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Good Planning Gone Bad

Dynamic inflationary pressures impacting today’s markets can cause unwanted transfer pricing outcomes and create meaningful tax risk. Early detection of such unwanted outcomes is key. Multinational enterprises (“MNEs”) must revisit approaches now to ensure they can properly plan for any transfer pricing adjustments that may be needed to accommodate for the impact of unexpected inflation.

Case Study: Impact of Inflation on Buy-Sell Distributor Transfer Pricing

Fact Pattern: Entity A sells complex machinery to an independent customer. Entity A sources this machinery from a foreign affiliate, Entity B, who produces the machinery using proprietary, patented technology and designs. Because the machinery is highly-customized, there is a time lag of 9-12 months between the time Entity A makes a sale to a customer and commissions Entity B to produce the machinery, to the time Entity B supplies the machinery to Entity A to deliver to the customer. Unanticipated increases in inflation occur between the time Entity A commissions the machinery from Entity B, to the time Entity B ships the inventory to Entity A to deliver to the customer.

Transfer Pricing for Machinery: Entity A purchases machinery from Entity B at a price equal to Entity A’s selling price to the independent customer less a margin of 15%. This 15% margin is determined by reference to an external benchmarking analysis that concludes a gross profit margin of 15% is consistent with the profit margins earned by distributors comparable to Entity A. Entity A requests that Entity B provide a cost estimate for the machinery prior to making a sale to the customer to confirm Entity B can earn a reasonable profit margin assuming Entity B receives 85% of the price paid by the independent customer.

Consequence of Unanticipated Inflation: Due to rising costs of supply in Entity B’s jurisdiction stemming from unanticipated inflationary pressures, Entity B’s standard cost of production is higher than anticipated at the time Entity A agreed on a price for the machinery with the independent customer. Because Entity B invoices Entity A based on the selling price that was established prior to the spike in inflation, Entity B incurs losses on the transaction. These losses create transfer pricing income tax risk in the jurisdiction of Entity B.

Action Items

TP Risk Management in Inflationary Times: Until the inflation tides recede, MNEs should be implementing risk management measures to measure the impact of inflation on intercompany transactions and related income tax risks through ongoing reviews. Catching an issue at its inception offers an MNE the most flexibility to successfully address the corresponding tax risks and catching the issue before year end is often a must. Once detected, the specific remedy is highly dependent on the facts and circumstances of the transaction, including the intended allocation of transactional risks.

BT’s TP Team is Here to Help

Bennett Thrasher’s transfer pricing practice has the expertise and resources to assist with adjusting transfer pricing approaches for MNE’s that have experienced unwanted outcomes as a result of the recent unanticipated rise in inflation. For more information on how our team can help your business confirm whether inflation is creating unwanted results and, if so, address these outcomes, please contact Ben Miller by calling (770)-396-2200.