Risk in TP: the four conditions for effective risk allocation

Why third party agreements are often inappropriate for intra-group transactions

Most people would agree that there’s little point in benchmarking a controlled transaction until that transaction has been properly delineated.

It would be as futile as attempting to value a property without first identifying its location.

Unconnected third parties instinctively price risk in to their transactions, by asking themselves questions such as ‘what happens if…?’ The answer to such questions – such as whether an agent is remunerated by commission or on a time-and-materials basis – can have a huge impact on the commerciality of arrangements.

Accurately establishing (and evidencing) the allocation of risk is a therefore key part of delineating a controlled transaction for transfer pricing purposes.

Based on the OECD TP Guidelines, four conditions must be present in order for a particular risk (or set of risks) to be allocated to a specific entity in the context of related party transactions. Those conditions are set out in the diagram above.

Ex ante contractual allocation of risk is number one on the list. In some circumstances, it may be possible to argue for the allocation of risk in the absence of a clear contract. But facts are rarely conclusive, and the taxpayer will have lost the opportunity to establish a robust position by establishing unequivocal evidence up front.

Unfortunately, contractual clauses which give effect to risk allocation do not fall into neat categories, and therefore the relevant agreements need to be considered as a whole. Relevant contractual considerations may include:

• The presence or absence of warranties or indemnities
• The type of warranties (e.g. standard of care vs specific service levels)
• Caps on claims
• Exclusions of types of claims (e.g. consequential loss)
• Structure of remuneration (e.g. cost plus vs commission)
• Guarantees as regards minimum remuneration
• Treatment of specific issues such as inventory and third party creditors

It’s worth noting that condition 4 (conduct of the parties not inconsistent with the terms of the agreement) generally means that it’s not appropriate to use third party agreements as the starting point for drafting intercompany agreements. This is because third party agreements will often contain procedural provisions which are unlikely to be appropriate in an intra-group context. One exception is where the pricing of the transaction is based on an internal CUP, and intra-group transactions are managed in exactly the same way as equivalent transactions with third parties.

Finally, you might like to know that we'll be looking at the issue of risk analysis in more detail in a future episode of our podcast.

Article by Paul Sutton

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