Transfer pricing during economic uncertainty

In December 2020, the Organization for Economic Cooperation and Development (OECD) provided guidance on the transfer pricing implications of the pandemic. As economic uncertainty continues, businesses must consider how to manage their transfer pricing to accommodate the situation and how to support and defend transfer pricing in the U.S. and abroad when intercompany transactions are affected by unexpected factors like rising oil prices and inflation. Following are three things to consider about transfer pricing today.

1. OECD comparability analysis: Comparing the budgeted and actual financials and the effect of unexpected factors

The OECD transfer pricing guidelines comparability analysis allows for arm’s-length outcomes to be supported through either the price setting or outcome testing approaches. The price setting approach refers to documenting reasonable efforts made by taxpayers to comply with the arm’s-length standard at the time the intragroup transactions were undertaken based on information that was reasonably available at that time. Using this approach, taxpayers can argue that a transaction is arm’s length in nature because prices were set at the start of the year to achieve an arm’s-length outcome. This strategy can support the arm’s-length nature of the transaction, particularly when a business is significantly affected by unforeseen circumstances.

In addition to relying on the price setting approach, taxpayers can support transfer pricing by modeling out the impact of the unexpected factors by doing the following:

• Preparing a detailed variance analysis of the business’s budgeted profit and loss statement versus actual results showing changes in revenue and expenses, with an explanation for variances resulting from any demand or supply-side disruption.
• Analyzing the profitability of the business, adjusted for what the outcome would have been if the unexpected economic effect had not occurred. This analysis should consider all factors that have a positive or negative impact on the taxpayer’s profits in a related-party transaction and should be supported by evidence.
• Outlining the rationale and evidence for any increased allocation of costs or reduction of sales (and subsequent changes in operating margins) to the taxpayer in the related-party transaction, taking into consideration the taxpayer’s function, asset, and risk profile.

Modeling could be particularly useful for companies affected by the situation in Russia and Ukraine. With many companies exiting Russia, some have sold their Russian operations at below market value, while others have terminated operations without selling the business, both of which will lead to additional costs and restructuring expenses incurred by taxpayers. In line with transfer pricing principles, taxpayers should prepare a detailed analysis on the exceptional costs and documentation to support the analysis, including identification of the parties responsible for performing activities related to such costs and the risks associated with these activities. This type of analysis can help determine and support, from an arm’s-length perspective, which entity within a taxpayer’s global structure should bear the financial burden of these decisions.

2. The commensurate with income concept

U.S. transfer pricing regulations have special rules and examples addressing uncertainty in forecasts and projections, but these regulations primarily focus more narrowly on intangible properties. Section 1.482-4(f) introduces the concept of commensurate with income (CWI) and discusses applying this special rule in the case of extraordinary events. Generally, adjustments should not be proposed for intercompany transfers or sales of intangible property if, due to extraordinary events beyond the control of the taxpayer that could not have been reasonably anticipated at the time the related-party agreement was entered into, the five-year aggregate actual profits are less than 80% or more than 120% of the prospective profits.

No specific guidance applies the CWI test to tangible property transactions, but the current extraordinary environment of economic uncertainty might present an opportunity to persuade the IRS to apply the CWI analysis more broadly to nonintangible property transactions. Taxpayers considering such a strategy should take steps now to evaluate and document the arm’s-length nature of all intercompany transactions using the principles of the CWI test.

3. Third-party arrangements

The arm’s-length standard is the foundation of IRS transfer pricing guidelines and regulations. One practical application of the arm’s-length standard in periods of high economic uncertainty is to mirror how third parties behave during these periods. The challenge with this approach, however, is that it is difficult to understand how other companies are responding to the economic environment in a contemporaneous manner. One way is to look at the quarterly filings of key industry players and competitors. Industry publications also might provide insights on the options that independent third parties are contemplating. For example, evidence of companies trying to renegotiate contractual terms and the success of these efforts could provide useful anecdotal evidence for how other taxpayers engage with third parties to support the arm’s-length nature of the taxpayer’s transfer pricing.

Looking ahead

Ongoing global economic uncertainty is likely to put pressure on government revenues and collections, which could lead to increased efforts by the IRS and other tax authorities to audit company transfer pricing. Adequate timely documentation is critical in ensuring that transfer prices can be defended in times of great uncertainty when transfer pricing outcomes cannot be accurately predicted. Taxpayers should work with their advisers to ensure that they are prepared to defend transfer pricing determinations in this highly volatile economic environment.