Multinational enterprises (MNEs) account for nearly 80% of world trade. Many countries depend on tax revenues from MNEs, which has led to tax authorities around the world frequently and aggressively targeting the appropriateness of transfer prices. As a result, transfer pricing, one of the main technical topics within global supply chain management, is now even higher on the agenda for CFO teams of MNEs.
Since 1979, the Organisation for Economic Co-operation and Development (OECD) has set international standards in transfer pricing. In January 2022, the OECD published the updated Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (Guidelines). In response, CFO teams of MNEs need to refine company-wide transfer pricing. But doing so won’t be as straightforward as it has been in the past. Significant changes in the world and the emergence of a new normal have made it unusually challenging for MNEs to simply follow the Guidelines on transfer prices without considering the impact on overall business operations.
Similar to an “intracompany” transaction price (between divisions within a single entity) in management accounting, the transfer price in international tax includes an “intercompany” transaction price between entities of one MNE group. More precisely, the OECD Guidelines define transfer prices as the prices at which an enterprise transfers physical goods and intangible property or provides services to associated enterprises.
In setting the price for the transfer, the MNE must apply the arm’s length principle, where the transfer price shall be determined based on the commercial or financial conditions that are like those between independent parties in comparable circumstances. In other words, the price must approximate one that would reasonably be used in a transaction between two unrelated organizations. According to the OECD Guidelines, these comparability factors include the (1) contractual terms; (2) functions performed, risks assumed, and assets used; (3) characteristics of property transferred or services provided; (4) economic circumstances of the market; and (5) business strategies pursued.
Finding an appropriate price isn’t always easy because every MNE has different comparability factors. For example, in some cases, there’s no open or clear market for the service or product on which to base the price. Many countries have long used the OECD Guidelines on transfer pricing as the basis for the legislation of their own domestic laws for taxing MNEs. In addition, MNEs now also use the explanations provided in the Guidelines as a reference in the application of global business operation beyond tax-related matters.
EXTERNAL FACTORS IMPACTING TRANSFER PRICES
Of the many recent developments, we believe the following five external factors have direct and critical impacts on transfer prices. These factors are closely correlated in many ways and have led to the era of a “new normal” (see Figure 1).
COVID-19 and its aftermath. The ongoing impact of the global COVID-19 pandemic has made it impossible to operate traditional transfer pricing structures. Of course, business impacts of the pandemic vary depending on the industry sector, product type, or geographic location. Yet most companies, especially those with a significant global presence, faced workplace transformation, supply chain disruptions, decline of financial liquidity, and restrictions to cross-border movements. Together, these impacts have contributed to a global economic downturn.
The OECD published Guidance on the transfer pricing implications of the COVID-19 pandemic in December 2020 to provide clarification and support for corporate taxpayers and tax administrations in evaluating and applying transfer pricing rules for fiscal periods impacted by the COVID-19 pandemic. With negative impacts on profitability, MNEs must review current transfer pricing policies to reallocate group-level profits based on the economic substance of each related party’s functions, risks, and assets.
Rising nationalism. From a political point of view, nationalism has recently become even stronger, with intense conflicts as populist leaders and their administrations have focused on the best interests of their own countries regardless of the impact on other countries. For example, political friction between the United States and China has arguably added complications for U.S. and China-based MNEs in many ways, as well as the suppliers and customers of these enterprises.
In more extreme cases, countries pursue tax incentives or deregulation designed to promote the reshoring of foreign subsidiaries to generate domestic employment and retain domestic tax revenues. Severe conflicts between countries may require a change in the overall supply chain and transaction structure. MNEs engaged in trade in Russia and in the European Union are facing difficulties with interrupted supply chains and energy procurement caused by the war between Russia and Ukraine and the indirect effects of economic sanctions.
With rising nationalism around the globe, MNEs need to monitor the change of local government politics continuously to readjust their transfer pricing policies in a timely manner and reduce business risks from political actions and events.
Digitalization. Digitalization and the Fourth Industrial Revolution have greatly changed global economies and work environments. Concepts such as AI, robotic process automation, the Internet of Things, blockchain, metaverses, cryptocurrencies, and nonfungible tokens have the potential to make our lives more convenient while also generating efficiencies in enterprise trade.