By now, we are all well aware of the difficulties of tax and transfer pricing planning, given the current economic conditions. The ability to manage cash has been front-of-mind, with transfer pricing an integral and necessary component. Yet, other critical transfer-pricing issues sit just on the horizon, and the work of the transfer pricing professional is far from over. Over the next several months, global value chains need to be re-assessed, with consideration of evolving from just-in-time to “just-in-case.” Planning for 2020 documentation should also be undertaken – waiting for the normal documentation cycle before gathering support for transfer pricing changes made in 2020 will likely result in additional time and cost outlays.
But between cash management concerns and longer-term value chain and documentation considerations, now is the time to rethink current-year transfer pricing. Addressing 2020 transfer pricing is critical in mitigating the risks of both potentially large year-end transfer pricing adjustments and future controversy. It may also provide the opportunity for transfer pricing optimisation.
Of course, one always needs support for transfer pricing adjustments, especially when what’s past is not necessarily prologue (with apologies to Shakespeare). Where can that support be found? Among the many published articles on the subject, few contain specific proposals for addressing the difficulty of adjusting transfer prices in this time of unprecedented upheaval in markets and economies. Even fewer offer a practical way forward for resource-constrained tax departments.
As an alternative, we propose something different – an approach that closely mirrors the historical benchmarking analyses you likely have been applying in past years for both compliance and price setting.
But first, it is useful to summarise where we are and why this is so important.
- Most companies develop their transfer pricing benchmarks based on publicly available financial reporting of comparable companies. (The alternative to using benchmarks derived from comparable companies is to use a methodology based on comparable uncontrolled prices (CUPs) or transactions (CUTs). In practice, CUP and CUT methodologies are used relatively infrequently.) A group or set of comparable companies usually includes as least ten and as many as 25 companies, although in some cases the sets can be either smaller or larger.
- Financial data for public companies typically becomes publicly available five to six months after year-end. So, 2019 data for a calendar-year company has just recently become available, and data for this year (2020) will not be available, for the most part, until spring of 2021.
- As a result of this lag, transfer pricing planning for any particular year typically is based on available financial data for the three-year period up to (but not including) the year in question. So, for example, transfer pricing planning for 2020 would generally rely upon financial data from the period 2017 to 2019.
- In “normal” economic times, this lag does not pose a significant problem, since there is generally little year-to-year variation in the financial results of a set of companies as a whole, and three-year averaging helps to smooth out such variation when it occurs.
- 2020 is anything but “normal times.” For companies trying to adjust their 2020 transfer prices (and arm’s length ranges) to address the effects of the COVID-19 pandemic, an analysis based on 2017 to 2019 financial data is almost useless, as prior-year financial information no longer provides a reliable indicator of current conditions.
What to do?
Broadly speaking, most suggested approaches fall into two groups – those relying on statistical adjustments to 2017-2019 financial data, and those based on analyses of the effects of prior recessions, especially the “Great Recession” (starting late 2008 and impacting subsequent years).
There are significant shortcomings to both approaches. The statistical-adjustment approaches often suggest relatively sophisticated analytic techniques that may be beyond the scope of practical implementation for most companies. The analysis of the effects of the Great Recession seems more promising in that it hews closer to traditional transfer pricing techniques. The applicability of this approach, however, is limited by the significant differences between how the Great Recession and the current Covid-19 crisis have affected specific industries and the economy globally.
There is a more direct and practical approach to current-year transfer pricing planning that does not involve obscure new data sources or complex analytic modeling techniques. The approach is based on a company’s existing transfer pricing methodologies, and involves using the most current market information available for its comparable set or industry. This information consists of quarterly financial results and analysts’ forecasts of the comparables’ financial performance.
Analysts at large brokerage firms follow and publish forecasts of companies’ expected quarterly earnings, typically for the upcoming two years (eight quarters.) The earnings forecasts are based on models of revenues and costs, and reflect both internal and external indicators. Among these factors are manufacturing and distribution costs, market conditions, and global economic and political factors. Depending on the company and industry, analyst forecasts may be updated whenever new information becomes available (but at least quarterly.)
Because earnings forecasts are published regularly and incorporate both internal and market information, they provide a valuable resource for transfer pricing analytics before annual financial data is available. These forecasts, along with quarterly SEC filings (Form 10-Qs), create close to real-time input, which can form the basis for adjusting transfer pricing policies during the current year.
While this use of earnings forecasts has broad applicability, there are caveats to consider. First, since the forecasts do not represent actual financial results, and quarterly results are typically unaudited, this approach may not be appropriate for documentation intended to meet OECD and local country documentation requirements. Second, this approach is necessarily limited to companies covered by financial analysts, and therefore forecasts may not be available for all comparables and all geographic regions.
Despite the caveats, the use of earnings forecasts provides a practical approach consistent with the methodologies most companies follow in setting their transfer prices. It involves no new analytic constructs and no complex adjustments to comparables. The analysis can be updated whenever necessary, as earnings forecasts are updated regularly. Further, it is self-correcting as quarterly financial results become available. In summary, using forecast data to help update transfer pricing is an approach that should be considered whenever a company is considering how to adjust their current-year transfer pricing in the face of current economic conditions.
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