Background
Many multinational companies, large and small, use the common low-risk based transfer pricing models, which typically include low-risk distributors, service providers, contract manufacturers, R&D centers, and other cost business units, in their supply chain model.
The low-risk models work in a manner that the low-risk entity bears limited risks, and as such, it usually earns a constant targeted, limited profit. Consequently, the remainder is allocated to the principal company. Typically, the principal company owns the significant IP of the group, responsible for most of the functions associated with the value drivers of the group and bears most of the group’s risks. Accordingly, when the group as a whole incurs a loss, the low-risk entity will record a limited profit margin. On the flip side, when the group earns significant profits, the low-risk entity will continue to record the same limited profit margin.
Low Risk, Not Risk-Free
Same as any type of transfer pricing methodology, low-risk models, amongst others, rely on the functions, assets, and risks analyses of the parties of the transaction. Low-risk entities bear a limited portion of the risks associated with the intercompany transaction. However, they are not risk-free, and they do bear, at least, the inherited macroeconomics risk associated with their activities. Such risk is typically referred to as market risk.[1] The COVID-19 pandemic is a clear example of a negative impact on the market conditions, i.e., the market risk. While the principal companies will bear most of the risks associated with COVID-19, the low-risk entities will also bear part of this risk, but to a limited extent.
Impact on the Low-Risk Entities
As we now understand that low-risk entities are affected by the occurrence of macroeconomic events, the question is if and how it impacts their targeted profit margins.
The targeted profit margins low-risk entities use result from a range derived from benchmark analyses of comparable companies. Typically, this range is a three-years weighted average of the comparable companies’ profit margins.
Since the arm’s length range is based on previous years’ financial data, with completely different market conditions than the current economic conditions as a result of the COVID-19 pandemic, it may be a reasonable economic approach to claim that the standard range does not completely reflect the current economic conditions.
As such, if the current intercompany pricing may deviate from standard range, the question then is to what extent should the low-risk entities deviate from their targeted profit margins. Such deviation should align with the magnitude of the risk they bear, and therefore, it is expected to result in a limited deviation. There are three main scenarios:
- Target a lower or the lowest point of the arm’s length range.
- Zero profit.
- Limited operating loss.
Targeting a lower/the lowest point in the range is considered as the most conservative approach out of the three. Since targeting a zero profit and even a limited loss may be considered as a reasonable approach, yet less conservative, it should be supported by appropriate economic analysis.
How to Set the Stage Today to Allow Profit Reduction
Most of the companies will likely file their 2020 tax return in 2021. One of the things multinational companies should consider doing before filing their 2020 tax returns is to amend their intercompany agreements, to support a deviation from the arm’s length range in a manner that their intercompany agreements will include pricing amendment when significant macroeconomic events occur. The same amendment in the intercompany agreement will support a position to use the lowest or lower point in the companies’ current standard range.
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[1] Section 1.46 in the OECD 2017 Transfer Priding Guidelines outlines that “The types of risks to consider include market risks, such as input cost and output price fluctuations.
