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Tips for Operational Transfer Pricing: Managing Through a Downturn

Jamie Eagan - VP Product Management Tax & Transfer Pricing

Jamie Eagan is VP, Product Management of Longview products at insightsoftware. Jamie holds a B.Sc. in Accounting and a minor in Economics from State University of New York at Fredonia.

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Global organizations face multiple challenges during economic downturns, but the fallout unique to COVID-19 has presented new and unusual obstacles for finance and tax teams. Transfer pricing (TP) is one function in particular that requires significant attention as organizations navigate the multiple disruptions across consumer demand and their supply chains. TP teams are playing a high stakes game of trying to price transactions as favorably as possible for the group (often against a backdrop of tightening cashflow problems and growing losses), while adhering to their existing TP policies and monitoring the many individual government tax legislation changes they must comply with.

One such challenge TP teams are tasked with is understanding changes in allocated risk across different entities within their supply chains. Namely, it’s to identify and mitigate “losses arising from the pandemic’s effect on their markets.” For example, car manufacturers may extract rubber via one entity, process it to create tires via a second entity, and then fit other components together to make a finished wheel via a third entity. Since these operations can be carried out in different countries and within different market segments, the risk to each entity from COVID-19’s impact will vary.

In some cases, to manage this rebalancing of risk, multinational enterprises (MNEs) may be able to adjust pricing between these different subsidiaries to reflect the changes in demand, raw material prices, workforce dynamics, and government policies. However, others may be locked into two- and three-year agreements with tax authorities that are no longer financially tenable. How can organizations monitor and manage their transfer pricing against these issues?

This is where operational transfer pricing comes in. It’s a specific function within transfer pricing that oversees the adherence to previously established pricing strategies between all corporate-owned entities across the entire global value chain. To do this, it ensures that cost allocation rules and calculations are applied properly, while still leaving some wiggle room to adjust pricing when needed based on rates, rules, formulas, and data changes over time.

This is why it’s so helpful: Operational TP allows your organization to monitor price changes, and intervene as needed, while individual business units respond to market shifts in order to maintain their individual profitability. The added level of oversight provided by operational TP allows organizations to maintain compliance with their internal tax strategies and external tax obligations, while still supporting these individual business units.

Carrying out operational transfer pricing in an effective manner is crucial as we enter into staged recoveries from the pandemic. Failure to do so can ultimately result in organizations ceding most of their profits—even retroactively—over to tax authorities. Here are a few contemporary challenges that TP teams must keep in mind:

Increasing Tax Scrutiny

COVID-19 related government loans and increasing national debts are raising the likelihood that authorities will fight more to protect their tax bases and collect every dollar possible. In order to do this, they will further scrutinize and challenge businesses attempting to shift profits or losses away into other jurisdictions. Organizations that have benefited from government-backed loans are also clear targets for tax authorities aiming to recoup the public tax dollars spent on government bailouts.

How well are you able to defend your internal pricing models in the event you undergo an audit, especially if you were a recipient of federal assistance?

Reallocation of Group Functions

If your global supply chain has been disrupted or impaired, how are you managing the reallocation of assets, functions, and risk associated with it? How are you evaluating the changes in pricing due to redistributed supply lines? This functional assessment must lead to prices that ultimately reflect what true competitors held at “arm’s length” would charge to unrelated parties.

How well (or quickly) can you change models to accurately reflect current market conditions while maximizing profitability?

Managing People Risk

For multinational organizations, transfer pricing is an integral part of intracompany processes. But it’s one that’s wrought with complexity and touches several stakeholders, each with different motivations and resources. In many cases, bonuses are paid out to business unit managers and executives based on profitability. If TP teams are unable to monitor and introduce gradual pricing updates throughout the year, surprising end-year adjustments can potentially lead to internal conflict with these same stakeholders. The best way to avoid this type of situation is by foreseeing necessary adjustments as early as possible and by managing communications with stakeholders to set their expectations of likely year-end profits.

How well are you able to manage the increasing amounts of data and processes required to more gradually roll out changes that affect your internal stakeholders?

Managing Cost of Taxation

MNEs need to balance the risks of paying too much tax with paying too little and then receiving hefty fines from the authorities. Through continuous fluctuations in market valuation, taxation regulations, and business operations, how well are you able to gain the visibility into your data to confidently defend your policies and identify gaps in targeted profitability? And can you do this while avoiding risks such as double taxation, underpayment penalties, and erosion of your reputation with consumers for not paying your fair share of tax?

As the business pivots its operations in respond to the COVID challenge, TP team must re-evaluate comparable data, redefine policies and adjust prices accordingly. Doing so helps organizations avoid making blunders that can cause severe reputational risk and incur heavy penalties from tax authorities that can entirely wipe out an organization’s profits—even retroactively.

Legacy Transfer Pricing Systems are Unfit for Today’s Demands

Historically, TP initiatives have been highly manual, resource-intensive processes managed in Microsoft Excel. Unfortunately for too many professionals, many companies are still using this manual approach today, which struggles to scale as both data volumes and organizational complexity soar. This results in inaccuracies and mistakes that can ultimately tank transfer pricing objectives.

These struggles are significant on their own, but are now even further intensified by global authorities that are keen on maintaining and increasing their tax bases. One such embodiment is the OECD’s Base Erosion and Profit Shifting (BEPS) Initiative. While this initiative allows tax authorities to challenge foreign governments that they suspect have created an unfair playing field due to too many tax concessions for multinationals, it also allows tax authorities to go directly after the enterprises for back taxes owed.

BEPS-related challenges will only become more significant over time, as governments look to ensure they collect the taxes they believe they are due in order to reduce the national debts that ballooned during the pandemic. Additionally, as further lessons are learned, it is only a matter of time for an even more stringent BEPS 2.0 to be ratified.

Against this background of increased public scrutiny, oversight from tax authorities, and growing business risk, it is ever more imperative to improve an organization’s operational TP practices.

Why Purpose-Built Operational Transfer Pricing Systems are a Game Changer

If the challenges we listed above look familiar, you should consider moving away from static Excel spreadsheets and look for a purpose-built operational TP system that enables you to quickly and accurately collect and organize transfer pricing data, identify gaps in targeted profitability, and gradually make corrections to avoid those end-of-year surprises when closing the books. A modern operational TP solution can help you:

1. Actively manage pricing at any time in your cycles

How well can you measure effectiveness against your strategy? Look for a system that supports automated data processing and dynamic calculations that enable more frequent monitoring and evaluation. This allows your teams to gradually adjust price-based forecasts as rates, rules, formulas, and data change over time. This also helps to ensure that you have access to the most current data to quickly review actuals, allowing you to dive deeper where needed and add supplemental data, such as detailed business overviews for accurate arm’s length comparables. And, if at all possible, make sure your teams have direct access to this data, without requiring the intervention of IT or outside consultants.

2. Standardize your approach on models to be consistent across the organization

Avoid the risk of errors in manual processes by implementing a standardized model across teams and business units to avoid ending up with incompatible data sets and inconsistent outcomes. A centralized process also helps prepare you for an audit, with a simplified, transparent method to track data and activities.

3. Nimbly change as needed, while substantiating with fact-based data

Evaluate your current processes for flexibility: Can they both monitor actuals and forecast potential scenarios through fluctuating events in order to forewarn and forearm stakeholders? As businesses are forced to be more agile, TP teams must respond in kind. If your processes are too rigid or spreadsheet-based, you are likely spending more time managing the solution than actually benefiting from it. Look for solutions that can quickly collect and organize transfer pricing data, identify gaps in targeted profitability, and ensure cost allocation rules are applied properly to better monitor and more gradually make changes throughout the year as opposed to surprising adjustments at year end.

Learn more about operational TP and how insightsoftware can help.

Whitepaper: How Multinationals Can Improve Global Transfer Pricing Forecasts to Address a Changing Global Economy