically available that were evaluated. Since the taxpayer has to substantiate that these risk control functions were or are being executed, it is also advisable to document internal communications on these matters and/or record risk control measures in board meeting minutes.

In conclusion, navigating these challenges requires meticulous documentation to demonstrate genuine risk control, ensuring that your financial transactions can withstand scrutiny and allows avoiding the pitfalls of double taxation.

In case you require any assistance in relation to the above, or any other tax matters, please do not hesitate to reach out to your contact within Taxperience. We are more than happy to assist you.