The technology, media, and telecommunications (TMT) sector continues to evolve at pace, as organisations respond to the recent challenges brought about by factors such as increased interest rates, reduced economic growth, and enhanced regulatory obligations in many major economies. Strategies to address these challenges include the deployment of cutting-edge technologies such as generative AI (GenAI), streamlining operations to focus on core products and services, and continuing to invest in innovation.
Understanding the risks faced by TMT businesses, and the commercial responses, is essential to a robust transfer pricing approach. This is particularly the case given the recent enhanced focus on applying the transfer pricing risk allocation framework.
The risk allocation debate
One of the key outcomes of transfer pricing actions 8–10 of the OECD/G20 BEPS Project completed in 2015 was an expansion of the guidance on the analysis of risks. The 2010 version of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the OECD TPG) included six paragraphs on risk analysis in Chapter I; the 2017 update to the OECD TPG resulting from the BEPS Project extended the risk analysis guidance to 51 paragraphs and introduced a formal six-step framework to delineate risk assumption. The guidance particularly emphasised the importance of identifying economically significant risks and allocating their assumption based on the conduct of the parties rather than just the contracts, as well as making a distinction between control over risk and broader risk management functions.
Since its introduction, questions have arisen in two main areas:
How to decide which party manages and assumes the risk; and
How to price the transaction given the risk allocation determined at the first stage.
Differences in views around the risk allocation framework are currently a source of transfer pricing disputes. Observing recent transfer pricing court cases in various domestic courts, the positions with respect to risk allocation and the approach to reward control over risk are often key determinants of court judgments.
In January 2024, in the midst of this uncertainty, the UK tax authority His Majesty’s Revenue and Customs (HMRC) published guidance on analysing risk in controlled transactions in an attempt to improve certainty (INTM485025 – Transfer pricing operational guidance: Accurate delineation of the actual transaction: Risk). This internal guidance discusses the relevant paragraphs within the OECD TPG, setting out HMRC’s views on key areas.
TMT sector experience
The uncertainty is particularly felt by groups operating in the TMT industry, given factors such as the innovative and disruptive nature of businesses in the sector and the intensive role of intangibles in driving value in the industry, meaning business risks are often prominent and significant. In addition, the sector has seen a marked increase in the geographic dispersion of senior decision makers providing contributions to risk control through their activity.
The risk control analysis provides a basis for answering certain fundamental questions, which are often not straightforward given the complex and dynamic nature of companies in the industry, including:
Which group companies should earn a stable, fixed, or target profit margin and which companies should share in the variable residual profits and losses of the group?
As a company develops and expands in functional scope, at what point does it meet the threshold for acceding to earning the residual profits and losses?
When a risk control function migrates between companies, does this migration mean that something of value has transferred?
TMT sector considerations in undertaking risk analysis
Identification of economically significant risks
The first step of the risk allocation framework is to identify the risks that are economically significant to the controlled transaction, where the economic significance is informed by the scale and likelihood of the risk outcome to the transaction (OECD TPG, paragraph 1.71).
HMRC states in its guidance that the “risks which are necessarily assumed in the generation of residual profit are the group’s economically significant risks, and these may be instructive as to the economically relevant circumstances of its group members. As such they may be an economically relevant characteristic of any transaction those group members enter into (per paragraph 1.36)”. This reinforces the notion that the key commercial risks that drive the overall variability in profits and losses for the group should be a main focus in the identification of economically significant risks.
In the TMT sector, the playing out of these key commercial risks has been well publicised during the recent sector downturn. Risks have included technological and product obsolescence, including the shift away from traditional forms of video content consumption towards streaming. Risks associated with talent acquisition and retention to support growing tech businesses during the pandemic led to a boom in hiring, which some companies are now reversing through significant and costly reduction-in-workforce programmes.
Investment in, and deployment of, GenAI is a potentially defining opportunity and risk for many TMT companies. According to research by Deloitte Insights, in many cases, the efficacy of GenAI enterprise software and a clear path to monetisation have not been proven. Despite this, required capital expenditure investment in GenAI by vendors is huge given the computing resources and chip requirements. This might lead to losses at the outset but potential profits farther into the investment life cycle. Understanding the effect of these risks on the organisation and the strategic business response is the core starting point of the risk allocation analysis.
Functional analysis of control over risk
Following the analysis of the contractual assumption of risk at step two, the third step of the six-step process is to conduct a functional analysis to determine which entities assume and manage risks. The focus should be on identifying risk control (the capability to make decisions to take on, lay off, or decline risk-bearing opportunities and responding to risks coupled with actual functional performance) as the driver of risk allocation rather than just day-to-day risk mitigation.
Identifying at what level of the organisation risk control occurs has been a key source of uncertainty in the application of the risk allocation framework, particularly in the TMT industry. HMRC states its view is that “the TPG show no bias towards any level of management”. Some TMT sector players have often achieved success adhering to the visionary top-down strategic direction, clear leadership principles, and agile decision-making approaches that embody their organisational culture and define how their business is conducted. This may indicate that the highest levels of the organisation that set the strategy should be where most of the risk control lies. However, functional analysis exercises often reveal non-hierarchical organisations in which reporting lines are blurred and more relatively junior people are enabled to make decisions and pursue opportunities as they see fit.
According to research published by the Federal Reserve Bank of Philadelphia, the emergence of GenAI as a potential economic growth driver is expected to increase the capital share of income (the share of national income that capital holders receive) and reduce the labour share of income (the share of national income that is received as wages, salaries, and other compensation). This follows a long period of stability in factor shares as AI adopts some of the tasks previously undertaken by people functions. As companies in the TMT industry roll out AI in their businesses, this may lead to a higher concentration of risk control as the decisions around the investment in, and development and implementation of, the technologies become the nexus for the increased allocation of risk outcomes, rather than broader-based people activity.
Functional analysis in respect of risk control can often be challenging; HMRC notes that a clear identification and functional analysis of each economically significant risk can be burdensome, but is key to a robust application of the framework.
Financial capacity
If the functional analysis indicates a party undertakes the risk control activities, in order to be allocated the risk, they must have the financial capacity to assume the risk outcomes. TMT company transfer pricing models are often centralised, with companies that are not classified as ‘entrepreneurs’ being characterised as service companies (for example, undertaking services such as sales support, contract R&D, reselling), often remunerated by way of a cost-plus service fee and lightly capitalised commensurate with this profile.
On the face of it, this lack of capital depth may indicate that the risk should not be assumed by the service company, even if the relevant decision-making functions in respect of the risk are performed within the service company. However, HMRC’s guidance states that “where an entity has the ability to control economically significant risks effectively and so enhance capital value, it is reasonable to suppose that capital could move to exploit that opportunity”. So, the lack of actual capacity in the service company does not form a barrier to risk allocation in the view of HMRC.
Allocation across entities and pricing the transaction
Step five of the six-step risk analysis approach requires the allocation of the risk to the relevant party and step six requires the accurately delineated transaction to be priced, taking account of the risk allocation. It is the application of these steps that arguably leads to the greatest uncertainty.
On one hand, the OECD TPG states that where more than one party makes contributions to risk control (which is often the case in complex multinationals with matrix organisational structures), the risk should be allocated to one place; namely, the entity exercising the “most control” (OECD TPG, paragraph 1.98), with the other contributors being remunerated for their control activities as appropriate.
Determining “most control” can be difficult. For example, consider a media and entertainment organisation in which content budgets and overall strategy are set centrally, but given the requirement to offer content that meets local geographical needs, tactical title-by-title allocations are local, with central final approval. The intensity of decision making is likely to be higher locally, but the overall strategic and investment decisions are central, and both are key to managing the risk associated with having content that meets audience preferences. Scenarios such as this example are common, and drive disputes over where the risk should be allocated.
On the other hand, the OECD TPG states that “compensation which takes the form of a sharing in the potential upside and downside, commensurate with that contribution to control, may be appropriate” (OECD TPG, paragraph 1.105).
HMRC states in its guidance that this “does leave open the possibility that contributions to the control of risk could be rewarded by reference to a [transactional profit split method]”. Therefore, according to HMRC, even if the risk is allocated to one party, another party could share in the risk outcome through the delineated transaction. This view has led to the belief that the profit split method may be more commonly applied. This has particularly been the case in the TMT sector given increased geographic dispersion of contributions as a result of the competition for certain tech talent, leading to businesses allowing more flexibility in location, with some companies even introducing ‘work from anywhere’ policies.
This risk allocation may lead to a spectrum of outcomes to price the relevant transaction. Where the contributing party exercises no control, it may earn a fixed benchmarked margin (e.g., return on costs), which may be enhanced where some control is exercised. Farther up the spectrum, where control is shared, a profit split approach results in each party sharing the risk outcomes.
As high-growth TMT businesses increasingly mature to move from a focus on launching and acquiring customers to a monetisation and profitability focus, the potential consequence of increased risk control functions in non-entrepreneurial jurisdictions in terms of overall profit outcomes changes. During the earlier ‘disruption and customer adoption’ phase, when the business is loss making, it may be important to evidence that local non-entrepreneurial contributions are not higher than a ‘no control’ position, to defend against the argument that an enhanced one-sided method (e.g., a strategic services fee or a value-based consultancy fee) should be applied to reward these contributions. When the business as a whole moves into consolidated profits, it may be more important to evidence that there is no shared control outcome.
While it is hard to define the thresholds clearly, it is prudent to develop indicators that may be associated with each part of the spectrum (e.g., share of relevant investment costs under control; share of senior headcount) that might trigger a review as the local contributions develop.
Key TP takeaways for the TMT sector
Given the debate in the application of the risk allocation guidance and the trends in the TMT industry, the importance of a detailed consideration of the risks associated with intercompany transactions by companies in the sector has never been greater.
The analysis should:
Identify economically significant risks;
Collate evidence that entities that contractually assume risks have and demonstrate their capacity to control those risks;
Identify all contributions to risk control; and
Support the remuneration approach for those contributions.
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