Best method analysis

Balancing transfer pricing in a recession is both
an art and a science, says Kathrine Kimball


Although some may consider transfer pricing a “black box,” the shared adage among most finance professionals is that transfer pricing is comprised of both art and science. The science of transfer pricing is grounded in financial data and the relevant tax laws while the art of transfer pricing is based upon an intuitive sense of which adjustments and assumptions may best align the scientific aspects with the realities of the business. At present, many transfer pricing practitioners believe that the recent dynamics in the global economy, such as unprecedented increases in corporate borrowing costs coupled with limited access to capital markets as well as total system losses for multinational companies, may require a different perspective in defining arm’s length behaviour. It is precisely this shift of economic reality that has created both a necessity and an opportunity for organisations to rethink their global transfer pricing.

Cyclicality of the sector

An industry analysis is the foundation of a transfer pricing framework and should seek to explain any deviations from the industry’s historical trends experienced during the recession. Most industries have been impacted by the current economic environment while a chosen few have been recession resistant. The cyclical industries that have been severely impacted by the recession, such as the financial services and automotive sectors, will require reconsideration of their financial analytics given the newfound government intervention and ensuing regulatory changes. As such, benchmarking in these industries must ensure accurate comparisons of financial results either through a search for comparable companies that are subject to similar regulatory conditions or the application of appropriate financial statement adjustments to account for differences in capital costs or SG&A burdens.

Best method analysis

The fundamental assumptions around the “best method” selection, as defined in most tax jurisdictions, must be challenged to test the relevancy of the method during recessionary periods. Although each country will address the best method and data requirements differently, as an example, the US tax law presents the rule under the Internal Revenue Code Section 1.482-1(c). For a transaction-based method, whereby an intercompany policy is established using the same terms as in third-party transactions, current market conditions may have changed a company’s terms with those third parties, creating a need to evaluate the applicability of that change to the intercompany transaction. For a profit-based method, the basic method may be appropriate yet an alternative profit level indicator may yield a more reliable result under depressed market conditions.

In the current environment, a comparison of the company’s performance to the comparables may prove challenging for several reasons. On the practical side, comparables used for profit-based methodologies will normally incur a natural attrition, which has now been accelerated during the recession through an increase in bankruptcy volumes. Moreover, there is a natural time lag in the availability of financial data that will create a misalignment in some cases and the potential risk of inappropriate comparisons of recessionary years with pre-recession years. According to US tax law, a basic premise of the best method selection is to employ the method which produces the most reliable measure of an arm’s length result given the degree of comparability between the taxpayer and the third-party transactions as well as the quality of the data and the assumptions (Ibid). As such, sensitivity to these fundamental data issues is always considered a best practice yet should be viewed as essential in this environment.

Legal and tax

Opportunities as well as risks may be found in a review of the current transfer pricing policy and the supporting intercompany agreements. The legal and tax departments of a company should jointly scrutinize and validate the use of the current terms of the intercompany agreements to ensure that the “…terms are consistent with the economic substance of the underlying transactions,” as outlined in the Internal Revenue Code Section 1.482(d)(3)(ii)(B)(1). For most companies, certain intercompany terms are worth further consideration, including a minimum return “guaranteed” for distributors or a minimum royalty paid to an affiliate for marketing intangibles. In the event of systemic losses, a company should reconsider the arm’s-length validity of such arrangements; it is likely that the tax authorities will do the same.

Risks and opportunities

Global transfer pricing policies must be reviewed in light of the current economic conditions to ensure that the risks have been properly mitigated and the opportunities have not been overlooked. The risks may be found either in the scientific dimension or the artistic dimension, the changes in the financial foundation or in the assumptions made surrounding the business model and the value drivers; the worthwhile opportunities will be found in the balance of the two.

Kathrine Kimball is VP of Ballentine Barbera Group, a CRA company. For more information