Transfer Pricing Strategies for the New NormalBy
Multinational enterprises need to reassess their approaches to transfer pricing in the face of changing global conditions.
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.
As Wilfred W. Wu, Henghsiu Lin, and James Jurinski wrote in “Adding Blockchain to Business Curricula” (Strategic Finance, August 2021), blockchain technologies will give us access to real-time data that will improve verification of transfer pricing by tax authorities while decreasing reliance on excessive paperwork and documentation. At the same, this digitalized economy will also displace some jobs while creating new ones, thereby altering MNEs’ business structures. As such, MNEs will need to adopt their transfer pricing policies based on changes driven by digitalization.
International taxation of the digital economy. After the global financial crisis in 2008, many developed countries experienced reduced tax revenues from MNEs’ tax plans. The OECD concluded that $100 billion to $240 billion (approximately 4% to 10% of global corporate tax revenues) are being lost annually due to tax avoidance by MNEs. As a result, the OECD and the G20 initiated anti-base erosion and profit shifting (BEPS) frameworks in 2012, with 141 countries adopting the BEPS project guidance.
The BEPS project is comprised of 15 actions that basically cover recent and controversial issues in the international taxation system, such as tax treaty abuse, permanent establishment, hybrid mismatch arrangements, harmful tax practices, and so forth (see Figure 2). Of the 15 actions, four are directly related to transfer pricing: Actions 8 through 10 focus on transfer pricing specifically, addressing intangibles, risks and capital, and high-risk transactions, respectively; and action 13 addresses transfer pricing documentation and country-by-country reporting. This underlines the importance of transfer pricing to international taxation systems.
As countries revise their domestic tax laws to reflect the BEPS project’s guidance, tax authorities from various jurisdictions may conduct more aggressive tax audits, which would likely lead to more disputes such as tax appeals and litigation. To mitigate these potential risks in advance, MNEs must apply consistent global transfer pricing policies, prepare substantial transfer pricing documentation, and manage justifiable allocation of global profits based on such factual relations.
Environmental, social, and corporate governance. The global movement toward better management of environmental, social, and corporate governance (ESG) issues has pressured corporations, including most MNEs, to improve their transparency. To address the governance aspect, for example, some Korean MNEs state on their websites that they have established and operated effective tax policies (including transfer pricing) that comply with the relevant regulations, which prove their sustainability in terms of governance. As shareholders’ and potential investors’ expectations on ESG management continue to increase, MNEs’ establishment and implementation of their global tax policies have become more important.
EFFECTIVE TRANSFER PRICING STRATEGIES
Transfer pricing isn’t an exact science. MNEs need to determine transfer pricing based on the unique characteristics of their business strategies, functional profiles, economic conditions, legal terms, etc. Consequently, there’s no single, perfect solution that all MNEs should adopt to cope with recent challenges.
Yet we propose that there are several general, yet very critical, points for transfer pricing implementation that MNEs can bear in mind. Our suggestions all start with the prefix “re-,” meaning again or backward. In this era of the “new normal,” now is the time for MNEs to take a step back and reconsider or reimagine their transfer pricing strategies to fully respond to the rapidly changing global environment.
Restructure businesses. As previously mentioned, MNEs must revisit their outstanding transfer pricing policies to determine whether they’re flexible to accommodate external or unexpected factors such as COVID-19. At the same time, they must review whether current transfer pricing structures are aligned to the groups’ future business prospects. When any vulnerable areas exist, MNEs may consider business restructurings.
For the evaluation of transfer prices, each MNE entity’s expected return (profit) can be determined depending on the level of functions performed, risks assumed, and assets used from an economic perspective. According to this concept, which is the basis of the transfer pricing analysis to be in compliance with the arm’s length principle, an entity with a lower level of functions, risks, and assets (e.g., a sales support service provider or toll manufacturer) would likely earn a lower level of profit potential, while an entity with a higher level of functions, risks, and assets (e.g., a full risk distributor or full risk manufacturer) would likely earn a higher level of profit potential.
MNEs’ business restructurings require a great deal of resources and administrative effort as they involve changes with cross-border contractual terms along with risk allocation and economic substance. For example, the parent company of a multinational group may decide to transfer shared services from a foreign subsidiary to the parent level in order to save costs. Moreover, a foreign subsidiary previously characterized as a licensed manufacturer might be transformed to a contract manufacturer to focus only on manufacturing activity without any sales to third parties. Another example is to restructure a sales support service provider (receiving commissions that will be exposed to a special tax issue called the permanent establishment in the relevant jurisdiction) to a limited risk distributor. Business restructurings need a careful approach for the economic substance under the changed structure, conforming to each entity’s functional profile while considering the risks assumed and assets used.
Revise transfer pricing policy. Business restructurings should be simultaneously conducted with a revision of existing transfer pricing policy. Even in the absence of major restructurings such as shutdowns, mergers and acquisitions, or the establishment of a new entity, transfer pricing policies should be reviewed and revised periodically. This revision can be made based on the current transaction structure by reasonably changing the economic substance of entities within an MNE group in order to reinforce a governance factor of the ESG concept.
A transfer pricing analysis is required either for planning purposes before conducting any transactions (the arm’s length price setting on an ex ante basis) or for year-end compliance purposes to evaluate whether a specific fiscal year’s transfer prices conform to the arm’s length principle (the arm’s length outcome testing on an ex post basis). This analysis mostly relies on the economic principle that, similar to third-party independent companies in the market, lower-risk-bearing entities with simpler functional profiles should earn routine margins, whereas entities with higher risks may earn higher profits (or proportionate losses). Thus, by adjusting the economic substance of entities within an MNE group, profit allocation for each of these entities should be adjusted according to the respective value chain.
Once a revision of the group transfer pricing policy is finalized, any changes should be consistently reflected in intercompany agreements. These agreements are fundamental and essential documents for proving the substance of transfer pricing transactions, especially for tax audits. MNEs may consider inserting or amending a special term into their intercompany agreements, such as a force majeure provision. Such a provision may include conditions that affect transacting parties’ profits under extraordinary or unexpected circumstances to more flexibly adjust or renegotiate transfer prices or trade terms.
Reestablish active measures. Most importantly, MNEs must prepare robust transfer pricing documentation for specific fiscal years—not only to comply with the relevant countries’ tax laws but also to reasonably describe and explain their transfer pricing positions in advance. Transfer pricing documentation is a narrative document, containing complex and often confidential quantitative and qualitative information. This documentation must synchronize with the group transfer pricing policy and intercompany agreement to prove that an MNE’s transfer price is implemented consistently and transparently. Especially for the fiscal years during COVID-19, customized documentation should explain how the global pandemic has impacted the MNE’s transfer prices and profitability as well as for the relevant industry, so its transfer prices are more reasonably evaluated.
To avoid future potential tax risks, an MNE may consider the most advanced and strategic action plan by implementing an advance pricing arrangement (APA). (For an introduction to APAs, see Juan Rivera and Ken Milani’s “Strategies for Global Operations,” Strategic Finance, January 2021.) According to the OECD Guidelines, an APA is a type of agreement between the tax authority and the MNE made in advance of future transfer pricing transactions that outlines an appropriate set of criteria such as a method, comparables, and appropriate adjustments. Basically, it sets the critical assumptions for future determination of transfer prices for transactions over a fixed period.
Because an APA application involves active and ongoing discussions between the tax authority and MNE to determine arm’s length prices to be applied for the applicable period, it usually requires a considerable amount of administrative burden. Nonetheless, the APA application can still be beneficial since an APA approved by the tax authorities may remove operational transfer pricing risks. For example, a large Korean electronics MNE with more than 20 foreign subsidiaries has enjoyed APA benefits for global management of operational transfer pricing risks. The company continuously renews previously concluded APA cases and submits new applications for international transactions with other subsidiaries.
Other Korean MNEs also use APAs. To demonstrate their transparency and effective governance with regard to global tax policies as part of their ESG agenda, it isn’t uncommon to see these companies specify on their websites that they have some concluded and ongoing APA cases.
Review recent regulatory updates. The member countries of the OECD/G20 inclusive framework on BEPS have all been continuously revising the reports on the BEPS project’s 15 actions. As part of the project, the most drastic change would be the introduction of a new digital tax under action 1, “Tax challenges arising from digitalization.” In July 2021, the member countries signed a historical reform of the international tax system with the digital tax’s two-pillar approach. Based on the OECD’s explanation, pillar 1 reallocates some taxing rights over MNEs from their home countries to the markets where they have business activities and earn profits, regardless of whether the firms have a physical presence there. Pillar 2 seeks to put a floor on competition over corporate income tax through the introduction of a global minimum corporate tax rate of 15% that countries can use to protect their tax bases.
Because the OECD is still receiving public consultations on discussion drafts for each pillar, the details of the digital tax’s two-pillar approach may be slightly revised. It’s still worth reading the draft reports, however, as these policies may eventually influence related industries and, thus, some MNEs will be significantly affected by their introduction. For instance, if countries around the world legislate the global minimum corporate tax rate of 15% into their domestic tax laws, MNEs that have initially set their complex global transaction structure focusing on tax savings wouldn’t benefit from such aggressive tax planning schemes anymore. Thus, those MNEs may seek to change their transaction structures to solely focus on their businesses themselves rather than to have numerous foreign subsidiaries without significant value chain activities utilized for the tax benefits. In addition to the digital tax, MNEs should closely monitor legislation of any new international tax regulations and recent tax audit trends to deal with any issues ahead of time.
In general, transfer pricing policies are developed as a collaboration between external advisors and in-house practitioners. Most MNEs seek external advisor evaluation of transfer prices for compliance and planning purposes, while the in-house practitioners implement recommendations from the external advisor evaluation. Strategic finance and management accounting teams, especially those dealing with transfer pricing in global supply chains, should be well-versed in recent transfer pricing developments—rather than outsourcing or relying on the knowledge of external advisors. With the suggestions we’ve provided, strategic financial leaders in companies of all sizes and sectors can be more proactive and well-prepared in adapting transfer pricing to deal with the era of the new normal.
Of all the measures mentioned, the most important part of any transfer pricing strategy is continuous reinforcement (see Figure 3). Management accountants need to provide their insights when following up on the actual implementation and to redesign policies in accordance with the rapidly changing global environment.