Part 1 - AL-Tax

International Taxation Handbook7.3 Between routine risk and high uncertaintyRegularly, the arm’s length analysis requires that the functional pattern of both/allrelated parties as identified members of the multinational’s value chain(s) is investigatedby means of function and risk analysis. This ensures an understanding ofthe arm’s length nature of transfer prices, i.e. whether the profit is a markup, a grossmargin, or a residual profit. In practice, the related parties of the multinationalgroup are characterized according to their functional pattern, including the riskstructure and asset deployment along the dimension ‘routine’ versus ‘nonroutine’.However, this dichotomy in characterizing economic activity appears shortsighted.As a next generation feature of transfer pricing, we propose to differentiatebetween functional type (risk versus uncertainty) and functional density (comparabilityversus uniqueness).7.3.1 Traditional terminologyIn classical transfer pricing terminology, functions are differentiated between ‘routine’and ‘nonroutine’. Nonroutine is often labeled as an entrepreneurial or strategyunit (cf. Paragraph 3.4.10.2b of Administrative Principles 2005). This differentiationhelps to assess which related party or which function along a value chain processwithin the multinational group is engaged in producing unique products and serviceswhich, for an economically sound organization, cannot or should not be procuredfrom outside. In classical transfer pricing language, such product or servicerequires the performance of a kind of nonroutine function(s). The more such unitsperform as nonroutine, the less the profit–loss result of such unit can be forecastedin advance. In other words, the result of such a unit turns out to be residual afterhaving remunerated the units with routine functions.Altogether, in traditional transfer pricing the profit type and income level ofthe organizational units of a multinational group depend upon the pattern of riskand assets assigned to certain functions. In mainstream transfer pricing, the patternis a routine/nonroutine dichotomy characterized by transfer pricing practitionerson the basis of a more or less undefined catalog of criteria which aresupposed to measure the scope of functions and risk.7.3.2 Distinction between risk and uncertaintyUnfortunately, what the mainstream approach misses is an economically sounddistinction between ‘risk’ and ‘uncertainty’. This distinction, however, is important156