Prepare Your Transfer Pricing Policies for the Coming Inflation Storm
27 March 2023In addition to navigating global transfer pricing rules, multinational enterprises (MNEs) need to be mindful of the economic environment to continue to comply with the arm’s length standard and remain tax efficient. Currently, rising prices are impacting transfer pricing, and MNEs should consider reviewing their intercompany positions and preparing for a more dynamic transfer pricing environment. Failure to do so may lead to unintended consequences and unanticipated risks.
Why Should MNEs be Concerned with Inflation’s Impact on Transfer Pricing?
Inflation will affect several aspects of transfer pricing arrangements, including through its impact on interest rates, foreign exchange rates, forecasts for budgeting or valuation purposes, intercompany agreements and asset-intensity adjustments. Therefore, MNEs will need to monitor their transfer pricing arrangements to ensure they are arm’s length as the macroeconomic environment continues to evolve.
This environment of rapidly rising interest rates could lead to more reviews and controversy between MNEs and tax authorities regarding intercompany financing.
Variable interest rates: Existing intercompany debt arrangements with variable interest rates will automatically adjust to changes in market interest rates, and MNEs should be mindful of any interest deduction limitations or thin capitalization rules that may apply in the jurisdictions in which they operate.
Fixed interest rates: Fixed interest rate loans will not automatically adjust; this may result in an intercompany interest rate that is no longer arm’s length if the loan is renewed with the same terms.
Safe harbor rates: Use of the applicable federal rate (AFR) under Treas. Reg. §1.482-2 will require taxpayer to review and adjust their intercompany loans to reflect the higher rates published by the IRS. MNEs that avail themselves of the safe harbor rates offered by the IRS need to monitor the rapid rise in the AFRs across short-term, mid-term, and long-term debt instruments and adjust accordingly.
Foreign Exchange Rates
While foreign exchange gains or losses may have been inconsequential in the past, they now may lead to material changes in an entity’s profitability and therefore must be monitored closely.
Foreign exchange gains/losses: MNEs need to monitor rapidly changing exchange rates and determine who would bear the burden of foreign exchange gains or losses among related parties. Foreign exchange hedging may be more relevant during this period of high inflation, so MNEs should allocate the related costs appropriately.
Forecasting and Budgeting Estimates
Many tax authorities closely scrutinize transactions involving intangible property (IP). The models used to evaluate these transactions rely on assumptions that are sensitive to inflation, for example, assumptions regarding interest rates, discount rates and forecasts of revenue and costs. Each of these items could be subject to examination and challenge. MNEs should perform sensitivity analyses around their forecasts (particularly those that are utilized in valuing IP) to determine how sensitive their transfer pricing is to their economic assumptions.
Forecast used in IP valuations: Forecasts used in IP valuations rely on various assumptions that are impacted by inflation, including growth rates related to revenue and costs. Transfer pricing valuations, cost sharing arrangements and budgeting will need to be updated frequently to try to capture these inflation effects.
Forecasts used for budgeting purposes: Budgets prepared by MNEs at the beginning of a fiscal year may not capture inflation-induced changes in standard costs during the year; this may lead to unforeseen deviations between actual results and the MNE’s stated transfer pricing policy. If left unaddressed, this could lead to large end-of-year transfer pricing true-up adjustments.
Intercompany Agreements are Critical
Use of contractual clauses increases flexibility: It can be quite difficult to predict the manufacturing costs of a product or the costs for the provision of services, especially in a highly inflationary environment. Companies should consider using contractual clauses (e.g., renegotiation of contract terms in extraordinary economic environments) that provide flexibility.
Rising inflation will impact existing covenants in loan agreements and the extent to which they may trigger a technical default. Maintenance covenants may include financial requirements establishing limits on borrowed funds, setting leverage ratio limits, operating margin targets or credit rating requirements for the parties to the agreement. The quickest solution is to identify and monitor the agreement maintenance covenants more frequently.
MNEs should review intercompany agreements to determine if the changing economic environment triggers the possibility of renegotiation under the terms of the agreement. Quite frequently, these agreements include clauses that allow one or both parties to initiate a renegotiation of the terms of the agreement when certain conditions are met.
With rising interest rates, MNEs and transfer pricing practitioners should expect asset-intensity adjustments to have a larger impact on arm’s length ranges. MNEs that do not consider these adjustments now or monitor the economic environment may end their fiscal year to find that the results of their intercompany transactions fall outside of the arm’s length range and require a large year-end adjustment.
Functional Characterization: Service Provider vs. Distributor vs. Entrepreneur
The functional characterization of an entity is significant in determining who bears the impact of inflation. Clear functional characterizations become critical in a transfer pricing analysis to properly allocate changes in profits levels due to inflation.
A “cost-plus” service provider should be insulated from the effects of inflation (at least in the short term for the duration of its contract) and may even welcome inflation because it increases the cost base on which a mark-up is applied. In the long term, the service recipient bearing these costs may wish to renegotiate terms in an effort to shift risk. It is important that the actual allocation of risk be reflected in the transfer pricing between related parties.
A limited-risk distributor should earn its target operating margin as guaranteed by the principal entity. To the extent that its sales are rising with the overall price level and its return percentage is fixed, a limited-risk distributor will earn more operating income in nominal terms. Similarly, a licensee paying a fixed royalty to an IP-owning licensor may earn more operating profit (in nominal terms) due to rising prices/revenues. Therefore, MNEs should monitor their intercompany transactions regularly to understand the impact of inflation and so they can periodically adjust their results to ensure intercompany transactions remain arm’s length.
In the case of cost sharing participants, multiple parties hold economic rights to the IP being cost-shared. Reasonably anticipated benefit (RAB) shares are normally adjusted annually to reflect new forecasts of revenues and costs in different jurisdictions. Differential rates of inflation across jurisdictions could lead to significant changes in the relative RAB shares compared to a taxpayer’s prior calculations. As such, MNEs in cost sharing arrangements should update their forecasts for changing macroeconomic conditions to calculate accurate RAB shares.
What if the Controlled Party’s Results are Outside the Comparable Company Range?
The arm’s length range of results may shift due to the impact of inflation, and the tested party may unexpectedly fall outside the arm’s length range. Therefore, MNEs should scrutinize and update their benchmarks to determine if they remain sufficiently comparable to the tested party, or if adjustments need to be made.
In addition, many industries (such as the consumer goods/retail sectors) experience volatility in profit levels due to inflation, and this will impact benchmarking in these industries. In practice, MNEs sometimes choose to refresh their benchmarks only once every three years. Given the current economic environment, MNEs should consider more frequent updates to their benchmarks to ensure that their controlled transactions fall within the arm’s length range. Furthermore, taxpayers may use a longer multiyear period (for example, five years instead of three) to help address volatility in a single year.
To keep abreast of changing market conditions, MNEs can implement transfer pricing automation technologies to monitor intercompany transactions more effectively in real time and to minimize control risk and year-end adjustments. This will assist MNEs to not only actively track the operational results of related parties engaging in intercompany transactions but also to perform transfer pricing adjustments more frequently.
The current macroeconomic environment is volatile, and most tax practitioners have not seen such conditions during their careers. The recent rise in the CPI to peak at a 40-year high of 9.1 percent during 2022 necessitates careful consideration of how MNEs will continue to comply with the arm’s length standard.
For more information, please reach out to our Tax Team.