Transfer Pricing in a Recession

Verrechnungspreise in einer Rezession

I. Economic Climate

With the world economy officially suffering a recession that is widely considered the worst since the Second World War¹ and the beginning of the recovery pencilled in for the end of 2010 the earliest by many analysts, it is becoming clear that the effects of the economic downturn will be felt for a long time. According to the IMF, the global economy will shrink by 1.3 per cent this year, leaving at least 10 million more people around the world jobless this year. Other economists, however, believe that the global decline will be worse, closer to 2%.²

While Austria has fared fairly well so far,³ it will also be affected by the worsening economic conditions in Europe that triggered the EU to double its recession forecast for 2009 to 4 % at the beginning of May from the 1.8 % predicted just three months ago. Of the major EU countries, Germany will fare the worst, with a 5.5 per cent decline in 2009. It is also expected that some 8.5 million jobs will disappear in the EU in 2009 and 2010, more than wiping out the number of new jobs created in the last two years.⁴ As the economy of the Eastern European countries is predicted to shrink by 5 % this year, Austria is sitting on what some analysts believe a ticking time bomb caused by the rising East European loan defaults, since its banks have invested some 246 billion dollars, more than half of the Austrian GDP, in neighbouring states like Hungary.⁵

II. Reduced Tax Revenues, Increased Enforcement

Tax revenues tend to fall during a recession, since more unemployment causes reduced personal income taxes, declining business profits reduce corporation tax revenues and sliding consumer spending hits income from VAT and duties. At the same time, in addition to the need to finance current programs, recession often makes it necessary for governments to create new social programmes to address the problems caused by rising unemployment, mortgage defaults, etc. Since it is difficult to reduce government spen ding to address growing budget deficits and the idea of raising taxes is a notoriously unpopular one,⁶ governments turn to increased enforcement to collect more revenues.

Globally, taxing authorities will increase their efforts to collect taxes needed to fuel their governments’ spending. A substantial increase in tax audits, including those focused on transfer pricing, is expected. At the same time, the difficulty and complexity of such audits are expected to increase as taxing authorities continue to become more sophisticated and open to sharing taxpayer information.

Multinational companies in this environment need to be able to defend their historical transfer pricing structures and consider ways to optimise current and future transfer pricing positions. Since in many industries MNEs are experiencing significant operating losses and are struggling for survival, the timing for the need of putting extra efforts into transfer pricing documentation is a rather inconvenient one.

The problem is made worse by the inherent information asymmetry between tax authorities’ and taxpayers’ positions. Current tax audits cover past years, and taxpayers have to support historical positions and decisions made in the past. When preparing documentation for current years and trying to address the issues caused by the economic slowdown, particularly when using market data to support pricing methods, taxpayers face a time lag, since currently available comparable information comes from periods before the downturn. By the time these years will be under tax audits, however, much of the uncertainty currently present will be resolved, and tax authorities will have the benefit of hindsight to judge and assess the transfer pricing measures implemented today.

III. The OECD Guidelines

The OECD Guidelines do not explicitly address the issue of transfer pricing during recessions. However, the basic condition behind the arm’s length principle is that the arm’s length price or profit in a related party transaction depends on what unrelated parties, under comparable circumstances, would apply. The application of the arm’s length principle is generally based on a comparison of the economically relevant characteristics of a controlled transaction with conditions in transactions between independent enterprises. Economic circumstances are one of the five comparability factors that have to be taken into account in comparing related party arrangements with conditions applied between unrelated parties.

The OECD Guidelines contain many references implying that changing economic conditions or business strategies may result in arrangements previously deemed arm’s length no longer being considered so. In the course of selecting comparable companies, business and product life cycles have to be taken into account. The Guidelines also acknowledge that unusual measures, such as loss-generating pricing policies, might be acceptable for limited periods, provided that independent enterprises could be expected to have determined prices in a comparable manner.

IV. Transfer Pricing During “Normal” Periods

Documentation that supports a taxpayer’s transfer pricing arrangements typically includes the conclusions of a functional analysis as well as an economic analysis. The functional analysis defines the characteristics of the tested party, determining its functions performed, risks assumed, and assets owned. Based on this analysis, the entity is characterised as a service provider, buy-sell entity such as a distributor, manufacturer, entrepreneur, etc. in the intercompany transaction under review. The characterisation of the entity as well as the availability of information determine the transfer pricing method that is used to support its intercompany pricing arrangements.

Unless comparable uncontrolled price information is available or the tested party is involved in the same transactions with unrelated parties (i.e. has internal comparables), the transfer pricing method tends to be based on the analysis of publicly available third party information which is reviewed on a gross or net profit margin level.⁷ The benchmarking analysis aims at selecting entities that are sufficiently comparable, taking into account the five comparability factors⁸ as well as the level of comparability required by the particular transfer pricing method chosen.⁹ If necessary, appropriate adjustments might be performed.
Most transfer pricing systems assume relatively stable economic circumstances so that parties involved in the intercompany transactions are able to plan and determine individual product prices which is generally done for a year ahead. If prices determined for the following period result in the tested party’s profit level falling outside the target range determined based on the economic analysis, companies often use (year-end) adjustments to bring the profits into the arm’s length range.

Benchmarking analyses are generally performed looking at a three- or five-year period for comparables information. Due to the time lag before financial information becomes publicly available, comparables searches performed in the first half of 2009 will contain information for the years 2005–2007 or 2003–2007, depending on the length of time period reviewed.

V. The Question of Losses

Uncertainty regarding market developments may make planning transfer prices very difficult during recession. Transfer prices set at the beginning of the year may turn out to be unsustainable due to the difficulties involved in forecasting costs, sales prices, and sales volumes. Adjustment payments may also become difficult if the production company or entrepreneur is suffering serious losses as well.

In recession, many multinational companies suffer overall losses. However, low risk entities, such as limited risk distributors, contract manufacturers, or service providers, are generally expected to make profits in conventional transfer pricing systems even if the group as a whole suffers consolidated losses. The question is whether this assumption remains sustainable during recession, or, in other words, which entities and in what proportion should bear the losses within an MNE during unusual economic circumstances.

The OECD Guidelines discuss losses in the context of an entity making losses while the MNE group as a whole is profitable. Even then, it acknowledges, associated enterprises, like independent ones, can sustain genuine losses, due to heavy start-up costs, unfavourable economic conditions, inefficiencies, or other legitimate business reasons. Particular business strategies may also justify losses for a reasonable period, such as setting low prices to achieve market penetration or the introduction of a new product to the market. Generally, related parties are expected to act as independent companies under comparable circumstances would.¹⁰

During recessions, even service providers cannot expect to make profits if all their customers are making losses. In fact, there is ample evidence that independent companies use below cost pricing to survive during the recession¹¹ and that significant price reductions often affect the service sector, which is generally considered low-risk.¹²

Based on the above, it should not be unconceivable for related enterprises to use, for example, pricing systems where a lowered or negative margin is applied on costs for a limited period, taking into account the performance of the group as a whole, the underlying economic conditions, and indications of the performance of independent enterprises in the same industry. Remaining system losses may be appropriately split according to material system risks as well as ownership of valuable property and strategic management or key decision-making functions.

According to the Report on the attribution of profits to Permanent Establishments (“PE Report”) issued in its final form on 17 July 2008, under the authorised OECD approach, the same principles should be applied to attribute losses to a PE as would be used to attribute profits.¹³ By analogy, this principle should also be applicable to members of an MNE group applying a profit split method.

VI. Selecting Comparables

Austrian tax auditors have expressed very strict comparability criteria in their reviews of benchmarking studies during recent tax audits and have summarised these criteria in articles as well.¹⁴ These requirements are often much stricter than those applied in the US or in other European countries. In particular, the following factors of the search strategy are critically examined by tax auditors in Austria:

• A different market situation within an industry may influence the profitability per geographic region; i.e. old EU member states are not readily comparable to CEE;
• the classification of a business activity based on industry codes (e.g. NACE) should be supplemented with keyword screening;
• Austrian tax auditors prefer a conservative approach of 25 % as independence criterion;
• the entity size should be similar, in terms of revenue and number of employees;
• the level of intangibles owned should be similar;
• an observation period of three to five years is expected;
• entities suffering losses should be eliminated; and
• companies in the start-up phase are deemed not comparable (regardless of their performance).

Some elements of the above list are questionable even under normal economic circumstances,¹⁵ but they may simply be unsupportable during recessions when special adjustments may become necessary in order to gain any meaningful information that takes the conditions faced by the tested party into account.

The first issue is the delay in public information becoming available, which means that current benchmarking analyses contain data from the period up to 2007, a period characterised by growth in many industries. Even when 2008 data become available later in 2009, however, comparables searches will reflect only the first indications of the approaching economic downturn. Benchmarking the boom years to set transfer prices during recessions could distort profit expectations significantly. However, currently there are no established criteria to adjust benchmarking analyses for recessions.

One approach would be to pay particular attention to industries with similar business cycles during recession years, and instead of looking at three to five-year periods, extended periods should be taken into account based on the business cycle of the particular industry. An alternative approach could be to conduct searches not in the most recent years, but in recession years, for example 2000–2001 in the European Union. One could also use data of recession years to adjust profit levels obtained through recent years’ financial information. Another potential adjustment could be to adjust the benchmarking data to the tested party’s expected sales volume or operating costs.

Theoretically, any observation within the interquartile range established by the benchmarking analysis should be considered arm’s length. In Europe, however, tax authorities generally expect companies to target the median, unless there are specific reasons for an entity to choose a different point within the range. In recession, taxpayers may consider whether the data lag in the comparables means that a different point within the range should be considered which better reflects the changed economic conditions.

Benchmarking studies often include an automatic rejection of loss-making companies when benchmarking routine functions, and this is a condition specifically expected by Austrian tax authorities. The compulsory elimination of loss companies (while including extremely profitable companies) tends upwardly to distort benchmarking. In fact, in a recessionary environment it may be particularly appropriate to include loss comparables in certain industry segments. Companies should be selected through the benchmarking process on the basis of functional comparability, regardless of their profit margin.

When neither internal nor external comparables exist, taxpayers could consider gathering information on other transactions or observations as supporting information, even if those transactions are not sufficiently comparable to be used directly for setting or supporting prices.

VII. Restructurings in Recession

Worsening economic conditions may force MNEs to restructure their operations as a necessary survival strategy. The ability to develop and sustain tax-efficient structures has significant implications for MNEs’ abilities to reduce costs and remain competitive.

Restructurings triggered at least partly by the recession may involve closing or relocating of unprofitable manufacturing or distribution operations, increasing centralisation, IP relocations, the implementation of cost contribution arrangements, etc. Recession-related restructurings are not explicitly covered by the OECD’s Discussion Draft on Business Restructurings,¹⁶ and the comments submitted until the deadline by February 19, 2008,¹⁷ generally concentrated on other issues with the draft document.

Although the discussion draft does not specifically list the pressures caused by economic slowdown as potential reasons for restructuring, it mentions more general reasons, such as the pressure from competitions or the need to increase efficiency and to lower costs. It also makes it clear that, as a result of a restructuring, the profits of an MNE group will not necessarily increase; it may only mean that the group remains competitive. Probably the most important clarification contained in the discussion draft is the express declaration that profit or loss potential is not an asset in itself and that the question is whether there are assets or rights of value transferred as part of the restructuring that should receive a specific compensation.

Some commentators, however, mentioned in the context of Issue note 2 on remuneration for the restructuring itself that there are tax authorities that have hinted at potentially requiring compensation for the closing of loss-making operations as well. Many others had an issue with the OECD’s position in the discussion draft which implies that long running relationships, rather than long-term contracts with enforceable rights, may trigger a need for compensation. The comments on this subject emphasised that in third party situations, compensation can only be claimed if there are legally enforceable rights attached to the contract. Long standing relationships can be and often are terminated or renegotiated between unrelated parties once the contract expires or by observing the notice period in the contract.
In a recession, renegotiation or cancellation even of long-term contracts has become customary in some industries between third parties, and many of these belong to industries that are generally considered “low risk” in the transfer pricing world, such as IT or HR services or warehousing. According to a study released by the Small Business Research Board in the US in September, for example, renegotiation is becoming a nationwide trend, with 15 percent of more than 1,000 small businesses surveyed reporting that they are renegotiating long-term, fixed-supply contracts.¹⁸ In Europe, the auto parts industry was particularly hit by bankruptcies and forced restructurings as a result of the large auto manufacturers cutting back on production.¹⁹ There is little doubt, however, that other industries could follow suit.

MNEs, therefore, should also have the possibility to renegotiate contracts if it can be demonstrated that unrelated parties under comparable circumstances would have done the same. In addition to this, under no circumstances should tax authorities expect compensation for renegotiating contracts that did not carry enforceable rights.

When considering the level of arm’s length pricing following a restructuring, structures established as a result of restructurings could potentially be subject to challenges based on the level of profits earned before the restructuring. The OECD Discussion Draft on Business Restructurings makes it clear that before and after comparisons should not be used as the basis for transfer pricing adjustments; however, it mentions that such comparisons could “play a role” in the analysis. Particularly in the case of restructurings triggered by the recession, however, any such comparison could be especially dangerous, since the profits in the period before the restructuring happened to include results from years of economic boom. It should be understood that profits would not have continued at pre-restructuring level even if the structure remained unchanged, and the restructuring might have been the only way for the MNE to remain in business.

VIII. Additional Considerations

Transfer pricing structures with built-in flexibility are advantageous in turbulent economies, providing ease in moving from one transfer pricing method to another or in moving within given pricing ranges based on pre-determined triggers. For example, a royalty rate may vary depending on results of a given year or sales volume, rather than being a fixed percentage of sales. This builds into the system a certain flexibility to have royalties that increase when the profits generated by the licensed intellectual property increase.

Taxpayers should also ensure that they have sufficient support for any change applied and that this support is carefully documented for defence in the future. Care should be taken to document the support for modifying a company’s transfer price, and such a modification must have the appropriate business case and economic substance.