Transfer Pricing in the face of current macroeconomic conditions
Chad Martin, Senior Manager/Office Lead, BaseFirma Denver
Eduardo Emmerich, Senior Manager/Office Lead, BaseFirma Houston
In the last two years, multinational enterprises (“MNEs”) have faced a consistently turbulent and challenging macroeconomic environment at the local, regional, and global level. MNEs’ tax teams are scrambling to understand and address the impact of physical supply chain disruptions on intercompany pricing and policy monitoring. Wild swings in the prices of inputs and final products, highly variable profitability across industries, realignment of business value chains, geopolitical pressures and risk, and tightening monetary policy are some of the significant complications MNEs are dealing as they seek to comply with transfer pricing policies and ensure results are consistent with the arm’s length principle. The following sections discuss some of the key transfer pricing risks caused by such macroeconomic challenges, and where possible, guidance to MNEs navigating them.
Volatility in prices and profits
MNEs that rely in part or in whole on product1 pricing as the lever by which to achieve arm’s length profitability are affected by swings in prices and profitability both from an implementation and from a compliance perspective. Consider, for example, a transfer pricing system in which a manufacturing entity sells to a low-risk distributor at a variable price intended to leave the latter with a target overall operating margin. Operationalizing a variable product pricing policy requires a MNE to balance increases in input costs (i.e., manufacturing costs) – or shortage/unavailability of inputs – with increases in sales prices charged to third–party customers, depending on the extent to which the MNE pass on rising input costs to its customers. Thus, as an example, whereas a policy markup of 30% on manufacturing costs was historically employed to achieve arm’s length profitability for the distribution entity, the combination of an inflated manufacturing cost base and lower distributor pre-transfer pricing profitability could mean that a significantly lower markup (or perhaps even no markup at all) is required to achieve the same results for the distribution entity. Companies with qualified cost sharing arrangements (“QCSAs”) may see calculations of reasonably anticipated benefits (“RAB shares”) become unreliable or even counterproductive to original goals, given the vast difference in current conditions from forecasts at the time the QCSA was executed. Even advance pricing agreements (“APAs”), generally regarded as a bastion of stability and certainty in the transfer pricing world, can be upended if, for instance, cost increases cannot fully be passed on to customers and therefore intercompany profit allocation balance cannot feasibly be maintained.
These pricing dynamics and macroeconomic uncertainties are likely to result in a heavier operational transfer pricing burden as intercompany policies must be monitored and adjusted with more frequency maintain defensible transfer pricing results for each counterparty’s year-end transfer pricing compliance. Various compliance issues arise from this situation. For example, MNEs that struggle to successfully align their policies with arm’s length results face administrative burden in period-end or year-end closing procedures, and/or audit exposure in jurisdictions where profitability has been adversely affected. Additionally, benchmarking of results under profit-based transfer pricing methods such as the Comparable Profits Method (CPM)/Transactional Net Margin Method (TNMM) can become challenging to apply or altogether unreliable. For example, the use of regional or worldwide sets may become harder to justify as economic conditions diverge. Government grants, subsidies, or other financial involvement can skew results in entire regions and industries (see the subsection below covering political pressure and risk). And the common practice of using benchmarking results lagged a year or more (due to data availability constraints in using audited financial statements of comparable companies) may fail to accurately reflect current year economic realities, especially in industries whose fortunes have risen or fallen significantly due to the highly variable business climate of 2020-2022. The OECD itself recognizes this dilemma in Chapter III, Section B, which acknowledges the limitations of ex-ante economic analyses, and that in turbulent market conditions “independent parties in comparable circumstances would not base their pricing decision on historical data alone.”
MNEs faced with one or more of the situations described above have several options to mitigate operational and compliance risks. Upgrading or enhancing ERP systems may make continuous profitability monitoring more efficient and effective, improving operational transfer pricing while simultaneously mitigating the risk of misalignment in policy and results. However, for reasons ranging from systems constraints to customs implications, taxpayers may find that they are no longer able to rely on variable pricing as a sole transfer pricing profitability “lever” to effect desired segment or entity results. As a result, MNEs may consider introducing new, complementary transactions such as variable royalties or high-value service charges to achieve the same outcomes. We recommend conducting a thorough planning and modelling exercise before introducing new transactions to ensure that the effects on income and indirect taxes are well understood, and that proper substance and economic benefit can be demonstrated. Furthermore, reevaluating or rewriting the functional and economic analysis sections of transfer pricing deliverables further justify the appropriateness of sets can be crucial in proactively addressing tax authority challenges, as can considering the applicability and appropriateness of available comparability adjustments better align the economic circumstances of comparable companies to the tested party. Practices such as updating year-end benchmarking sets with quarter-end comparable company results and drafting a robust analysis of the impact of macroeconomic factors to explain out-of-range results for fiscal years 2020-2022 can help alleviate the incongruence posed by lagged benchmarking results. Finally, the use of corroborative analyses, which provide justification for transfer pricing results using an alternative profit level indicator and/or transfer pricing method, may also be a valuable tool for companies seeking to align their financial results with transfer pricing benchmarks.
MNEs pricing transactions using the Comparable Uncontrolled Price (“CUP”) or Comparable Uncontrolled Transaction (“CUT”) methods, which compare intercompany pricing to that of similar or identical products, services, or intangibles with or between unrelated parties, may also experience challenges in responding to price volatility. For example, the terms of third-party agreements typically referenced when setting intercompany product prices may have been modified or voided in the past two years due to economic turbulence. We recommend undertaking a thorough review of the continued applicability and comparability of the CUPs/CUTs to ensure that any recent developments do not the arm’s length pricing of intra-group transactions.
A less obvious but nonetheless significant consideration for MNEs with intercompany tangible transactions is the impact of higher shipping costs on transfer pricing policies and results. Typically, intercompany agreements specify which entity bears shipping and logistics costs, and how and whether such costs are subject to any applicable markup/margin calculation. According to Statista, a research company, global container freight rates ballooned over 800% between September 2019 and September 2021, before plateauing and declining somewhat in recent months.2 Such costs may significantly impact segmented financial statements used for transfer pricing calculations, and allocation of these expenses should be considered and memorialized in intercompany agreements in accordance with the relative functions, assets, and risks undertaken by the parties to the transaction.
Realignment of business value chains
A fundamental principal of most transfer pricing regimes is that a MNE’s allocation of taxable income (or losses) should align with its business value chain; in other words, routine functions should earn routine profits and entrepreneurial/high value functions should earn residual profits or losses. Due to the supply chain turbulence that has characterized much of the mid-2020 to 2022 global economy, entire industries have experienced an upheaval in business value chains. Functions that were once regarded as routine or of secondary importance have since become primary drivers of success or failure. For example, for many tangible goods industries, sourcing, procurement, and supply chain management are now key differentiators in business performance. Conversely, functions such as strategic marketing may currently be less prominent as a value driver, as widespread robust demand for goods along with current supply chain bottlenecks shifts MNEs’ tactical focus to the supply side.
The past two years have shown that macroeconomic or industry-wide shifts can be equally disruptive to value chains. It is generally recommended that taxpayers reassess their value chain analyses any time a significant business restructuring or major macroeconomic changes occur. Therefore, MNEs should consider refreshing such analyses by holding new or additional functional interviews with key departments to ensure that their transfer pricing models continue to reflect key drivers of profit within the MNE group. On a more technical level, MNEs should also consider whether functional characterizations used to select a “tested party” for profit-based comparative analyses remain appropriate. For example, a group entity characterized as a “limited risk” entity may, under current conditions, be assuming far more market, inventory, and/or other risks than when the transfer pricing model was initially established.
Political pressure and risk
MNEs operating in certain jurisdictions and industries are facing unprecedented levels of political scrutiny and uncertainty. Sectors such as energy, mining, and pharmaceuticals have recently come under intense pressure from national and supranational governing bodies, as exemplified by the United Kingdom’s recent decision to pursue a windfall tax on the “excess” profitability of energy companies during a year in which supply-related issues have driven energy inflation not seen in decades.3 Such ad hoc policies may impose a potentially significant financial burden on affected MNEs, tempting MNEs in targeted sectors to use transfer pricing planning to blunt the impact of such unfavorable tax policy developments. However, utmost caution should be exercised before using transfer pricing to mitigate such windfall taxes as the targets of such measures are likely under greater scrutiny for potential tax face significant reputational risk. Therefore, MNEs should carefully review the economic substance of current and planned intercompany transactions and policies to ensure full compliance with applicable transfer pricing regulations in tandem with corporate governance.
Similarly, many countries around the world are exhibiting elevated political risks that can affect transfer pricing structures directly (e.g., sanctions or export bans cutting off transactions between affiliates) or indirectly (e.g., intangible asset valuation impacts from higher country risk premiums). For example, the war in Ukraine has sent geopolitical shockwaves throughout Europe and beyond, leading MNEs to reconsider their operational footprint and processes. Trade tensions between the United States and China has impacted the decision-making of MNEs in industries ranging from telecom to semiconductors. Corporate tax functions should closely align with operational and management personnel stay regularly apprised of strategic business shifts, and financial models and forecasts should be updated with increased frequency to continuously monitor the impact of geopolitical and other burgeoning risks.
Tightening monetary policy
By mid-2022, many governments and central banks worldwide have begun taking measures to combat inflation and distorted labor markets by implementing policy changes such as aggressive increases in central bank interest rates. The impacts of higher rates on transfer pricing range from the obvious (e.g.,, their net profit impact on group entities engaged in intercompany financing with floating rates) to the less apparent (e.g., the provision in many jurisdictions’ transfer pricing regulations, including the United States’, that intercompany trade receivables outstanding for long periods of time must accrue interest at an arm’s length rate).
In addition to the direct impact of monetary policy on transfer pricing structures, the current trend of monetary tightening also tends to place MNEs under increased scrutiny from tax authorities stretched thin by reduced budgets and the prospect of revenue shortfalls. MNEs across all industries should expect an uptick in tax audit activities for fiscal year 2022 and likely should prioritize preemptive measures to ensure compliance with local transfer pricing regulations such as preparing required transfer pricing documentation and annual filings.
While the economic environment of the past two years may seem to be an extreme aberration from the norm, the fact remains that for the near-term future, supply chain disruptions and geopolitical upheaval may continue or worsen. It is therefore essential that MNEs carefully evaluate their current transfer pricing practices and compliance, while also staying alert to potential planning opportunities that can better align the group’s transfer pricing structure with the goals of the business. We recommend MNEs thoroughly review their transfer pricing policies, intercompany agreements, benchmarking methodologies, and value chain, as well as adopt a defensive stance in the face of a likely surge in audit activity in coming years. The past two years have presented a host of transfer pricing challenges to MNEs, making an effective and decisive transfer pricing function an even higher priority for tax departments worldwide.
Chad Martin leads BaseFirma’s Denver Office, where he specializes in US and international transfer pricing advisory in areas including planning, implementation, compliance, and controversy. He has ten years of experience serving multinational clients across all major industries. Chad can be reached at Chad.Martin@BaseFirma.com.
Eduardo Emmerich leads BaseFirma’s Houston office and has 12 years of experience serving multinational clients with documentation, planning, audit defense and APA across a number of industries, including oil and gas, consumer products and life sciences. Eduardo can be reached at Eduardo.Emmerich@BaseFirma.com.