How would a downgrade affect transfer pricing?

To my international readers, this post uses South Africa as an example, but the analysis is generic and could be applicable to any country that faces a downgrade.

South Africa’s credit rating could be downgraded to “junk” at the end of the week (3 June 2016). In simple terms this would mean that South Africa will have to pay a higher interest rate for its debt as South Africa is seen as a riskier investment by lenders. This will have knock on effects on the economy and in short, it may play out as follows.

This ultimately may require a different funding strategy altogether…

Investors may stop investing in South Africa which means prices of South African assets will drop due to the lack of demand for South African debt and shares listed on the JSE. This will weaken the Rand‚ inflation will increase and South African companies will have to endure higher costs and interest rates.

South Africa’s GDP is only marginally growing and a downgrade may push South Africa into a recession. Considering all this (and this is by no means a detailed picture) I would like to explore how this could affect transfer pricing? Transfer pricing is very fact dependent but I will try explore this topic on a generic basis.

graph-36929_960_720The first thing that comes to mind is that companies are less likely to make profits in an economy that is in a recession. Companies that make losses are generally seen by tax authorities of greater risk as they are perceived to shift profits. So the questions here is whether the losses are due to commercial activities or due to transfer pricing arrangements. Most likely the losses are linked to the economy/downgrade but there may be additional scrutiny from tax authorities and it is up to the companies to support their losses. Again, transfer pricing studies are very fact dependent, but where a company uses benchmarking studies to support the arm’s length principle it will be difficult to support losses. This is due to the fact that benchmarking studies usually provide positive interquartile ranges, and where a company is loss making it may not be able to support its pricing unless it looks towards the minimum which is an outlier to the range and is usually not seen as a good comparable. There are different solutions to this issue depending on the facts and circumstances, one of the more obvious solutions would be to select comparables from a comparable economic environment. But will this solve the issue?

Many South African companies already see their profits reduced/eliminated by foreign exchange losses. This causes similar issues as the above, and with a downgrade this is only likely to get worse.

Moving away from loss making entities, a downgrade in the economy will also affect the credit ratings of borrowers within the economy, which results in higher interest rates payable. This in turn may have a knock on effect on a company’s thin capitalisation. Increased expenses will have an affect on the company’s debt capacity which means it is not able to borrow as much as previously. Companies which previously had acceptable amounts of debt now may be thinly capitalised and therefore may not be allowed to deduct the full interest expense as a tax deduction. Additionally, the increase in the interest rate may also receive additional scrutiny from tax authorities.

One must also keep in mind that South Africa has exchange controls in place to monitor cross border payments. Where a company is seen to be of higher risk, it will have to pay a higher interest rate. It is likely that a higher interest rate requires a more stringent approval process from the South African Reserve Bank (or authorised dealer) and the approval may even be disallowed. This ultimately may require a different funding strategy altogether, such as using equity over debt.

Another point to mention is where South African companies are remunerated on a cost plus basis, be it on a gross cost or return on total costs (see differentiation here), these companies are now becoming less competitive as doing business in South Africa overall is becoming more expensive. So the question here is whether from the other related parties side, the transactions overall still make commercial sense or are we potential causing a transfer pricing problem in the other jurisdiction?

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