Times are tough. But as multinational businesses wrestle with serious economic pressures, transfer pricing remains central to ultimately balancing their global tax burdens and minimizing tax controversies. Transfer pricing strategies developed in a more stable business environment may not yield satisfactory or appropriate results in the face of unusual stress. Working with their operational counterparts, tax directors should monitor and, as necessary, modify the company's transfer pricing situation.
Transfer pricing methodologies (TPMs) applied to cross-border transactions between commonly controlled entities evaluate the parties' relative functions, risks and assets, and then value them using benchmarks based on "comparables." The financial evaluations of the "tested party" and the comparables are typically based on profitability measures. All of these elements may be profoundly affected in a protracted economic downturn.
Evaluating the effect of business volatility on transfer pricing and potential responses involves several levels of analysis.2 First, the nature of the problem — if any — must be identified. Then, as a better understanding of the relevant factors and drivers develops, various ameliorative steps can be weighed. Special considerations may apply to taxpayers with advance pricing agreements (APAs) or currently in the APA process. Of particular note, loss situations expose the tension between the usual one-sided methodologies that test the profitability of only one of the related parties — generally requiring some profit — and the fact of overall system losses. More balanced bilateral profit (or loss) sharing methods are available only where all parties have intangibles, and are complex to negotiate and implement.
Diagnosis: Identifying The Problem
Review The Characterization Of The Related Parties. Transfer pricing methodologies depend on which of the related parties is treated as the "tested party" —usually the one with the simpler role — and how that party is characterized. For example, it can make a difference whether the tested party is considered a buy-sell distributor or a sales agent, or whether various functions are considered independently (e.g., distribution functions and other support services) instead of being considered on an integrated basis (e.g., as a value-added distributor). This can affect what kind of TPM is used as well as the type of comparables considered. If a profit-split method is used, both related parties are taken into account and their relative roles must be characterized.
This simple initial reference point is critical in evaluating the effect of business developments. You must have in mind the "base case" core functions, risks and assets of the related parties in order to identify changes and their potential effect, as well as appropriate comparables. Particularly important in the down-economy context is mapping which entity bears which risks.
Evaluate The Extent Of And Reasons For The Erosion Of The Tested Party's Profitability. Pinpointing the most pertinent factors can be particularly helpful in suggesting potential remedies. Then, the scale and likely duration of the key problems should be reviewed to determine whether it is worth considering new TPM approaches or whether a quick reversal of fortune could moot the issue or, worse, produce more disadvantageous results. For example, as discussed more fully below, a sharp drop in sales might be addressed through a rate-of-sales-growth adjustment mechanism, but if a recovery over two or three years would largely obviate the problem under an averaging or term test method, the complexity of developing such a modification may not be warranted, or the converse adjustment in later years may be undesirable.
Potential contributing factors may include:
- Decline in sales (units/value) and rate of any decline
- Decline in unit prices and rate of any decline
- Increases in costs: variable costs, fixed costs, financing costs, etc.
- "Restructuring" costs (e.g., layoffs, severance, consultants, shut-down of facilities)
- Financial/business problems of suppliers
- Financial/business problems of customers; worsening credit risks
- Inflation or deflation
- Currency effects
- Changes in assets, including working capital elements
- Government support3
- Controlled group priorities and structuring
- Change in competitors' behavior and circumstances
- Change in identity of competitors (e.g., through bankruptcy, exit, or consolidation), and implications for the tested party's market share
- Offsetting positive factors could include decreases in certain costs because of lowered demand or deferred investment or expansion costs
Look At The Economics Of The Other Related Party. Consider the same factors as above with respect to the other party to the cross-border transactions, and how its situation might affect the tested party. For example, bankruptcy of a key supplier of the parent company could adversely affect the subsidiary's access to products to sell, though the extent of the problem would depend on possible alternative sources. Among other things, these matters could create acute effects on the cash needs of the related party.
Evaluate What Is Happening To The Comparable Companies. The comparable companies used as a reference point for testing the arm's-length nature of the related party transactions are obviously pivotal. They may also be experiencing adverse (or occasionally favorable) effects from current economic conditions, which can affect their profitability as well as their very comparability to the tested party. To side-step transfer pricing penalties, taxpayers are expected to use the most current reliable comparable data at least through the end of the taxable year being evaluated, and possibly up to the tax return filing date.4 Even in the context of an APA (discussed later), periodic review and updating of comparables may be required — or desirable.
The obvious first step is to obtain the most recent financial information available for the comparables and see what it shows. Unfortunately, however, up-to-the-minute financial data reflecting the downturn effects will probably be unavailable.
If it appears, in fact or anecdotally, that the comparables' results may diverge from those of the taxpayer, you should resurrect the key comparability factors that were originally used in identifying the comparables set: product, industry, functions, level of the market, or other variables. Then events tied to these factors that are pertinent to the comparables' profitability as well as their comparability to the tested party can be reviewed. In the latter respect, consider ways in which the comparables' situations differ from those of the tested party, e.g., in respect of business cycle, severity, volatility, ability to react, actions being taken, government intervention/ support, relative importance of financing availability/rate, and regional variations. Also, comparables may be disappearing through bankruptcy, close-down, sale, or consolidation.
Universal Remedies
Tough times call for more, not less, attention to transfer pricing. The following three suggestions are broadly applicable:
- Really Update Your Transfer Pricing Studies. Stable business conditions often lull taxpayers into routine updates of pricing studies. Volatile business conditions suggest the opposite — and perhaps even starting from scratch. Specific ideas that may be relevant are set forth in the next section of this article.
- Revisit Current Results Frequently, And Leave Time For Serious Evaluation Of Potential Post-Year-End Adjustments. If at all possible, make pricing adjustments before year end. While taxpayer-initiated adjustments under Treas. Reg. § 1.482-1(a) (3) may turn out to be needed, interpretative issues abound. Of particular concern is the possible lack of congruity in the local rules applicable to the foreign side of the transactions.5
- Invest In Sophisticated Economic Analysis In Appropriate Cases. Extreme circumstances put a premium on expertise in terms of econometric theories and methods, industry analysis, and assessment of economic effects. "Cook-book" analyses are unlikely to suffice. (An interesting example of practical econometrics can be found in the indexing concepts recently suggested by an IRS economist.6) While a cost-benefit analysis is always in order, the costs of a messy hindsight-oriented audit should not be underestimated.
The Medicine Chest: Deploying Data To Treat Transfer Pricing Ailments
If a company is having, or anticipating, difficulty in satisfying its previously established TPM, there are a number of potential remedies to consider. "Going bare," i.e., blithely awaiting audit, should be a relatively last resort given the likelihood of increased enforcement by revenue-strapped tax authorities.
Scrutinize The Tested Party Data For Anomalies. Evaluating the appropriate treatment of sizeable restructuring costs may be particularly important. Determine whether applicable financial accounting standards would consider such costs as operating expenses or below-the-line items, and how such items are treated in the database that is used to extract the comparables' data. This analysis may also include an evaluation of Form 10-K data for the particular comparable set to see if similar situations have arisen and how these have been treated. These considerations are pertinent because financial statement data is typically used for comparability purposes.7
Review The Comparables. This is also an early-on consideration. Examine whether any companies have disappeared through bankruptcy, consolidation, etc., whether new comparables have emerged, and, of course, whether the financial results of the comparables have changed. These results include not only profit measures and their components, but also the effects of asset intensity adjustments (e.g., the turnover of working capital elements may have lengthened).
A particularly resonant aspect of comparability is the similarity or dissimilarity of economic conditions. Treas. Reg. § 1.482-1(d)(3) (iv) looks to "the significant economic conditions that could affect the prices that would be charged or paid, or the profit that would be earned," including the economic condition of the particular industry and whether the market is in expansion or contraction. As with respect to other aspects of comparability, material differences must either be adjusted for or will diminish the reliability of the comparison.8
Unfortunately, even if the comparable set is suitably refined, sufficient current data may not be available reflecting the effect of the downturn. Clues might be found by checking recent quarterly reports for trends, or by reviewing prior downturn periods in the pertinent industry to see if a pattern can be identified that could be simulated in the current setting. Locating a taxpayer-similar pattern in a suitable comparable set is the preferred result, since quantification of the differences sufficiently to make a specific adjustment may be quite challenging.
Reconsider Screening Techniques For Comparables. A frequently mentioned issue is whether it is appropriate to include unprofitable companies in the comparables set, or to at least loosen the screening criteria that tend to exclude poorly performing companies (e.g., maximum number of years of losses, size of losses). This could be helpful in lowering the target profit range if the pertinent industry or industries have been deteriorating for a while, so that comparables with poorer financial histories are reinstated. Otherwise, the effect might not be useful until a few years down the road as today's economy plays into the results, particularly if averages are used.
New screens may become appropriate, such as relative sales growth/decline,9 receipt of substantial government assistance or intervention, geographic location, or screens based on other pertinent variables that reflect the economic situation.
Reconsider Testing/Averaging Periods. The section 482 regulations mention "the effect of business cycles" as a circumstance warranting consideration of multiple year data. They also suggest that multiple year data "may be considered to determine whether the same economic conditions that caused the controlled taxpayer's results had a comparable effect over a comparable period of time on the uncontrolled comparables. . . ."10 Multiple year averages are intended to "reduce the effect of short-term variations that may be unrelated to transfer pricing."11 Today's business environment may suggest a lengthening or shifting of the business cycle previously used to determine the pertinent averaging period; the U.S. automotive industry comes to mind as one where a much longer averaging period may be appropriate to reflect the depth of the current hole.
The regulations would also support building in a lag factor to account for different cycles, or the timing of data availability, between the tested party and the comparables. Remember also that the regulations envision consideration of comparable or tested party data for years after the year under review.12 It obviously would entail risk for a taxpayer to try to rely on this authority through anticipation of future results; likewise, there are some fairness issues in terms of the use of hindsight by the IRS.13
Moving in the other direction, it may be appropriate to switch to single year comparisons, rather than multi-year averages, on the basis that history is an unreliable guide these days. One might even mix single-year data for the tested party with multi-year data for the comparables (as is routinely done in some foreign jurisdictions), though this is more appropriate as an exception, not the rule. Of course, single-year testing can reverse itself quickly, so this type of approach should only be taken with your eyes open.
Refute The Notion That The Problem Is Caused By Erroneous Transfer-Pricing. One important step is to determine — and document — the cause of the profitability reversal. If that cause is far removed from related-party transaction pricing (and not reflected in the comparable data), a defense of the taxpayer's lower results can be developed. An easy-to-understand example is where an earthquake affects the supply of a critical, custom component, causing extended dislocation in the taxpayers' supply chain and crimping sales. One tries to demonstrate that the tested party is affected in a unique way compared with the comparables (or their available data), that such way is not related to transfer pricing, and that the comparables nonetheless remain the best comparables available.
Demonstrating the independence of the cause may be more complicated in the context of a widespread economic downturn. For example, adverse effects on sales of heavy equipment because the tested party is unable to provide ample or affordable credit to its customers due to limitations on accounts receivable or other financing seems quite independent from transfer pricing — unless it could be argued that an unrelated equipment supplier, on an arm's-length basis, would have been expected to make some price concessions, or provide financing, to help its distributor cope with the extraordinary situation. In the same vein, if the comparable companies are experiencing similar credit problems, and (this is a big "and") those problems are reflected in their available financial results, the special circumstances defense — on a stand-alone basis — might be diluted. If relatively real-time comparable data is available, however, one would expect to see reduced profits, which would separately provide support for the tested party's poor results. Given the many external, unusual, and sizeable factors at play today, the governments' working through this type of issue in various contexts may lead to significant developments in transfer pricing theory.
One way to illustrate "special" business circumstances would be to graph several years of taxpayer data for key ratios — e.g., receivables turnover, expenses to sales, sales vs. industry sales, etc. The objective would be to demonstrate unusual variations and then adjust the tested party's profitability for comparability purposes to simulate "normal" conditions. To be unbiased, a similar adjustment would need to be made to the comparables' data, as pertinent and feasible.
Another way of demonstrating the irrelevance of transfer pricing to the tested party's plight is to show that the tested party is affected in the same way that its competitors — even if not its comparables — are affected. The trickiness here is that if the competitors are not comparables because, for example, they are more vertically integrated, it may be hard to show the pertinent relationship. Current industry sales or price information or trends available from market sources or trade groups may be helpful.
Satisfying the IRS concerning non-transfer-pricing causation may be difficult. But there can never be any harm, and there could well be an ultimate benefit, from identifying and comprehensively documenting your analysis of the attendant business circumstances (including press clippings relevant to the industry). The contemporaneous nature of this analysis adds a sympathetic flavor, and it can in any event be surprisingly difficult to retrospectively reconstruct events down the road, especially with personnel turnovers.
Micro-Manage — In A Good Way. If a company has identified one or a few pertinent factors that are affecting profitability, a specific adjustment tailored to that issue may be supportable. Treas. Reg. § 1.482-1(d)(2) specifically provides that adjustments must be made to reflect material differences between controlled and uncontrolled transactions if the effect of such differences can be ascertained with sufficient accuracy to increase the reliability of the result. Such adjustments must be based on commercial practices, economic principles, or statistical analysis.
For example, if rapid sales decline is the chief culprit, consider adjustment models based on an econometric analysis of the relationship between rate of sales changes and profitability, preferably in the pertinent industry sector.14 This can lead to a simple adjustment factor, ratcheting the target profitability range downward to correlate with the rate of sales declines. Such an adjustment has the attractive feature (from the government's perspective) of moving in the other direction when sales increase. Another example: If a dramatic change in the availability or price of a key input is the problem, reversal of the price divergence or an analysis to derive an adjustment based on a price index may be reasonable.15
Reconsider Other TPMs. Previously discarded TPMs may need to be revisited, as businesses adapt to the market conditions, to determine what is now the "best method." For example, a captive manufacturing affiliate may start taking orders from unrelated parties to use otherwise idle capacity at its plant, thus creating some potential CUPs (comparable uncontrolled prices). Careful analysis, however, would be needed to evaluate whether such distress pricing is an appropriate CUP.16
Adapt To A Change In The Characterization Of The Tested Party. If a change in the pertinent marketplace or an events-forced restructuring within the related group changes the characterization of the tested party, a different TPM or comparables set may be in order. For example, the tested party's customers may for reasons of frugality either do without or move in-house services they previously purchased, as a result of which a value-added distributor may evolve into a much more "simple" distributor.
Another option may be to deliberately change the characterization of the tested party through a corporate restructuring. By reducing functions and risks, a lower profit target may be warranted. While this runs smack into the current global controversy regarding profit-stripping through conversions of related parties into limited-risk entities,17 the shoe might be on the other foot in terms of government fiscal concerns if local losses are being reduced. In any event, it would be critical to demonstrate the business exigencies driving the change and to document the actual shift in functions in risk.
Separate Short-Term And Long-Term Effects And Dislocations. Despite the gravity of current events, companies should consider the likely duration of the adversity. Overreaction to today's situation (e.g., an adjustment mechanism that relies on trends or indices) may — and should — bite later. This "bite" may occur in TPM negotiations (the IRS likes methods with "reciprocal" features) or as a practical matter (a government making concessions now will look for recompense later). These types of considerations may make it preferable to "tough it out" now and hold to unadjusted target profit ranges, assuming the other government does not interfere. If two high-tax jurisdictions are involved, the net tax effect may be minimal if the methodology is not challenged by one of the governments and there are no significant differences in the taxpaying status of the related parties (e.g., in respect of NOL utilization potential).
Use A "Loss Split" As A Sanity Check. Some tax authorities have long used a rough profit-split computation as a sanity check on a CPM method. Treas. Reg. § 1.482-1(c)(2)(iii) suggests that confirmation of results by another method may be helpful. If a revised TPM sanctions a loss to the tested party, the existence of a "system" loss, particularly one that is shared in a function/risk-appropriate fashion with the related party, could be extremely important in achieving bilateral acceptance.18
Check Routine Returns In A Profit-Split Method. If a profit split method is used, the taxpayer should not forget possible adjustments to routine returns (usually the less controversial element). If circumstances have turned a profit split into a loss split, prepare for likely controversy, despite the theoretical symmetry of the result.
Special Considerations For Taxpayers With APAs
Advance Pricing Agreements contracts between the taxpayer and the IRS (or foreign tax authority) contain various provisions potentially pertinent in the instant situation. Failure of the specified tests (e.g., falling below the target profit levels) requires a post-year-end adjustment. If this adjustment is not made, the IRS may nevertheless enforce the APA terms and make appropriate adjustments, or it may cancel the APA if a revision is not agreed to.19 Other changes to the tested party's operations or external events may breach the "standard" critical assumption (that there be no material change in business activities, functions, risks or assets) or custom ones. The standard critical assumption, however, expressly states that "a mere change in business results" will not cause a failure.20 Sometimes a TPM or critical assumption provision contains specified consequences in the event of a failure,21 but this is not very common.
Appropriate diagnostic and remedial steps for taxpayers with APAs who are experiencing financial pressures due to the economic downturn include:
First, Of Course, Review Compliance With APA Requirements. Check not only profit targets but also other features (e.g., annual asset intensity adjustments, operating profit definition, and pertinent accounting methods) and critical assumptions (e.g., required financial ratios or market share). Post-year-end adjustments may be required, and will not pose foreign consistency concerns if the APA is bilateral.
Consider Application Of APA To Current Situation. Coverage definitions in an APA may not have anticipated the kinds of changes that are occurring. For example, the APA should be checked to see how — or whether — it would apply if consolidations, acquisitions, or expansions to take advantage of a competitive void were to take place. In some cases, the complexity of a restructuring may make non-coverage desirable. If a significant division or product line is eliminated or sold, one must consider whether the remaining business can support the APA TPM.
Consider Cash Flow Implications Of Post-Year-End Adjustments And Secondary Transactions. Primary transfer-pricing adjustments can trigger secondary deemed transactions and related tax adjustments. Rev. Proc. 99-3222 provides the opportunity to minimize these consequences, but only if funds are appropriately transferred. Most APAs incorporate an election into these rules by analogy (so-called revenue procedure treatment),23 but current financial constraints may preclude the necessary cash movement or NOLs may dilute the secondary consequences.24 In the latter situation, substituting the secondary tax consequences for a cash movement, by not electing revenue procedure treatment, may make sense.
Consider Potential Consequences If APA Violation Is Not Corrected. One possible outcome in the current environment is that the APA requirements cannot be met, or that contractually required adjustments to satisfy the APA tests are not in fact made. If a critical assumption is breached or the TPM requirements, including corrective adjustments, are not satisfied, APA rules trigger potential revision or cancellation (as of the failure year).25
An ineffective APA means that the previously APA-covered transactions become subject to regular IRS audit. Although an audit context may present the opportunity to raise defenses or provide explanations that might not fit within the four corners of the APA, there is also the potentially significant wild card of how the IRS Field, with hindsight, will evaluate both the basic transfer pricing situation and the changed circumstances. If significant amounts are involved, lengthy discussions and controversy are likely. Another potential downside is possible souring of IRS or foreign tax authority relationships from exiting an APA context in which the governments have invested substantial resources and effort.
Importantly, under standard APA provisions, the IRS may alternatively choose to enforce the APA, notwithstanding the failures.26 Thus, the taxpayer does not have a clear option to deliberately fail an APA in order to avoid its requirements.
Overall, odds are that an attempt to revise the APA, with a relatively sympathetic audience living in the moment, may be preferable to failure, if time and financial circumstances permit.
Potential For Revising The APA. IRS procedures permit this (consistent with "the interests of sound tax administration"),27 including necessary competent authority proceedings in a bilateral case. The general expectation is that good faith efforts will be undertaken to preserve the APA relationship. This is not guaranteed, however, and negotiations toward a bilaterally acceptable revision when there is little or no profit to go around may be protracted and uncertain in result. APA revisions to date have been rare, and other countries may not have specific revision procedures.
Recent public comments by the APA Office Director, Craig Sharon, signal a flexible but principled approach as the Office feels its way through the fairly extraordinary situation.28 The APA Office has assembled a special group of experienced economists and team leaders to track requests and reactions to help develop consistent positions. Examples of events that might trigger failure of the standard critical assumption include "a merger, discontinu[ation of] a business or fil[ing] for bankruptcy." Reciprocal TPM features are to be expected. According to Mr. Sharon, "If we are going to do something unusual today, when the economy turns around we are going to look to see if something needs to be done on the upside. . . . [W]e will have to work to make sure taxpayers don't get the benefit of the bad years twice."
Ways To Revise The APA. Possibilities run the gamut of the TPM modifications/adjustments discussed more generally earlier in this article. Approaches mentioned by APA Office personnel and others29 include:
- Refining the selection of comparables to exclude companies that experienced different effects
- Refining the selection of the averaging period (presumably this could include lengthening or shifting the comparative periods)
- Allowing comparables that experienced different effects but adjusting them for differences
- Measuring the arm's-length range using a statistical technique other than the interquartile range.
- Widening the single-year range, presumably subject to a narrower cumulative test
- Lowering the range, possibly with a future kicker
- Adjusting the range (e.g., via indexing), with potential movement in both directions. Regression analysis may be utilized, e.g., to reflect the relationship between profitability and sales "shocks."30
- Targeting different point(s) in the range
- Updating/revising the comparables (permanently or periodically)
- Devising a special adjustment to eliminate the effect of non-comparable events, including adjustments to account for government support
- Adjusting the term of APA
Throughout the planning and negotiation of an APA revision, one should keep in mind the trade-off between flexibility and certainty.
Special Considerations For Taxpayers Currently Negotiating An APA
Now is the time to take a harder look at the comparables, whether the comparables or ranges are to be fixed for the term of the APA or subject to annual or periodic review or adjustment, and the averaging period(s) to be used for the tested party and the comparables. The potential for movement in asset intensity adjustments or the mixture of relationships underlying blended ranges may also be an appropriate matter for negotiation. Most particularly, attention should be given to the design of customized critical assumptions or contingent adjustments to the TPM keyed to particular triggers (e.g., rate of sales growth or price of key commodity inputs). Thoughtful creativity is in order.31
Of course, introducing new issues or proposing changes to tentatively negotiated features may slow down the progress of the APA. (This may be a plus, however, if you are waiting for updated comparable data.) If the case is already in the bilateral competent authority negotiation phase, adjustments to the APA term — to either shorten or lengthen it — may be considered if reaching agreement becomes otherwise difficult. Shortening the term, of course, merely postpones the day of reckoning (to audit or a subsequent APA), and for that reason may be unattractive to the parties or the tax authorities.
Other Possible Therapies: Tangential Steps Or Effects? Opportunities?
A company's transfer pricing analyses and APAs tend to be concentrated on its major cross-border transactions, such as product sales. Although this is both necessary and logical, there may be other intercompany transactions where review and revision can be helpful in the current environment.
Review Intercompany Lending. Venturing outside the safe-harbor interest rates set forth in the regulations may be desirable in some cases. For example, if the parent company's external borrowing rate has increased significantly, this may be useful in adjusting intercompany rates accordingly (after taking into account differences in creditworthiness).32
Consider Intercompany Guarantee Fees. The temporary services regulations strongly suggest that arm's-length rates should be charged for intercompany guarantees.33 This may be helpful in moving cash to the parent, subject to consideration of the local income tax consequences. Deduction of the fee should not hurt the subsidiary's regular transfer pricing compliance, since financial costs are not considered in determining operating income. There is, however, some current cross-border controversy regarding the effect of the regulations' "passive association" concept in valuing guarantees.34
Review Charges For Intercompany Services. These need not be rendered at cost even if they are eligible for the no-mark-up "services cost method" under the temporary regulations.35 Conversely, consideration could be given to adopting the services cost method for eligible services which have previously been charged out with a mark-up.
Consider The Effect Of Commensurate-With-Income Rule On Intangibles Transactions. If intercompany royalties are designed to reflect the section 482 commensurate-with-income rule, automatic adjustments may occur as income decreases (and, surely, as sales decrease). An IRS Advice Memorandum,36 however, has taken the position that taxpayers may not make non-formulaic proactive adjustments when income deteriorates, on the theory that the periodic adjustment rules in the intercompany intangibles rule in Treas. Reg. § 1.482-4(f)(2) may only be invoked by the IRS. The IRS has officially taken the same position in the temporary cost sharing regulations (Treas. Reg. § 1.482-7T(i)).
Low Marketplace Values May Present Transfer Opportunities. The cost of transferring intangibles (e.g., to centralize holdings) may be reduced by depressed industry conditions, as various arm's-length measurements are likely to be diminished (e.g., "income" or market capitalization methods37). Ensuring the relative accuracy of projections is important to avoid subsequent IRS adjustments under applicable periodic adjustment regulations. Realistic assessments, to the extent possible, will also minimize "loss-trapping" if low-tax jurisdictions are involved; some chickens may have recently come home to roost for prior-year transferors who are now witnessing low-tax-benefit losses.
Silver Lining?? Last but not least, industry consolidation may increase the tested party's market share and competitive standing and improve its short- or long-term profitability.
Conclusions
More than ever, attentiveness to the transfer pricing of intercompany transactions is called for in a recessionary economy. Discipline is important even if corporate energies are focused on business crises. Changes to related and unrelated parties can have major effects on transfer pricing compliance and planning, with concomitant effects on cash flow. The legitimate consequences of risk-bearing may be severely tested. This is a time to be proactive and creative, not just reactive, and experienced economists should tip the cost-benefit scale in the right direction.
Tax authorities can be expected to be both vigilant in testing for TPM failures and aggressive in protecting against lost revenues. Documentation will be more important than ever. And the flip-side of modified methods must be kept in mind, looking forward to the eventual turnaround and avoiding overreaction to current conditions.
Given the financial extremes being encountered, considerable uncertainty about the success of re-crafted TPMs seems likely. Countered by the need to evaluate such uncertainties under the FIN 48 rules, this may be a good time to consider an APA (or APA revision). The APA Office's sensitivity and attention to these issues could pay off with a reasonably flexible TPM, which could temper the uncertainty from a controversy perspective while retaining some movement (in both directions) as companies battle their way out of the recession.
Footnotes
1. The author expresses her appreciation for comments by the following colleagues at Caplin & Drysdale: John M. Breen and Elizabeth H. Peters.
2. For simplicity, this article assumes a single set of transactional relationships, though the group's multiple relationships should of course be inventoried and similarly assessed. The discussion focuses on profit-based transfer pricing methods such as the comparable profits method (CPM), but analogues would apply to other methods.
3. In some circumstances, a government agency/facility could become a related party for transfer pricing purposes, generating additional, and particularly difficult, transactions to analyze. These complexities are outside the scope of this article. See Bas de Mik & Chris Faiferlick, Turmoil in the Financial Markets: Impact on Transfer Pricing, 17 BNA Transfer Pricing Report 871 (March 19, 2009), which focuses on particularly affected companies in the financial industry.
4. See Treas. Reg. §§ 1.6662-6(d)(2)(ii)(A)(2) and -6(d)(2)(iii)(B)(9).
5. See Patricia G. Lewis & John M. Breen, Coming Full Circle? Secondary Adjustments and Repatriation in Transfer Pricing Cases, 17 BNA Transfer Pricing Report 3 (May 8, 2008).
6. David Broomhall, Dynamic Adjustments in Transfer Pricing Agreements, Business Economics (April 2007).
7. See, e.g., Treas. Reg. § 1.482-5(c)(2)(iv), referring to potential adjustments to account for material differences in the accounting for stock-based compensation among the tested party and comparable parties.
8. Treas. Reg. § 1.482-1(d)(2). See also OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrators (1995) (Transfer Pricing Guidelines), ¶¶ 1.15 and 1.30. Paragraph 1.55 suggests that "government interventions" should be treated as market conditions and affect the intercompany pricing in the same way as they would in transactions between unrelated parties, though the methodology for doing this is obscure.
9. See Aydin Hayri & Richard A. Clark, Firm Profitability in Recessions: Parts I and II, 10 BNA Transfer Pricing Report 905 (March 6, 2002), and
11 BNA Transfer Pricing Report 29 (May 1, 2002).
10. Treas. Reg. §1.482-1T(f)(2)(iii)(B).
11. Treas. Reg. §§ 1.482-1(f)(2)(iii)(C)-(D).
12. See also OECD, Comparability: Public Invitation to Comment on a Series of Draft Issue Notes (May 10, 2006) (Comparability Issue Notes), "Timing Issues in Comparability," ¶¶ 30-33, and "Multiple Year Data," ¶¶ 1-21.
13. OECD Comparability Issue Notes, "Timing Issues in Comparability," ¶¶ 24-28.
14. See Aydin Hayri & Richard A. Clark, supra note 9 (both articles).
15. Although Treas. Reg. § 1.482-1(d)(2) says that "unadjusted industry average returns themselves cannot establish arm's-length results," that should not preclude industry or market data as an adjustment component.
16. Cf. Treas. Reg. §§ 1.482-3(b)(5)(ii) and -3(b)(5)(iii), Example 2, cautioning that data from public exchanges or quotation media may not be appropriate under extraordinary market conditions, giving the example of the effect of a war in major oil producing countries on world petroleum markets.
17. See OECD, Transfer Pricing Aspects of Business Restructurings, Discussion Draft (Sept. 19, 2008).
18. See OECD Transfer Pricing Guidelines, ¶ 3.31, suggesting that the effect on the profits of the other parties to a transaction may act as a counter-check of the conclusions reached under a CPM-like method.
19. See Rev. Proc. 2006-9, 2006-1 C.B. 278, § 11.06, and Model APA attached to IRS Announcement 2009-28, 2009-15 I.R.B. 760 (April 13, 2009).
20. See Appendix B in Model APA, supra note 19.
21. See IRS APA Office Training Manual, APA Study Guide, at 69.
22. 1999-2 C.B. 296.
23. Rev. Proc. 2006-9, § 11.02(3).
24. See Lewis & Breen, supra note 19.
25. Rev. Proc. 2006-9, § 11.06.
26. See Model APA, supra note 19, § 5.d.
27. Rev. Proc. 2006-9, supra note 19, § 11.05.
28. 17 BNA Transfer Pricing Report 762 (February 19, 2009).
29. Report on January 10, 2009, ABA Section of Taxation panel discussion, BNA Daily Tax Report I-2 (January 13, 2009).
30. See Aydin Hayri & Richard A. Clark, supra note 9 (both articles).
31. Possibilities suggested by an APA Office commentator (see note 29, supra) include: having the parties commit up front to using future financial data for comparables to test open APA years; including a critical assumption under which the APA terminates if the economy declines below a specified threshold; having an APA range adjust based on an agreed index; and placing contingencies in the APA that would modify the TPM if a downturn occurs.
32. Treas. Reg. § 1.482-2(a)(2)(i) considers a relevant factor to be "the interest rate prevailing at the situs of the lender or creditor for comparable loans between unrelated parties."
33. See § A.11.d of the regulatory preamble (T.D. 9278, 71 Fed. Reg. 44466, Aug. 4, 2006), disagreeing with the idea of a "uniform no charge rule" for financial guarantees.
34. For example, the General Electric Capital Canada Inc. case in the Tax Court of Canada.
35. Treas. Reg. § 1.482-9T(b).
36. A.M. 2007-007 (March 15, 2007).
37. Cf. Treas. Reg. § 1.482-7T(g) (methods for valuing platform contribution transactions in cost-sharing arrangements).
This article is designed to give general information on the developments covered, not to serve as legal advice related to specific situations or as a legal opinion. Counsel should be consulted for legal advice.