Limited Risk Doesn’t Mean No Risk for MNEs

The exhibit shows the operating margin for 16 CMs from 2007 to 2019.¹  The data confirms several tenets of transfer pricing. Most of the firms have operating margins between 1% and 5%, and although there is variability over time, most firms stay within this range. More important, several firms had operating losses, at least for a short period, and those that could not remain viable in the long term discontinued operations. The period around the Great Recession shows much higher variability in operating margin and greater likelihood of loss. While a similar analysis for distributors is not included, similar results can be expected.

The exhibit illustrates that while these CMs usually earn some amount of profit, it is not a foregone conclusion. The notion of absolute profitability likely comes from the implementation methodology, on the one hand, and the need to demonstrate that the results are consistent with an arm’s-length outcome, on the other hand. The most common method for evaluating an entity’s transfer price is the comparable profits method (CPM) – a method that infers arm’s-length pricing based on measures of profitability, such as the full-cost markup or return on sales. If the profitability of the tested party is within the (interquartile) range of profitability for comparable companies, then the pricing is considered arm’s length. This range of results often is used in an intercompany agreement, and it is common to see language that the LREs should earn cost plus a markup. The problem is that the LREs receive payments for any cost incurred regardless of output or sales. Transfer pricing typically deals with determining the appropriate markup without considering the cost per unit.

What MNEs should do now

MNEs should consider adjusting the markups and returns paid to LREs as the economic impact of COVID-19 ultimately will be reflected in the CPM ranges beginning in mid-2021. The impact of COVID-19 likely will be universal and likely will cause a decline in the three-year weighted average range of results. The risk to an MNE of reducing the profitability of LREs in anticipation of these expected results likely is small as most countries evaluate the results on a multiyear basis. 

MNEs also should review any in-place intercompany agreements to determine whether the reduced markup should be applied to all operating costs. The current pandemic highlights the shortcuts that typically are taken for the sake of simplicity and to ease implementation, as most agreements call for reimbursement of total cost plus a markup without consideration of output. These shortcuts create potential risks as taxing authorities expect LREs to be profitable. These risks could be mitigated if the markup is applied to a cost per unit of output. Avoiding such shortcuts would better reflect arm’s-length contracting and could result in losses at the LREs if output is less than budgeted. 

If the markup is to be applied to all costs, then an MNE could consider using the force majeure provisions, which would terminate the agreement. Doing so likely would suspend payments to the LREs if they are unable to provide services and would allow the entrepreneur to renegotiate the agreement once the pandemic is over. While taking such an action certainly is plausible, uncertainty exists as to how the taxing authorities would respond.

¹ Data derived from publicly accessible information.