Managing Transfer Pricing in the Economic Downturn

Caused by the COVID-19 Pandemic

Business leaders, tax practitioners, and attorneys are considering how to address the serious challenges that may arise from disruptions in commercial activities due to business closures, travel restrictions, and stay-at-home orders that were put in place in many countries around the world in order to reduce the spread of COVID-19. This is also impacting transfer pricing systems, which is the focus of this article. Among the multitude of questions that business professionals will have to deal with will be how to manage losses attributable to these extraordinary events within their intercompany transfer pricing systems.

Business leaders, tax practitioners, and attorneys are considering how to address the serious challenges that may arise from disruptions in commercial activities due to business closures, travel restrictions, and stay-at-home orders that were put in place in many countries around the world in order to reduce the spread of COVID-19. Although this is not the first economic downturn many current practitioners have lived through, it has numerous unique features, including supply-side and demand-side elements that have differential impacts on various sectors of the economy. Many industries stand to experience an extraordinary, material, and potentially short-term volume impact on business during 2020 caused by the prolonged disruption to daily life, interruptions in supply chains, job losses, and potential erosion of consumer confidence. Longer-term recessionary impacts in 2021 and later years, if any, will only become evident in the future. Among the multitude of questions that business professionals will have to deal with will be how to manage losses attributable to these extraordinary events within their intercompany transfer pricing systems.

Is an Adjustment Warranted?

Although this may sound like a truism, taxpayers should avoid making decisions regarding their transfer pricing arrangements that may not be seen as prudent after the current crisis is over, including when these decisions are examined in a tax audit context years later. Any changes should be made after careful consideration and analysis of the facts, circumstances, and available data.

How should the taxpayers decide whether transfer pricing adjustments are warranted in the first place? In transactions between affiliates that the current transfer pricing policy treats as “routine” on one side and as “entrepreneurial” on the other, the decision whether to adjust the results of the legacy transfer pricing policy depends on the actual roles that the routine and “non-routine” affiliates performed during the downturn. For example, facts about how proactive the routine affiliate was in mitigating the impact of the economic downturn should be examined. It is crucial to document these facts as close to the timing of the events as possible and incorporate them either into transfer pricing documentation or into a future “audit defense file.” In transactions in which joint profit is shared among two or more affiliates (e.g., under a profit split method), the question to be examined is how independent parties would split the losses caused by an event not under their control in the context of the joint venture implicit in the profit split. For example, one such query would be to determine whether arm’s length parties would make retroactive profit adjustments or would instead have agreed on prospective adjustments.

Assuming the decision to proceed with adjusting transfer prices has been made, the next step is to consider exactly what tools to use to accomplish it. Some of the methods that may be employed are described in this article, although this is not an exhaustive list. Selection of any particular method and its application should be based on analysis of the specific taxpayer’s facts and circumstances together with an assessment of the available evidence from relevant third-party benchmarks and comparables.

Managing Intercompany Pricing of Transactions That Use One-Sided Methods

While the taxpayer’s financial results and forecasts will reflect the current economic conditions, the same is not necessarily true for the available benchmark comparable company data. This may be because some potential comparables are not affected in the same way as the taxpayer, or because up-to-date results for comparables are not yet available. Continued use of the benchmark comparables’ data that are not synchronized with the taxpayer’s time period presents serious challenges to taxpayers in terms of setting prices for the current year, budgeting for coming years, and complying with applicable transfer pricing regulations. To ensure that potential benchmark comparable company data are indeed comparable and reflect the actual economic circumstances for the related parties, the following adjustments can be considered:

Comparisons Over Multi-year Periods

The one-sided transfer pricing methods presuppose that returns for routine functions are to be determined by reference to a normal range of returns for comparable entities over a one-year or multi-year period. The normal range of returns is, typically, understood as the interval comprising the second and third quartiles of the range of returns calculated from the benchmark comparables’ financial results achieved during normal economic times. However, when entire sectors of the economy are driven away from the realm of doing business-as-usual, the interquartile range of comparables’ results achieved in prior periods will unlikely be a sensible benchmark. If multiple years of data are used to calculate an arm’s length range (as would be the case under U.S. regulations), period-average results for the selected profit level indicators (PLIs) need to reflect the estimated benchmark PLI results including 2020, and the benchmark results observed exclusively for 2020 rise in importance as indicators of arm’s length returns during 2020.

Using Forecasted Financials for the Comparable Companies

When the economic conditions in which the comparables have achieved their profit levels are materially different from the current economic conditions facing the tested party, it may be appropriate to consider using current-year forecasted results of the comparables to calculate the arm’s length range. Moreover, companies that are good comparables in normal economic circumstances may not be closely comparable in the circumstances of the COVID-19 downturn because of the differential economic impacts noted above. In addition, there are implementation challenges stemming from the availability and reliability of up-to-date financial forecasts for the available benchmark comparable companies. Nonetheless, this approach may still provide a useful indication when setting prices for budget purposes.

Re-Examining the Set of Comparable Companies

In the case of sharp and unexpected revenue decline, the key factor that affects a firm’s profitability (e.g., the magnitude of the operating loss) is the proportion of its fixed costs to variable costs. Unlike variable costs that fall in proportion to a decline in revenue, fixed costs cannot be reduced quickly. Therefore, one of the key comparability factors in an economic downturn will become the ratio of the comparables’ variable costs to fixed costs. The comparable companies selected for calculating the prior arm’s length range can be re-examined to isolate those that have experienced similar levels of sales decline or that most closely match the tested party’s ratio of variable to fixed costs, and the arm’s length range can be recalculated using only the subset of such comparable companies. Alternatively, in situations where reliable data for the comparable companies are not available, a pro forma analysis of the related party financial results may provide suitable evidence on the anticipated or budgeted results (i.e., “but for” the downturn) to demonstrate and document their arm’s length character.

Adjusting the Historical Comparables Data

A regression analysis can be used to determine the systematic differences in a given PLI among past years of observations, and an adjustment for the current period can be applied to historical financial results of the comparable companies using this systematic component. Other regression-based analyses can be performed to measure the systematic relationship between changes in sales and profitability of the comparables or to account for the differences in the ratio of fixed costs to total costs among the comparables. This can be done using existing comparable sets, depending on sample size and reliability of the resulting coefficients, or expanded sets. The resulting regression coefficients provide an estimate of the decrease in profitability (as a percent of sales, assets, etc.) for each percentage of decrease in sales volumes and can be used to adjust each comparable company’s profitability based on the percentage decline in the taxpayer’s sales. Historical financial data of the benchmark comparable companies recalibrated using such regression analyses can then be used to derive the adjusted arm’s length range.

Managing Transfer Pricing Systems Based on Profit Split Methods

The conceptual paradigm underlying the profit split method is a joint venture between two or more parties, each of which makes both routine and non-routine contributions to the venture.

The paradigm implicit in the profit split method is the assumption that the joint venture partners contemplate a normal range of business risks and potential business outcomes. The profit split method, at least as delineated in the Treasury Regulations and the OECD Guidelines, does not address how the joint venture partners would or might respond to unforeseen events that dramatically change the economic environment of their business.

Except possibly for force majeure clauses, which excuse performance in the event of such natural or man-made disasters as hurricanes and wars, generally there is no typical contractual provision in arm’s length joint venture agreements that governs the consequences of unforeseeable events that materially impact the economic circumstances of the venture. Nevertheless, for transfer pricing purposes it is necessary to postulate how the joint venture partners would decide, either ex ante in the joint venture agreement or ex post in amendments to the agreement, to modify the terms of their venture to take account of the unforeseen events. While there is no single course that joint venture partners in general might be predicted to choose, there is one that, in the context of profit splits, parties at arm’s length could reasonably adopt, either ex ante or ex post.

The question that arises in extraordinary economic conditions is how extraordinary risk should be allocated between the routine and non-routine functions. Since the implicit agreement imposed by the residual profit split method under normal circumstances is for the routine functions to bear risk within the interquartile range of comparables’ rates of return and for the non-routine functions to bear the residual risk, a logical extension of this agreement to extraordinary conditions would expand the band of risk borne by the routine functions beyond the normal, interquartile range of returns for comparable routine functions but not beyond the full range of returns observed for comparable routine functions, which includes observed extreme returns as well as normal returns. While the central 50 percent of the comparables’ range (i.e., the median) may be appropriate in ordinary circumstances, part or all of the other 50 percent of the comparables’ range should be feasible in extreme circumstances. In addition, the adjustments described above for the application of one-sided methods are all applicable for determining the returns for routine contributions under the residual profit split method.

Alternatively, losses associated with these unforeseen events can be isolated and split on a different basis than normal operating results are split. In a residual profit split context, without any adjustments to the routine benchmarks, these losses would be attributed to the non-routine, entrepreneurial activities and would be split between the entrepreneurs. The extraordinary losses resulting from a substantial decline in production and sales arguably result from risks borne by the entire business, and not just the entrepreneurial activities. They should therefore be allocated separately based on a measure that represents both routine and non-routine activities. For example, in a profit split system where residual profits are shared based on capitalized costs of entrepreneurial activities (i.e., entrepreneurial assets), the extraordinary losses can be allocated by total assets of the business, including both the routine and non-routine, entrepreneurial assets of the business. The important step in implementing this allocation is to quantify the losses attributable to these extraordinary events, which would include all direct costs readily attributable to addressing the unforeseen events and indirect costs or lost profits due to disruptions in economic activity. One way to measure the impact on profitability is to examine the difference between budgets prepared before and after these unforeseen events or between budgets prepared prior to these events and the actual year-end financial data for the business.

What to Do Next?

Although the methods to address transfer pricing challenges brought on by the current economic downturn will inherently be specific to each taxpayer, there are a number of practical action steps all taxpayers should take:

• Determine whether a change is required to the current transfer pricing policies;
• Complete an analysis to determine losses associated with the extraordinary events and determine which entities will bear associated risks;
• In anticipation of preparation of transfer pricing documentation, discussions with tax authorities, and potential disputes in the future, carefully document contemporaneous evidence, considerations for any changes in transfer pricing policies, and any analyses undertaken;
• Re-examine the suitability of each of the comparable companies used in the existing transfer pricing system and prepare adjustments that may be appropriate to account for the impact of extraordinary events; and
• In cases where transactions are covered by advanced pricing agreements (APAs), be prepared to fully disclose to the relevant tax authorities the facts and circumstances that impact operations and financial results of the taxpayers, and present proposals for any amendments to the APA.

This article was previously published in Tax Notes International, Volume 98, Number 3, April 20, 2020, and is republished here with permission.

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Dr Vladimir Starkov is an economist and a testifying expert specializing in transfer pricing and asset valuation. He has provided consulting services for multinational companies, closely held businesses, tax authorities, attorneys, and other clients. His experience encompasses a variety of industries, including AgroSciences, automotive, banking, biotechnology, high technology, consumer electronics, manufacturing of consumer and industrial products, electric utilities, pharmaceuticals, petrochemicals, retail, and others.

Dr. Starkov has participated in engagements involving various tax controversy proceedings, including negotiation and implementation support for unilateral and multilateral Advance Pricing Agreements (APA) with tax authorities in North America, Asia, and Europe, design of intercompany pricing methodologies, valuation of intangible property transferred in intercompany transactions, including cost sharing arrangements, and preparation of transfer pricing documentation, including master files and local files for different jurisdictions. Dr. Starkov has conducted business valuation and valuation of intangible assets held by multinational businesses. He analyzed stock option compensation and consulted on strengthening banks’ internal controls. Dr. Starkov has submitted policy advice to the Organization for Economic Co-operation and Development (OECD) on various aspects of transfer pricing rules and testified at OECD public consultation meetings. Over the course of his career, Dr. Starkov has authored whitepapers and bylined articles, and delivered speeches on various topics related to the valuation of intangibles and transfer pricing.

Dr. Starkov holds a PhD and MA in economics from West Virginia University, and an MS in environmental engineering from Mendeleyev University of Chemical Technology, Russia.

Dr. Starkov holds a Certified Valuation Analyst (CVA) and a Master Analyst in Financial Forensics (MAFF) credentials from the National Association of Certified Valuators and Analysts (NACVA).

Dr. Starkov can be contacted at (312) 573-2806 or by e-mail to Vladimir.Starkov@nera.com.

Dr. Higinbotham is a PhD economist and Chartered Financial Analyst (CFA) charter holder with more than 25 years of consulting and research experience in the public, private, and academic sectors. At NERA, Dr. Higinbotham applies his expertise to the intercompany pricing controversies encountered by NERA’s clients around the world.

Prior to joining NERA, Dr. Higinbotham served as A.T. Kearney’s Chief Economist and led A.T. Kearney’s Economics Group. In that role, he led the firm’s transfer pricing practice, where he focused on both litigation and advisory work, with a particular emphasis on the pharmaceutical, electronics, and automotive industries. 

Dr. Higinbotham can be contacted at (312) 573-2803 or by e-mail to Harlow.Higinbotham@nera.com.

Ms. Mert-Beydilli is an Associate Director in NERA’s Transfer Pricing Practice focusing on developing and defending effective arm’s length transfer pricing strategies for multinational companies. She specializes in designing and analyzing intercompany transfer pricing policies and valuation of intangible and intellectual property. Her areas of expertise include designing pricing methodologies through the use of value chain analysis, determining appropriate intercompany prices for tangible and intangible transactions as well as intercompany services, assisting clients with negotiating and implementing Advance Pricing Agreements with tax authorities, and supporting clients in tax controversy situations. She has advised multinational corporations in a variety of industries, including clients in the automotive, construction, and industrial machinery, information technology services, and power generation sectors.

Ms. Mert-Beydilli can be contacted at (213) 346-3035 or by e-mail to Nihan.Mert.Beydilli@nera.com.