Inflation and rising interest rates increase TP risk for businesses. Companies need to provide supporting documentation to justify deviations from their policy and benchmarked ranges. Companies should also consider the impact on valuations, investments, and their financing structure.
How to mitigate TP risk from inflation and rising interest rates
In the past few years, companies have fought off multiple challenges such as Covid-19, changes to the way of working and inflation due to rising energy prices and supply chain challenges.
Whilst some indicators show that inflation is abating, the increased operating costs, continued pressure on supply chains and increasing interest rates will have knock-on effects on returns which companies should proactively address via their transfer pricing, intercompany agreements and financing.
Justifying the allocation of profits
For organizations with principal models, there has always been a tension between value driven by the headquarter vs. local operations. This has been exacerbated with BEPS 2.0 drivers such as Pillar I that requires sufficient allocation of returns to local entities, and Pillar II, which ensures that returns are adequately taxed. In addition, trends towards digitalization and remote working have increased decentralization, shifting substance and principal decision-making away from central hubs.
This raises the question to what extent local entities should bear the cost of risks arising from their operations. The impact of inflation can include systemic, groupwide increases in operating and wage costs. Some of these may be passed onto customers but could still result in decreased sales leading to lower system profits. Impacts can also be more locally driven, resulting from temporary shutdowns, or hyperinflation leading to significant forex losses. The organization will need to decide whether the principal should bear these costs, and subsequently, provide argumentation in the Transfer Pricing documentation to justify the allocation of the costs or incurred losses.
Such an exercise is critical, not only in the case of a local tax audit to justify that the local entity has been sufficiently remunerated, but also when defending the deductibility of costs at the principal location.
During the COVID-19 pandemic, pressure on margins forced many organizations to consider allocating losses to so-called “limited risk” entities due to extraordinary circumstances. The OECD released guidance stating that while limited risk entities normally are not expected to make losses, in certain circumstances routine entities may also need to bear such risks. The guidance provides examples of adjustments (for timing, risk, working capital, etc.) and arguments which may be used to justify returns deviating from the interquartile range of benchmarked companies.
Reviewing, applying and reconsidering contractual agreements
When justifying routine returns, the terms of intercompany agreements need to be considered.
Some agreements, such as those based on a cost-plus or fixed return on sales, already have terms that automatically account for increased costs or depressed sales. It is then important operationally to consider mechanisms which would allow these terms to be implemented, such as adjusting price lists and making periodic amendments in the case that actual results differ from the budget.
In the case that local lossmaking entities need to be made profitable, there may not be an appropriate mechanism in the agreement to do so. For instance, when the principal is selling to a local distributor based on a fixed margin where there are limited external revenues, it may not be possible to adjust the pricing of the sale of goods so as to provide the distributor with a target margin. Alternative mechanisms may need to be considered, such as a service or marketing fee, along with supporting documentation justifying the change in policy.
Finally, if there are Advanced Pricing Agreements in place, it is recommended to contact the tax authorities to consider whether adjustments should be made.
Accounting for rising interest rates
To manage inflation, central banks have raised interest rates, making it even more important to use the most recent available data to determine intercompany rates.
In addition, the rise in interest rate leads to an increase in financing costs of valuations and investments. Hence, companies should pay attention to the timing of the transfer of a group asset as this could have tax consequences based on the value of the asset and also make sure to adjust the discount rates in line with increasing market rates.
Rising interest rates also offer opportunities to improve their cash management via cash pooling, allowing the group to leverage internally on available balances. This way, a smaller proportion needs to be borrowed from external lenders, which in turn leads to lower financing costs.