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TP Risk Simulation - A Practical Method for the Arm’s Length Reallocation of Risks in Business Restructurings
The 2010 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations require that multinational enterprises (MNEs) restructuring their business model thoroughly examine the allocation of risks between associated enterprises. Taxand France, Netherlands, Spain, UK and US describe a methodology that enables a quantification of the allocation of risks in a business restructuring, and helps to evaluate whether the allocation of risk is arm's length. The method uses the technique of economic simulation modelling.
On 22 July 2010, the OECD Council published the 2010 version of the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. The revised version contains a new Chapter IX on the transfer pricing aspects of business restructurings. Chapter IX aims to provide a formerly lacking OECD guidance on the transfer pricing aspects of the conversion of, amongst others, full-fledged distributors into limited-risk distributors (''LRD'') or commissionaires for a related party that may operate as a principal.
One of the critical issues1 covered by Chapter IX is the arm's length allocation of risks between principal and the LRD or commissionaire. In paragraph 9.10 the report states:
''Risks are of critical importance in the context of business restructurings. An examination of the allocation of risks between associated enterprises is an essential part of the functional analysis. Usually, in the open market, the assumption of increased risk would also be compensated by an increase in the expected return, although the actual return may or may not increase depending on the degree to which the risks are actually realised (see paragraph 1.45).2 Business restructurings often result in local operations being converted into low risk operations (e.g. ''low risk distributors'', or ''low risk contract manufacturers'') and being allocated relatively low (but generally stable) returns on the grounds that the entrepreneurial risks are borne by another party to which the residual profit is allocated. It is therefore important for tax administrations to assess the reallocation of the significant risks of the business that is restructured and the consequences of that reallocation on the application of the arm's length principle to the restructuring itself and to the post-restructuring transactions.''
The notion expressed in the new chapter is conform to the general notion in economic theory, that there is a positive correlation between risk and expected return: the higher the risk, the higher the expecte return. Although the 2010 Guidelines emphasise in general terms that there should be an arm's length relation between risk and expected profit, they give no clear guidance on how MNEs and tax administrations should evaluate that relation.
Taxand France, Netherlands, Spain, UK and US aim describe a method for doing so. Before describing the method, attention should be given to the theoretical relation between risk and return.
Your Taxand contacts for further queries are
Antoine Glaize, Taxand Global Transfer Pricing Leader
T. +33 1 70 38 88 28
T. +31 20 301 66 33
T. +31 20 301 66 33
T. +44 207 715 5234
T. +1 415 490 2253