Craig Kirsten and I touch on Risk vs Return from a transfer pricing perspective during COVID-19. Please let us know your thoughts on the below in the comment section.
As COVID-19 wreaks havoc across the globe, a topic that is unlikely to have surfaced on the first page of a multinational entity (MNE) group’s red flag report is transfer pricing. That said, it will be the MNE groups who identify, confront, and mitigate material risks, including transfer pricing, that will navigate through the COVID-19 storm.
A key part of a typical transfer pricing analysis is the characterisation of entities party to an intra-group transaction. Entities could be characterised as distributors, manufacturers, service providers, and lenders to name a few. We characterise entities through a detailed analysis of the functions performed, risks assumed, and assets used by the transacting entities.
On the surface, characterisation may seem glaringly obvious; however, within these wide characterisations, we have to further dissect exactly what type of distributor, for example, an entity is. The main key to do this is determining the assumption of risks for the entity that is characterised.
In the open market, we would expect the level of risk that an entity assumes to correlate with its potential return. As such, a limited risk distributor within a group with low levels of “uncertainty” should expect low potential returns or margins. Low as they may be, under arm’s length conditions they should be relatively certain and losses should be rare.
A common distribution model within MNE groups sees a parent company supplying goods to a subsidiary for distribution in a developing market. The parent leads the strategic intent and assumes all inventory and credit risks through reimbursing the distributor for bad debts and obsolescent stock. As the parent principally assumes most of the risk, in good times it should be rewarded through any excess returns but in bad times it should bear the brunt of losses. As you would have guessed, our subsidiary is a limited risk distributor and its returns or margins should be relatively stable under arm’s length conditions regardless of the economic climate.
Given the state of the global economic climate, most MNE groups are hunkering down and hoping to ride out the COVID-19 storm. It only takes basic economics to connect the virus to a decline in demand that will certainly get worse as it takes hold of the developing world.
With a decline in demand, our limited risk distributor will start to feel the pinch as the top line stagnates and turns to negative growth. Purchases may be reduced, but fixed overheads ensure that operating margin declines. Stock obsolescence and ageing debtors throw salt onto the widening wounds.
Through good times, a MNE group uses transfer pricing principles to support a low margin for our limited risk distributor; however, now that the tables have turned, it will take a parent’s bail-out to ensure transfer pricing principles are adhered to and the limited risk distributors margins are maintained. These principles do not, of course, only apply to distributors – disasters such as COVID-19 can heighten and disperse risk across any supply chain. In times like these, it is vitally important that MNE groups are aware of their own transfer pricing framework and the actions required to maintain arm’s length parity across the group.