TAX NEWS - DECEMber 2009

Transfer Pricing: 2009 year-end transfer pricing actions - Business not as usual

The United States, and the rest of the world, is in the midst of a severe economic downturn, an undeniable fact that has upended many taxpayers' carefully constructed tax planning policies.

Transfer pricing is particularly vulnerable to the uncertain economic conditions, as taxpayers need to consider not only how to document and defend their current year transfer pricing positions, but also how to adapt to the new environment, which usually involves reduced profitability, losses, restructurings, and ever-more aggressive tax authorities, vigilant to preserve their tax revenue base.

Taxpayers are not completely defenseless against the changed economic conditions; to the contrary, there are strategies available to manage the impact of changed economic conditions on transfer pricing. The approaching year-end should help focus taxpayers' attention on the possibilities to revisit their transfer pricing policies.

On the positive side, Congress added another variable to the tax planning equation by passing a few weeks ago a provision that permits businesses with net operating losses (NOLs) in tax years 2008 or 2009 to carry back those losses for five years.

Many companies are attempting to evaluate their 2009 loss position as quickly as possible so they can make important elections under the new law. Since for many companies transfer pricing results can materially impact their U.S. income, transfer pricing needs to be part of the overall evaluation of the company's 2009 U.S. NOL position.


Impact of the down economy

For transfer pricing purposes, the downturn in the economy has been felt in:
- Lower end-customer sales volume and prices,
- Increased bad debts,
- Increased redundancy costs,
- Reduced capacity utilization,
- Plant or operations closures,
- Losses on sale of equipment, and
- Exaggerated currency gains and losses.

As a result of the recession, income or losses could end up in entities inconsistent with the original planning. The recession could also impact tax goals; for example, cash repatriation to the home country may become a top priority, and typical taxplanning structures may be adversely affected. Changed priorities may require taking a fresh look at transfer pricing policies and compliance models, in many cases before year-end.


Action steps

A general framework for dealing with the costs incurred because of the downturn may be as follows:
- Determine who should bear the costs,
- Determine whether you can make an adjustment,
- Determine the appropriate adjustment to make, and
- Determine how you will document the adjustment.


Who should bear the costs?

The first step in determining the proper entity to bear the costs is to review the intercompany agreement. Is the cost addressed in the intercompany contract? And more broadly, what is the economic substance of the relationship? Who made the decisions? Did the entity incurring the loss have the capital to bear the loss?

Limited-risk entities, a commonly used structure for limiting taxable income in certain jurisdictions, are particularly vulnerable to the downturn. These entities, which include stripped distributors, toll manufacturers, and contract manufacturers, generally earn a guaranteed profit (not necessarily taxable income). For companies with overall consolidated losses, these guaranteed-profit arrangements generate current cash tax expenses, and the question often comes up whether the limited amount of risk that such entities do assume would allow them to bear recession-related excess costs.

Interestingly, some local tax authorities are preparing for potential loss-shifting into their jurisdictions, and have taken steps to forestall such a development. For instance, China's State Administration of Taxation in July issued a circular requiring single-function Chinese entities of multinational enterprises that incur losses to maintain transfer pricing documentation for the year in which the loss occurred, regardless of whether the entity has met the threshold for maintaining documentation.

The tax authorities' intent is to prevent multinational companies from transferring losses caused by the financial crisis to their Chinese limited-risk entities through transfer pricing.


Can you make an adjustment?

As with the question of who should bear the cost, the first step in determining whether the taxpayer can make an adjustment is to review the intercompany agreement. Does the contract permit a retroactive change in price? Equally important, does local law permit a change in price? If so, are both before- and after- year-end adjustments allowed? And perhaps most important, does the adjustment make economic sense?

If the answer to the above is yes, taxpayers should consider making pre-year-end adjustments to put entities back into the range. However, such a move may have U.S. tax and accounting implications, as well as non-U.S. implications, and raise Customs and VAT issues.

If a taxpayer misses the window of opportunity for making a year-end adjustment, it could try reflecting amended results on its tax return. The U.S. tax regulations allow taxpayers to make adjustments on Schedule M of a timely filed original return after the close of book year-end. However, foreign tax rules should be reviewed to determine whether post-year-end adjustments may be included in local tax returns.


Appropriate adjustment

If an adjustment is allowed, and the taxpayer decides it is the right thing to do, the next step is to determine the amount of the adjustment. The taxpayer should attempt to identify and quantify the costs incurred (such as plant shutdown costs, redundancy costs, and capacity underutilization costs).

The next step is to look at the profits of comparable companies. Profitability benchmarks, the most common means of setting and testing transfer prices, will be thrown off by the recession. For instance, a tested party's comparable benchmarks that may have been used in the past may not be as affected by the recession as the tested party itself. In other words, a comparable company may have had a 5 percent reduction in sales, whereas the tested party suffered a 20 percent reduction. Traditional comparable search strategy may also result in fewer comparables, as the least profitable comparable companies may go out of business. In sum, simply using last year's ranges or updating the comparables using the same comparables that have been used in the past may not be appropriate, because the economic circumstances have so dramatically changed.

A better approach may be to take a fresh look at comparables search strategies, and to develop selection criteria that may not have been emphasized in "normal" times. The goal is to modify search strategies without contradicting positions taken in the past or limiting options for the future. For example, traditional search strategies would have rejected companies in Chapter 11 or with "going concern" issues, as well as loss-making companies and companies without data for each year.

However, when tested parties are exposed to recessionary impact, one may need to consider revising these traditional search strategies. It may also be appropriate to reconsider whether multiyear testing, which has been used historically, remains appropriate.


Documentation strategy

In the event the taxpayer determines that an adjustment is warranted, increased documentation will likely be required. For example, the taxpayer must explain how the down economy affected its business, and provide factual, legal, and economic support for the adjustment.