Should groups rethink their transfer pricing in light of the recent economic turmoil

During 2022, businesses and consumers have been buffeted by economic challenges, including disruption to global supply chains, staff shortages and soaring energy costs.

The economic impact

These factors are contributing to the highest UK inflation rate in 40 years, with the consumer price index (CPI) rising by 9.9 per cent in the year to August 2022 and the Bank of England’s latest forecast predicting it will increase to around 11 per cent later this year despite government intervention on energy costs. Public discussion has focused on households, but the impact is also felt by businesses. According to the Office of National Statistics, input costs for producers increased by 20.5per cent in the year to August 2022 and private sector pay was growing at an annual rate of 6 per cent between May and July 2022. Margins will be reduced where these increased costs cannot be passed onto customers.

Central banks are raising interest rates to combat this inflation. In the UK, the Bank of England raised the UK base rate from 1.75 per cent to 2.25 per cent in September 2022, following increases from the historical low of 0.1 per cent that applied as recently as December 2021. Following recent events, many are now predicting further significant increases in the UK base rate over the short to medium term.

All of these factors can impact real-world pricing for transactions between unrelated entities and, in turn transfer pricing arrangements for transactions between related entities. As well as impacting the taxable profits of related entities, transfer pricing arrangements have implications for VAT and customs duties. As such, an early review of transfer pricing policies and their implementation could prove valuable for groups with entities operating in different tax jurisdictions. 

Transfer pricing – dealing with downside risk

Transfer pricing policies should ensure that each group entity is rewarded commensurately based on the functions they perform, assets they hold, and risks to which they are exposed. The economic shocks described above may result in costs rising and sales falling, and from a transfer pricing perspective it is important that the impact of each material factor is recognised in the appropriate entity. For example, if an international wholesaling group’s head office is responsible for managing logistics risks and additional costs are incurred because the Suez Canal is blocked or the cost of shipping rises, these costs should sit with the head office company, not with entities acting as the local distributors.

In an ideal world, existing transfer pricing policies would be sufficiently robust to operate effectively despite the changed economic circumstances. However, this will not always be the case in practice, and groups should consider whether, in the current economic climate, their transfer pricing policies reflect the business’s operating model appropriately and whether the intra-group charging mechanism is producing appropriate and supportable results.

Impact of inflation 

Similar consideration should be given to the impact of inflation more generally.

The terms of intra-group agreements may address inflation, although in many territories inflation has been so low for so long that it would have been easy to overlook. 

In some cases, transfer pricing policies will respond to inflation automatically. If an entity providing services is rewarded using a margin on cost, then the increased cost base will be picked up, passing on the impact to the purchaser. But the question can easily become more complex: if a charge is made based on budgets at the start of the year, which party bears the risk that costs are higher than forecast? Would a purchaser acting at arm’s length automatically accept inflationary price rises – would it have any choice – or is there a point where the service provider becomes uncompetitive and the parties would renegotiate, potentially with a specified inflationary uplift or the introduction of a cap and a floor to the charge? The answer will depend on the business’s facts and circumstances and the risks for which each entity is responsible, but these questions should be addressed when they arise, as retrospective changes are more likely to be challenged by tax authorities.

Impact of interest rates

An increase in the base rate may increase intra-group interest costs where rates are set with reference to a published rate such as the sterling overnight index average (SONIA). Similarly, arm’s length interest rates on new lending are likely to be higher. Both circumstances may affect the affordability of borrowing – the borrower’s financial leverage and/or interest cover – either reducing the amount of new debt funding that may be available at arm’s length, or triggering concerns over compliance with covenants on existing arrangements. The latter may receive particular focus from HMRC given the recent decision in the case of HMRC v BlackRock Holdco 5 LLC. 

Other, less obvious, implications should also be considered. Where interest rates have been used for the purpose of calculating working capital adjustments, this may mean the results of prior benchmarking exercises are inappropriate going forward.  Similarly, discount rates used in the valuations of assets transferred between group entities may need to be reviewed, particularly where these assets are characterised as hard-to-value intangibles.

Action required 

Whilst there is plenty for businesses to consider at the moment, transfer pricing should not be overlooked. Confidence in transfer pricing policies and processes is essential, not just for compliance purposes but also for wider commercial transparency around group entity profitability. Reviewing transfer pricing policies and their operation is recommended, as is ensuring that they are presented and supported robustly in transfer pricing documentation. This last point will be particularly pertinent for UK members of multinational groups that will be in scope of the new transfer pricing documentation requirements scheduled to take effect in the UK from 1 April 2023.

For more information, please get in touch with Duncan Nott, Suze McDonald, Simon Taylor and Paul Minness, or your usual RSM contact.