Focus on the economic substance
First of all, it can be reassuringly put on the record that the legal framework for transfer pricing was not radically changed by the BEPS project. The result of BEPS can be summarised – in a somewhat simplified way – as the “modernisation of the arm’s length principle”. The characteristic feature of this modernisation consists in having an even stronger focus on the issue of economic substance according to BEPS when verifying the arm’s length nature of transactions. This focus on the economic substance can most evidently be understood by looking at the section on “Risks” in the OECD Guidelines from 2017 (Section D 1.2.1) – this was massively expanded. In a total of 50 paragraphs (the single biggest section of the complete guidelines), here the OECD emphasised that when the transfer pricing is being verified the relevant risks need to be identified and, subsequently, based on both the contractual allocation as well as, in particular, the actual management of economic risks.
In this case, the contractual allocation merely provides a first step in the analysis. Given that the allocation of risks frequently coincides with the entitlement to participate in business profits (or to a share of the residual profits), the OECD has stressed that, under tax law, such an entitlement may only be granted to an enterprise that also actually has the economic possibility to exert influence on these risks (via risk management and risk mitigation) and likewise has the financial capacity to bear these risks.
While, already prior to BEPS, functional and risk analyses should have formed the core of any transfer pricing system, the importance of such analysis for the sustainability for tax purposes of such systems has been amplified once again. As regards control over risks, the OECD has now clarified, for the first time, that the operational execution of risk management can indeed be outsourced, however, the business risks always have to lie with the enterprise that also bears the contractual risks. To this end, the staff of this enterprise have to have the requisite skills and (decision-making) competencies and proof of this shall be provided upon request.
Interim conclusion: The OECD’s tax policy objective, which all fiscal authorities support, is clear – to prevent business profits being shifted to “letterbox companies” via the contractual allocation of risks, in the future. For Germany, the more stringent requirements with respect to the obligations to provide documentary evidence on economic substance manifest themselves in the Ordinance on the Nature, Content and Extent of German Transfer Pricing Documentation Requirements (revised in 2017).
Description of economic substance in inter-company agreements
Regardless of the many discussions, BEPS should not generally be a reason for concern or for doing things for the sake of doing them. This is because, in principle, transfer pricing systems that complied with the arm’s length principle prior to BEPS will remain as such within the framework of BEPS. In particular, for taxpayers whose transfer pricing is closely linked to business procedures and for whom substance is not an issue there is hardly cause for concern.
Unfortunately, BEPS nevertheless has resulted in an increased need for documentation as well as additional potential for conflict within the scope of upcoming tax audits. The respective effort (time-wise as well as financial) and risks can however be minimised to a large extent by proactively reviewing existing inter-company agreements. In particular, you should check to see if the existing agreements fully reflect, in a comprehensible way, the contractual allocation of functions and risks.
Example: Accordingly, in the case of make-to-order agreements or distributor agreements you would have to check, for example, whether or not major strategic decisions were actually – and demonstrably – being taken by the ordering party (principal). In this connection, you should likewise immediately think about how, if requested to do so, you could provide proof of the requisite substance for that at the level of the principal. Moreover, you should check to see if the contractual agreements are actually being properly implemented. If entities that perform routine functions (e.g. make-to-order manufacturers) report volatile net profits, or even (permanent) losses then this could be an indication that the contractual agreement and the economic substance are not sufficiently mutually compatible and thus, from a tax perspective, there are risks. Frequently, selective contractual adjustments can be sufficient here in order to reduce these types of risks.
Particular documentation requirements for intangible assets
The rules on intangible assets have constituted a specific focus of BEPS. The above comments on the increased importance of economic substance apply here analogously. In this context it has to be noted that, in the future, legal ownership by itself will no longer be sufficient to allocate (residual) profits to a company that arise from the commercialisation of rights. Within the scope of audits, it will be necessary to demonstrate which company has assumed the economic functions (risks) in relation to the development, further enhancement, protection, preservation and commercialisation and what importance has been attributed to the respective functions for the intangible asset. The respective allocations should be properly reflected both in contract research agreements (strategic objectives, monitoring of milestones, performance-unrelated remuneration) as well as in licensing agreements (right to grant sub-licences, specifications and participation in marketing initiatives, etc.)
Recommendation: By reviewing inter-company agreements it will be possible to efficiently ensure that economic substance and the profit allocation arising from the agreements are mutually compatible. A consistent contractual basis will make a major contribution to the minimisation of tax risks in the area of transfer pricing.