Limited Risk Doesn’t Mean No Risk for MNEs

| 4/30/2020
Limited Risk Doesn’t Mean No Risk for MNEs

This is the third in a series of Tax News Highlights articles covering international taxes and what companies need to consider during and after the current global pandemic.

From a tax perspective, many multinational enterprises (MNEs) structure their operations using a three-party arrangement: an entrepreneur owner, a contract manufacturer (CM), and a limited risk distributor (LRD). Under this structure, the entrepreneur economically owns the nonroutine intellectual property and assumes certain risks, which allows it to claim the residual profit or loss in the supply chain. The CMs and LRDs (collectively, limited risk entities, or LREs) earn normal (or routine) returns and should not normally share in the residual profits or losses earned by the entrepreneur.

COVID-19-induced social and business restrictions have limited or completely shut down sales, production, and services for many MNEs. As a result, MNEs and their tax advisers need to examine the implications of any three-party arrangements. A central question to be resolved is whether LREs should continue to earn a profit while possibly forcing the entrepreneur into a ruinous residual loss. Depending on the length of the global pandemic and the adverse economic consequences, many MNEs could earn consolidated losses but still owe taxes in many of the jurisdictions in which their LREs operate.

LREs typically earn normal returns because they generally do not own nonroutine intellectual property. Their business is about providing manufacturing capacity (labor and property, plants, and equipment). Given the lack of significant barriers to entry, they operate in a highly competitive environment, and competition extends to location, delivery, and price. LREs continuously are moving operations from one low-cost jurisdiction to another to maintain their competitive advantage.

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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.

Exhibit 1
Source: Crowe analysis.

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.

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Barry Freeman