Managing Uncertainty: The Concept of Risk and Its Allocation in Modern Transfer Pricing Analysis

In basic economic principles, risk is directly proportional to return. The higher the risk taken by an entity, the higher the expected profit. In the context of transfer pricing, risk analysis is not merely a supplementary formality, but a vital component of Functional, Asset, and Risk (FAR) Analysis that determines how large a "slice" of profit an entity in a multinational group is entitled to receive.

Global guidelines such as the OECD Transfer Pricing Guidelines 2022 and UN Transfer Pricing Manual 2021, as well as local regulations in Indonesia (PMK 172/2023), Malaysia (TP Guidelines 2024), and Singapore (IRAS TPG 8th Edition), have now shifted from merely looking at risk allocation on paper (contracts) to testing the substance regarding who actually controls (control) that risk.

Definition and Identification of Risk

Risk, in the context of transfer pricing, is defined as the effect of uncertainty on business objectives. Every business decision—from launching a new product to granting credit to customers—contains uncertainty about whether the actual result will accord with expectations.

Economically Relevant Risks

Based on Indonesian Tax Audit Guidelines (PER-22/PJ/2013) and Malaysian guidelines, risks that must be identified include:

1. Market Risk: Fluctuations in input prices, market demand, and competition.
2. Inventory Risk: Risk of stock value decline or obsolescence.
3. Credit Risk: Risk of customer default.
4. Financial Risk: Fluctuations in currency exchange rates and interest rates.
5. R&D Risk: Uncertainty of the success of new product development.

Six-Step Framework (OECD & UN)

OECD and UN recommend a six-step framework for analyzing risk, which is also adopted in principle by tax authorities in Southeast Asia:

1. Identify Specific Risks: Determining economically significant risks.
2. Contractual Analysis: Looking at who assumes the risk based on the written contract.
3. Functional Analysis: Looking at the actual conduct of the parties regarding risk management.
4. Interpretation: Testing whether the contract matches actual conduct, and whether the risk assumer has control and financial capacity.
5. Risk Allocation: If the party in the contract lacks control/capacity, the risk is reallocated to the party possessing them.
6. Pricing: Determining the transfer price based on the adjusted risk allocation.

Key Concepts: Control and Financial Capacity

This is the core of the post-BEPS (Base Erosion and Profit Shifting) transfer pricing paradigm. Just because a contract states "PT A assumes the risk of R&D failure", does not mean the tax authority will accept it.

A. Control over Risk

According to Malaysia Transfer Pricing Guidelines 2024 and OECD, for an entity to be considered as assuming risk, it must have "control". Control is defined as the ability to make decisions to take on, lay off, or decline opportunities containing risk, as well as decisions on how to respond to that risk.

In Singapore, IRAS affirms that if risk allocation in the contract differs from economic substance (who makes decisions), then economic substance prevails.

B. Financial Capacity

The entity assuming risk must have the financial capacity to bear the negative consequences if the risk actually materializes. This capacity is defined as access to funding. If an entity does not have the financial capacity to bear losses, the risk will be reallocated to the party possessing that capacity.

Application Case Studies in Various Jurisdictions

Indonesia: Substance Over Form

In PMK 172 of 2023, Indonesia affirms that risk analysis is an inseparable part of functional analysis. If the Taxpayer cannot prove that they actually control the risk, then the risk can be disregarded or reallocated.

Malaysia: Recharacterization Strictness

The Malaysia Guidelines 2024 provide an example: If a company provides a loan without security where no independent party would do so due to high risk, the tax authority (DGIR) can disregard or recharacterize the transaction.

Funding and "Cash Box" Entity

If an entity only provides funds but does not control the research risk, the entity is considered a "Cash Box". According to OECD and UN, such an entity is only entitled to a risk-free return on the funds lent.

Consequences of Risk Misallocation

• Profit Reallocation: Tax authorities will move the risk (and the accompanying profit) to the entity that actually controls that risk.
• Price Adjustment: An "Entrepreneur" entity (high profit) can be downgraded to a "Service Provider" status (cost plus profit).
• Transaction Disregard: The transaction structure can be disregarded entirely if it is not commercially rational.

In the current tax landscape, "Paper" (Contracts) is no longer an absolute shield. Risk in transfer pricing is about the substance of decision making. For Taxpayers in Indonesia, Malaysia, and Singapore, it is crucial to ensure that the entity recorded as assuming risk in the TP Doc truly possesses (1) competent directors/management to take decisions, and (2) a strong balance sheet to absorb losses. Without these two things, your risk allocation is vulnerable to correction.

References

1. OECD. (2022). OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022. OECD Publishing, Paris.
2. United Nations. (2021). Practical Manual on Transfer Pricing for Developing Countries (2021).
3. Ministry of Finance of the Republic of Indonesia. (2023). Regulation of the Minister of Finance of the Republic of Indonesia Number 172 of 2023 concerning the Application of the Principle of Fairness and Business Prevalence in Transactions Influenced by a Special Relationship.
4. Directorate General of Taxes. (2013). Regulation of the Director General of Taxes Number PER-22/PJ/2013 concerning Guidelines for Audit of Taxpayers Having a Special Relationship.
5. Inland Revenue Board of Malaysia. (2024). Malaysia Transfer Pricing Guidelines 2024.
6. Inland Revenue Authority of Singapore. (2025). IRAS Transfer Pricing Guidelines (Eighth Edition) (2025).