Understanding risks assumed in comparability analysis
Risk assumption is a key consideration in transfer pricing because it affects the expected returns of parties to a related party transaction. In a comparability analysis, it is not enough to identify which risks are stated in the contract. Taxpayers should also assess which party controls the economically significant risks and has the financial capacity to assume their consequences.
Why risk analysis is important
A proper risk analysis helps determine whether the allocation of profits between related parties is consistent with the arm's length principle. Generally, a party that assumes greater economically significant risks may expect a higher potential return, if it has the capability and authority to manage those risks.
In a functions, assets, and risks analysis, the latter supports the selection of reliable comparables by examining whether the tested party and comparable independent parties bear similar risks under comparable circumstances.
How risks are evaluated
The OECD approach employes a six-step risk analysis to accurately delineate the risks in controlled transactions. The analysis begins by identifying the economically significant risks in the transaction and reviewing the contractual arrangements to determine how those risks are allocated between associated enterprises. A functional analysis is then performed which essentially determines which entities makes decisions regarding the assumption, management, and mitigation of risk, as well as which entities have the financial capability to bear the consequences if those risks materialize.
A party may be regarded as assuming a risk when it exercises control over that risk and has the financial capacity to bear its potential consequences. If the contractual allocation is not aligned with the parties' actual conduct, the risk allocation may need to be analyzed based on substance rather than form.
Once the risk allocation has been accurately delineated, the final step is to determine the arm’s length pricing so that the returns associated with economically significant risks accrue to the entity that both controls and assumes those risks, while other entities are compensated only for the functions they perform.
Common risks considered
Common risks reviewed in a comparability analysis include market risk, inventory risk, credit risk, foreign exchange risk, operational risk, product liability risk, research and development risk, staff turnover risk and financial risk. The relevance and significance of each risk will depend on the nature of the controlled transaction and the industry in which the parties operate.
Manufacturers are generally exposed to risks related to production, inventory, product quality, and market demand. Distributors commonly bear market, inventory, credit, and foreign exchange risks. Meanwhile, service providers, including business process outsourcing (BPO) entities, are often exposed to operational risks, staff turnover risks, service quality risks, and customer concentration risks.
Why risk allocation matters in selecting comparables
The extent to which risks are assumed may affect both the expected returns of the tested party and the selection of reliable comparables. For example, a limited-risk distributor typically performs routine distribution functions and may be protected from significant market, inventory, or credit risks through its contractual arrangements with related parties. As a result, it would generally be compared with independent distributors that perform similar functions and assume comparable levels of risk.
In contrast, a full-fledged distributor that bears market, inventory, and credit risks, and has greater autonomy in its business operations, would ordinarily expect a higher level of return. Comparing a limited-risk distributor with a full-fledged distributor may therefore lead to unreliable results because their risk profiles and profit expectations differ significantly.
Similarly, a contract or toll manufacturer generally performs manufacturing activities on behalf of a related party and may have limited exposure to market and inventory risks. On the other hand, a full-fledged manufacturer often assumes broader entrepreneurial risks, such as capacity utilization, inventory obsolescence, product liability, and fluctuations in market demand. Consequently, the selection of comparables should consider the nature and extent of risks assumed by the tested party to improve the reliability of the comparability analysis.
(Section 6(b)(2), Revenue Regulations No. 2-2013; Revenue Audit Memorandum Order No. 1-2019; Chapter I, Section D.1.2.1, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, 2022)
For Philippine transfer pricing purposes, taxpayers should ensure that contractual risk allocation is supported by actual conduct, decision-making functions, and financial capacity, as these may be considered by the BIR in reviewing the taxpayer's functions, assets, and risks analysis and comparability analysis. A well-documented risk analysis strengthens the reliability of comparability analysis and helps support compliance with the arm's length principle.