Transfer Pricing can be a complex subject that is in constant flux. Further, working in transfer pricing for the financial services industry brings additional challenges due to the regulatory overlay that impacts the way in which taxpayers manage their intragroup arrangements.

Read more about Transfer Pricing in our previous blog posts part 1 and part 2.

Global economic, financial or sanitary crises like the one we are all currently experiencing bring unprecedented stress to Transfer Pricing models and policies that will most likely trigger changes at multiple levels.

For those groups with natural financial year, Q2 is rapidly approaching and with it, the immediate need to decide whether changes or updates of their Transfer Pricing models will need to be introduced to cope with unexpected fluctuations in financial results.

Changing your Transfer Pricing arrangements

Most Transfer Pricing practitioners would confirm that introducing changes to the policies or intragroup arrangements is not to be taken lightly. Legacy risks arise, and often long and painful negotiation and documentation activities have to be undertaken to ensure it is all properly explained and rationalized should queries arise.

If changing a Transfer Pricing setup under standard market conditions is a challenging endeavour, what happens when such change is triggered by the occurrence of extraordinary losses caused by a global pandemic?

In the following sections we reflect on key points to keep in mind when looking at your Transfer Pricing arrangements and whether a reassessment needs to be made to ensure it produces the intended outcome under normal or extraordinary business circumstances.

When losses occur in risk-free or limited-risk-service providers

Most discussions on Transfer Pricing policy setting start with the concept of routine and non-routine functions to then assess suitable models to apply in each instance. It is often the case that the entity performing the routine or support functions is described as a “limited risk service provider” and is commonly compensated using a cost-plus method. This would naturally entail that a different entity or group of entities is responsible for covering the costs of the service provider, including the relevant profit margin. However, it is also possible to remunerate such service entities using internal or external comparables[1], for example those providing IT services or execution support where market references are abundant.

In times of crisis, it is important to ensure that your entities performing routine or supporting functions and compensated under a cost-plus basis do not experience losses arising from intragroup arrangements. This is a good barometer to determine whether the initial method was properly set and whether implementation has been properly done. If your limited-risk service provider ends up with losses in its books, then either there are issues at implementation level or the Transfer Pricing model applied is not correct.

In times of reduced revenues, compensating to the service providers may put additional pressure on the entities paying for such services, potentially exacerbating the losses of the service recipients.

On the other hand, service providers remunerated using internal or external CUPs may end up with losses due to the decrease in sales volumes or increase in costs during the crisis. If some of these entities are in aggressive tax jurisdictions, it might be advisable to check whether a material reduction in profits or shifting from profits to losses could trigger additional tax or regulatory risks and if one-off arrangements to loss-protect the entity shall be introduced (see following sections).

When losses occur in entities performing entrepreneurial, value-adding or key entrepreneurial risk taking (KERT) activities

When moving up the value-adding scale, there are group entities performing some sort of value-adding activity that may or may not be considered as entrepreneurial or risk-taking. For these types of entities, the cost-plus method is normally not suitable and other alternatives such as CUPs, profits or fee splits are considered.

Typically, fee splits are not used to remunerate limited-risk service providers, and one of the implications is that entities or functions compensated using fee splits may be exposed to ordinary or extraordinary losses if their cost bases are larger than the revenues or fees received.

One relevant example to keep in mind is the role of sales or marketing teams, in specific in countries like Switzerland. In recent years, there has been significant pressure from the tax authorities to move away from a cost-plus type of model and adopt a fee or profit split for such activities. As mentioned earlier, under a fee split ordinary losses may arise if the fees received are not enough to cover the cost base. However, if a profit split was adopted, at the end of 2020 the sales or marketing entity may end-up with a net loss allocation from a foreign booking location. This may not only create tax risks, but also create material regulatory risk, in particular since only a few sophisticated jurisdictions are comfortable with the concept of profit and loss allocation.

In our experience, it is unlikely that tax authorities and regulators would be supportive of net loss allocation to sales or marketing teams, regardless of the Transfer Pricing method used or the relevance of the activity in the value chain.

For entities with a pure KERT profile, it is clear that losses, ordinary or extraordinary, could arise as part of the normal business activities and hence not worth spending a material amount of time covering the topic. The key point to highlight here is that before assigning a KERT-type of label to your entity or activity, it is important to make sure that it would not present issues if at the end of the financial year losses are either triggered locally or attributed from foreign jurisdictions.  

When losses occur in the context of global trading or offshore booking models

What if the losses arise in the context of trading-related activities? Losses every so often arise at book, portfolio or desk level in trading, risk management or hedging locations, in particular within the investment banking or commodity industries. However, such losses are usually incorporated as part of the base-case scenario due to the inherent volatility of the markets and are often expected as part of the mechanics of the model.

More often than not, said traders or risk managers are based in financial centres with sophisticated tax authorities and experienced regulators who are used to discussing the reallocation of profits and losses from booking to trading locations. However, even in these locations, authorities and specifically regulators are rarely pleased when receiving unexpected losses that could potential jeopardize the health of their banking system, in particular when these materialize at once from basically every major financial group with local presence.

In the years after the 2008 financial crisis, many tax authorities and financial regulators became a lot more interested in such global trading models and in the premise of reallocation of profits and losses from booking to trading locations. Several financial centres in Asia, Europe and the Americas introduced limits to the amount of losses that could be attracted by the trading location or recommended alternative mechanisms to minimize the volatility in the results of the local trading hubs. Some of the options commonly put on the table were either stopping the trading activity whatsoever (not operationally viable), providing regulatory capital in the trading location in addition to the capital provided in the booking location (too expensive), moving the traders from a profit split model to a cost-plus method (difficult to support from the tax and transfer pricing perspective) or providing other creative alternatives to mitigate the downside exposure of the trading locations.

Under these circumstances, many financial groups came up with innovative yet robust ways of dealing with such loss-scenarios, such as risk participation arrangements, quasi-insurance payments or claw-back approaches. Many of these are still prevalent in these days and will prove useful if material losses materialize in 2020.

The impact of capital when dealing with losses

The interesting point to explore at this point is the relevance of capital, in particular in the financial services industry. While in the past cash boxes or capital providers were allocated a sizeable portion of the profits, in the post-BEPS[2] period we see this occurring less and less to avoid challenges from tax authorities.

The work under Action 8-10 of the BEPS action plan suggests that capital by itself does not guarantee an extraordinary return or a sizeable portion of the profits if there are no material people functions attached to it[3].

However, in situations such as a global crisis and in times of volatility and financial losses arising virtually in all industries, what is the actual role that capital plays in the value chain? If the entity providing capital for the relevant controlled transaction is remunerated with a risk-free return, is it correct to assume that losses will be allocated to such entity? Is it fair or correct to see the capital-providing entity simply as a balance sheet provider with no risk assumption?

These are valid questions with no simple answer and evidently the answer depends on the country, industry and intragroup setup. Broadly, the capital provider can be remunerated with different types of returns on its capital-at-risk:

  • Risk-free: It would be challenging to expect that the capital provider absorbs any losses arising from the day-to-day business if it is remunerated with a risk-free return. As such, in this case, it could be said that the capital provider is simply a facilitator of an asset required to conclude or underwrite a transaction.
  • Market return: When the return to capital increases from risk-free to a market return, then the risk profile of the capital-providing entity changes. There is no universal definition of “market return”, but it is certainly higher than risk-free, and it is commonly benchmarked to whatever is the minimum threshold yield expected in that product, industry or market. As such, some degree of risk exposure is expected and hence some losses could be absorbed by the capital-providing entity.
  • Extraordinary returns: If as part of the policy the capital-providing entity receives a return on capital higher than the reference market return, then it could be foreseen for this entity to take a sizeable portion, if not all, of the ordinary or extraordinary losses occurring in the business. Hence, significant risk exposure is expected from the capital-providing entity directly in line with the level of returns.

When looking at the treatment of capital and where to allocate losses, it is crucial to do it in parallel with the assessment of the key people functions to ensure that both are aligned and produce the expected results.

As such, aside from the alternative ways of dealing with losses commonly used in the global trading industry such as risk participation or claw-backs, there could be other ways of upgrading the models using an adequate return to the capital provider to minimize the contagion effect of losses and centralize them in a manageable jurisdiction. Depending on the tax appetite of the group, it could be advisable to concentrate the losses in fewer jurisdictions where results have been consistently strong in the past, where the regional or global head offices are domiciled or where additional shelter may be provided from the local tax authorities.


As mentioned in previous sections of this note, it is critical to model and assess before Q2 whether the Transfer Pricing models and policies in place in your organisation would produce arm’s length results during 2020 by properly dealing with profits and losses. If issues or mismatches are identified, a quick remediation exercise shall be envisaged to mitigate potential tax and regulatory risks before the race to year-end.

Financial groups operating in Switzerland should review carefully the following elements to ensure intragroup arrangements are not prone to challenge by local authorities:

  • Allocation of profits to a group of entities and allocation of losses to a different group of entities
  • Allocation of profits to low tax jurisdictions and allocation of losses to high-tax jurisdictions
  • Occurrence of ordinary or extraordinary losses in limited risk service providers
  • Allocation of losses to highly regulated entities with limits on profitability levels
  • Over-remuneration for capital providers with no bearing of financial risk
  • Under-remuneration for capital providers with material financial risk exposure
  • Allocation of losses to sales or marketing teams based in Switzerland
  • Allocation of profits to low-substance jurisdictions and allocation of losses to high-substance entities
  • Material swings in PnL[4] for entities fully remunerated on a cost-plus basis with no material changes in cost base

If you are interested in further discussing risk mitigation mechanisms such as risk participation agreements, claw-back arrangements or how to properly determine the return to your capital provider, please feel free to reach out to Luis Sanchez, Ralf Eckert or Thomas Steinbach.

[1] Comparable uncontrolled price method, or CUP.

[2] Base erosion and profit shifting (BEPS) refers to tax planning strategies used by multinational enterprises that exploit gaps and mismatches in tax rules to avoid paying tax. Developing countries’ higher reliance on corporate income tax means they suffer from BEPS disproportionately. BEPS practices cost countries USD 100-240 billion in lost revenue annually. Working together within OECD/G20 Inclusive Framework on BEPS, over 135 countries and jurisdictions are collaborating on the implementation of 15 measures to tackle tax avoidance, improve the coherence of international tax rules and ensure a more transparent tax environment.

[3] Work under Action 9 addressed the level of returns to funding provided by a capital-rich MNE group member, where those returns do not correspond to the level of activity undertaken by the funding company.
The guidance (…) will ensure that capital-rich entities without any other relevant economic activities (“cash boxes”) will not be entitled to any excess profits. The profits the cash box is entitled to retain will be equivalent to no more than a risk-free return.
The work under Actions 8-10 of the BEPS Action Plan will ensure that transfer pricing outcomes better align with value creation of the MNE group. Moreover, the holistic nature of the BEPS Action Plan will ensure that the role of capital-rich, low-functioning entities in BEPS planning will become less relevant.

[4] Profits and Losses.