Transfer Pricing: Strategies to Implement in Advance of a Downturn

This article was updated on May 1, 2020.

With a pandemic impacting the world, even tax practitioners can be forgiven for not placing transfer pricing high on their list of priorities. For now, physical and economic wellbeing are naturally foremost among everyone’s concerns. Once the present COVID-19 disruption passes, more traditional matters such as transfer pricing will resurface, but they too are likely to be affected by the economic ramifications of the pandemic. Dealing with the transfer pricing fallout will likely be more successful and less painful if thoughtful preparation takes place now. Indications thus far are that this impact will be severe, possibly unprecedented, and thus the usual transfer pricing prescriptions might not suffice.

The focus of this article is on how companies should start planning now for the documentation challenges that lie ahead for transactions that predate the onset of coronavirus.

At the end, we share some ideas for companies to avail themselves of the transfer pricing opportunities that a recession presents.

Unexpected Transactions in a Recession

There’s no question that the pandemic will have far-reaching consequences in many dimensions, some of which have yet to be foreseen. Companies may be forced to enter into transactions they weren’t forecasting. Struggling affiliates may need intercompany lending to ease their cash flow troubles—what is the right interest rate? Supply chain interruptions may require different intercompany flows of goods and services to meet customer demand—how should those flows be priced? And with large numbers of employees working remotely, there may be unanticipated changes in a company’s permanent establishment footprint—what’s the correct income to attribute to each location?

These aren’t unusual issues and transfer pricing can provide resolution, but it would be easy for a company to be caught unawares. Besides determining the right prices for these flows, new intercompany agreements and ultimately transfer pricing documentation may be required.

At the same time, though, there’s an impact on existing transaction flows. Below are some of the ways the method most commonly adopted in transfer pricing studies is prone to leaving a company exposed to surprise—and arguably unfair—transfer pricing adjustments when a severe recession strikes. It also sets forth a selection of possible solutions.

Challenges for the Comparable Profits Method and the Transactional Net Margin Method

The typical practice of most companies is to undertake a transfer pricing study sometime after the tax year has closed, to be prepared alongside the tax return. There may or may not be intercompany pricing adjustments during the year to hit a particular target return for a given related-party entity, but usually these adjustments are small, and the transfer pricing analysis is often a roll-forward of what was done for the prior year.

The vast majority of transfer pricing analyses apply either the comparable profits method (CPM) if US-based or its closely-related alternative, the transactional net margin method (TNMM), if The Organisation for Economic Co-operation and Development (OECD)-based. In other words, the profitability of the “tested party” is benchmarked against that of comparable companies, usually for a prior period because up-to-date data would be unavailable. For example, a company’s 2019 result might be compared with the performance of the comparables over the period from 2016 to 2018. Each year, the comparable companies’ financial data might be refreshed and, from time to time, a new search for comparables undertaken. Ordinarily, there’s nothing inherently wrong with this custom.

To account for the usual economic swings in the business cycle, the common practice is to use three-year or even five-year average rates of profitability. Of course, even in normal times, this can sometimes be problematic because databases may not be contemporaneous with the financial data of the tested party and may not reflect any inflection points in industry performance, such as the onset of a downturn or, conversely, a boom.

In the present pandemic-induced downturn, we can expect this misalignment to be much more pronounced and render comparable company profitability ranges unreliable, if not downright misleading. No amount of running different searches is likely to resolve the challenge because the economic effects are likely to be so radical and so far-reaching across the domestic and global economy—especially in certain sectors, such as hospitality, travel, retail, and other services. It’s only once the publicly available financial data for comparable companies catches up with the downturn that a more reliable benchmarking can be accomplished.

Assembling a Defense File Now

A prudent practitioner should anticipate the transfer pricing challenge outlined above by assembling a file of documents that evidence the disparity between what was expected in terms of entity performance and what ultimately transpired. For example, data could be gathered on first-quarter or mid-year results prior to the impact of the virus on the business, financial projections, or investor presentations, so that the “counterfactual” case can be more easily presented.

While tax authorities may, in the end, insist on looking at actual results, one line of defense can be that what transpired in year-end profitability was the result of an extraordinary circumstance and certainly not caused by faulty transfer pricing. The projected result for the entity is benchmarked as normal, against the historic financial performance of comparable companies, as if the virus hadn’t occurred.

The transfer pricing report would then present the case that the entity would’ve been within the comparables’ range if only it hadn’t been thrown wildly off course by the pandemic. Of course, projections aren’t the same as actual results, but at least this approach gives the taxpayer some position to defend.

Adjusting Ranges for a Recession

Transfer pricing regulations and guidelines usually permit taxpayers to make adjustments to financial data if the adjustments improve the reliability of the benchmarking. In effect, presenting a counterfactual result as above is a means to adjust the financial data of the tested party to strip out the effect of the recession. A complementary analysis might attempt instead to adjust the financial data of the comparable companies as if those companies’ financial results had been likewise affected and present the tested party’s result as filed on its tax return.

While notionally appealing, there’s a degree of arbitrariness in those adjustments that would, in turn, give a tax authority license to make its own adjustments if it accepted this approach. Unlike the tested party, it’s a matter of speculation as to how those companies would’ve performed without the recession because their projections wouldn’t be publicly available.

Adjusting Financial Results of Comparables

One simple option would be to shift the entire benchmarking range downwards by adjusting the financial results of the comparables. If we reason that the industry-wide effect—or rather comparables-wide, because they might be from multiple industries—is uniform, then we could perhaps adjust each company’s profitability measure down by the same number of percentage points, for example, and that adjustment in turn could be based on what has happened to the tested party.

So, for instance, if the tested party’s operating margin fell by four percentage points, we might reduce each of the comparable company’s operating margins by four percentage points. While arguably crude, at least this has the merit of normalizing for the recession. At the same time, however, it masks the effect of tested party-specific factors that could, of course, include incorrect transfer pricing.

Regression Analysis

A more refined approach might use econometric regression analysis to quantify how movements in sales affect profitability, all else being equal. It would then extrapolate how that factor alone affected the profitability of the tested party and the comparable companies, because each would likely have experienced different changes in sales. One would expect sales reductions to account for the lion’s share of any profitability plunge in the coming year or so.

At the same time, a regression analysis could take into consideration other non-transfer pricing factors, such as elevated costs because of supply chain bottlenecks or alternative sourcing of raw materials or finished products. These approaches have been successfully deployed in transfer pricing documentation reports and audits, especially as tax authorities may be hard-pressed to present their own counter analyses.

Sharing Risks in Extreme Times

Now is also a good time to consider if underlying assumptions about the transfer pricing arrangements are still intact. For example, in the past, it might have been assumed that some related parties bear limited risks, and therefore merit a guaranteed range of profitability, while other related parties are entrepreneurial and therefore should shoulder the full impact of profit fluctuations.

However, in the extreme conditions arising from COVID-19, it could be argued that a different paradigm should prevail, wherein all transacting parties bear some risk. This then is a departure from the simple CPM/TNMM mentality to one more like a residual profit split scenario. Under the latter, some or all related parties would be ascribed a routine return corresponding to their routine activities and risks, but all would also share in the remaining profits or losses to some degree.

Those entities that have less control over their destiny and have less capacity to bear risk would accordingly be assigned a lesser share of the residual profit or loss. Nevertheless, they would be a participant in that sharing and thus could end up with an overall loss if their residual loss wiped out the profit on routine activities. Tax authorities around the world have long accepted this method, but it does depend on the preparation of a solid functional analysis that explains why all related parties are, to a greater or lesser extent, risk-takers, even if only apparent in the context of extreme operating circumstances.

This functional analysis would then allow for reconciliation with any prior CPM/TNMM approach to transfer pricing. Ideally, intercompany agreements should reflect this sharing of risk under extraordinary circumstances, in much the same way as third parties might renegotiate a contract if one party experiences unexpected challenges. It might be stating the obvious, but re-writing contracts should take place now rather than once the tax year has ended.

Opportunities in a Recession

Although there will undoubtedly be challenges in defending transfer pricing results in the coming years, there is also a transfer pricing silver lining that companies might be unwise to ignore.

Interest rates are exceptionally low, globally. This gives multinationals an opportunity to re-finance or enter into new intercompany lending arrangements that could have beneficial tax impacts long after the recession has ended. At the same time, with economic forecasts depressed, businesses—and in particular intangible property (IP)—are likely to be less valuable today than only a few months ago, at least for the foreseeable future. For those companies that had been contemplating an IP migration, this could be the ideal time to follow through on those plans.

Next Steps

These are not easy times for companies. However, some measure of preparation now can at least help mitigate the likely challenges on the transfer pricing front to come. In addition, when the time does come to defend a company’s transfer pricing positions, there are reasonable and creative options to reduce the risk of a large adjustment and possible penalties. At the same time, it may pay companies to act now on the opportunities that have surfaced with lower interest rates and depressed economies.

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