Page 163 - SAIT Compendium 2016 Volume2

PN 7/1999 Income Tax acT: PracTIce noTes PN 7/1999
6.4 A functional analysis can assist in identifying the intangibles and the way in which they are used. While judgment will still be needed to determine an appropriate reward for their use, a better decision is likely to be made once the nature of the intangibles and their role in the pro t-earning process are properly understood.
6.5 For example, an enterprise may be the legal owner of a trademark and the name that it legally protects. It may attribute to these trademarks a high value for which it seeks a direct reward. Under licence, subsidiary enterprises in different countries may separately produce, market and support goods bearing this name and trademark. A functional analysis should identify each party’s contribution to any manufacturing intangible or marketing intangible. If the economic contribution to the intangible is shared between the parties, but only one party enjoys legal ownership of the intangible, the other party would, at arm’s length, be expected to seek some form of reward for its contribution. This would need to be taken into account in determining the arm’s length price, and could in uence the selection of a transfer pricing method or the manner by which comparability is assessed against uncontrolled licence agreements.
7 Treatment of Risk
7.1 Asigni cantportionoftherateofreturnearnedbyacompanyre ectsthefactthatthecompanyisbearingrisks of various kinds. In the open market, this assumption of increased risk will be compensated by an increase in the potential expected return (although this does not mean that the actual return must necessarily also be higher, because this will depend on the degree to which the risks borne are actually converted into realised pro ts).
7.2 Anappraisalofriskisalsoimportantindeterminingarm’slengthprices.Forexample,controlledanduncontrolled transactions will not be comparable if there are signi cant differences in the risks assumed for which appropriate adjustments cannot be made.
7.3 Thepossiblerisksassumedthatshouldbetakenintoaccountinthefunctionalanalysisinclude: (a) risks of change in cost, price, or stock;
(b) risks relating to success or failure of research and development;
(c) nancial risks, including change in the foreign exchange and interest rates;
(d) risks of lending and payment terms;
(e) risks for manufacturing liability; and
(f) business risk related to ownership of assets or facilities.
7.4 The functions carried out will, to some extent, determine the allocation of risks between the parties and, therefore, the conditions each party would expect in arm’s length dealings. For example, a distributor taking on the responsibility for marketing and advertising is risking its own resources in these activities. It would, therefore, be expected to have a commensurately higher anticipated return from the activity than if it did not undertake these functions. This is in contrast to a distributor acting merely as an agent and who is reimbursed for its costs and receives the income appropriate to that lower risk activity. Similarly, a contract manufacturer or a contract research provider that takes on no meaningful risk would be entitled to a smaller return than if it had assumed the risk.
7.5 Consistencyofriskallocationwitheconomicsubstance:
(a) It must also be considered whether a purported allocation of risk is consistent with the economic substance of
the transaction. In this regard, the parties’ conduct should generally be taken as the best evidence concerning the true allocation of risk. A manufacturer may, for example, sell property to a related distributor in another country and claim that the distributor assumes all of the exchange rate risk. However, if the transfer price appears to be adjusted to insulate the distributor from the effects of exchange rate movements, the purported allocation of exchange rate risk may be challenged on the basis that it is inconsistent with the conduct of the parties.
(b) An additional factor to consider in examining the economic substance of a purported risk allocation is the consequence of such an allocation in arm’s length transactions. In arm’s length dealings it generally makes commercial sense for parties to be allocated a greater share of those risks over which they have relatively more control, and from which they can insulate themselves more cheaply than the other party can.
(c) There are many risks, such as general business cycle risks, over which normally neither party has signi cant control. At arm’s length, these risks could be allocated to either party to a transaction. Analysis is required to determine to what extent each party bears such risks in practice.
(d) For example, when considering who bears any currency exchange or interest rate risk, it will be relevant to consider the extent to which the taxpayer or the multinational has a business strategy that deals with the management of such risks. Financial arrangements such as hedges, forward contracts, as well as put and call options, both ‘on-market’ and ‘off-market’, are now in common use. Where, as a result of the multinational’s business strategy, the taxpayer bearing the currency and interest rate risk fails to address such exposure, it will be evident that the taxpayer is not actually bearing the economic currency and interest rate risk. Such a practice, if not accounted for appropriately, could lead to signi cant pro ts or losses being made which are capable of being inappropriately sourced in the most advantageous place to the multinational.
8 Concluding Comments
8.1 The preparation of a functional analysis is an important tool that can assist in ensuring that an arm’s length consideration is determined in accordance with internationally accepted principles.
8.2 Afunctionalanalysiscanbeperformedwithvaryinglevelsofdetailandcanserveavarietyofpurposes.Thescope of the analysis will be determined by the nature, value and complexity of the matters covered by international dealings and the nature of the taxpayer’s business activities. These include the strategies that the enterprise pursues and the features of its products or services. Also, factors such as the pricing method that is used and availability of data will affect the extent to which the analysis can be conducted.
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