How inflation affects Transfer Pricing?
RoyaltyRange
Global inflation adds complexity into Transfer Pricing by affecting cost structures, profit margins, comparability, and regulatory examination. These difficulties can often arise using transaction-based methods such as Comparable Uncontrolled Price (CUP), Comparable Uncontrolled Transaction (CUT), Cost Plus (CP), or Resale Minus (RM), as rising costs significantly impact the analysis and lead to reduced margins impacting Transfer Pricing. To reduce these challenges, multinational companies must adjust their Transfer Pricing policies and documentation to reflect the current inflationary environment, ensuring compliance with the arm’s length principle and avoiding tax risks.
This can be especially relevant if your company‘s Transfer Pricing model is based on guaranteed operating margins for certain entities. Many multinational companies operate with contract manufacturers, contract service providers, and/or limited risk distributors. These entities typically have limited control over the risks and assets relevant to their transactions. In contrast, the contracting party managing these key risks and assets is referred to as the ‘principal.’
From a Transfer Pricing perspective, limited risk entities are expected to earn a modest but stable profit, often calculated as a percentage of costs using the ‘cost plus’ method or of revenue using the ‘Return on Sales’ (RoS) method. The principal retains or absorbs any residual profit or loss. The applicable arm’s length margin for these methods is documented in the Transfer Pricing policy and intercompany agreements and should be reviewed annually through a benchmarking study. If the limited risk entity’s financial results fall below the arm’s length margin specified, the principal may need to make a year-end adjustment.
In the current economic climate, where costs for resources, energy, and labour are rising, it may not always be feasible for the company to increase market prices correspondingly, leading to reduced margins. This situation raises the question of how these rising costs should affect Transfer Pricing. Specifically, should the principal compensate for higher costs or lower margins? Under a Transfer Pricing policy that relies on a stable cost-plus method, these rising costs could potentially result in a higher actual profit for the limited risk entity.
Time
Traditionally, seasonality has been a key factor in comparing commodities and other cyclical goods. However, in the current inflationary climate, all goods and services should be compared to third-party transactions that occurred around the same time. In the past, if the benchmark transaction occurred within the same fiscal year as the intercompany service, timing was less critical. However, under current economic conditions, timing becomes significantly more important.
With inflation driving fluctuations in interest rates and bond yields, what was once a primary focus on the borrower’s credit rating now requires equal attention to the origination timing of the loan. While factors like the loan’s currency and duration remain important, in today’s environment, the timing of the origination is as critical as the credit rating.
When employing the Transactional Net Margin Method (TNMM) or Comparable Profits Method (CPM) for analysis, inflation impacts the margins (PLIs) of both the tested party and the comparables as well as inventory and labor costs for transactions involving both tangible goods and services. Consequently, it is essential to ensure that the time periods for the tested party and comparables are closely aligned to ensure accurate results.
Agreements
In many situations, the agreements governing intercompany transactions will outline the conditions under which deviations from the agreed-upon policy are acceptable. At arm’s length, these agreements should specify that the party responsible for managing a particular risk should also bear the financial impact if that risk materializes. Therefore, it is important to determine, which party should bear the burden of the extraordinary circumstances, such as the increased costs in this case.
To determine whether deviations from the agreed policy are permissible under the arm’s length principle, the following factors should be considered:
- Contractual Agreements: The terms and conditions outlined in the contracts between the parties.
- Actual Practices: How the parties operate and conduct their activities.
- Functions, Risks, and Assets: The roles, risks, and assets of each party involved.
- Market Behaviour: How third parties in the same market are responding to the current extraordinary circumstances.
- Realistic Options: The feasible alternatives available to the parties involved.
It is also important to evaluate which margins, whether Cost Plus or Return on Sales (RoS), offer the most appropriate benchmark given the current circumstances.
In this context, it’s worth evaluating the following aspects:
- Historical Data: Using data from previous years with higher-than-average inflation rates might be more relevant than relying solely on the most recent data.
- Benchmarking Range: A different point within the benchmarked interquartile range, or even the entire range, might be more appropriate for comparison.
Depending on the situation, using multi-year data for the limited risk entity may be beneficial. Averaging data over three to five years, including the current year, can help keep margins within policy ranges and reduce the need for year-end adjustments.
If you decide to modify the agreement or deviate from the standard benchmarking approach, it’s crucial to prepare detailed documentation supporting these changes and explaining the decision-making process. Conversely, if you choose to adhere to the policy, this decision and rationale should be reflected in the Transfer Pricing reports to meet documentation requirements.
If you need assistance in finding the right comparables or selecting the appropriate method for your benchmarking analysis, consider exploring the solutions provided by RoyaltyRange here.
Sources:
https://kpmg.com/ch/en/insights/taxes/transfer-pricing-manage-inflation-risk.html
https://www.ey.com/en_it/tax/8-ways-interest-rates-affect-transfer-pricing-and-how-to-adapt