2.4.1 Contractual terms of the transaction

A transaction is the consequence or expression of the commercial or financial relations between the parties. Where a transaction has been formalized by the associated persons through written contractual agreements, those agreements provide the starting point for delineating the transaction between them and how the responsibilities, risks, and anticipated outcomes arising from their interaction were intended to be divided at the time of entering into the contract.

The terms of a transaction may also be found in communications between the parties other than a written contract. The written contracts alone are unlikely to provide all the information necessary to perform a transfer pricing analysis. As such, further information will be required by taking into consideration evidence of the commercial or financial relations provided by the economically relevant characteristics in the other four categories (see paragraph 2.2.5). Taken together, the analysis of economically relevant characteristics in all five categories provides evidence of the actual conduct of the associated persons. The following example illustrates the concept of clarifying and supplementing the written contractual terms based on the identification of the actual commercial or financial relations.

Company P is the parent company of an MNE Group situated in Country P. Company S, situated in Country S, is a wholly-owned subsidiary of Company P and acts as an agent for Company P's branded products in Country S market. The agency contract between Company P and Company S is silent about any marketing and advertising activities in Country S that the parties should perform. Analysis of other economically relevant characteristics and in particular the functions performed, determines that Company S launched an intensive media campaign in Country S in order to develop brand awareness. This campaign represents a significant investment for Company S.

From the example above, the characteristics of the transaction that are economically relevant are inconsistent with the written contract between the associated persons. Therefore, the actual transaction that should be delineated for purposes of the transfer pricing analysis is as per the conduct of the parties.

In transactions between independent parties, the divergence of interests between the parties ensures that contractual terms concluded reflect the interests of both parties and will ordinarily seek to hold each other to the terms of the contract. The contractual terms will be ignored or modified if it is not in the interests of both parties. However, the same divergence of interests may not exist in the case of associated persons, or any such divergences may be managed in ways facilitated by the control relationship and not solely or mainly through contractual agreements.

Therefore, it is important to examine whether the arrangements reflected in the actual conduct of the parties substantially conform to the terms of any written contract, or whether the associated persons' actual conduct indicates that the contractual terms have not been followed, or do not reflect a complete picture of the transactions, or have been incorrectly characterized or labelled by the persons, or are a sham.

Where there are material differences between contractual terms and the conduct of the associated persons in their relations with one another, such as the functions they actually perform, the assets they actually use, and the risks they actually assume, considered in the context of the contractual terms, IRBM has the right, based on the factual substance, to accurately delineate the actual transaction.

2.4.2 Functional Analysis of Functions Performed, Risks Assumed and Assets Employed

In transactions between two independent persons, compensation usually will reflect the functions that each person performs (taking into account assets used and risks assumed). Therefore, in delineating the controlled transaction and determining comparability between controlled and uncontrolled transactions or entities, a functional analysis is necessary. This functional analysis seeks to identify the economically significant activities and responsibilities undertaken, assets used or contributed, and risks assumed by the parties to the transactions. The analysis focuses on what the parties actually do and the capabilities they provide.

For this purpose, the structure and organization of the associated persons and how they influence the context in which the MNE operates must be explained, in particular, how value is generated by the group as a whole, the interdependencies of the functions performed by the associated persons with the rest of the group, and the contribution that the associated persons make to that value creation

Functions are activities performed by each person in business transactions such as procurement, marketing, distribution and sales. The principal functions performed by the associated person under examination should be identified first. Any increase in economically significant functions performed should be compensated by an increase in profitability of the person.

Usually, when various functions are performed by a group of independent persons, the party that provides the most effort and, more particularly, the rare or unique functions would earn the most profit. For example, a distributor performing additional marketing and advertising function is expected to have a higher return from the activity than if it did not undertake these functions.

In comparing functions performed, it is also important to identify and consider the assets (tangible and intangible) that are employed, or are to be employed, in a transaction. This includes the analysis of the type of assets used, (e.g. plant and equipment, the use of valuable intangibles, financial assets) and the nature of the assets used (e.g. the age, market value, location, property right protections available, etc.

  1. Tangible assets employed

    Tangible assets such as property, plant and equipment are usually expected to earn long-term returns that commensurate with the business risks assumed. Profitability of a company should rightfully increase with the increase in the amount, as well as the degree, of specificity of assets employed. Quantifying these amounts whenever possible helps determine the level of risks borne and the level of profit a company should expect.

  2. Intangible assets employed

    Intangible assets are also expected to generate returns for the owners by way of sales or licensing. It is thus essential to identify the parties to whom the returns generated are attributable.

Risk is inherent in business activities and persons undertake commercial activities because they seek opportunities to make profits. Identifying risks goes hand in hand with identifying functions and assets and is integral to the process of identifying the commercial or financial relations between the associated persons and of accurately delineating their transactions. Evaluation of risks assumed is crucial in determining arm's length prices with the economic assumption that the higher the risks assumed, the higher the expected return.

Controlled and uncontrolled transactions are not comparable if there are significant differences in the risks assumed which appropriate adjustments cannot be made. Therefore, risks assumed by each party has to be identified and considered since the actual assumption of risks would influence the prices of the transactions between the associated persons and is an economically relevant characteristic that can be significant in determining the outcome of a transfer pricing analysis.

In this section references are made to terms that require initial explanation and definition as below:

  1. The term "risk management" is used to refer to the function of assessing and responding to risk associated with commercial activity. Risk management comprises of three elements:

    1. the capability to make decisions to take on, lay off, or decline a risk-bearing opportunity, together with the actual performance of that decision-making function;
    2. the capability to make decisions on whether and how to respond to the risks associated with the opportunity, together with the actual performance of that decision-making function; and
    3. the capability to mitigate risk, that is the capability to take measures that affect risk outcomes, together with the actual performance of such risk mitigation.

  2. "Risk assumption" means taking on the upside and downside consequences of the risk with the result that the party assuming a risk will also bear the financial and other consequences if the risk materializes. A party performing part of the risk management functions may not assume the risk that is the subject of its management activity, but may be hired to perform risk mitigation functions under the direction of the risk-assuming party.

  3. Financial capacity to assume risk can be defined as access to funding to take on the risk or to lay off the risk, to pay for the risk mitigation functions and to bear the consequences of the risk if the risk materializes. Access to funding by the party assuming the risk takes into account the available assets and the options realistically available to access additional liquidity, if needed, to cover the costs anticipated to arise should the risk materialize.

  4. Control over risk involves the first two elements of risk management defined in (a), that is:

      1. the capability to make decisions to take on, lay off, or decline a risk-bearing opportunity, together with the actual performance of that decision-making function; and
      2. the capability to make decisions on whether and how to respond to the risks associated with the opportunity, together with the actual performance of that decision-making function.

    It is not necessary for a party to perform the day-to-day mitigation, as described in (a)(iii) in order to have control of the risks. Such day-to-day mitigation may be outsourced, as Example 2 illustrates. However, where these day-to-day mitigation activities are outsourced, control of the risk would require capability and performance to determine the objectives of the outsourced activities, to decide whom to hire as provider of the risk mitigation functions, to assess whether the objectives are being adequately met, and where necessary, to decide whether to adapt or terminate the contract with that provider.

  5. Risk mitigation refers to measures taken that are expected to affect risk outcomes. Such measures may include measures that reduce the uncertainty or measures that reduce the consequences in the event that the downside impact of risk occurs.

The concept of control may be illustrated by the following examples.

Company A appoints a specialist manufacturer, Company B to manufacture products on its behalf. The contractual arrangements indicate that Company B undertakes to perform manufacturing services, but that the product specifications and designs are provided by Company A, and that Company A determines production scheduling, including the volumes and timing of product delivery.

The contractual relations imply that Company A bears the inventory risk and the product recall risk. Company A hires Company C to perform regular quality controls of the production process. Company A specifies the objectives of the quality control audits and the information that Company C should gather on its behalf. Company C reports directly to Company A. Analysis of the economically relevant characteristics shows that Company A controls its product recall and inventory risks by exercising its capability and authority to make a number of relevant decisions about whether and how to take on risk and how to respond to the risks. Besides that, Company A has the capability to assess and take decisions relating to the risk mitigation functions and actually performs these functions. These include determining the objectives of the outsourced activities, the decision to hire the particular manufacturer and the party performing the quality checks, the assessment of whether the objectives are adequately met, and, where necessary, to decide whether to adapt or terminate the contracts.

Assume that an investor hires a fund manager to invest funds on its account. Depending on the agreement between the investor and the fund manager, the latter may be given the authority to make portfolio investments on behalf of the investor on a day to-day basis in a way that reflects the risk preferences of the investor, although the risk of loss in value of the investment would be borne by the investor. In such an example, the investor is controlling its risks through four relevant decisions:

  1. the decision about its risk preference and therefore about the required diversification of the risks attached to the different investments that are part of the portfolio,
  2. the decision to hire (or terminate the contract with) that particular fund manager,
  3. the decision of the extent of the authority it gives to the fund manager and objectives it assigns to the latter, and
  4. the decision of the amount of the investment that it asks this fund manager to manage.

Moreover, the fund manager would generally be required to report back to the investor on a regular basis as the investor would want to assess the outcome of the fund manager's activities. In such a case, the fund manager is providing a service and managing his business risk from his own perspective (e.g. to protect his credibility). The fund manager's operational risk, including the possibility of losing a client, is distinct from his client's investment risk.

This illustrates the fact that an investor who gives to another person the authority to perform risk mitigation activities such as those performed by the fund manager does not necessarily transfer control of the investment risk to the person making these day-to-day decisions. For entities claiming to have control over risk by outsourcing risk mitigation activities, they will have to give evidence of a sequential and scheduled monitoring and administering done by them. In cases where monitoring is performed online, the controlling entity should be able to substantiate and show proof of those activity performed by them.

Also, where a controlling entity has control over the activity done by their local subsidiary or related party, the controlling entity may have Permanent Establishment (PE) in Malaysia (subject to Double Taxation Agreement between Malaysia and the relevant country) as the local entity will be said to be performing activity on behalf of the controlling party.