What it means to align profits with value-creation activities Profit potential is a function of risk , risk is connected with decision-making , and decisions are made by people . At arm ’ s length , no rational economic actor would be willing to accept significant risk — and therefore profit potential — without the ability to manage that risk . Broadly speaking , key business risks are those that may disrupt a business ’ s ability to create value for its shareholders or other key stakeholders . The significant people functions ( e . g . “ DEMPE ” functions 4 ) required to manage business risk are often referred to collectively as “ managerial substance .” Having managerial substance means having employees with the experience and expertise needed to perform management functions to take on , mitigate , or lay off key risks in the business . 5 These employees are responsible and accountable for , and authorized to make , key business decisions . These decisions may or may not include outsourcing the execution of value-add activities ( such as contract research and development , manufacturing , marketing , sales facilitation , and distribution activities ) to related or third-party providers . As decision-makers determine the nature and extent of risks assumed and managed , it can be argued that to align profits with value-creation activities is to align managerial substance with profit potential . The conduct of related parties within a group determines how each related party will be characterized for transfer-pricing purposes . Simply stated , limited-risk or routine entities are entitled to stable profits ( for example , a fee calculated from costs with a markup or an operating margin as a percentage of sales ) regardless of how the group performs as a whole . Conversely , an entrepreneurial entity employs the key decision-makers that entitle it to the residual , non-routine profits ( or losses ). A common transfer pricing risk is that a revenue authority will assert that key value-driving activities are being directed , controlled , and authorized by employees in a jurisdiction where a related party has been characterized as a limited-risk entity . To address this risk , here are four sample questions you may want to ask about your business : 1 . Who is designing , directing , authorizing , and / or evaluating core business strategies ? 2 . Do your “ limited-risk ” entities autonomously perform risk-mitigation functions that manage key business risks ? 3 . What can be inferred from your employees ’ LinkedIn profiles and from internal corporate communications in this regard ? 4 . Does the contractual allocation of risk to a related party align with the actual conduct of the related party ? That is , have any contractually allocated risks ( and associated profit potential ) been assigned to an entity that is functionally deficient ?
An ounce of prevention is worth a pound of cure One advantage a taxpayer has over a revenue authority is an intimate understanding of its business . This can be a valuable advantage in a tax dispute , especially if the facts are documented contemporaneously ( in Canada this means within six months of the taxation yearend ). Because a transfer-pricing audit can occur up to seven years after the taxation year-end in question ( potentially after a new IT system implementation , for example , or after key employees leave the company ), contemporaneous documentation may lend the taxpayer credibility and prevent the perception of convenient hindsight bias . Therefore , whatever the size of your business , it ’ s critical to document the facts on an entity-by-entity level each and every year to realize your greatest advantage in a transfer pricing audit . What are the facts ? In the event of a transfer pricing audit , an intercompany legal agreement is typically the first piece of evidence reviewed by a revenue authority , as it sets out the intentions of the related parties from the outset . Such agreements provide a starting point to understanding the related-party transaction ( s ) under review and how the responsibilities , risks , and expected benefits from their interaction are to be divided ; these are then compared to the actual conduct of the related parties .
4
In the context of intellectual property , DEMPE functions are development , enhancement , maintenance , protection , and exploitation activities .
5
Key business risks could include research and development , market , inventory , credit , foreign exchange , regulatory , product liability , and / or warranty risks .
6
OECD ( 2010 ) OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2010 , OECD Publishing , dx . doi . org / 10.1787 / tpg-2010-en .
38 CPABC in Focus • Mar / Apr 2017