Transfer pricing perspectives: Winds of Change - PwC

A simplified illustration of the issueThe issue has traditionally arisen mostfrequently in practice in industries wherelong‐term contracts are common andearly‐stage decisions on specificationand price can have significant profitor loss repercussions over the life of acontract. These may relate to industrieslike professional services, financial orcommodity trading, and construction,but for the purpose of illustration wewill consider the kind of contract that acomponent supplier might enter into in theaerospace industry. For simplicity, assumeall of the key contractual terms, includingspecification and prices are decided bya contracting committee in location A.That committee will also decide whichof the manufacturing entities within thegroup should deliver the contract; in thiscase, location B delivers the contract inits entirety. The costs of the committeeare recharged throughout the group on acost‐plus basis.Location B sells finished parts directlyto the customer. Six years in to a 25-yearcontract, location B is experiencing heavylosses, with no prospect of significantimprovement. Mainly, this is a consequenceof unrealistic assumptions made by A in thecontracting process.The OECD Guidelines say that if risks areallocated to the party to the controlledtransaction that has relatively less controlover them, the tax authority may wish tochallenge the arm’s-length nature of suchrisk allocation 6 . In this simplified example,location B did not have control over thedecisions that gave rise to risks that it hasborne to its detriment. One might say that,at arm’s-length, B would have been morecareful about accepting the contract, butin practice B had no choice, it was a ‘donedeal’. Cases like this often end up witha lump‐sum transfer pricing adjustmentbetween location A and B, such that A bearsthe portion of the loss which has arisenas a consequence of the decisions whichit took during the contracting process.Important supplementary issues then needto be addressed, in particular in respectof the nature and timing of this adjustingpayment and the associated accounting andtax consequences.A critical aspect that is left out of thisexample in order to keep it simple is thelocation of the capital within the groupwhich underpins the ability to take thecontract risk in the first place. Often thisis in neither location A or B, and alsoneeds to be taken into account in thepricing solution. The main purpose of theillustration is to point out that the needfor mechanisms to match the outcome ofa risky decision with the location of thedecision is not new. In practice adjustmentsof this nature have in the past been mainlyabout loss reallocation, because losses getmost tax authority attention. But as theOECD Guidelines point out 7 , by definitionthere should be potential for upside anddownside in the risk‐taking location 8 . Justas there was no mechanism in the exampleto attribute losses to location A, therewould equally have been no mechanismto attribute profits had the risks forwhich they were responsible resulted inhigher profitability.6OECD Transfer Pricing Guideli.e. Para 9.22.7OECD Transfer Pricing Guideli.e. Para 1.45.8“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 thedegree to which the risks are actually realised” (OECD Transfer Pricing Guideli.e. Para 1.45).34 Transfer Pricing Perspectives. October 2011