In our most recent article, “Transfer Pricing Not Immune to Coronavirus," we discussed the impending economic disruptions on the supply chains and production centers of multinational enterprises (MNEs). Currently, it is unknown whether the U.S. economy is heading toward a recession that may be more severe than the 2008 financial crisis. The outbreak of COVID-19 (“Coronavirus”) is taking an increasing toll on the U.S. economy as the stock market continues to fluctuate wildly since January of this year. 

Uncertainty continues to loom as the number of confirmed cases in the U.S. continues to climb. This has led to stress on the financial system that spreads to the rest of businesses, which may cause businesses across various sectors to report operating losses for the current and upcoming years. The longer the Coronavirus outbreak lasts, the greater the chance that a recession may start a chain of defaults as subprime mortgages did during the 2008 financial crisis. In this article, we will discuss the possible effects of a recession within the scale of the 2008 financial crises would have on transfer pricing benchmarks. 

Possible Effects on Economic Benchmarks

For purposes of determining whether a company’s transfer pricing is deemed to be compliant with the transfer pricing rules, the most prevalent method is the Comparable Profits Method (CPM) [1]. Under the CPM, the company compares a selected profit ratio, known as the profit level indicator (PLI), to the same profit ratio of unrelated companies that are found to be functionally comparable.  The application of the CPM produces a range of profit results and the applicable Treasury Regulations provide for use of the interquartile as the measurement range. The interquartile range is defined as the middle part of a range of data, i.e. the data points found between the first and third quartiles. If the company’s PLI (e.g., net profit margin) is within the interquartile range of comparable company results, then the company’s transfer pricing is generally deemed to be compliant with the arm’s length standard.

The potential effects that the Coronavirus can have on transfer pricing can be illustrated by examining the effects the 2008 financial crisis had.  For example, during the period 2006 to 2011, the median of the interquartile range of PLIs was at a 5-year average low in 2008 for wholesale distribution companies. Although the crisis began in 2007, the decline in PLIs was not fully seen until 2009, with 2009 reflecting the lowest median of PLIs. However, this is not a surprise since the stock market crash of 2008 did not occur later in the year in September making 2009 the first full economic period suffering under the weight of the global financial crisis. Companies may see a different result in the current case, since the Coronavirus pandemic occurred earlier in the year and with a drastic disruption to the physical supply chains. In 2008, the cause was one of a loss of financial confidence.

This may cause concern for companies, as a drop in the tested party profits could cause some MNEs’ transfer pricing policies to become non-compliant, as the PLI measure may fall below that of the benchmark range. However, because the generation of losses is due to unforeseen global health and economic circumstances, the losses could be acceptable to tax authorities if the circumstances giving rise to the losses are clearly explained and placed into context of the overall transfer pricing policy. Since transfer pricing benchmarks look to three-year weighted averages to establish an acceptable interquartile range, one year of unpredictable data may not shift the three-year weighted average median significantly, thereby potentially exacerbating the issue.

Benchmarks based on three-year historic data may not fully reflect the economic circumstances of MNEs in 2020 and therefore it may be advisable to perform additional comparability adjustments based on regression analyses, volume effects and differences in cost structure, cost of capital to capture the impact of increased risks, and other adjustments, as well as reviewing where in the arm’s length range to target to explain tested party losses due to non-transfer pricing reasons.

A&M Taxand Says

A&M recommends for companies to review their intercompany pricing for their intercompany transactions contemporaneously and potentially make adjustments before the end of the fiscal year to reflect the current economic environment.  Whether or not adjustments are needed depends on the length and severity of the Coronavirus pandemic. This coronavirus crisis highlights the importance of thorough transfer pricing documentation and since the creation of documentation is an ongoing process, companies should start preparing documentation as soon as possible.

[1] The CPM is a transfer pricing method set forth in the Section 482 Treasury Regulations and its functional equivalent under the OECD Transfer Pricing Guidelines is the Transactional Net Margin Method (TNMM).