BEPS Action 9: Risk and capital

SUITS THE C-SUITE By Maria Cristina V. Chan

Business World (11/23/2015 – p.S1/3)

(Second of two parts)

In last week’s article, we started discussing Action 9 of the Organisation of Economic Co-operation and Development’s (OECD’s) Base Erosion and Profit Shifting (BEPS) 2015 Final Reports, which specifically addresses transferring and allocating risk and capital among group members of a multinational entity (MNE). In particular, Action 9 provides guidelines to ensure that inappropriate returns will not accrue to an entity solely because it has contractually assumed risks or provided capital.

We discussed the first three steps that address the misallocation of risk, which are: (1) Identifying economically significant risks; (2) contractual assumption of risk; and, (3) Functional analysis in relation to risk. We now continue with the other steps and a discussion on supply of fund.

Step 4: Interpreting steps 1-3

The next step is to interpret the information resulting from Steps 1-3 and to determine whether the contractual assumption of risk is consistent with the conduct of the parties and the other facts. This is carried out by analyzing:

1) Whether the associated enterprises follow the contractual terms; and,
2) Whether the party assuming risk exercises control over the risk and has the financial capacity to assume risk.

For this purpose, Action 9 provides the following general guidelines:

· Where a party contractually assumes a risk and applies such in its conduct, and also exercises control over the risk and has the financial capacity to assume the risk, no further analysis is necessary.

· Where differences exist between the contractual terms related to risk and the conduct of the parties which are economically significant, and would be taken into account by third parties in pricing the transaction between them, the parties’ conduct in the context of the consistent contractual terms should generally be taken as the best evidence concerning the intention of the parties in relation to the assumption of risk.

· If it appears that more than one entity is capable of exercising control over a risk, the entity actually exercising control through capability and functional performance is the one that assumes and controls the risk.

· If more than one party exercises control over a specific risk, the party that has the financial capacity to assume the risk is the one that assumes the risk.

· If two or more parties assume a specific risk, together control the specific risk, and each has the financial capacity to assume their share of the risk, such assumption of risk should be respected.

· If the party assuming the risk either does not control the risk or does not have the financial capacity to assume the risk, further analysis under Step 5 needs to be performed.

Step 5: Allocation of risk

In allocating risk, Action 9 provides that risk should be allocated to the enterprise (1) exercising control and (2) having financial capacity to assume the risk.

If more than one enterprise exercises control, allocation should be made to the enterprise that exercises the most control, while the other should be remunerated based on the importance of the control activities performed. Where no enterprise is identified as having control over the risk and financial capacity to assume it, the guidance provides that further analysis needs to be conducted to identify the underlying reasons and actions that led to such situation. An assessment of the commercial rationality of the transaction may also be necessary.

Step 6: Pricing of the transaction, taking into account the consequences of risk allocation

According to the guidance in Action 9, the accurately delineated transaction should be priced in accordance with the tools and methods available, taking into account the financial and other consequences of risk-assumption. The guidance provides that the assumption of risk should be compensated with an appropriate anticipated return (i.e., sharing in the potential upside and downside), and risk mitigation should be appropriately (and separately) remunerated. Where a party contributes to the control of risk, but does not assume the risk, such control function should also be appropriately (and separately) compensated commensurate with the contribution to control. A party which, under these steps, does not assume the risk, nor contributes to the control of that risk, will not be entitled to unanticipated profits or required to bear unanticipated losses arising from that risk.

If the above steps are used in analyzing risk in a controlled transaction, the risk of misallocation of risk would and should be addressed, in order to accurately delineate the actual transaction in respect to a particular risk.


The supply of funds involves risks; hence, it is also discussed in Action 9. It is not uncommon within an MNE group for one group member to provide funding to another group member. Normally, the group member providing the funds should be appropriately compensated. However, where a capital-rich group member without any other relevant economic activities (i.e., a “cash box”) provides funding, but cannot control financial risks in relation to the funding, the guidance provides that said cash box is entitled to no more than a risk-free return, or even less if the transaction is determined to be commercially irrational.

In summary, with the issuance of Action 9, MNE groups should now ensure that the contractual allocation of risk in relation to transactions among group members matches the actual allocation of risk and is compensated accordingly. Compensation must correspond to the value created through the underlying economic activity carried out by the members of an MNE group. Moreover, the use of a capital-rich, low-functioning group member as source of funding should now be avoided.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.

Maria Cristina V. Chan is a Tax Senior Director of SGV & Co.