Survival techniques: transfer pricing in a sick economy.

• Author: Lewis, Patricia Gimbel

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 support (3)

* 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 crossborder 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. [section] 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 economis. (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...